To be successful with any business, it’s imperative to have a good understanding of financials. Some businesses might seem like they’re successful but eventually fail due to poor accounting.
One of the most important tools to achieve business success is the profit and loss or P&L statement for short. Besides this statement, it’s also wise to learn about other types of financial statements like balance sheets and cash flow statements. This post will cover the differences between fundamental statements, the structure of a P&L statement structure, preparation tips, and related small business accounting tips.
What is a P&L statement?
The P&L statement can be referred to as an income statement and shows the company’s revenue, and expenses during a specific period of time (usually quarterly or annually). This statement can go into intricate detail, but the simple formula is revenue – expenses = profit. It’s always important to keep this simple formula in mind and to compare income statements from different time periods. For example, revenue might increase from Q2 to Q3, but an important expense line item like costs of goods sold might increase substantially. Having detailed income statements will allow the business to easily diagnose their financial problem(s).
Cash flow statement
A cash flow statement is similar to an income statement as it records a company’s financial health in quarters or per year. However, the cash flow statement uses cash accounting while a P&L statement is based on accrual accounting. Cash accounting recognizes revenue and expenses only when money changes hands, but accrual accounting recognizes revenue when it’s earned, and expenses when they’re billed. Under the cash method, accounts receivable and accounts payable aren’t recognized because they represent future transactions.
The main formula for a cash flow statement is taking cash flow from operating activities- cash flow from investing activities- cash flow from financing activities+beginning balance=ending cash flow or Free cash flow (FCF). This might seem complex, but it’s easier when you understand how to categorize cash flow into the 3 categories (operating, investing, or financing).
Operating activities include production and sales of a company’s product or service. Some examples of operating cash flow items include raw materials, advertising and building inventory. Investing activities include the purchase or sale of necessary assets like buildings, equipment, or dividends received. Financing activities are any items that impact the long term debts or equity of the company. Some common items include selling stock, issuance of debts (i.e bonds) or payment of dividends.
The balance sheet is another key financial statement that is integral to a business’s financial health. Unlike the cash flow or income statement, this sheet refers to what the company owns or owes during a specific point in time. It doesn’t record items on a quarterly on annual basis. The balance sheet has many intricacies, but the main formula is Assets=Liabilities+Shareholders’ Equity.
Assets are items that the company owns like cash equivalents, inventory and accounts receivable (anticipated revenue that hasn’t been paid yet). Assets can be broken down into short and long term assets. Inventory would be considered a short term asset because it’s very liquid or can be easily converted to cash. On the other hand, an asset like land would be considered long term because it’s illiquid or harder to sell. Othe assets include intangible items like goodwill and trademarks.
Liabilities are items that a company owes to other parties like debts, interest payments or wages payable. Like assets, liabilities are either short or long term determined by the ease of payoff. For instance, a short term loan would be easier to pay off than a large issuance of bond securities. Companies raise funds by issuing bonds to investors, who will receive their initial investment plus interest. Bonds can be considered a long term debt obligation, as the company usually pays these investors back over a longer time period ranging from 5-10 years.
Shareholders’ equity is the portion of the company that is funded by shareholders. A common example of this includes dividend payments to investors, which is used interchangeably with the shareholder. Many investors are motivated by dividend payments, which is a percentage of their investment they will receive annually by holding the stock. Issuing dividends is a great way to entice investors to buy and hold a company’s stock. Retained earnings fall under the shareholders’ equity category and are monies that the company will use to pay shareholders, pay off debt or reinvest in the business.
Another important function of a balance sheet is that it allows the company to calculate important ratios. These ratios are used to show the financial health of a firm and attract future investors. There are many ratios, but some of the most common ones include the current ratio, debt to equity ratio and inventory turnover.
The current ratio (current assets/current liabilities) shows if a company is paying its current debts on time. A higher ratio means that the company is very liquid and has sufficient cash on hand in comparison to short term liabilities. The debt to equity ratio (Total Liabilities/Total Stockholders’ equity) demonstrates if a company is paying off its long term debts on time. A debt to equity ratio of 2 means that creditors have funded $2 per every $1 of shareholder funded monies. Lastly, the inventory turnover ratio (cost of goods sold/average inventory for the year) measures the times’ inventory is completely sold. A high inventory ratio means a company can control it’s merchandise effectively. Cost of goods sold refers to the direct costs of creating a product like labor and material costs.
Why do you need a P&L statement?
- Demonstrates a company’s financial health. A business can use this sheet to measure revenue and expenses. Since this document captures a business’s financials during a specific time period, it’s easy to track progress over time. A profit and loss statement can be seen as a map, as it will help businesses stay on track. A P&L statement can also be seen as a budget as budgets are the personal finance equivalent of an income statement.
