In the arena of not-so-good news, along with so many other things these days, there’s a lot of chatter about a possible recession on the horizon. Just when you thought things might be looking up… Inflationary insults to injury for business owners.
These days are getting tougher. Hang in there.
And of course, if you want to process what that might mean for your business, please reach out:
Aside from worrying about the troubles an economic downturn could bring, another thing you’re going to want to pay close attention to (so your business isn’t leaking profits or headed towards financial disaster if the future is indeed looking a little bleak) is your P/L statement.
Likely, you already have access to this kind of report. At least I sure hope so.
Especially after last week, when I talked about how to build it correctly. So naturally, this week I want to focus on how to interpret it. Because this one financial statement can give you a whole lot of insight into where your company is at and where it’s headed.
But only if you know what you’re looking for.
So, let’s dive in, shall we?
Making the Most of Your Business’s P/L Statement
“War is 90% information.” – Napoleon
We can’t hammer this in enough: Your profit and loss statement (P/L) is one of the most important documents in your business, and putting it together is only half the battle. To really make the most of what the P/L offers, you have to understand the story it’s telling about your business. You must know how to read it.
There’s a lot of information on there about your revenue and expenses past, present, and future. Sifting through it, knowing what to pay attention to, and what to let alone for the moment are all key to making good decisions for your small business. So, let’s revisit what it is and then we’ll focus on learning how to interpret it.
A basic picture
Your P/L shows your revenue minus expenses and helps make clear how your business turns revenue into profits. Details of your profit and loss can reveal insights into your business performance including your strengths and weaknesses. You can also use it to easily see how you stack up against your competitors.
In addition to aiding management decisions, P/Ls are also used by public companies as financial statements for disclosure. Others – including the IRS – use your P/L, too, for many reasons. Two of the biggest groups are investors and lenders examining your company for risk.
To the lender, you must show your financial stability and the ability to take on more debt. Investors want to see you’re not too heavily leveraged and that you have enough over for dividends and future growth.
What to look at and watch for
You can study your P/L a long time and keep learning about your company, but a quick analysis starts with a few basic points.
Year-on-year comparisons. Look for such big changes as a drop or spike in sales. Assuming you’re not a seasonal business, do the big periods have to do with anything special you did at that time?
Trends. What’s the trajectory of your business? Are your strategies paying? Comparing annual performance will also help you see whether revenue is outpacing your expenses.
Projections. For future cash flows, look at your income sources and ask yourself if they’re sustainable. Your direct costs subtracted from your revenue also give you your gross margin – examining where it’s gone over the past year or so can help you determine how your cash flow is likely to do near term.
Expenses. Are your biggest ones justified? Are there ways to reduce expenses overall?
P/Ls can also show warning signs of trouble. The proper relationship between revenues and expenses, for instance, has to make sense to pass with the IRS.
Other signs you should look for in the P/L include:
Declining profit. Your company is growing; it can become harder for you to keep individual quotes, jobs, and revenue streams in your head. Gross profit can fall without you even noticing it – unless it’s spelled out clearly on a P/L. Revenue growth with declining reserves and operating profit margins can also show you that your costs are climbing faster than your sales.
Income consistency. Is your income steady or spiky? Here you can spot if a surge in profit came from gradual growth or a specific event or promotion and whether you should try to repeat that event in the future.
Jumps in A/R. This could just indicate the good news that you’re selling more. It can also mean your customers are paying you more slowly.
Decline in sales and marketing. Conventional wisdom says you need to spend about 10 percent of your gross revenue on sales and marketing. Did you?
Increase in the percentage of wages and other costs. You hire more people as you grow, but revenue should increase alongside such operational expenses as wages. Do expenses make sense for the period you’re looking at? Remember that some costs are fixed long-term. Others like supplies or wages could vary especially these days.
Bear in mind…
What the P/L tells you could depend on your accounting method. There are generally two methods: a cash basis or an accrual basis. (We’ll look at both in more detail in a future article).
With a cash basis, revenue and expenses are recognized when the cash moves. An accrual method accounts for revenue when it is earned and expenses when they occur rather than when money changes hands. Obviously, the actuality of the figures in the P/L could be different depending on which accounting method you use.
And of course, check your math. Wrong figures on even the most scrupulously prepared P/L send your decision-making down the wrong path.
Finally, what’s your bottom line really telling you? Net profit is always good, but a net loss doesn’t always mean you’re headed for the rocks. It just means you have to do some informed adjusting.
Which is, after all, the whole point of understanding your P/L.
Profit and loss statements can be tricky to figure out, but critical for the success of your business. If you want some help looking yours over to get a clearer picture of what lies ahead for your business, reach out:
My team and I are here for you.
In your corner,
Masterpiece Accounting Services