Small BusinessOperationsAccounting

What is a profit and loss statement, and how to create one?

Are you looking for ways to better manage your income and expenses and get a clear understanding of your company's financial performance? Then it’s time to create a profit and loss (P&L) statement.

A profit and loss statement can provide you with a snapshot of your business's financial health, helping you make informed decisions about managing your money, cutting costs, and growing your business.

Here, we cover important details merchants should know about profit and loss statements. Plus, we'll walk you through creating your own. So, let's get started!

What is a profit and loss report?

Also known as a profit and loss statement, a profit and loss report is a document that summarizes your company's financial performance over a specific period.

It shows you how much money your business earned (revenue), how much it spent on items like supplies, rent, and employee wages (expenses), and what the overall profit was (net profit).

The profit and loss formula is simple: Revenue - Expenses = Net Profit (or Loss).

Benefits of preparing a profit and loss statement for a small business

A profit and loss statement can be a valuable tool for any business owner. It can provide insights into your company’s financial health, help you make informed decisions, track progress toward goals, and assist with financial planning.

In other words, think of it as a financial report card that can help streamline your financial data and show you how well your business is doing.

Here are some of the advantages of a profit and loss statement:

  • Provides a quick look at your finances. A P&L is a fast way to determine whether you’re turning a profit. It shows you how much money you've made, how much you've spent, and your net profit.
  • Helps make informed decisions to grow your business. You can see which products or services generate the most revenue, which expenses are the highest, and which areas need improvement. This can help you identify areas where you need to cut costs or invest more resources and make strategic decisions about how to grow your business.
  • Identifies cash flow issues. A P&L statement can help identify cash flow issues before they become a major problem.
  • Tracks progress toward goals. Compare your financial performance to past periods or industry standards to see how you're doing.
  • Assists with financial planning. It can provide insights into potential revenue and expenses, helping you create a realistic budget and forecast for the coming months or years.
  • Helps with tax prep. This summary of your company’s revenue and expenses can help relieve some stress during tax time.
  • Simplifies financial reporting. It provides a clear and concise summary of your company’s financial performance, making it easier to communicate with investors, lenders, and other stakeholders.
  • Attracts investors and lenders. Stakeholders want to see that your business is profitable and financially stable before they invest in you.

Key components of a profit and loss statement

Small business financial statements like a P&L report can look a little different depending on the industry you’re in.

For instance, a P&L statement for a service-based company like a tutoring business or a graphic design firm might look different compared to a product-driven business like a clothing brand or a manufacturer.

However, the main components of a P&L generally apply to all businesses. Here’s what you can expect to see in your statement:

  • Revenue: The total amount of money a business earns during the specified period. It includes sales, fees, commissions, and any other income the business generates.
  • Cost of goods sold (COGS): The direct cost of producing or acquiring the products or services, including material and labor expenses. It does not include indirect costs like overhead.
  • Gross profit: Gross profit is the difference between revenue and COGS. It represents the amount of money a business has left after deducting the direct costs.
  • Operating expenses: These are the indirect costs of running a business, such as rent, utilities, payroll, marketing expenses, and depreciation.
  • Operating income: The profit a company generates from its normal business operations, before deducting interest and taxes.
  • Other income and expenses: Other income and expenses are non-operating items that are not directly related to the core business activities of a company. They may include interest income, interest expense, gains or losses from the sale of assets, and other one-time or non-recurring items.
  • Net profit: Net profit is the final profit or loss earned by a business during the specified period after subtracting all expenses.

Types of profit and loss statements

A business can use several types of profit and loss statements, depending on its needs and goals. Here are a few of the most common ones:

  • Single-step profit and loss statement: One of the simplest types of P&Ls, it lists all revenue in one section and all expenses in another. This is a good option for small businesses that don’t have many revenue streams or expenses.
  • Multi-step profit and loss statement: This type of statement is more detailed than the single-step statement. It breaks down the revenue and expense categories into multiple sections to provide more insight.
  • Comparative profit and loss statement: This type of statement compares the company's financial performance over two or more periods, such as monthly or quarterly.
  • Projected profit and loss statement: This statement estimates the company's financial performance for a future period, such as a quarter or a year.

Ways to prepare profit and loss statement

There are two main ways to prepare a profit and loss statement:

  • Cash method: This method records revenue and expenses when cash is received or paid out. That means revenue is recognized when the customer pays for the product or service, and expenses are recognized when the business pays for them.
  • Accrual method: This method records revenue and expenses when they are earned or incurred, regardless of when cash is received or paid out. For example, if a company delivers a product to a customer on credit, the revenue would be recognized at delivery, even if the customer doesn't pay until a later date. This method is typically used by large businesses.

The key difference is the cash method recognizes revenue and expenses when cash is received or paid out, while the accrual method recognizes revenue and expenses when they are earned or incurred.

For example, say a business bills $10,000 to a customer in December, but the customer doesn't pay until January. Under the cash method, the revenue would be recognized in January when the cash is received. Under the accrual method, the revenue would be recognized in December when the services were provided.

How to create a profit and loss statement?

Now that you understand the ins and outs of a P&L statement, it’s time to create your own.

Once you’ve gathered and organized all your financial documents, follow these steps to prepare a profit and loss statement:

  • Step 1: Add up your revenue and sales numbers to determine your company’s total revenue.
  • Step 2: List of all operating expenses incurred during the specified period. Be sure to categorize each expense to make it easier to organize and analyze.
  • Step 3: Calculate the cost of goods sold (if applicable). If your business sells products, calculate the cost of goods sold (COGS) by adding up the cost of materials, labor, and other expenses related to producing or acquiring the products sold during the period.
  • Step 4: Determine the gross profit by subtracting the COGS from the total revenue.
  • Step 5: Deduct all operating expenses, such as rent, utilities, salaries, and marketing expenses, from the gross profit to calculate the operating profit.
  • Step 6: Add or subtract any non-operating income and expenses (i.e., interest income or expenses, gains or losses from the sale of assets, or one-time expenses) to calculate your net income.

Don’t stop now: Learn about typical revenues and expenses for businesses and discover more strategies for preparing financial statements.

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