There are so many entrepreneurs that don’t understand profit and loss statements. This means that they never look at them. If you are in the same position then keep reading. Below there are basic tips to help you understand this crucial financial tool.
The formula for all P&Ls is very simple: sales – costs = profit.
The top of the statement usually shows the sales and below the sales are the costs. Then the profit is at the bottom.
The thing that usually makes it difficult to grasp is that different words can be used for sales, costs and profits. For example, revenue or income are words that can be used instead of sales. Expenses be used for the term costs and net income may be used instead of profits. As well as this, the term income statement is often used instead of P&L. Once you know these different terms, it shouldn’t be too difficult to grasp.
To make the P&L statement easier to read, sales may be subdivided. For example, if sales come from customers dining in a restaurant, taking out or using catering service, the sales can be divided into three sub-categories. Then at the end, all sales are added together (total sales).
Similarly, 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, but once you get below the total sales line everything else you see is a cost, broken out in one way or another.
One of the most useful ways to subdivide costs is into those costs that 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, the cost of the workers who assemble the widgets and the costs of the production facility. These costs are referred to as cost of goods sold (COGS) because they can be tied directly 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 1who 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 – COGS = gross profit
- gross profit – SG&A = profit
So, that’s P&Ls made easy! We can also help you with balance sheets.
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