A lot of valuable information in those numbers
Earlier this year in this column we discussed the balance sheet and all of the components that go into it. In that column we explained that the balance sheet was the true sign of the health of a business. However, it is the profit and loss statement that most business owners choose to watch most closely.
As compared to the balance sheet, the profit and loss statement tells the story of what has happened in the business during the accounting period whether it is a month or year. As compared to the balance sheet, the profit and loss statement is much easier to read and understand.
Let’s look at a profit and loss statement as it would be created for a single month and see what we can learn. The first part of the statement contains the revenue, or sales of the business. It may be stated in one line, or can be broken down according to how the sales occurred – cash, bankcard, or ‘house’ charge account.
The second line of information is probably the most confusing aspect – ‘cost of goods sold’. What is commonly thought to be a number equal to the amount of inventory purchased is not the case. It is what the name implies; it is the cost of goods sold and not the cost of goods purchased.
It is a mathematical calculation that begins with the amount of inventory, at cost, on the first day of the month. Added to that amount is the cost of the inventory purchased, at cost, during the month, and then subtracting the amount of inventory on hand, at cost, on the last day of the month. The resulting answer is the ‘cost of goods sold’ and is stated as a dollar amount.
The third line of information is the gross profit. It is calculated by subtracting the cost of goods sold from the revenue. The gross profit is stated in dollars and cents. With many profit and loss statements to the right of this dollar amount is the same information stated as a percentage and is referred to as the gross margin.
The next section of the statement is the one most people are familiar with. It is the operating expenses. Things such as rent, payroll, utilities, advertising and all of the other expenses associated with operating the business are listed here.
In listing the expenses, they can be arranged in any sequence. Traditionally, expenses that are related are grouped together. As an example, the telephone, water, gas and electric bills would be sequentially listed as they are all occupancy costs. They would be shown on the profit and loss statement next to other occupancy expenses such as rent or mortgage payment and property taxes.
The proper sequence is that which helps the owner to best understand the profit and loss statement and to make the appropriate decisions about the business. All of the expenses are added together for a summation of ‘total operating expenses’ that is then subtracted from the gross profit amount.
There is one item that does not appear as an expense. Even though checks are written for inventory through the month, inventory is not an expense. The inventory that is paid for during the month is a part of the cost of goods sold calculation that we have previously explained.
As with the gross profit and gross margin, each of the operating expenses is likely to be stated as a percentage as well as in a dollar amount. When stated as a percentage, that operating expense percentage is referencing the revenue. As an example, if the dollar amount of rent is also 8%, this indicates that 8% of each dollar of revenue goes toward paying the rent.
These percentages are important to monitor as there exists industry guidelines to help an owner measure the success of their business. Continuing our rent example, if guidelines show to this owner that rent should be approximately 5%, we can see that the rent is too high with regards to the revenue. There exists several possibilities for solutions; negotiating for a lower rent, increasing revenue, or finding other expenses that can be lower than industry standards so that operating expenses as a whole will be in line.
As we subtract the operating expenses from the revenue, the resulting number is the net profit for the month for the business. And again, the net profit is stated as a dollar amount and as a percentage.
The purpose of the profit and loss statement is not to just eat up your time and give an accountant something to do. Instead it is meant to be a tool that you can and should utilize as an integral part of your management decision process. And as we mentioned in a previous column, your profit and loss statement is the starting point for your creating a budget and a projectionary cashflow chart.
Without it, you are just hoping that what you have done in the past will continue to work or that the mistakes you have made will not repeat themselves. And as the title of a book suggests, hope is not a strategy.