At the most basic level, a profit & loss statement (a.k.a. an income statement) is a report that shows your income minus expenses.
However, if you look a bit closer, a profit & loss (or income statement) is an important tool for managing your business and avoiding financial difficulties.
In this post, we’ll take a deep dive into what a P&L Statement is, how you can use it to get a pulse on your business and some warning signs that you might find and suggest what to do to address it.
What’s a Profit and Loss Statement?
Successful business owners review their profit & loss at least every month. This gives you a pulse on how your business is doing by clearly showing your revenue alongside your expenses.
If your bookkeeping isn’t up to date and/or you don’t have a profit & loss to review every month, then maybe it’s time to take a look at your bookkeeping processes.
How can you use your P&L to inform your pricing strategy?
Once you are in the habit of reviewing your P&L statement, you can use it to make data-driven decisions around your pricing strategy.
This starts with calculating your gross profit, which is your sales minus direct expenses. Your direct expenses are any staff members and materials that go into delivering the product or service you sell.
When many businesses prepare a quote or work out their pricing, they usually use one or both of the following two methods: bottom-up pricing and top-down quoting.
To calculate a price using the ‘bottom-up’ method, here are the typical steps:
- Start with the materials cost, e.g., $400
- Add the labour cost, e.g. 4 hours x $40 per hour = $160
- The total cost so far is $560
- Now add a markup, which could be a percentage, or a set amount, or a random number based on variables like how much you like the customer. Let’s say we add 20% of the cost, i.e., $112
- Voila! The price of your quote is $672
To calculate a price using the ‘top-down’ method, here are the typical steps:
- Decide how much the total price will be, based on your competitor’s pricing, or how much you think the customer will pay, or increase last year’s fee 3%, or some other method. Let’s say $799
- Subtract a margin, say 20% or $159.80
- The remainder ($639.20) you can use for the cost of your product/service
- Find a materials supplier that will give you a low-enough price. Say you find the materials from one supplier cost $441.20
- Find a contractor or employee that will provide the labour for a low-enough rate. Say you find a contractor who quotes $255
- Add the materials and labour costs together and compare this to step 3. Oops, your costs from steps 4 and 5 are higher than the result of step 3
- Repeat steps 4-6 until your costs are low enough. Restart from step 2 or step 1, if needed
- Voila! You have a price to quote to the customer
What are the top warning signs to look for in your P&L statement?
Warning Sign #1: Declining profit
As you grow, eventually you can’t keep such a close eye on the individual quotes, prices, or jobs.
If you can see that the gross profit goes down each month, this is an early warning sign. The next sign is usually revenue increasing, but your bank balance declining. This happens when the costs are increasing faster than the sales.
There are a couple of ways to address this:
Solution 1: Examine (and lower) your expenses
The first is to look closely at your costs and see if they are actually increasing and why.
- Are your materials costing more than they used to?
- Is the productivity of your workers declining?
- Are your paying your team more?
Solution 2: Raise your prices
Yes, there is a risk that they might not buy from you. But would you want someone to buy from you if you lost money every time?
Warning Sign #2: Decline in sales and marketing spend
In order to grow a business, you need to invest in sales and marketing. A rule of thumb is to spend at least 10% of your sales revenue on sales and marketing.
If you are spending less than that, you could wind up seeing your business stagnate or decline.
Warning Sign #3: Founders aren’t paying themselves a regular salary
If you want to build a sustainable business and you don’t have a trust fund, you should pay yourself a regular salary that is higher than the minimum wage in your area.
As you are building your company, you may need to pay yourself a tiny amount. As the business grows, make sure to increase your own pay.
In addition, remember the business profit should NOT be your pay. You should be paid for the work you do in the business, just as if you were an employee. You should also get a return on the business asset that you own, like any other investment.
This will help you avoid building yourself a stressful job instead of a business because it forces you to build in enough profit margin to pay someone else to do the work.
It’s also a critical concept if you ever want to sell your business because you’ll get a much higher sale price if the new owner can pay someone else to run the business, or if they can consider the profit as an extra-high wage for themselves.
Warning Sign #4: Increase in Wage Costs As Percentage of Revenue
If your business is growing, then you should expect to hire more. So, an increase in wages by itself shouldn’t be alarming.
However, if there isn’t a corresponding increase in revenue, then this could indicate a decrease in profitability and cash flow.
Warning #5 – An increase in your accounts receivables
While this is technically on your balance sheet and not your P&L, this is another warning sign you should know.
On the one hand, this could mean you are selling more. (YAY!)
However it could also mean that your customers are paying you more slowly. This can lead to all kinds of problems like:
- A decrease in cash flow
- Problems meeting payroll
- Not putting enough money away in a tax savings account
- Increasing interests on your credit cards as they are being paid late or loans aren’t being repaid in a timely manner
However, the most important thing is to make sure your bookkeeping is up to date and accurate; otherwise you won’t be able to see the warning signs. Or worse, you’ll see the wrong warning signs.
P&L Statement FAQs
What is an income statement?
It is simply the recap of the total income and expenses of the business over a specified amount of time. Many business owners want to analyze their income and financial statements monthly, quarterly, or annually. The documents are often used to track operating income or if you need to report any income for a loan application.
What are the different income statement formats?
There is a single-step income statement and a multi-step income statement. The single-step income statement is a simple and straightforward option. There is one part solely for revenue, including operating and non-operating revenue. The second is where the business lists all expenses including operating and non-operating expenses.
The multi-step income statement is similar to the single but is broken down into subcategories, including operating and non-operating categories. You will also find another section listed as cost of goods sold which helps to further break down the costs.
What is included under revenue?
Under revenue, a business should include operating revenue from the sale of their inventory, interest received on a loan and gains on any long-term assets.
What is included under expenses?
Under expenses, a business will list operating expenses, including payroll expenses, insurance, and marketing costs. Non-operating expenses include interest expense, lines of credit, and interest payable for debt. The cost of goods sold includes the production and purchase of the materials and the costs associated with all the inventory. Finally, the loss statement includes any damages from a lawsuit or the loss of a sale of assets.
How do you format your income statement?
If it is strictly for internal purposes and information, then the formatting doesn’t matter as much as you may think. However, you still want to make sure to include all of the components we have mentioned in this article to ensure that it is as thorough and as accurate as possible.
What is a cash flow statement?
In financial accounting, the cash flow statement shows any changes in the balance sheet and shows how income affects the cash, and it breaks down all financing activities for the business.
What are some income statement red flags?
Revenue manipulation, misrepresented expenses, cookie jar accounting, nonrecurring transactions, and one time transactions may all be considered big red flags when it comes to your income statements.
Revenue and expenses on an income statement are both vulnerable to manipulation, so when any of these red flags are spotted, it is essential to go back and investigate everything thoroughly.
Read the income statement and the management discussion of the business along with the balance sheet, cash flow statement, and other notes to see what happened.
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