Profit & Loss Statements: A Guide for New Entrepreneurs

Every commercial enterprise, whether you are a freelancer or run a limited company, needs to understand the fruits of their labour. To look back at a particular period of time (usually the end of the financial year) and understand whether they made a profit or a loss, and the appropriately-named Profit & Loss Statement (also often referred to as an income statement or P&L) is the document for that.

What is a Profit and Loss Statement?

A Profit and Loss Statement is a historical financial document that summarizes a company’s revenues, costs, and expenses over a specific period of time passed, typically the previous quarter or year. It provides a comprehensive picture of a business’s profitability and financial performance that ultimately displays whether your company made a profit or a loss. 

Key Components of a Profit and Loss Statement:

• **Revenues:** The total income earned by the business from its core activities.

• **Cost of Goods Sold (COGS):** The direct costs associated with producing goods or services.

• **Gross Profit:** Calculated as Revenues minus your COGS.

• **Operating Expenses:** The indirect costs of running the business, such as rent, salaries, and utilities.

• **Net Profit:** The final profit after deducting all costs and expenses from revenues.

What’s the difference between COGS and Expenses?

This confuses most entrepreneurs so don’t feel alone if you find it hard to understand the difference! Let’s break it down for you. 

COGS (Cost of Goods Sold)

COGS represents the direct costs involved in producing the goods or services that a company sells. These are the costs *directly tied to the production* of what your business offers.

Examples of COGS:

Expenses

Examples of Expenses:

In a Nutshell:

COGS: Direct costs of creating what your business sells. Think of it as the cost of the ingredients in a recipe.

Expenses: The general costs of running the business, not directly tied to creating the product or service. Think of it as the cost of keeping the kitchen running so you can cook.

Why is a Profit and Loss Statement Important?

For aspiring entrepreneurs, understanding the Profit and Loss Statement is vital for several reasons:

• **Profitability Insight:** It reveals whether your business is making a profit or incurring a loss.

• **Performance Analysis:** Helps in assessing the financial performance and identifying areas for improvement.

• **Investor Attraction:** Essential when seeking investment, as it demonstrates your business’s profitability.

• **Strategic Planning:** Aids in setting financial goals and developing strategies for growth.

How to Read a Profit and Loss Statement

Interpreting a Profit and Loss Statement is straightforward with the following approach:

1. Analyse Revenues: Review the total income generated by the business.

2. Assess Costs and Expenses: Examine both direct and indirect costs, and identify areas for cost reduction. 

3. Evaluate Net Profit: Determine the final profit or loss, which indicates the overall financial health of the business.

A Tip for Increasing Profit in Your Business!

It’s common for entrepreneurs to focus on increasing their revenues and that’s understandable, but if your goal is to quickly increase your profit, there is a quicker way… 

Imagine you’re running a little café. Every cup of coffee you sell brings in some money, but it also costs you a bit to make – you’ve got to buy the beans, pay the barista, and keep the lights on!

Decreasing Costs by a Euro:

Let’s say you find a way to cut costs – maybe you find a supplier who sells coffee beans for a Euro less, but the quality is just as good. That extra Euro you save goes straight into your pocket (or the business’s pocket, to be more precise) as profit. It’s like finding a Euro in the pocket of an old jacket – it’s all yours!

Increasing Sales by a Euro:

Now, let’s consider the alternative – increasing sales by a Euro. It sounds great, but here’s the catch – for every extra cup of coffee you sell, you still have to cover the costs of the beans, the barista’s time, and so on. So, not all of that extra Euro you earn is profit, and, depending on the profit margin of your business, you’ll likely need to increase your sales by €10 or more to make an extra Euro in net profit – the rest goes back into covering costs. 

In a Nutshell:

Decreasing your costs is like a financial shortcut. You’re directly boosting your profits without having to sell more. It’s often simpler and more within your control.

Increasing sales is definitely good, of course, but it’s a longer route to increasing profits. You have to cover additional costs, and selling more can be challenging – it might mean more marketing, more competition, more time, and more risk.

So, for a small business owner, finding ways to cut costs is usually a more straightforward, efficient way to boost profits compared to increasing sales!

Integrating Profit and Loss Statements with Business Plans

But back to your P&L. Your Profit and Loss Statement is an essential element of your business plan because it offers tangible proof of the effectiveness of your financial strategy. 

When developing a business plan, you’ll need to:

• **Incorporate Financial Projections:** Use the Profit and Loss Statement to outline financial projections and validate the feasibility of your business model.

• **Highlight Profitability:** Showcase your Profit and Loss Statement to potential investors to demonstrate the profitability and financial health of your business.

• **Inform Strategic Planning:** Utilize insights from the Profit and Loss Statement for informed financial planning and setting achievable goals.

Conclusion

Financial statements seem complicated at first, but you need to learn how to read them. They’re not only essential for your business plan but they also guide your strategic decisions, attract investments, and ensure the financial well-being of your business. 

Onwards Entrepreneurs!