Simply put, it’s the space between profit and loss that offers value…
You started your business for a whole range of reasons and making a profit was (hopefully) one of them. You measure how much you’re making with a Profit and Loss statement (or P&L for short). But your P&L can tell you a lot more than just simply how many $$$ you’ve made this month. With a simple calculation, you can glean insights from your profit and loss and open up a whole world of understanding about your business.
What is a Profit and Loss?
A typical P&L comprises several parts.
The top half shows the various sources of income a business may receive over a particular period. This may be revenue from selling goods or services or other income, such as bank interest or dividends.
Next, the costs incurred to produce the goods or services are subtracted to give what is known as the gross profit. If your gross profit is negative, it means your making a loss on every item or service you sell.
Finally, the bottom half lists all the running costs of the business, also known as overheads. This includes rent, power, and communication costs that you need to pay consistently, regardless of the levels of sales. Often they also include salary and wages. When these costs are subtracted from the gross profit, the net profit (before tax) is determined.
The net profit is how much your business made during the period. The period can be any length of time, from a day to a year (or more), but typically is either a month, a quarter or one year.
So far, so good?
Does it tell me how well is my business performing?
The results of your P&L will allow you to work out two key performance indicators (KPIs), to offer deeper insights into how well your business is performing.
Gross Profit Margin = Gross Profit / Total Sales x 100
Here is an example:
Gross Profit = $80,000
Sales = $400,000
Gross Profit % = $80,000 / $400,000 x 100 = 20%
Multiplying by 100 allows a measure of gross profit expressed as a percentage of total sales. This allows easier comparisons with previous margins as well as similar businesses, irrespective of any fluctuating costs or sale levels. Essentially, it means for every $100 in sales you generated, you make a $20 profit before overheads.
One key question to ask is has the margin improved? Is the margin equal to the industry average, or preferably even better? If not, it would be time taken to investigate the causes of this problem. For example, has there been an increase in the cost of materials or labour hours? A declining margin is a sign of potential trouble, as it means you are making less money on every sale.
Can I use my P&L to forecast profitability?
Similarly, the net profit margin will help reveal how profitable your business is when all overhead costs are deducted from the gross profit.
Net Profit Margin = Net Profit / Total Sales x 100
Here is an example:
Net Profit = $50,000
Sales = $300,000
Net Profit % = $50,000 / $300,000 x 100 = 17%
This KPI will allow you to spot any trends and differences before they become disasters. Has the net profit margin fallen? You need to dig for the causes behind this. Was it due to marketing costs that contributed no increase in sales? Are other costs increasing? If so, why?
These calculations can also be used to control costs in your business.
Final thoughts on P&L reports
The Profit and Loss Account is an important financial document that will allow businesses to use gross profit and net profit margins as benchmarks to continue to set improvement goals. These benchmarks can be internal (current performance against previous results) and external (the average for the industry type).
For a more detailed discussion, have a look at this presentation.