Why a profit and loss statement is essential for your business — and how to create one
How do you know if your business is successful? Well, you can take a look at your online reviews — good reviews are a good indicator that you’re doing something right. You can conduct a customer analysis — serving new or more customers each month means that word is spreading about your business. Or you can search for your business online — if your business shows up near the top of the search results, you’re on the right track.
But these methods are abstract ways of measuring success. When you think about the true success of your business, you need to know how it’s performing financially. Is your business bringing in a profit? Or are you losing money? Even a beloved business can fail if it’s not performing financially.
A profit and loss statement can help you measure business performance and, in turn, business success. It’s one of the three most important financial statements you can use in your small business, along with a balance sheet and cash flow statement (but more on that in a bit). If you’re ready to understand the true success of your business, read on.
What is a profit and loss statement? And why is it important?
A profit and loss statement, also called an income statement, is a crucial financial statement that summarizes the income and expenses of a business during a specified period. It’s common to generate a profit and loss statement monthly, quarterly, and annually.
In layman’s terms, a profit and loss statement tells you if your business is making a profit or if you’re losing money.
You can use the information provided by the profit and loss statement to determine if your business earns enough money to cover its costs and expenses, if you can afford to pay yourself as a business owner, and if your business model is sustainable.
If your profits aren’t where you’d like them to be, the profit and loss statement can help you identify your top spending categories and where you might be able to make cuts. It can help you determine your lowest earning revenue streams, so you can make informed business decisions — like pricing your products and services.
On the flip side, if your profits are looking good, the profit and loss statement can show you your top earning revenue streams, so you can focus on the things that make your business more money.
Over time, the profit and loss statement can chart your business growth, reveal sales trends, and give you the insight you need to make smart financial choices for your business.
Three key components of a profit and loss statement
Your profit and loss statement will vary based on your business’s income and expenses, but every income statement includes three main components.
1. Income (or revenue)
Income or revenue refers to your operating revenue or the revenue you generate from primary business activities — like selling products or services.
The profit and loss statement will also include your non-operating revenue or other income that is generated outside of your core business operations. This includes income from interest earned on business capital, rental income, or income from strategic partnerships (like advertising).
Finally, the income statement may include gains or one-time non-business activities that result in income, like selling a company vehicle or the sale of long-term assets.
The first expense you’ll find on the profit and loss statement is the cost of goods sold or the cost of sales. Cost of goods sold refers to the costs of producing the goods sold by your business, including the cost of materials and labor.
Primary expenses refer to the cost of business operations — these are expenses related to employee wages, sales commissions, and utilities (like electricity).
The profit and loss statement will also include other expenses or secondary expenses. These expenses are linked to non-core business activities, like paying interest on a loan, paying taxes or penalties, or one-time expenses like legal fees.
3. Net income (or net revenue)
Finally, the profit and loss statement will result in a net income number. If this number is positive, it means your business is earning a profit. If it’s negative, you’ve spent more than you’ve earned.
It’s important to note that net income takes all expenses into account, even the unusual or one-time expenses. For that reason, this number can tell you if you made or lost money in a specific time period. But if you’re hoping to gauge the day-to-day operations of your business, the net operating income may be a better indicator.
How to write a profit and loss statement
What does a profit and loss statement look like in practice? And how can you create one? If you use accounting software like QuickBooks, generating an income statement is nearly instantaneous. QuickBooks tracks and organizes your business’s accounting data for you, making it easy to access and review your income statement anytime.
If you’re not using accounting software, a bookkeeper can prepare this report on your behalf. And if you’re a new small business owner, an Excel income statement template can be a helpful place to start. However, as your business grows, it will become harder (and less accurate) to track everything in Excel.
Take a look at this example profit and loss statement from QuickBooks:
Now let’s break it down by line.
Income refers to operating revenue — the revenue you generate from primary business activities, like selling products or services.
Cost of goods sold refers to the costs of producing the goods sold by your business.
Expenses refer to primary expenses, or the cost of business operations.
GROSS PROFIT - EXPENSES = NET OPERATING INCOME
Remember, your net operating income gives you a good idea of how your business operates financially on a day-to-day basis, without any unusual expenses or revenues.
Other expenses are linked to non-core business activities, like paying interest or taxes.
Net other income refers to other revenue or gains. Remember, these are the one-time or non-business activities that result in income for your business.
NET OPERATING INCOME - OTHER EXPENSES + NET OTHER INCOME = NET INCOME
A positive net income means a profitable business. A negative net income means you’re losing money. Track your net income over time to accurately track business growth and identify profit problems early on.
Using a profit and loss statement to measure business success
By now, you know that a profit and loss statement is a key tool to measure your business success. But it’s just one of three important financial statements you need to run and operate your business successfully. The profit and loss statement, balance sheet, and cash flow statement work hand-in-hand to give you a complete financial picture.
Where the profit and loss statement compares income to expenses and shows profit or loss over time, the balance sheet records what your business owns (your assets), what it owes (your liabilities), and your business’s net worth (or shareholder equity). The balance sheet subtracts what you owe from what you own to calculate your business’s net worth.
A cash flow statement helps you evaluate money flowing in and money flowing out of your business. This statement can help you determine if you have enough cash to pay your bills and can predict the amount of cash you’ll need to fund your business operations in the future. It’s important to note that a business can be profitable but still struggle with cash flow. For this reason, a cash flow statement is an essential partner to your profit and loss statement.
These three reports work together to provide you with valuable insight into your business’s financial performance. And answer the oh-so-important question, “Is my business successful?”
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