Understanding the Profit And Loss Statements of Your Business

Bookkeeping is an important activity that every business should carry out rigorously. The balance sheet, income statement and cash flows are the mo...

  • Understanding the Profit And Loss Statements of Your Business
    Terry Foyley Image Terry Foyley

    Understanding the Profit And Loss Statements of Your Business

    Bookkeeping is an important activity that every business should carry out rigorously. The balance sheet, income statement and cash flows are the most important financial statements that form the core of your company’s account book. These statements help in organizing the flow of information so that effective decisions can be taken at the right time to avoid failures and pave way to success. Any application for loan or investments essentially calls for the need of up to date financial statements that will present your financial status and help them analyse the risks involved with your business.

    While each of the financial statements have their own importance and particular needs, the income statement, most popularly known as the profit and loss statements gives an accurate picture of your net worth. This article will guide you through understanding the varying components and the importance of the profit and loss statements of your business.

    Profit and loss statement

    P&L statements are prepared over a specific period of time, which could be 3 months to a year. The major data included in al income statements are the sales details and income totals along with the various expenses from internal accounting records. By subtracting the expenses from the income, the profit or loss incurred is shown. The income statements and the balance sheet are usually reviewed together as the results of the income statements affect the balance sheet.

    Components

    Net sales

    Net sales include the total sum of all the invoices billed to customers minus the discounts offered to customers. Any sales returns from customers and industry imports are also deducted and the final figure is used for comparative analysis.

    Gross Profit

    Gross profit is calculated by deducting the cost of good s sold from the net sales. Cost of goods includes the manufacturing, merchandise and customer service expenses. It also includes the material costs, labour and factory expenses involved in producing the products sold. The value of gross profit reflects the company’s profitability.

    Gross profit = net sales – cost of goods

    Gross profit margin

    It represents the proportion of gross profit you gain for each dollar of revenue obtained.

    Gross profit margin = (gross profit/net sales)*100

    Operating profit

    It represents the profit obtained from core operations exempting the expenses from taxes and interests.

    Operating profit = gross profit – operating expenses.

    Net profit

    It is the value of total amount earned after paying up all the expenses.

    Net profit = operating profit – (taxes + interest)

    Net Profit after Tax

    Net profit after tax gives a practical measure of the operating success of the company. You must remember that tax expenses are also deducted from the gross profit itself.

    Dividends/Withdrawals

    The value of dividends/Withdrawals depends upon the type of business. If you are a partnership or proprietorship this item represents the withdrawals by the business owners. When this figure exceeds the profits the net worth is drastically reduced.

    Working Capital

    Working capital is the amount of funds available for the working of the current business operations. This figure helps in determining the amount of excess cash required to fund the current expenses. It is the difference between the current assets and current liabilities.

    P&L statements – generic structure

    In general a profit and loss report will have two sections.

    • Revenue

    Details of income from both primary and secondary business activities as well as any other type of financial gains.

    • Expenses

    Some of the characteristics of a profit and loss statement are listed down.

    • P&L statements are accrual based reports. They include both the credit amounts that you haven’t yet paid as well as the debt details that you haven’t yet received from debtors who owe you money.
    • It includes the details on the total income and total expenses for the chosen period.
    • It does not include any personal, capital, loans or repayment of loan principle details.
    • It includes the interest in a business loan and the depreciation on capital items.

    Analysing the P&L statement

    Read through your income statement and note how much sales have increased or decreased since the previous report. Revenue from total sales is the important section of your report and is part of the primary revenue. As the secondary revenues are usually unpredictable, it is recommended to focus more on increasing your primary sales revenue. You can also break down the sales figure into separate product lines to see which products are performing well and which are lacking.

    By looking at the expense data, you should be able to note down the areas where costs can be reduced.

    To understand the income statements and use it to manage your business effectively, you need to monitor certain ratios. These ratios are categorized into three groups as given below.

    • Solvency ratios : measures the effective operations of the business and the capacity of the company in satisfying its obligations
      • Quick ratios, Current ratios, Current liabilities to net worth ratio, current liabilities to inventory, total liabilities to net worth, fixed assets to net worth .
    • Efficiency ratios: measures the quality and efficient usage of the company’s assets.
      • Collection period, sales to inventory, assets to sales, sales to net working capital, accounts payable to sales.

    • Profitability ratios: measures the performance of the business.
      • Return on sales, return on assets, return on net worth( return on equity)

    You must check your profit and loss statements regularly to properly deal with unexpected cost spikes and plan your operations efficiently.