Previously, we took a detailed look at balance sheets and reviewed how to use the information they provide to make sound choices for your business. This week we’re examining another important financial document: the profit and loss statement.
Unlike a balance sheet that is a snapshot of your business at a set point in time, a profit and loss statement paints a picture of your business’s performance over a period of time. In this one report, you’ll see a summary of sales, costs and expenses for any time period you choose. Using Xero, you can run this report by month, quarter, year or even weekly if that’s helpful in your business model!
How is the data calculated?
The first section of your profit and loss statement will be your sales or turnover minus your direct costs. Direct costs are the raw materials, salaries or equipment used to directly create your product or service. The resulting amount is your gross profit.
From there, your overhead or indirect costs such as rent, advertising and administrative salaries are subtracted to calculate your operating profit, or profit before tax. Indirect costs are any expenses that support your business as a whole and cannot be directly attributed to what you sell.
Last, your tax payable is subtracted, and the number you’re left with is your net profit.
Sales – Direct Costs = Gross Profit
Gross Profit – Overhead = Operating Profit
Operating Profit – Tax Payable = Net Profit
So what does it tell me?
In order to interpret the profit and loss statement, you need to understand gross and net profit margins. The gross profit margin is the percentage of money left over after you subtract your direct costs. If you have $100,000 in sales and $10,000 in direct costs, your gross profit margin is 90%.
Gross Profit Margin = Gross Profit / Sales
The net profit margin is your net profit compared to your sales. With $100,000 in sales and a net profit of $70,000, your net profit margin is 70%.
Net Profit Margin = Net Profit / Sales
But how does that help my business?
By understanding and tracking your gross and net profit margins over time you will have a solid financial understanding of your business as a whole. For example, if you notice net profit margins decreasing from one time period to another, you can take steps to find out why and redirect resources that may have been going to waste. Alternatively, if you are only watching your sales, you might get excited about an increase, but not realize that increase required an exponential rise in expenses and actually caused the overall health of your business to decrease.
While profit and loss statements are easily generated, especially when using accounting software like Xero, it’s good to have an advisor who understands and can explain the particulars of your business. If you have questions about how we can help you, get in touch!