Tax & admin 8 June 2017

What is a profit and loss statement and why is it important?

accounting
The profit and loss statement can give clear indication of the health of a business

Understanding whether a business is profitable or not is fundamental to the success of the business. Writing for Business Advice, Ormsby Street’s Rob Drury explains to readers what a profit and loss statement is and why it’s important to your venture.

If you’re the business owner, you need to know where to act to maximise your profit, and if you’re an investor, you want to know that the business is heading in the right direction or whether there are some key areas requiring attention.

This all sounds like you need to be a numbers whizz to understand all the ins and outs, but in reality, the profit and loss statement is a simple mechanism that can give some clear indication of the health of a business.

What is a profit and loss statement?

Often referred to as the income statement, the profit and loss statement is one of the cornerstones of business financial analysis and reporting.

Its role is to summarise the revenue, costs and expenses of the business over a period, giving an insight into the business’ ability to generate a profit.

All over the world, profit and loss statements tend to follow the same structure of revenues, cost of sales, and operating expenses, with the statement calculating gross and net profits from these numbers. Here’s an example:

Revenues (a) £100,000
Cost of Sales (b) £40,000
Gross Profit (c) = a-b £60,000
Operating Expenses (d) £20,000
Net Profit (e) = c-d £40,000

When we’re down to the information about operating expenses, then we’re looking at the other costs of the business, including salaries of non-production teams, salaries of service based teams, marketing, rent, and more.

As we move down the profit and loss statement, the line detailing cost of sales includes any costs that are directly related to the generation of revenue, so would include things like the parts bought to make the widget, and the salaries of the team who make it.

Revenues are simply what the business has sold to make money, whether it is a product or a service.  It could be widgets or it could be servicing of the widgets, either way it’s brought some money into the business.

Why is a profit and loss statement important?

By structuring the finances of the business in this way, it’s straightforward to see what’s going on and to ask some key questions that can impact how the business is run, such as:

  • Is the cost of sales too high, and do we need to become more efficient at making the item or source a cheaper supplier?
  • Are revenues too low and not generating enough money to cover the operating costs? Do we need to get more customers or look at charging more for what we sell?
  • Are the operating expenses too large, and do we need to start making some cost savings?

These are questions that banks will be asking when they’re looking to loan funds to the business and have asked to see the statement, and they are the questions that investors will ask when they are considering the viability of investing in a business.

Notable investor and founder of Desktop.com, Francis Gaskins omce said: “People will just walk away if they don’t have a healthy income statement.”

What else should I consider?

As useful as the profit and loss statement is, it isn’t the only document that a business needs to review regularly.

Balance sheets will show a snapshot of where you owe money and where it is owed to you, as well as where your funds are tied up, and cash flow statements, as the name suggests, shows you the inflow and outflow of money in the business.

Make sure you look at all the financial statements at your disposal. Warning of focusing too much on the profit and loss statement, founder of Dell Technologies, Michael Dell, said: “We were always focused on our profit and loss statement. But cash flow was not a regularly discussed topic.

“It was as if we were driving along, watching only the speedometer, when in fact we were running out of gas.”

Robert Drury is head of product at small business cash flow platform Ormsby Street

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