From the outside, it may seem like financial advisers do their best Nostradamus impression to make strategic decisions and navigate the business. But it’s not tea leaves, tarot, or The Almanac guiding their hand – it’s the profit and loss (P&L) statement.
No other document gives such a comprehensive snapshot of overall financial health. Conducting a P&L statement analysis on a regular basis is an important part of managing your financial wellbeing. By pairing the P&L report with other key documents, like the balance sheet and income statement, you can fully understand the state of your financials and where there may be room for improvement.
What Is a profit and loss statement?
A profit and loss statement shows a company's income and costs over time. It’s the most informative financial document a business has, and is often the first document bankers or potential investors will want to review when assessing a business. Statements are typically issued once a year, but they may also be issued quarterly. It’s based on a very straightforward formula: Revenue – Expenses = Profit.
By subtracting expenses from income, the P&L statement makes it easy to measure profits and see an overview of the financial health of the business. The main categories that can be found on the P&L include:
- Revenue (or sales)
- Cost of goods sold (COGS); also known as cost of sales
- Selling, general & administrative (SG&A) Expenses
- Marketing and advertising
- Technology/research & development
- Interest expense
- Net income
Be careful to not confuse the P&L statement with a balance sheet. A balance sheet shows the assets, liabilities, and shareholder equity of a company at a given point in time. The revenues, costs, and expenses incurred over a given period of time are summarized in a profit and loss statement. These materials show whether a corporation can make money by increasing sales, cutting costs, or doing both.
The P&L tells you at a glance whether a company is profitable or not, making it an incredibly valuable tool for financial advisors. By analyzing the statement, you can uncover important information that will help your client thrive financially.
Furthermore, you’ll be able to identify financial strengths and weaknesses, and whether or not a company would be a wise investment. It’s a document that will be requested by anyone evaluating a business, and it’s wise to refresh it at least on a quarterly basis.
Creating a profit and loss statement
There are two primary strategies for creating a P&L statement, and the best method will depend on the size of the business.
The single-step process, which is mostly used by service-based companies and small businesses, calculates net income by subtracting expenses and losses from revenue and gains. All income line items have a single subtotal, and all cost line items have a single subtotal. At the bottom of the report, you'll find the net profit or loss.
This strategy uses a single calculation: Net income = (Revenue + Gains) – (Expenses + Losses)
The multi-step process, which is an alternative to the single-step approach, distinguishes operating income and operating expenses from other revenue and expenses to find the gross profit. This approach is best suited for companies that rely on inventory.
The multi-step method uses three calculation steps:
- By subtracting the cost of products sold from net profits, the gross profit is estimated.
- By subtracting operating expenses from gross profit, operating income is estimated.
- To measure net profits, the net sum of non-operating sales and gains is added to non-operating expenditures and losses.
How to analyze a profit and loss statement
Understanding how to read and analyze the profit and loss statement is incredibly important for any business. Some of the many ways to analyze the P&L statement include …
- Comparing change over time to understand when your business’s most profitable seasons and growth trends.
- Comparing industry benchmarks and competitors to see if there is potential for you to generate more income.
- Examining margins (gross profit margin, EBITDA margin, operating margin, net profit margin) to uncover areas for more efficiency in your business.
- Rates of return to understand what is generating the most income.
- Valuation metrics (EV/EBITDA, P/E ratio, price to book, etc)
- Uncovering areas for improvement
Also, there are two important accounting principles that financial advisors need to be aware of when interpreting a P&L.
- Don’t confuse profit with cash
Profits on the P&L statement do not translate directly to cash in the bank. Even if transactions were made on credit, accountants record them in the P&L report. That means the transaction isn't yet cash — instead it’s accounts receivable, which isn't quite cash flow.
- Understand accrual versus cash basis accounting
The accounting method used to track revenue and expenses will affect the snapshot given by the P&L statement. Revenue and expenses are recognized and registered as they arise in accrual accounting, whereas cash basis accounting does not track these line items before cash is exchanged.
When analyzing a firm internally, comparative reports are generally the most valuable way to leverage the P&L statement. These reports can be used to compare changes over time to understand how your business is evolving and when it has been most profitable. It can also help you uncover any potential issues with your cash flow. For most businesses, the four most important areas to analyze are:
- Revenue: The amount of money a business is taking in.
- Expenses: Every financial advisor knows you have to spend money to make money. This includes costs like payroll, marketing, etc. Depreciation of equipment also falls under expenses.
- Losses: The amount by which expenses exceed revenue.
- Gains: One-time events or unexpected income that bring in additional money to the business.
No crystal ball required
The four areas above give a broad overview of the status of a business, but there is even more helpful information to be gained by analyzing changes to the P&L over time. Public companies typically issue P&L statements on an annual basis, but this analysis could be done on quarterly or even a monthly basis.
It’s important to focus on what matters most to your business, whether it be growing revenue or improving margins. That’s where a tool like Causal can really help your company. Our tool plugs right into your database, helping you generate the right calculations, visualize results, and get to the insights behind the data faster.
Understanding how to draw insights from this valuable tool will not only help your business, but also enable you to better assist clients. Knowing where your business stands financially is the first step to creating a roadmap to reach future goals and continue growing. With solid P&L data, there’s no need for wizardry or crystal balls – you’ll have all the information needed to make strong, informed decisions.