What is a Profit and Loss Statement Meant to Show to Small Business Owners?

The Profit and loss (P&L) statement is an important financial report for businesses. This accounting statement summarizes the income and expenditure of a business. More specifically, the statement shows the income and expenses that a business incurs during a particular period.

Understanding the P/L statement is important to know about the financial health of a business. In this blog post, we will explain the purpose and importance of the financial statement.

Profit and Loss (P&L) Statement: An Overview

A profit and loss (P&L) statement helps business owners to know about the ability of a company to sustain its operations. The financial statement provides information required to know whether the company is operating on a profit or sustaining losses.

The main sections of the P/L statement include the following.

• Income – Sales or Revenues
• Cost of Goods Sold
• Gross income
• Expenses
• Administrative expenses
• Marketing expenses
• Rent
• Utilities
• Depreciation
• R&D expenses
• Financial charges
• Net expenses
• Taxes
• Net Income/Loss

Let’s take a close look at some of the important elements of the profit and loss statement.

1. Revenues

The revenue section shows the income from the business. The section may also be called sales or income. It only includes operating income or income earned from the main operations. The non-operating income is shown differently than the operating income.

The accounting method used for recording expenses determines when the revenue is recorded in the P/L statement.

With the accrual method, the revenue is recorded at the time of sale. In other words, revenue is reported under the accrual method when the income is earned. The time when the payments are made is not relevant.

The gross sales amount is adjusted depending on the prior experience of customer refunds or returns by creating an allowance. This is deducted from the revenue amount to arrive at a more realistic revenue.

In contrast, revenues are recorded at the time of sales receipt under the cash-based accounting method. With this method, customer returns or refunds don’t affect revenues. The reason is that the revenues are recorded only when the customer pays instead of when the sales are made under this accounting method.

2. Cost of Goods Sold (COGS)

COGS is another important section of the P/L statement. This section shows the cost of the materials or inventory used for creating the products sold to customers. The cost of goods sold is deducted from the revenue to determine the gross or actual revenue.

Let’s suppose that your company sold a watch for $2,000 that cost you $1,000. The revenue will be recorded as $2,000 in the P/L statement. The cost of goods sold will be deducted from the revenue that will result in a gross revenue of $1,000.

3. Expenses

Expenses section shows all the cost incurred in operating the business. The expense reported in the P/L statement is also known as operational expenses.

One important expense that you need to understand is the depreciation expenses. Depreciation expense is only included under the accrual-based accounting. This expense is not reported under the cash-based accounting method.

Depreciation expenses are incurred on certain assets of the business. Some of the assets for which depreciation expenses are calculated include the following.

• Furniture & Fixture
• Computer Equipment
• Machinery

You need to capitalize the above assets by calculating the depreciation expense. There are different methods for calculating the depreciation expense including simple method, declining method, double declining method, and more.

All methods used for calculating depreciation expenses involve dividing the cost of the asset over the useful life of the assets. The simple method involves the same depreciation expenses each year. In contrast, depreciation expenses are decreased with declining and double declining methods.

Amortization is similar to deprecation, but it is applicable for non-tangible assets. Intangible assets as the name suggests don’t have a physical form. Examples of assets for which amortization is calculated include goodwill and patents.

Another important expense that you should understand is the bad debts expenses. The bad debt allowance is created based on experience about customers not paying the amount due. It is an estimation of the percentage of customers who are not likely to pay the amount due.

4. Gross and Net Profit (Loss)

Gross profit (loss) is calculated by deducted expenses from the gross revenue figure. The amount reflects the difference between the revenues and expenses.

If the income exceeds the expenses, the company has made a profit. On the other hand, if the income is less than the expenses, the company has made a loss.

Net profit figure is calculated after deducting finance charges and tax.

Investors generally compare the earnings before tax (EBT) of different companies. This is because the tax rates are different from one state to another. Some investors also add back depreciation and amortization expenses for comparing profit and loss statements of different companies.

Conclusion

Understanding of the profit and loss statement is important for business owners and investors. The financial statement provides information about the profitability of a company. No business can operate for long with losses. The P/L statement shows whether the company is operating at a profit or sustaining losses.

A quick view of the P&L statement will let you know whether a company is making profit or losing money. You can delve deeper through horizontal and vertical analysis of the business. The horizontal analysis involves comparing changes over time. In contrast, vertical analysis involves determining the relevant size of the expense items to the revenues during a period.

The main purpose of understanding the P/L statement is to gauge whether the company should continue operations or close the business. The financial statement provides valuable information to investors to determine the return on investment (ROI) potential of the business.

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