A profit and loss statement, also called a P&L statement, income statement, or expense statement, is an essential summary of business operations from a financial perspective.
These business records are important to understand for a company to find success and to grow in a positive and manageable manner. The profit and loss statements are one way that leaders and potential lenders can see if the business has turned a profit during the time period covered by the report.
Knowing how to read and write a P&L report is important for anyone who is upper management or works with the business’ finances. Let’s dive into some of the surface-level definitions to increase your basic understanding of the report.
Definition of a profit and loss statement
A profit and loss statement is a record of the revenue and expenses that a business dealt with in a predetermined period of time, which can be a single month, every quarter or the entire year. The report also includes net profit and provides managers with a good way to see how the company is performing at a high level.
Here is a short breakdown of what should be included in a profit and loss statement of a publicly-traded company.
Revenue
Normally, this is the first thing reported in a P&L statement. The business solution company Paychex says that revenue “may be referred to as sales, gross receipts, or fees.” It is also important to note that operating revenue is different from non-operating revenue, which includes passive incomes like interest. In a P&L statement, only operating revenue is addressed.
Cost of goods sold
This section only applies to the companies who sell products or goods, but it can easily be adjusted for businesses that focus on services. The cost of goods sold (COGS) includes the cost of materials used to manufacture the product and the overall price of inventory. Then, this is subtracted from the revenue that was received from the goods sold. This calculation will ultimately determine the real cost of the product.
General expenses
As you may already know, an expense is how much it costs to keep your business running and to generate revenue. Recording the expenses is extremely important, not only for the report but to use for comparative analysis in the future. From an operating expense, administrative expense to potential interest expense, there are many different aspects to this section.
Here are some examples of expenses that should be included in the profit-loss statement:
- Advertising and other marketing costs.
- Building, warehouse and office rent.
- Utilities.
- Different kinds of insurance.
- Vendor payments.
- Professional fees: accountants, partners or attorneys, for example.
- Payroll.
Record all the expenses and add them together to find the total expense for that time period. Along with general expenses, you need to calculate the income tax expense. This can be done by multiplying the taxable income by the tax rate. This will reveal how much will need to be paid to the government.
Profit/loss
There are several different kinds of profit, which include gross profit and net profit. Gross profit is the difference between the revenue or gross receipts and the COGS. Sometimes this ends up being a loss in the long run when the revenue is less than the general expenses.
It’s important to note that the IRS requires that active businesses turn a profit in at least three of five consecutive years. If this does not happen, the IRS “classifies your business as a hobby” and “it won’t allow you to deduct any expenses or take any loss for it on your tax return,” according to TurboTax.
Writing a profit and loss statement
As a small business owner, you might feel overwhelmed with the idea of writing your own profit and loss statement – is it worth the cost to hire the job out externally. Luckily, that isn’t your only option.
There are several different ways to write a profit and loss statement. Free templates are available online that you can use to create a P&L statement to help you get started. If you use an online accounting service, either for your business or personal use, chances are that they offer a financial statement outline.
Freshbooks is an example of a service that offers a free template, as well as paid options. Most of the time, these choices are adequate and should work well. However, you may want to try creating an original template that suits the nuances of your business more comfortably. It’s a good idea to create a template either way because it will be easier for people to read and compare from one time period to the next.
Important components of a profit and loss statement
We already discussed the different things that should be included in your profit and loss statement, but let’s take a closer look at the different components. When it comes down to it, a P&L statement has three parts: expenses, revenue and net income.
As you read, you can break down these parts even more. For example, when you must record expenses, direct costs – any expense that can be directly connected to a specific item, good or service – are included to provide further detail.
A cash ratio is how businesses measure their liquidity in a ratio. The ratio can be seen as the company’s total available cash: current liabilities. While this is not necessary to include in a profit and loss statement, it is a good indicator of whether a company can repay short-term debt. This is valuable information for current and potential lenders. To dive in more to liquidity and cash, consider writing a cash flow statement in addition to your profit and loss statement.
P&L statements are often used in addition to a cash flow statement or balance sheet to get a more complete understanding of business operations and finances. This way, the bank can make more informed lending or credit decisions that will benefit both parties in the long run.
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