- Motivate investors to buy shares/debt of a firm. Any company that really wants to grow and expand its reach has the goal of going public. This means a company will sell shares (stocks) or debt (bonds) to investors to raise funds by going public on a stock market exchange like Nasdaq or the S&P 500. This is also referred to as an IPO or an initial public offering and there are many key figures in this process which include investment banks. Investment banks help companies achieve a successful IPO and only want to work with companies that have sufficient revenue, manageable expenses, and a healthy profit margin.
- Teaches fundamental financial concepts like gross vs. net profit. Many entrepreneurs are easily excited by big revenue and profit numbers. Yet, they don’t know the difference between gross and net profit. This is important because net profit accounts for interest payments, taxes, depreciation, and amortization. The net profit margin’s formula is net profit divided by revenue multiplied by 100. This percentage is used to compare companies and industries against one another and the profit before interest, taxes, depreciation, and amortization is referred to as EBITDA.
Check out our guide to the Net Working Capital
Fundamental structure and analysis of a P&L statement
As mentioned earlier, the fundamental structure of a P&L statement is revenue-expenses=profit. However, it’s more detailed in practice and usually follows this example:
- Less cost of goods sold (COGS)
- Equals gross profit
- Less marketing expenses
- Less administrative expenses
- Fewer distribution expenses
- Less Research and Development (R&D) expenses
- Equals Profit before interest, taxes, depreciation, and amortization (EBITDA)
This is a more detailed, yet relatively simple structure. Some line items to pay close attention to include COGs and EBITDA. COGs is important because it includes all direct costs of creating a product like labor and raw materials. Yet, it doesn’t include indirect or operating expenses. These expenses would be captured in separate line items like marketing costs, and some companies lump these costs under a line item labeled selling, general and administrative expenses (S,G&A). Other indirect expenses include rent, utilities, insurance, and payroll costs.
How to prepare a P&L statement?
Luckily, it’s relatively simple to create an income statement thanks to technology. A company could start by using an excel spreadsheet and graduate to pre-built templates. Quickbooks is a premier software for small business that assists with bookkeeping, invoicing, estimated payments and even creating an income statement with free templates. This software also offers businesses free balance sheet and cash flow statement templates. Yet, it could be wise to consult an accountant or tax professional to ensure your work is error free. This would be prudent if a business experiences rapid growth, has numerous revenue streams along with expenses or has trouble turning a profit.
When creating an income statement, it’s wise to know the differences between operating and non-operating income/expenses. The main difference is that operating income/expenses are related to the day to day business processes while non-operating includes one-off items like revenue from selling real estate. Therefore, it’s could be smart to create separate P&L statements with one for each type of income/expenses.
Another important concept is that these three key statements are interrelated as one item from each sheet will impact another. For example, net income from the P&L statement increases the shareholder’s equity on the balance sheet. Another example includes the depreciation/amortization expense line on the income sheet being transferred under the operating section of the cash flow statement. Lastly, the net earnings after interest, tax, and amortization flow to the balance sheet as retained earnings Retained earnings are used to pay shareholders, reinvest in the business and pay off debts.
Small business vs. self- employed P&L statements
Many self-employed business owners are just themselves and are nicknamed “solopreneurs.” Others have just one or two employees, which could make them question the need for all of these statements. However, there is one financial statement every business or solopreneur needs which is the P&L statement. Unlike employees, self-employed individuals don’t have W-2 income and must report their earnings and expenses on Schedule C. Self employed individuals use Schedule C to record their revenues, expenses, and other costs. Schedule C can also be used if a self-employed individual applies for any type of loan.
Schedule C is included in an individual’s tax return including form 1040, Schedule A, B, and others. A self-employed person can use either the cash or the accrual method to complete this schedule. The only exception to this rule is that sales and inventory purchases must be recorded using the accrual method. It’s possible to change accounting methods even if a schedule C has been filed using IRS form 3115.
Schedule C is the required form for all self-employed individuals, and it’s also wise to have a separate P&L sheet that is constantly updated. This will make it easier to accurately complete Schedule C and instill a high level of attention to detail. A high level of detail will help the self-employed person catch mistakes and tighten important figures prior to getting out of control. Other self-employed individuals like contractors receive payments from multiple clients. Therefore, it would be smart to itemize revenue per client. Also, it’s wise to itemize expenses similar to this manner. Lastly, it’s recommended that self-employed individuals monitor and change their income statement monthly.
The unfortunate reality is that most small businesses fail due to poor cash flow. These businesses could have significant revenue, but that is useless if it can’t manage it properly. Many startups succumb to this fate and great accounting skills can prevent failure. Some of the most important accounting concepts are knowing the right sheets which include a P&L statement, Cash Flow Statement, and Balance Sheet. This trifecta will allow any business to manage its cash flow properly. This guide also covered important accounting terms, which are valuable to all businesses like the cost of goods sold, types of profit and how to prepare a P&L sheet.
Disclaimer: This post is not tax advice, but education. Consult a tax adviser or CPA for tax advice.