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Don’t just file away your profit and loss statement, take a look at it!
Here are a few basics that will help.
Most entrepreneurs start a business because they are passionate about the primary work of the business — which usually isn’t accounting. This means that most entrepreneurs aren’t completely comfortable reading or interpreting the monthly financial reports they receive…that is if they receive them at all.
We often meet entrepreneurs who never even look at their profit and loss statements (P&L) because they don’t understand them and explanations have been too complicated or non-existent. While we can’t teach you all the ways to read a P&L, we can give you some basics that will help you with this important financial tool.
All P&Ls are based on a very simple formula:
Sales – Costs = Profit
It really is that simple. Everything else is a matter of breaking out sales or cost into more detail and adding subtotals. Sales are typically shown at the top of the P&L. Costs are shown below sales. Profit is displayed at the bottom. You may see a lot of other numbers and subtotals as you look down the column, but it is still sales minus costs equal profit.
To further complicate things, different words are often used for sales, costs and profits. This can make digesting financial information seem more difficult than it really is. For example, sales can also be called revenue, income or top line. Costs may be called expenses, outlays, payments, or burn. Profits can also be referred to as net income or bottom line. In fact, the P&L itself can also be called an income statement. All of these different terms can be confusing, but don’t let it throw you or deter you from embarking on one of the most important disciplines for any entrepreneur…regular review and analysis of your business’s financial performance.
Sales
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. Typically, these three components would be added together in a line called total sales.
Costs
Similarly, costs are usually broken into various components. There are a multitude 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 common and useful way to subdivide costs is into costs that are directly associated with delivering your product or service and costs that are not. These divisions are commonly shown as “Cost of Goods Sold” and “Selling, General & Administrative Costs”, respectively.
Costs: Cost of Goods Sold (COGS)
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), but again, it is essentially, the direct costs associated with delivering your small business product or service.
Gross Profit
Another term you may often see or hear is Gross Profit (or Gross Margin). This is what the business earns after it subtracts the cost of delivering its product and/or services. Simply put…
Sales – COGS = Gross Profit
Costs: Selling, General & Administrative Costs (SG&A)
The remaining costs of the business after COGS 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).
The Summary P&L
With these costs added, the P&L is now broken down into sections as follows:
Sales
– Cost of Goods Sold
Gross Profit
– Selling, General & Administrative Costs
Profit
Get Started Now!
If you have been filing your P&Ls away without reading them, you are not alone. However, understanding your small business P&L is essential to being able to run your business successfully. The most important thing is to start. If you need help getting started or interpreting your results, contact Barba CFO. We have helped many small businesses begin to read and analyze their financial performance. Contact us here for our expert CFO for hire assistance.
Need help understanding your Balance Sheet, too? Check out this blog…
5 Things You Should Know When Reading Your Small Business’s Balance Sheet
For more on costs, click below for our free ebook on reducing small business costs.
