Understanding Profit and Loss

The adage that, what you can measure is what you can manage, is just as true for your finances as for any other activity. In order to measure your profit you need to follow a certain set of rules in order to be able to compare your results with others.

Profit is your incentive for being in business; without profit you will lose interest and after a while will not bother. Profit is your reward for taking the risk to be in business. One should understand that generally speaking the higher the risk the higher the reward (or loss if it goes wrong) and the lower the low risk the lower the reward.

It is true that nobody will take any risks without a suitable reward in return for taking the risk. All business is risky (some more than others) so no reward (profits) means no business. This article addresses profits and loss and provides some insight into the account drawn up to record the information.

The purpose of this article is to provide a basic understanding of the components of a profit and loss statement that a startup entrepreneur should use to enable him or her to become financially independent.

The Profit and Loss Statement

When one look at a profit and loss statement drafted by an accountant it looks like a very complex document. Whatever format the profit and loss statement is in, the basis of the document is to systematically summarize the revenues, costs and expenses incurred during a specific period of time.

The profit and loss account is significantly different form the balance sheet as it is a record of the business trading activities over a given period of time or for a specific project. On the other hand the balance sheet is a snapshot of financial position of the business at a point in time.

The Profit and Loss Statement Frequency

The norm is to get a statement like this produced by the auditor or accountant at least once a year.

Any acute businessperson will tell you that one cannot manage a company on information received once a year only, and therefore it is strongly recommended that the timing of the profit and loss statement should be aligned with the frequency of the activity that is measured. It may be necessary to draw up a profit and loss statement at the conclusion of each significant event or milestone in a project. In some cases it is necessary to have the profit and loss statement up to date and live all the time to ensure the profitability of a project.

The reason why this is so important is that these records provide information that shows the ability of an entity to generate profit by increasing revenue and reducing costs. In certain circles the profit and loss statement is also known as an income statement or an income and expense statement.

The Profit and Loss Statement Structure

The profit and loss statement generally follows a standard format however the format is less important than the accuracy of the information.

The statement begins with an item for revenue or sales. This is followed by the costs of operating the business. This is normally subdivided into a section called the cost of sales and the operating expenses.

The cost of sales is nothing else than the cost of preparing the goods sold in a format where it is ready to deliver to a customer. This normally includes all production and raw material cost.

The operating expenses comprise of items like marketing and sales costs, research and developing cost and general administrative and overheads costs.

The final section contains the tax and interest and finally the distributable profit or loss is revealed.

Calculating Profit and Loss

Starting with the revenue or sales one deducts the costs of sales for this. The revenue is the money you receive for the sales made. It can be complicated but a simple example will suffice.

If you have sold 100 items for $1-00 each and gave customers discount on items sold to the value of $5-00 your sales income will be $95-00

The cost of sales includes all the cost directly associated with preparing the item ready for sale. Remember to include labor and raw material cost that can be directly linked to the production unit. If the labor cost came to $20-00 to produce the 100 items and the total raw material cost per product was $0-25 per item the cost of sales would be $45-00 [$20-00 %2B (100 X $0.25) = $45-00]

This calculation results in the figure known as the gross profit. In our example the gross profit will therefore be $50-00 [$95-00 - $45-00 = $50-00]

The operating expenses are calculated next. This normally constitutes of marketing and sales costs, research and developing cost and general administrative and overheads costs. The operating expenses are normally not traceable to a single produced or sold product. Once the operating expenses are deducted form the gross profit you will have your operating profit or also sometimes called EBIT (Earnings Before Interest and Tax). If you calculate the operating expenses at $ 20-00 for the particular project the operating profit will come to $30-00 [$50-00 - $20-00 = $30-00]

In order to calculate your net profit you need to deduct all taxes and interest expense. For the purposes of this article no tax and interest are accounted for. In some cases the profit and loss statement continues to reflect how much money is distributed to shareholders and how much is kept behind to finance future projects. It is also this figure that the accountant would normally transfer to you balance sheet.

There is a number of websites from where you can download free profit and loss statements templates (normally an excel spreadsheet template). The best idea is to download one of these and then customize it for your own situation.

Uses of the Profit and Loss Account

The primary use of the profit and loss statement is to monitor and measure profit, as discussed above. For this reason one needs to ensure that the information recording is accurate. To this end you need to make sure that you include all relevant costs. Significant problems can arise if the information is inaccurate. You may be under the impression that you company is making profit and growing but in reality you are slowly going out of business.

Once you have accurately calculated the profit or in some cases the loss, the information can be used for judging how well the business is doing compared to itself in the past, compared to the managers' plans and compared to other businesses. It will also assist you to adjust your cost structure as you will be able to see profit leaks that you may not have been aware previously.

Conclusion

It is always a struggle to get entrepreneurs to do administration as most of them fly by the seat of their pants. If you wish to be successful and is not one of those few geniuses that can see the profit or loss without doing any calculations, you have to force yourself to record at least the income and expense information and use it as explained above.

Knowing which projects are making profit and which are loosing income and then taking the necessary action to rectify it is an integral part of becoming financially independent.

© Carl Marx 2009