You'll hear it called the Income Statement, the Profit and Loss statement, or even the P&L. Well, it's all the same thing: it's the statement that shows the amount of income collected or earned and the amount of expenditures or expenses incurred during a given period of time.
It's also the first statement you should review in your business's financial statements every single month.
Do you set annual sales or profit goals? How do you know if you're on track during the year? How do you determine what to pay yourself and what to set aside for the infamous Uncle Sam?
Your P & L is the guiding light for answers to all of these questions.
But if business accounting feels scary or out of reach, or if you’re reading this thinking, “Wait – I need to review my financials every month?!”... then this, my friend, is the post for you.
The basics: A few things to keep in mind
Before we jump into decoding your P&L and getting you running your financials like a pro, let’s run through a few principles and definitions.
So, what exactly is on a profit and loss statement?
P&L refers to “Profit & Loss.” It’s a financial statement or report that shows you how much money came into your business (revenue collected) and how much went out (expenses incurred) during a specific time frame. If your income is higher than your expenses, you’ve made a profit. If your expenses are higher than your income, you’ve incurred a loss. Thus the name “Profit & Loss”, or P&L.
Define revenue and expenses.
Revenue refers to all streams of income from products or services you offer. Expenses refer to any costs associated with producing the products or services you sell, plus any general business costs.
How do I make sure my income and expenses are showing up consistently?
There are a few different ways that businesses track revenues and expenses, but we’re going to stick with the simplest one: cash basis accounting. That means revenue and expenses are only recorded when cash is received or payments are made. It is the simplest method of accounting for small businesses – and it’s probably what you’re doing already.
How to create a simple but effective monthly financial review
Now that we’ve got the basics covered, let’s talk about how to apply this process to your business. I promise this doesn’t need to be complicated or time-consuming!
Here's the method I use in my own business every single month:
1. Completely and accurately record all transactions for the month.
You want to make sure that you've captured all of your transactions - either by directly importing them from your bank or by manually entering the receipts. Tools like Freshbooks and Quickbooks make this really easy… and they’ll help you out in later steps too, as we’ll see in a minute.
If you don't directly import from your bank, now is a good time to reconcile your bank statement. You'll find any missed transactions, bank fees, etc. during this process.
If you use a payment processor such as Stripe, Square, or PayPal and have a merchant account, you'll probably need to create a journal entry (i.e. an entry in your spreadsheet or bookkeeping software) that records the merchant account fees as expenses and grosses up the amount of your revenue.
Example: Mia runs an online clothing boutique. For the month of January she had sales of $5,000. However, her bank deposits at the end of the month only totaled $4,850, because her payment processor charges a fee of 3% sales for every transaction and held back the last $150 as payment. To make sure she’s keeping track of this properly, Mia needs a journal entry to record Merchant Account Fees as an expense of $150; then she should increase her recorded sales by $150 (from $4,850 to $5,000).
2. Run the automatic report for the month.
Hopefully you're using an application or software that makes it super easy to generate and print reports (this is that extra benefit of using accounting software that I was referring to earlier!). Briefly scan each line item shown, and circle anything that looks odd or out of place. It could be due to a transaction that was incorrectly categorized or one-time collections or expenditures. Basically, you just want to be sure you’re familiar with all of the transactions and that they reflect your activity for the month. You'll want to know anything that could affect your budget going forward so that you can adjust your goals accordingly.
If you’re not using an accounting software, you should use a spreadsheet (or even just a sheet of paper) to list all of your sales and expenses for the month. Subtract the expenses from the sales, and that’s your profit. Just be sure not to include Owner’s Draws. That’s money you’ve taken out of the business to pay yourself or for your own personal use. It doesn’t get included in your P&L.
3. Analyze the current month's operations.
Here’s an “agenda” of sorts to work through as you do your review, moving through each of the areas in bold. I’ve included some additional definitions here, as well as key questions to ask yourself.
Start by looking at money you make selling your products or services.
Questions to ask:
- How many income streams are recognized?
- What is the percentage mix of sales – that is, do I have diversified streams of income? Does the breakdown of revenues from each of those sources align with what I was expecting?
- Are my advertising dollars working for me? Knowing where sales conversions are being made helps us make executive level decisions necessary for sustainability and growth.
Now, look at the areas where you’re spending money. You’ll do this by examining both the cost of goods sold (meaning, the cost to make or sell your product(s) or provide your service(s)), and your operating expenses (meaning, any other costs necessary to run your business, such as - office rent or leased space, advertising, supplies, web hosting, subscriptions, etc.).
Questions to ask:
- Am I making efficient use of my resources?
- Where can I decrease costs without affecting quality - such as wholesale pricing from suppliers, shipping costs, etc.?
Net Profit/Net Income
Your net profit/net income is also called the bottom line. You’ll calculate this by taking your revenue and subtracting your expenses (i.e., your Cost of Goods Sold and your Operating Expenses).
You should use the bottom line as the basis for your salary, estimated taxes, and business savings. I use the 50/50 split: I allocate 50% to paying myself and 50% to my business, of which 30% is for taxes, and 20% is for business savings.
Questions to ask:
- Does my net profit align with my expectation for the current month’s earnings / annual goals?
- For every $1 in sales or service, how much do I take home?
- Is this amount of profit sufficient to sustain me? How can I reduce expenses?
Wrapping it up
If you do these three steps every month, you'll never have a question about what to pay yourself, when you can invest in your business (think: courses, conferences, and equipment), or how much dear old Uncle Sam expects come tax time.
That's our walkthrough of the profit and loss statement. I hope it was super helpful to you. I’d love to answer any questions you might have, so feel free to ask away in the comments! Also, if you interested in learning more about how to keep more profit in your business, check out this post I wrote for the Think Creative Collective blog on Keeping More Profit in Your Business.