Welcome back (or for the first time). This is the third article in our series to help business owners understand financial statements. Today we are diving into the income statement, also known as the Profit & Loss Statement or simply as the P&L.
Here are the two previous articles if you would like to start at the beginning:
- Article #1: How To Make Sense of Your Most Important Business Financial Statements
- Article #2: How To Understand Your Balance Sheet
The illustration we’ve been using has been a bicycle with training wheels, since learning to read and understand the value of these reports can be a challenge at first (like riding a bike). But (also like riding a bike) once you can do it, you will open yourself and your business up to a whole new world of freedom and possibilities!
The Income Statement
Your Income Statement (also called a “Profit and Loss Statement” or “P&L”) is actually a very simple formula: Total Income – Total Expenses = Profit. It isn’t any more complicated than that.
However, it can look complicated when you begin to add subcategories to the “Income” and “Expenses” parts of the equation. Most (but not all) businesses have several categories of income as well as a number of expense categories. Listed together, they can make for an intimidating spreadsheet full of numbers, but at the end of the day the equation is still: Total Income – Total Expenses = Profit.
3 Things You Should Understand About Your P&L
- It is absolutely essential. This report gives you a snapshot of your business’s financial health over a range of time. As a small business owner, you need to know how profitable your business is – or isn’t. (And, let’s face it, if you’re not profitable…you will have a hard time staying in business.)
- It doesn’t tell you everything about your income. Your P&L isn’t designed to show you when you are going to collect that income. For example, let’s say you’re in a service industry. The money received for work you haven’t completed yet isn’t technically “income” until you’ve finished the job. Additionally, you may have sent the invoice but haven’t received payment yet. The books may show revenue but if cash hasn’t been received, you could show profit but the money isn’t in the bank yet. So you could have an awesome profit but no cash.
- It doesn’t tell you everything about your expenses. I think we can all agree that accounting doesn’t always make sense to folks who aren’t accountants. For example, if your company purchases raw materials to make widgets, the expense for the raw materials isn’t recorded on your P&L as a cost until you actually sell the widgets. So you may have paid a large amount of cash, but it won’t hit your P&L at the same time or in the same amount. Likewise, you might purchase a large piece of equipment or a vehicle that requires financing. Due to accounting and tax rules, the expense of that purchase might be recognized on your P&L upfront (which would decrease your profit but could help decrease your tax burden for the year) even though you’re paying for it over five years; or the cost might be spread out over 15 years for tax purposes even though though you paid it off in five years. Since accounting doesn’t always match the expense with the actual cash outlay, it’s important to consider multiple statements to help you see the whole picture.
Key Numbers to Look For on Your P&L
Let’s define some of the key numbers you need to know:
- Revenue – your income every time you sell something. You will want to show this in groupings of income types for more accurate reporting. For example, if you are a restaurant you may want to know how revenue breaks down between food sales, bar sales, and catering sales. Each of these buckets represents an income type.
- Cost of Goods Sold (COGS) – the cost to make what you sell (including hourly labor expenses). This includes: purchases of inventory, freight to ship the inventory, delivery costs, packaging costs, etc. For a service based business, instead of parts and inventory, COGS includes expenses related to your production or service team.
- Operating Expenses (OPEX) – everything else it costs to keep the lights on, service your customers, market your business, etc. This is often referred to as overhead. These are costs you generally incur regardless of your revenue amounts
How Your P&L Can Help You
Your P&L does a great job of showing how your business is doing financially over a period of time. It equips you to make better spending decisions and shows you what adjustments could increase profitability. The bottom line is that it gives you the insight you need to make awesome business decisions.
Your P&L, when combined with your Balance Sheet and Cash Flow Statement, gives you a trifecta of tools to run your business with confidence.
If you’d like to learn more about Income Statements, check out this video from Kahn Academy.
With a basic understanding of your P&L and Balance Sheets, you’re hopefully feeling more confident now. But if this was a 2-wheel bike that you didn’t know how to ride yet, you’d be understandably shaky. That’s because the 3rd report (or “wheel”) is missing still. Once that’s in place, giving you a more complete picture of your business’s numbers, you’ll have a pretty stable three-wheeler to zip around on. So we continue our discussion on essential financial reports next with a look at the Cash Flow Statement.