Having a good handle on the finances of your business is essential if you want to stay afloat and turn a profit. To ensure you understand the most important aspects of your business, The Neill Family Group have created the monthly set of articles titled Understanding Your Business Series.
The Understanding Your Business Series is The Neill Family Group's initiative to share the collective knowledge of our team with business owners. Our goal is to enhance business owner's financial literacy and equip them with the tools needed to ensure a solid understanding of important aspects, such as cash flow management, analyzing Profit & Loss and Balance Sheets, and interpreting other critical elements like HR and taxation law.
If there is a topic you would like us to cover let us know!
Our inaugural topic is understanding and reading a profit & loss statement, one of the primary indicators of your businesses health.
Reading A Profit and Loss Statement
Your profit and loss statement (otherwise known as P&L or income statement) helps you understand your business performance and profitability over time. It’s sometimes called an Income statement and its main purpose is to list income and expenditure.
Whereas a balance sheet is a snapshot in time, the P&L shows transactions over a specific period of time.
This can be a month, quarter, financial year or any other period, and it can be a stand-alone report or a comparative period report.
Together with the balance sheet, these two reports provide a comprehensive understanding of the financial position and performance of a business.
The profit and loss statement has two main sections: income and expenses
These may be further subdivided depending on the complexity of the business and reporting requirements.
Income or Revenue
Income primarily includes main business activities such as sale of goods or services. Other income such as interest received, capital gains or income from secondary business activities is also reported.
Expenses are usually divided into two sections: direct costs, or cost of goods sold, and expenses. Cost of goods are those that are directly linked to the provision of services or sale of goods. For example, if you buy widgets from a wholesaler and sell them at a marked-up value, the cost of the widgets is a direct cost, not an overhead expense.
Other types of direct costs might be importing and freight costs, contractor costs or certain equipment. Some direct costs are fixed, that is, they are the same from month to month, or they could be a fixed percentage of sales; others vary in value but are still related to the income producing activities.
Overhead expenses are all the other expenses required to run the business, regardless of the level of income: for example, rent, utilities, bank fees, bookkeeping fees, professional development costs, vehicle costs and staff costs. Many of these costs form the basis of working out your break-even point, or how much it costs just to open the doors for business.
There are some expenses which may be reported as a direct cost in one business but an indirect cost in another type of business, for example, merchant fees or contractor costs.
The Bottom Line
Total income minus total expenses results in the net profit (or loss), is often called ‘the bottom line’. Often business owners are just interested in looking at the bottom line, but a true financial picture requires an understanding of several reports and an ability to see the big picture that the reports are illustrating.
The P&L is a vital tool to analyse for trends over time
What does your P&L tell you about relationships and ratios between sales and expenses, seasonal changes and annual trends?
Have all your direct costs been allocated correctly?
Have you recouped all billable expenses from customers?
Financial statements help you understand the big picture for your business. With deeper understanding of your business operations and performance you can make informed decisions about your business finances.
Want to learn more about Profit & Loss analysis?
These are some reference sites that we recommend to further enhance your understanding of Profit & Loss Statements.
Business.gov.au are a great reference and also have a handy excel template you can download to create your own (for anyone not on an accounting system like Xero, MYOB or QuickBooks etc)
Business Victoria go into a quite a lot of detail on all aspects of running your business and have templates for Profit & Loss, Balance Sheet and Cashflow Statement - three vital reports each business should use.
Commonwealth Bank whilst this article is focused on larger organisations, the using the concepts of certain financial ratios when analysing a Profit & Loss is important - and gives you and understanding of what the banks look at when you apply for their products such as a business loan or overdraft account etc.
The Motley Fool is a goldmine of information for investors and while their article is tailored to investors it is as detailed an explanation as you can get - especially if you want to understand the difference between accrual or cash preparation methods!
We hope after reading this you are ready to download your company's P&L statement and start analysing the health of your business!
If you have any questions relating to your business' financial reports please book a session with Stuart Neill, Joanne Poyser or any of our advisors!