Why a profit and loss statement is essential for your business — and how to create one
To know if your business is successful, you need to be able to measure your success. Gaining new customers every year or being named in your local round-up of the best businesses is great, but the reason you’re in business is to make money, so that’s what you need to measure.
Not every business will make a profit right from the start, and that’s okay. But your business should be steadily progressing along the path to profitability. In order to determine whether your business is going in the right direction, you need to create a profit and loss statement.
What is a profit and loss statement?
As the name suggests, a profit and loss statement tells you whether you earned money (made a profit) or didn’t (took a loss) in a specific period of time – usually a month, a quarter, or a year. A profit and loss statement is sometimes called an income statement. It is, along with the cash flow statement and the balance sheet, one of the three critical financial statements you should produce for your business.
In layman’s terms, a profit and loss statement tells you if your business is making a profit or if you’re losing money.
Why is a profit and loss statement important?
A profit and loss statement is a critical 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. A profit and loss statement will answer three key questions about your business:
- Can my business cover my costs and expenses?
- Can I afford to pay myself a salary?
- Is my business model sustainable?
The real value of a profit and loss statement is that, if you complete one regularly, it will alert you to potential issues in time for you to course correct. It will identify where you need to make changes in order to get the results you want. If you can see where the issues are, you can determine what to do about them, whether that means cutting costs, raising prices, eliminating a particular product or service, or something else. It can also show you what is working well, so you can focus on those areas.
The three parts of a profit and loss statement
A profit and loss statement isn’t very complicated. It has three main parts – income, expenses, and net income. Let’s look at each of these.
Income is sometimes called revenue, and it’s the money that your business brings in the door. This can be income that comes from selling your products and services, but it’s also income from other things like interest, investment returns, or income from strategic partnerships (like licensing or advertising deals). If you sell a piece of equipment or property that you no longer need, that’s income too. Income usually falls into three categories. Operating revenue is the income you get from selling goods and services – this is usually the main ‘business’ of your business. Non-operating revenue is interest, rental income, licensing fees you collect, and so on. Gains or one-time business activity is a category that would include revenue from the sale of equipment and so forth.
Just as income includes all the money that comes into your business, expenses include all the money that goes out. Every business has different expenses, so you only need to include the ones that apply to you. The first expense on most profit and lost statements is the cost of goods sold. This includes materials, labor, and other costs required to produce what it is that your business sells. If your business is strictly a consultancy, and you don’t sell any products, your cost of goods sold will be zero. If you make products and sell them, your cost of goods sold includes everything required to produce those products. If you resell products you have purchased, your cost of goods sold is the amount you paid to buy those products. Then you will have primary expenses, which are expenses you incur as part of running your business. Salaries, commissions, and utilities are considered primary expenses. Secondary expenses are the other expenses that aren’t linked to your business activity. Loan interest, taxes, and legal fees or other one-time expenses are secondary expenses. When you record your expenses in your profit and loss statements, be as detailed as you can. Put each item on a separate line, so that if you need to make adjustments, you can easily see where you might be able to pare back some of your costs.
3. Net income (or net revenue)
Now, subtract your expenses from your income. This gives you net income (or net revenue), which is the amount you have ‘left over’ after you’ve paid your expenses. If this is a positive number, you’ve made a profit. If the number is negative, you’ve recorded a loss. Don’t despair if that’s the case, though – many businesses aren’t profitable in their first year, or even several years. If your profit and loss statement shows, for example, a $10,000 profit, yet you have no money left at the end of the month, take another look at your expenses. That section should reflect what you actually paid out during the month, not just regular recurring expenses.
How to create a profit and loss statement
Every business’s profit and loss statement looks different, but they have a lot in common. Here’s what you need to know to create your own profit and loss statement and keep tabs on your business’s financial health.
Use your accounting software
If you use accounting software like QuickBooks or FreshBooks, you can generate one quickly. Just make sure all of your income and expenses have been accurately recorded. If they have, you can review your profit and loss statement at any time.
Ask your bookkeeper
If you don’t use accounting software, but use a bookkeeper, they can prepare a profit and loss statement for you. Preparing periodic financial statements should be part of the service your bookkeeper provides for your business.
Use a spreadsheet
If you’re just starting out, or you don’t use a bookkeeper or bookkeeping software, you can create a spreadsheet to make your profit and loss statement. There are many Excel templates available, or you can start your own from scratch. As your business grows, you should consider moving to accounting software or hiring a bookkeeper, as your financial statements will become more complicated.
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.
Other financial statements
The profit and loss statement shows you how much income you have brought in and how much you have spent over a specific period of time. It shows whether your business made money or lost money over that time. But there’s more to running a business than your P&L can show, so there are other financial statements you should also prepare.
A cash flow statement shows the money going in and out of your business. It can help with cash flow management, which is something that even profitable businesses struggle with.
A balance sheet shows what your business owns (assets) and what it owes (liabilities). The difference between these two items is your business’s net worth or shareholder’s equity. It shows the value of your business. Seasonal businesses, or those that extend payment terms to customers, need to be particularly mindful of cash flow.
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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