Getting to grips with your figures: what the bejeezus is a profit and loss?
Most businesses start up because the entrepreneur behind them is passionate about their idea and the primary workings of that idea as a business, and not because they’re desperate to understand the essential accounts that will need to be kept in order along the way. While you don’t need to become ACA-qualified yourself and should instead put your books in the hands of an awesome accountant (hello…that’s what we’re here for, guys!), it’s only going to benefit you to know the basics, starting with your profit and loss statement – an important financial tool that’s not as intimidating as it may first look, and is pretty darn helpful once you’ve got your head around it*.
All profit and loss statements (P&Ls) adhere to a basic formula: sales minus costs = profit. The aim of the statement is to summarise the sales and costs that your business has incurred during a specific period (usually a financial quarter or year), thus providing information about the company’s ability to generate profit by increasing sales, reducing costs, or both. Typically, sales are shown at the top of the P&L, costs are shown below sales and profit – ‘the bottom line’ – is below those at the bottom. And just to clarify, sales can also be referred to as revenue or income, costs can be called expenses, profit can be called net income and P&Ls can also be referred to as income statements, statement of operations, statement of financial results or income, earnings statement, or expense statement.
Your P&L will be broken down into various sections, each with its own subhead, and the sales and costs listed under those subheads can be broken down into multiple sources. For example, figures from a restaurant’s sales will likely come from customers who dine in, those who take out, and also from outside catering, and their costs will be broken down in a multitude of ways including rent, food, drinks, kitchen equipment and wages. Besides this very straightforward breaking down of a P&L (again, see ‘*’ below) and its basic terminology, there are many other subdivisions to consider, and of course P&Ls will differ from business to business, but here’s a brief glossary of essential terms that will only aid your understanding.
Often referred to as the ‘top line’ as that’s where it sits on your P&L, revenue is the money that your business is bringing in from sales. If you’re a non-profit company, this equates to money raised from fundraising. In common practice, a company will have a separate table that details their sales and then bring the total sales number over to the P&L. Your revenue is crucial as it’s what you need to cover your expenses – the lower your revenue, the lower your expenses need to be in order to remain profitable.
Also known as cost of goods sold (COGS), direct costs are costs incurred when you make your products or deliver your services; things like rent and wages aren’t included here, but anything that directly contributes to each sale is. Examples of direct costs are consumable supplies, direct materials, sales commissions, and freight. For a shop selling bikes, for example, the direct cost of every sale is what the shop paid to buy the bikes from the manufacturer. For that manufacturer, direct costs include the cost of the metal and plastic used to make the bike.
Revenue minus direct costs = gross margin, which tells you how much money you have left to cover the rest of your expenses after you’ve covered the cost of the product or service you are selling – if you buy a widget for £1 and sell it for £3, your gross margin is £2. If you have a high gross margin, this means that it costs you very little to deliver your product or service and you will have the majority of the money from every sale left to cover your expenses.
This is an umbrella term for all of the expenses that you incur to keep your doors open, excluding your direct costs. Expenses minus direct costs = operating expenses, which includes things like rent, salaries and benefits, marketing costs, research and development costs and utilities.
Also known as EBITDA – earnings before interest, taxes, depreciation, and amortisation – your operating income is worked out by subtracting your total operating expenses from your gross margin: gross margin minus total operating expenses = operating income.
The action or process of gradually writing off the initial cost of an asset, or paying off a debt with regular payments.
Special expenses associated with assets that your company owns. Over time, assets like vehicles and large pieces of equipment lose their value and that decline in value is expensed here.
The declaration of any taxes that you pay or that you expect to pay on your sales.
A business’s total revenue minus the cost of sales.
The ‘bottom line’, net profit is your business’s true profitability after accounting for all operating expenses and cost of goods sold (COGS). Total sales – (cost of goods sold + operating costs) = net profit. For example, if your business makes £10,000 in sales and it cost you £7,000 to make your products plus an additional £1,000 on operating costs, your net profit is £2,000: £10,000 – (£7,000 + £1,000) = £2,000.
That’s the basics of your profit and loss statement explained – a P&L shows you how much money you’re making or losing in a specific time period, allowing you to compare past performance and detect any possible financial pitfalls going forward.
*As it’s likely you’ve already gathered, this is a just a simple explanation of the basics of a profit and loss statement. In the not-too-distant future, we are going to invite a guest accountancy professional to expand on the topic further, providing a more in-depth analysis and some examples too. Please do shout if there’s anything specific you’d like us to cover!