Picture this – you own a small, fairly well established business. Your product or service is in high demand, and it shows. Sales have taken off; they’ve been consistently high for the last 12 months. Business is great!
And then, you realise your profit isn’t growing in line with your increased sales. How does this happen, and how can you fix it?
Let me ask: when was the last time you checked your profit and loss statement? It’s one of the most important reports to your business, as it reveals if your company is making a profit, breaking even or running at a loss. This is pretty important information to have, don’t you think? Constant monitoring of your profit and loss statement is crucial.
What is the profit and loss statement?
Put simply, a profit and loss statement shows your total revenue over a set time period (often monthly or quarterly) compared to your total expenses for the same period. Subtract the expenses from the revenue and you get your company’s net earnings – it will be a profit or a loss.
When your revenue is higher than your expenses, you make a profit. And conversely, when your expenses are higher than your revenue, you’ll see a loss.
Revenue includes details of all your primary business activities (e.g. sale of products and services) and secondary activities (e.g. bank interest). Importantly, it’s the total amount of money you’ve accrued over this period, NOT the total amount of cash coming into your business.
- Cost of goods sold (COGS) or cost of service (COS) – the ‘direct’ cost to make the product or service you sell (e.g. labour, raw materials)
- Operating expenses (OPEX) – the ‘indirect’ costs of running your business (e.g. rent, salaries, utilities, insurance) This is basically any other cost not directly related to the production of your product or service.
Any tax payments for that same period are also recorded on the profit and loss statement.
Important figures we can analyse
Let’s look at what can we extract from our profit and loss statement:
Gross profit = sales revenue – COGS
This is a good indicator of overall production efficiency and a key figure for setting prices and sales targets.
Operating profit (or profit before tax) = Gross profit – OPEX
This profit is generated from core operations and doesn’t include expenses from taxes or interest.
Net profit = Operating profit – (tax payable + interest)
This is the ‘real’ profit AKA the ‘Bottom Line’. It’s the total amount earned (or lost) after expenses.
Gross profit margin = (gross profit ÷ sales revenue) x 100
This is the ratio of gross profit to revenue, expressed as a percentage.
For example: Company ‘A’ sells a product that makes a gross profit of $180,000 and revenue of $400,000
You divide $180,000 by $400,000 = 0.45
Then you multiply by 100 = 45%.
So for each product Company A sells, it makes 45% of the sales price as profit.
Net profit margin = (net profit before tax ÷ sales revenue) x 100
This compares the net profit before tax (gross profit less fixed or indirect costs) to revenue.
For example: Company ‘A’ has a net profit of $60,000
You need to divide $60,000 by $400,000 = 0.15
You then multiply x 100 = 15%
So what can we do with all of this?
Once you’ve been monitoring your profit and loss statements for long enough (say 12 months) you have some good data to work with and you can start to improve on business processes and efficiencies. For example, if you see your gross profit margin starting to decrease, you can identify why and make appropriate changes. It could be due to a reduction in sales, reduction in selling price (due to lower consumer demand) or a rise in inventory costs.
Net profits don’t always increase proportionately with increased revenue, so seeing your net profit margin decrease allows you to straight away look for the expenses that have increased out of proportion to the sales and work on cutting those expenses – before they exceed revenue!
To determine if your profits are measuring up to other businesses in your industry, you can benchmark your profit margins. This will help you find out where you’re doing well, and where you need to improve.
How often should you review your profit and loss?
The more frequently you monitor your business progress, the sooner you can spot trends that need to be changed. As a rule of thumb, a monthly profit and loss statement is ideal to see how your business is travelling financially.
To a solid future!
Profit and loss statements are historical reports, but are vital for budgeting. Using this historical data, you can make realistic forecasts about revenue and expenses. Setting long-term financial goals will be strategic and pragmatic, rather than pure guessing.
Remember, profit and loss statements are one of the most important reports for your business. It can’t tell you everything that’s going on within your business, but it can tell you a heck of a lot about how your business is really travelling.