Understanding Accounting & Finance, Part 2 – The Profit & Loss Report.

The Profit & Loss (P&L) is one of the key monthly management reports which tells you how you are doing financially, for a month and for the year to date. 

It can help you see if you are on track to make a profit for the year, and show you areas to look at in order to help you control your costs.

As a business owner you are always keen to know if you can employ more staff or if perhaps you are employing too many staff, your profit and loss will help you to make this decision. It also allows you to pinpoint and focus in on other areas of your business that need attention, so you can deal with problems quickly and keep your business on track and growing.

You can also use it to compare your financial position with the previous years figures, both for the reported period and the year to date. In many P&L reports comparative figures for the previous year (or month) are shown alongside the current figures, along with a third column showing the variance (the difference between the two).

Comparing two or more time periods helps you to determine your profitability and financial position, it can also provide you with motivation for you and your team; for example, let’s say you had a tough 2019, but things are much improved in the current period, you can look at your current month’s numbers and say, ‘Last year was a really rubbish, but look at how things have improved this year’ (Ironic with covid-19 I know, but you get the idea).

Your P&L will only look at the relevant income and costs which relate directly to the month you are reporting on. So for instance, if you raise a sales invoice in one month (let’s say August 2020) but it relates to work to be done in September 2020, then your finance team will move that income into September.

On the cost side, let’s look at rent, which is normally a quarterly cost; if you get a rent invoice in August, the cost will need to be split equally between the three months it covers; in this case August, September and October. This just means that your monthly numbers will show you the ‘true’ income and costs for the month you are in. 

There is a lot more that a P&L can show you, especially where costs are involved. You can also calculate various ratios in order to analyse the figures. I go into this in more detail on my ‘Understanding a Profit & Loss’ training video.

A – Z of P&L Terminology.

Contribution (Contribution Margin)

Turnover minus variable expenses.  The contribution margin reveals how much of a company’s turnover will be contributing to the fixed expenses and net income. Basically, this is the portion of sales that helps to offset fixed costs. This is important because it shows you how much money is available to pay for fixed costs such as rent and utilities.

Cost of Sales

Cost of goods sold (COGS) are the direct costs attributable to the production of the goods sold by a company.  This amount includes the cost of the materials used in creating the good, along with the direct labour costs used to produce the good.

Depreciation

This is found in the overheads section, and is the cost of ‘wear & tear’ on your assets; for example computer equipment, company vehicles (if owned) and office furniture.

Direct Costs/Direct Expenses

Refer to materials, labour and expenses related to the production of a product.

Gross Profit

Also known as ‘the top line’; it is the turnover minus all costs directly related to the turnover.  These costs can include manufacturing expenses, raw materials, labour, selling, marketing and other expenses.

The Gross Profit calculation is nearly identical to the contribution margin, with one primary difference; it includes both variable and fixed costs.

Gross Profit Margin

This is the difference between the turnover and the costs of goods sold divided by the turnover. It is shown as a percentage. It shows us how healthy our ‘top line’ is and how much money is left over after subtracting the cost of goods sold.

Net Profit

Also referred to as ‘the bottom line’, it is the net income or net earnings.  It’s a measure of the profitability of a company after accounting for all costs.

Net Profit Percentage

This is the after-tax net profit divided by the turnover times by 100. This shows you the percentage of turnover you keep as profits after paying all of your costs.

Overheads

Overhead expenses are are all costs on the income statement except for direct labour, direct materials, and direct expenses.  Overhead expenses include accounting fees, advertising, insurance, interest, legal fees, labour burden, rent, repairs, supplies, taxes, telephone bills, travel expenditures, and utilities (to name but a few…..)

Profit Before Tax

Exactly that…..

Ratio Analysis

Ratios  compare figures in your financial statements and give you insights into things like profitability, liquidity and operational efficiency. I go into this, and give specific examples, in my ‘Understanding a Profit & Loss’ training video.

Revenue

See Turnover

Sales

See Turnover

SRS Ratio (Payroll to Revenue)

This helps you to see if you have a suitable level of employees for the turnover your business is generating. For service companies, this is normally between 50% and 60%; if you are in the manufacturing industry it can be lower.

Basically, a high percentage could mean you have too many employees for the work being done, and likewise, a low percentage may mean that you are working your employees to death…..

This ratio can be negatively effected if you have a number of employees on a very high salary level, or lots of employees on a very low salary level.

Sundry Income

Other income, for example, from interest received from a business savings account.

Turnover (Sales or Revenue)

The income that a business has from its normal business activities, usually from the sale of goods and/or services to customers.

Variable Expenses

Are costs that change in proportion to the good or service that a business produces. These costs can change over time. Examples of these include direct labour costs, cost of raw materials used in production and utility costs.


P&L reports can look different for each company, and for each industry, however they should include most of the above terminology, so hopefully you will have a clearer understanding now. If you need help decoding your company’s P&L, or you need one set up for your business, then give me a call.

Published by Kim Masters

Kim is a South African living in Bedfordshire. She specialises in helping businesses and individuals with their finances, combining her 25 years of accounting experience with her passion for healing therapies.

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