Understanding a Profit and Loss Statement is Important for Business Owners and Decision Making.

Here is the second part to our blog about understanding financial statements - Balance Sheet, Profit and Loss Statement, and Statement of Cash Flows.

This comes about based on a post a saw in Facebook from a builder who was not being educated by his accountant about the financial statements and how important it was for him to understand the statements and what the numbers meant to make informed decisions.

Components of a Profit and Loss (P&L) Statement

1. Revenue (Sales/Income)

   • Definition: Total income generated from the sale of goods or services.

   • Importance: Indicates the effectiveness of sales strategies and market demand. Ideally you want to utilise the minimum amount of resources to generate sales/income so that your profits are more efficient.

2. Cost of Goods Sold (COGS)

   • Definition: Direct costs attributable to the production of goods sold or services rendered (e.g., raw materials, labor).

   • Importance: Helps assess production efficiency and gross margin. This is important to identify wastage and how to become more efficient at producing your goods and services.

3. Gross Profit

   • Formula: Revenue - COGS

   • Importance: Shows the profitability of core business activities before operating expenses. This higher the gross margin the more efficient you are at producing your goods and services.

4. Operating Expenses

   • Definition: Expenses related to regular business operations, including:

     • Selling Expenses: Marketing, advertising, distribution costs.

     • General & Administrative Expenses (G&A): Rent, utilities, salaries of non-production staff.

   • Importance: Reflects how efficiently the business controls overhead costs. This is a crucial part of the P&L because you can increase profits dramatically just by finding items of operating expenses that add no value to the customer experience and still produce your goods and services.

5. Operating Profit (EBIT - Earnings Before Interest and Taxes)

   • Formula: Gross Profit - Operating Expenses

   • Importance: Measures profitability from core operations before financing and tax considerations. This is important because the business should be self sustaining to pay its taxes and financing costs still leaving positive cash flow in the business.

6. Other Income and Expenses

   • Definition: Non-operational income/expenses like interest income, dividends, or one-time gains/losses.

   • Importance: Provides a complete picture of all sources of profit or loss. This ranges from one off sale of capital assets, foreign exchange gains or losses, dividend income or interest income, etc.

7. Net Profit Before Tax

   • Formula: Operating Profit + Other Income - Other Expenses

   • Importance: Indicates total profitability before taxes are deducted.

8. Taxes

   • Definition: Income tax owed based on tax regulations at the time.

   • Importance: Provides clarity on the company’s tax obligations and usually this is determined under tax laws.

9. Net Profit (Net Income or Bottom Line)

   • Formula: Net Profit Before Tax - Taxes

   • Importance: The final measure of profitability, indicating what remains for reinvestment, reserves, or distribution to stakeholders.

     
     

Importance of the PL Statement in Decision-Making

1. Performance Measurement:

   • Evaluates whether the business is profitable and identifies trends over time. This is tied to your business strategy and market share.

2. Cost Management:

   • Helps identify areas where costs can be reduced without compromising quality or efficiency. This is tied to your systems, processes and tasks for creating value for your clients by providing goods and services.

3. Strategic Planning:

   • Informs decisions on expansion, product development, pricing strategies, and market entry/exit. This is part of your strategy and depending on your industry the P&L allows you to decide your next move.

4. Budgeting & Forecasting:

   • Provides a basis for setting future financial goals and allocating resources effectively. The P&L provides a picture from past performance and based on market volatility, opportunities and threats you can forecast future financial performance to meet future obligations and reap the rewards of investing in your business.

5. Investor Confidence:

   • Offers transparency to investors and stakeholders, influencing funding and partnership decisions. This is important to shareholders who have put up capital or loaned the business money to get started or keep supporting it during difficult times or periods of rapid growth.

6. Creditworthiness Assessment:

   • Lenders and creditors use it to evaluate the risk of lending money to the business. This is similar to a personal mortgage application and lenders will want to see if your business can have the ability to pay from its operations.

7. Regulatory Compliance:

   • Ensures the business meets financial reporting requirements set by regulatory bodies. The P&L is a document important for some stakeholders in order to see if your business is complying with regulations - this depends on the type of reporting you adopt and generally the board of directors in a company or sole traders decide the level of accounting required to capture all economic activities in a business.

8. Dividend Decisions:

   • Helps determine the availability of profits for distribution to shareholders. If you trade through a company, you can decide if distributions of profits as cash dividends can be made without compromising future obligations for the company and its creditors.

   
   

By regularly analysing the P&L statement, businesses can make informed decisions that align with their financial goals and operational strategies.

If you want to meet us virtually or in person, email us at admin@cmgadvisory.co.nz so that we can guide you and help you execute strategies that will help you improve your business' chance increasing sales and profits while managing your financials in an effective and educational manner.