Are you a small business owner? Want to learn how to analyse profit and loss sheets effectively? Follow these simple steps to analyse your business health.
Small businesses need to proffer extra care to their income and expenses during the nascent stage of their growth. By using a profit and loss or income statement, an organization can swiftly summarize its business revenues, costs, and expenses for a specific period.
A profit and loss statement reflects how a business transforms the revenue into profits, helps the organization weed out unnecessary expenses, and make effective decisions. Investors and creditors consistently study the P&L statement prior to showing any interest in the association. In short, the statement records gains and losses that occurred during the specified timeline.
What is a Profit and Loss (P&L) Statement?
The Profit and Loss (P&L) Statement is a financial statement that portrays the company’s revenues and expenses for any period of time selected. Such records present the financial health of the business, and its ability or inability to produce profits.
In fact, with the assistance of the P/L Statement, you can also set up a cash flow statement. A cash flow statement is a fiscal report that shows all cash inflows and money outpourings. On the off-chance that you have made any investments, which is a valuation strategy used to appraise the worth of speculation dependent on its normal future incomes and tally records.
Cash vs Accrual Basis
Before we commence with analysing the profit and loss statement for small business, it is pivotal to identify whether your business follows a cash basis or accrual basis of accounting.
- Cash Basis of Accounting– It alludes to a bookkeeping method that recognises incomes and costs when cash is received or paid out. It is the simplest form of record keeping i.e. records are maintained by inflows and outflows of cash/ bank alone. This method is preferred only when you don’t deal with account receivable or account payable. Such a method is used in small businesses which do not require to track their receivables or payables.
- Accrual Basis of Accounting- It refers to the accounting arrangement when revenue or expenses get recorded when an exchange happens, rather than when cash is received or paid. The method follows the matching principle of accounting. It is the most preferred method by business houses as it portrays a clearer picture and reporting of companies assets and liabilities.
How to Analyze P&L Statement
Before learning how to analyse P&L, it is pivotal to get acclimatized with the outlook of P&L. So have a look at the sample P/L Statement below for your perusal –
Now hover over these touchstones to analyse your profit and loss statement:
- Sales- Sales are one of the simplest and best ways to measure the health of the business. Compare the sales figures of one quarter with others, and try to figure out if the change is positive or negative. Set the specific benchmark and stick to it.
- Calculated metrics- Setting some metrics helps you to track the health of your business. When you know that you are falling within the set metric or percentage, you are running a sound business and vice versa. Generally, business houses should aim for profit ratios between 10% to 20%. Here are the three metrics that you can calculate-
– Net profit margin = (revenue – costs – expenses) / revenue
– Operating expense ratio = total operating expenses / revenues
– Gross profit margin = (revenue – cost of goods sold) / revenue
- Income taxes – It refers to all the taxes levied by state and local bodies on reported profit. The higher the rate of taxes, the lower the profitability. Usually, when businesses file their taxes, they never record the revenue as taxable income, instead expenses get deducted then taxable income is calculated.
- Common Size Analysis- It is the smart process of analyzing the P/L statement where each line item on the P&L is converted to a % of revenue. This helps to measure the outcome of the business when compared to other businesses within the same industry.
- Cost of Goods sold- Don’t forget to evaluate the cost of goods sold, which means if your cost is surging, then the revenue should go up simultaneously. Otherwise, it can affect the profitability of the business. Cost of goods sold includes material cost, salesforce costs, distribution costs and labour costs.
Profitable firm businesses show uniformity and coherence in their P&L statement in terms of income and cost. Income and expenses need to be monitored rigorously so that they can mirror the fundamental change in the business stipulations.
On the same lines, non-recurring and exceptional income should be prudently monitored to check the growth and propensity of the business. Let’s understand with the help of an example – Suppose your business sells any worthwhile assets which may negatively impact future growth. Similarly, exceptional income may augment the odds of waiver of future expense reimbursements.
Indeed, the principal goal of any business organization is to check its profitability. One of the primary ways to check this is through analyzing the P/L Statement as it gives a fair idea of the organisation. By studying these parameters, small business houses can obtain better insight into their business, scope of investment, and secure financing from a bank.
In a nutshell, the profit and loss statement is one of the key financial statements along with the balance sheet and cash flow statement that mirrors the company’s performance and financial status during a particular period of time. Get ready to dissect your P&L sheet like an ace!