Business owners usually go into business for a myriad of reasons. These owners are usually proficient at their craft. A good plumber decides to open a plumbing business or a chef decides to start a niche restaurant. Accounting isn’t one of the skills that excite or are important to the owner. At least, not to start.
After the business is off and running the owner begins to discover that accounting is a process. This process requires time to manage. But owners haven’t been trained on how to interpret data on financial statements.
So here is a quick overview on how to read the profit and loss statement for your business. Often the profit and loss has other names. These are income statement or even P&L
for short. We prefer income statement, because it tells you how much money has come in, gone out, and how much remains. All financial reports are telling a story.
Profit and loss statements tell you a story. One based on a simple formula — sales minus costs equals profit. The entire statement breaks down this formula. How much money did you receive during a given period? Minus the costs associated with running your business and what remains is profit.
On a P&L, costs display below sales and profit is at the bottom. You may see many subtotals as you look down the column, but it is still sales minus costs equal profit. Always keep this formula in mind.
There are some nuances to the income statement. Even in this article, there exists a vernacular that can cause some points of confusion. Unfortunately, we sometimes use different words for sales, costs and profits. Just like we use different words for profit and loss statements. This can at times make accounting seem difficult. For example, sales can also be revenue or income. Costs may be called expenses and profits may be net income. Don’t let them distract you from the story the statement is telling you. Keep with it and you will understand.
Moreover, your company’s sales may be broken into several different sources. For example, the sales of a restaurant may come from customers who dine in or take out or from catering. Such a business may choose to break sales into those three pieces. These three components would be added together in a line called total sales.
Costs are usually broken into various components. For example, you may see material costs, labor costs and overhead broken out separately. There are an infinite number of ways to break out costs. Once you get below the total sales line everything you see is a cost, broken out in one way or another.
One of the most useful ways to subdivide costs is into those direct costs. These are directly associated with delivering your product or service and those that are not. Consider a company that makes and sells different types of widgets. It will have the cost of the components used to make the widgets. It will also have the cost of the workers who assemble the widgets and the costs of the production facility. These costs, referred to as cost of goods sold (COGS), can be directly tied to the production of widgets.
In a service business, this is called the cost of service (COS). For example, a lawn maintenance service would include the cost of the employees who do the work, fuel costs, and the cost of other supplies (such as fertilizer and grass seed).
Sales minus COGS is known as gross profit (or gross margin). This is the money the business earns after it subtracts the cost of delivering its product and/or services. It is also the money needed to cover the other costs associated with running the business and still generate a profit.
Other costs of the business are not associated with the production of widgets. Such costs might be the cost of the people who sell the widgets, the cost of the accountants who produce the P&Ls and even the president’s compensation. These costs are most often referred to as selling, general and administrative costs (SG&A). With this addition, the P&L is now broken down into two parts:
- Sales minus COGS equals gross profit
- Gross profit minus SG&A equals profit
If you file your P&Ls away without reading them, you are not alone. At the end of the day your P&L is an essential tool you need to run your business. Don’t miss out on what they have to offer you.
If you have questions about your P&L’s ask us a question. We love helping and deciphering the story your P&L is telling. What is your story? Until next time, be good.