Being aware of the financial status in the business world is very important.
Among the biggest tools that do indeed accomplish this for you is the Profit and Loss Statement, or P&L, also referred to as income statement.
It is a tale in figures or rather more appropriately put, it describes your business's financial performance over a defined time.
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In the blog, I take the reader through what profit and loss accounting entails, why it's necessary to know, and how the statement may be used for better business decisions.
What Is Profit and Loss Accounting?
Profit and Loss Accounting is a method of presenting the revenues, costs, and expenses of a business over some specific period in reports, either by quarters or yearly.
The P&L statement gives you a picture of how well your business can create profit either by raising revenues or by reducing costs, or both.
For the business owner it's basically very important to understand this statement because it tells you not only what has happened in the past but also in what way things might happen in the future.
A current profit and loss account breaks up into several major parts. Let's have a look at all of them in detail:
1. Sales
Sales or turn-over is gross income that has already been realized because of the operation of business without taking into consideration the deductions made.
Of the two terms, there exists a difference between gross sales and net sales.
Gross sales are only the amount of sales that have been generated whereas net sales are the sales deducted by returns, allowances, and discounts.
In showing this, take an example of there being a firm producing commodities that amount to 100,000 but takes back that money to the said amount sum up to 5,000, and the bottom line income would be 95,000.
2. Cost of Goods Sold (COGS)
COGS would be those direct costs as would relate to the cost of goods sold by your firm.
Such examples would include raw materials, directly used labor for the production process of making of your products.
It is very important because it determines your COGS, that leads directly to your gross margin.
Calculation: If your firm spent 40,000 in material and 20,000 on labor. Then COGS will be 60,000.
3. Gross Profit
Gross Profit is an important number which tells you exactly how much, and to what percentage, a business utilizes its resources to create the goods that are being sold.
It can be found by subtracting COGS from revenue.
Formula:
Gross Profit=Revenue−COGS
Now you put the numbers you've done above to work. You assume you have revenues of 95,000, and COGS of 60,000, so you would calculate the gross profit as such:
95,000 - 60,000 = 35,000.
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4. Over Head Expenses
Over Head Expenses - These are expenses incurred running your business and have nothing to do with the production stage of the goods or services.
It might include rent, utilities, salaries, marketing, and many more.
Managing over head expenses is the biggest activity associated with an increase in the overall profit.
For example, you can demonstrate that you have running expenses worth $20,000 that should form your bottom line because it relates to your running income.
5. Operating Income
The operating income is one of the ways by which you will know what is going on within the core activities of an enterprise and this can be calculated after subtracting operating expenses from gross profit.
Formula:
Operating Income=Gross Profit−Operating Expenses
Therefore, in the above illustration, if you have a gross profit of 35,000 and operating expenses 20,000, then it would be equal to 15,000 operating income.
6. Other Income and Expenses
Not all business income is realized from core operations. Think of other income sources, for instance, interest or investment income in the chapter.
Other expenses are interest paid on loans. You apply these figures to have a sharp picture of your business's profits and losses.
7. Net Income
Net Income is the bottom line figure in the P&L statement. It is the result of deducting all the expenses including taxes and interest from the bottom line.
Net Income = Operating Income + Other Income - Other Expenses
Another case whereby if you get your operating income at 15,000 and have other incomes at 1,000 while the other expenses are at 3,000 your net income will be 13,000.
Why is Profit and Loss Accounting Important?
There are various reasons why you need to understand and keep a check on your Profit and Loss Statement:
1. Financial Health Analysis
A P&L statement will make you aware of how healthy your company is financially. You will know whether you're generating enough to meet your costs, where you need to cut down or increase.
2. Budgeting and Forecasting
Past P&L statements can be reviewed to obtain a practical budget and forecast of future periods.
You may use it for planning your expenses, determine your sales targets, and even anticipate potential financial challenges.
3. Investment Analysis
In general, investors and creditors consider your P&L statement before investing or lending you money.
A healthy net income can impress the investors, while easy procurements of loans are available.
4. Stakeholder Communication
Clear financial reporting increases the confidence among the firm's stakeholders, such as employees, investors, and suppliers.
A reliable P&L statement shows transparency and accountability in the management of the finances.
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Analyze Your Profit and Loss Statement
You now have your P&L statement that one can analyze to gain some very good insights into how your business operations are going.
Check the following key performance indicators.
1. Gross Profit Margin
This ratio shows what percent of revenues is more than COGS; it shows how well you are producing goods.
Formula:
Gross Profit Margin =100× ( Gross Profit /Total Revenue )
Gross Profit = Revenue - Costs Of Goods Sold
2. Operating Profit Margin
This shows what percent of revenues is left with the business after operating expenses have been covered. It hence helps a firm determine overall efficiency of operations.
Formula:
Operating Profit Margin = 100× ( Operating Profit / Revenue)
Operating Profit = Revenue - Operating Expenses
3. Net Profit Margin
This is the last of profitability measures showing that what percent of revenues is left behind for a profit after all expenses.
Formula:
Net Profit Margin = 100 × ( Net Profit / Revenue)
Net Profit = Revenue - ( Costs of Goods Sold + Operating Expenses + Taxes + Interest )
Common Issues in P&L Accounting
A P&L statement might appear like a very straightforward item to prepare; however, many problems may arise, though:
1. Revenue Recognition
The question of revenue recognition becomes problematic when the selling item is done over a period.
There is a need to ascertain when and in what situation the revenues should be realized that requires knowledge of existing accounting standards.
2. Expense Control
There is a need to control operating expenses if the net income is to be maximized.
Most operating ventures find it troublesome to strike a balance between burning through their hard-earned cash to serve clients and curtailing spendings.
3. Variability In Accounting Method
Due to various accounting methods, financial reports may vary. The selection of the right method whether it is cash or accrual alters revenue and expense recognition.
4. External Economic Factors
An economic decline, market fluctuations, and an unexpected occurrence affects revenues and expenses.
This is why you should be constantly updating and revising your financial plans.
Conclusion
Finally, in brief, understanding Profit and Loss Accounting is a foundation for efficient business management.
P&L statement of your company is not only a source of knowledge about the company's financial performance but also information for strategic decisions.
You can successfully run a business from profit-loss accounting so long as you take charge of its components and on a regular basis analyze your company's financial performance.
A well-kept P&L statement is more of a requirement; it is a tool that can lead your business into a bright future.
One should make it a culture to go through and use the P&L in guiding one's decisions as one moves on.
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