Most small business owners would agree that their Profit and Loss statement is among the more straightforward financial reports to understand. It’s typically represented in two parts.
The top half of the statement reveals the various sources of income the business has received for the period covered, such as a month; quarter, or full financial year. After subtracting the cost of producing your goods or services (Cost of Sales), it shows your gross profit figure. The bottom half of the statement lists the businesses running costs (operating costs or business overheads) such as rent, office expenses and communication costs that you need to pay each month. When these costs are subtracted from your gross profit, the result is an operating profit figure (or EBITDA). So far, so simple, but you can learn more.
How well is your business performing?
These two results enable you to work out two key performance indicators (KPIs) that offer important insights into how your business is performing.
The first, your gross profit margin, is the gross profit expressed as a percentage of sales.
To work this out (if your accounting software doesn’t do this automatically for you), is to divide the gross profit figure by the sales total and multiply by 100 to get the percentage.
Here’s an example:
- Gross profit: $80,000
- Sales: $400,000
- Gross Profit Margin: 80,000 divided by 400,000 = 0.2 x 100 = 20%
Multiplying by 100 allows you to study the gross profit margin as a percentage, so you can easily compare this result with previous periods, irrespective of fluctuating costs or sales levels. Has the margin improved? If not, it’s time to investigate the causes. For instance, has there been an increase in the cost of materials or production labour?
You can now compare your gross margin to similar businesses because turning the result into a percentage overcomes any differences in size. Regardless of whether they are smaller or much larger businesses, it’s the gross profit percentage (GP %) that tells the performance story.
Depending on which sector you operate in, your VCFO or Accountant can help you find the average GP percentage for your industry. Your aim should then be to at least equal the industry average, and preferably do even better. You can also aim to improve your gross margin results against previous periods.
How profitable is your business?
The operating profit margin reveals how profitable your business is when your overhead costs are deducted from the gross profit. It’s worked out using a similar formula. For example:
- Operating profit: $50,000
- Sales: 300,000
- Operating Profit Margin: 50,000 divided by 300,000 = 0.166 x 100 = 17%
This KPI empowers you to spot trends before they become disasters. If your operating profit margin has fallen, you need to dig deeper to understand the causes. For example, you may find your marketing costs have blown out with no increase in sales. The lesson here would be to measure your marketing and advertising cost to see what is working, so you can drop any unproductive activities.
- Use your gross profit and operating profit margins as benchmarks to set improvement goals. Try to improve both on internal benchmarks (your current performance against previous results) and external benchmarks (the average for your industry type).
- Don’t rely on just an annual profit and loss statement. You can’t effectively drive your business forward using a rear-view mirror that reflects dated data – you need more up-to-date figures. Use your accounting software to generate more frequent profit and loss statements, such as monthly or quarterly statements. These enable you to take prompt action to fix any negative trends before they do serious damage to the business.
- Remember you can always get in touch with a VCFO to help you interpret trends in your results so you can take the right corrective action.