Profit & Loss Basics

The Profit & Loss Statement (also known as the Income Statement) is one of the three key financial statements for your business, along with the Balance Sheet and the Cash Flow Forecast. Individually & collectively, these statements provide important insights into the health or your business and inform decision makers with the information needed to drive positive change, such as increasing profits and operational efficiency whilst maintaining quality and ethics.  

Let’s dive in and look a little deeper into what the Profit and Loss Statement is, and how to produce & and use it.

What is a Profit & Loss?

A Profit & Loss Statement (P&L) shows the total of your business’s Income (money coming into your business) & Expenses (Cost of Sales & Operating Costs) (money that relates to your core business operations going out) over a set period of time, whether monthly, quarterly or annually. At its core, the purpose of the P&L is to reveal whether or not your business is making money, as well as providing insights into the financial effectiveness of your business operations and overall health of your business. It differs from the Balance Sheet in that it reports on different financial activity types; this is why the different financial statements can be used collectively to build a full picture of your business. 
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In the world of accountancy there is a “P&L Formula”, which looks a little something like this:
Revenue - Expenses = Profits or Losses  

An example Profit & Loss Statement is provided below:

​How to create a Profit & Loss

Accounting Software
As with the balance sheet, all figures that appear on your P&L are fed through from all of your day-to-day double entry bookkeeping transactions, and therefore if you’re using an electronic accounting software, your P&L is very quick and simple to create.

For instance, using the Xero accounting package, the process looks like this:

• Go to Reports - then, Profit and Loss
• Set the date range (the time period for your P&L)
• You can select comparison period/s to identify trends in your data (this is an optional step) 
• To customise the report, further optional items include:
  • Accounting Basis - either Accrual or Cash
  • Show account codes
  • Show decimals
  • Show percentage of trading income 
• Click Update

It can be a very simple process.

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Manual Approach
A manual approach will require you to pull together the key information from your prime bookkeeping records, and outline them in the suggested structure here, or via other online sources. You can build the P&L using a spreadsheet or by hand - either way, the following elements should be included:

INCOME
A summary of all of your business income generated from sales within the time period. This may come from different revenue streams, such as products, services, resells or other sources, and all should be detailed on your P&L. 

LESS COST OF SALES
This section outlines all of the costs attributed to the production or sale of your business’s products or services. This may include raw materials, manufacturing costs or product purchases for resell. 

GROSS PROFIT
Your Gross Profit can be calculated by deducting your Cost of Sales from your Net Income. 

LESS OPERATING EXPENSES
A summary of all expenditure that relates to running your business, including rent & utility costs, payroll, hardware, advertising, etc. 

NET PROFIT 
Your Net Profit can be calculated by deducting your Gross Profit from your total Operating Expenses. This is known as your bottom line, and shows the financial result of your efforts for the time period, before tax.

How to use a Profit & Loss

Business owners can analyse their Profit and Loss Statements, and identify trends in their data over time to understand what actions they can take within their business to increase operating efficiency and drive profits. 

The P&L holds the “Top & bottom line”, which literally means the top line of the statement, which holds the Total Revenue for the time period, and the bottom line of the statement, which reveals the Net Profit (The example above can be used for visual reference). The bottom line, net profit, shows whether your business is generating profit or losing money.

The statement can also show your;

• Gross Margin - The return you generate on business sales, taking into account the costs that goes into generating them, e.g. raw materials, manufacturing, etc. 
  
• Operating Margin - The profit generated after the costs of goods and the spend that goes into the day-to-day operations of your business. The higher the operating margin, the healthier your business is. 
  

A review of your monthly P&Ls over an annual period may reveal trends in the numbers, such as:

• A reduction in sales over time but an increase in profits - upon further investigation, it may be clear that you’ve gradually refined your operating expenditure to maximise profits. You’ve decided that a slight increase in your marketing budget may improve revenue & profits over the following period. 
  
• An increase in sales but a continual overall loss on the bottom line - A deeper dive into the figures may show that your operating costs are far too high and an immediate cut to any unnecessary spending is of vital importance to bring the business back into profit. 
  

We hope that this has provided some useful insights into producing and using a Profit and Loss Statement. Stay tuned for the final article in the financial statement series, Cash Flow Forecast Basics.