The Profit and Loss statement is the performance report of your business. It gives you important information about how much money you are bringing in, how much it costs you to create the products you sell, and how much it costs you to run your business.

Because of that, most business owners think it should reflect how much cash the business generates. But this is rarely the case. That’s because cash comes in and goes out in ways that aren’t reflected on the profit and loss, and some items on the profit and loss aren’t reflected in the cash balance.

Even so, generating a profit is essential to generating cash. Managing that cash is the key to how much you actually keep.

The sections of a profit and loss are:

-Gross Revenue—This typically equates to sales of products and services. If your business statements are run on the accrual basis, it is the amount that was billed to your customers. If you are on the cash basis, it’s the amount that you were actually paid for.

-Cost of Sales—the cost of producing the goods and services reported in the gross revenue number. The basic equation is Cost of Sales = Beginning Inventory + Purchases – Ending Inventory. To get this reported accurately requires either an inventory tracking system or taking a periodic physical inventory. Many small businesses just report the purchases number, which can work if inventory values are stable from month to month. NOTE: if your report is on the cash basis and you have a lot of uncollected revenue, this number might not accurately reflect the cost of producing the products in the Revenue figure.

Gross Revenue less Cost of Sales gives you your Gross Profit.

Gross Profit divided by Gross Revenue gives you your Gross Margin Percent. This is the amount of  sales that is available to cover operating expenses.

Cost of Sales divided by Gross Revenue gives you your Cost of Sales %. This is an important number for figuring out how an increase or decrease in sales will affect the amount of money you have to cover your operating expenses, and therefore affects your Net Profit.

Operating Expenses are business expenses that are for running your business, aside from producing the products you sell. It includes things like rent, utilities, administrative costs like professional fees and office supplies, and marketing expenses.

Gross Profit less Operating Expenses is your Net Income. That’s what is available for owner draws, investments in equipment and other capital expenses, and paying down debt.

Getting familiar with the components of the Profit and Loss can be extremely useful in modeling and budgeting for future growth and higher profits. For example, if your goal is to increase Sales without considering the other components, you can get unexpected results.

I used to work for a large corporation in a division that built custom products. Our Marketing department would work with a customer to get specs on the product, give those to Manufacturing and Accounting to calculate the cost of building the product and projecting the profit based on the quote to the customer (actually, the cost would be projected BEFORE giving the quote). Then we would build the product and after it shipped, do a review to see if we were able to produce it for our projected cost, or if unexpected issues with the specs caused us to miss the targeted profit. After one spectacular loss because the marketing guy missed the specs by a mile, he optimistically pointed out that we would make it up in volume. Um, no. If you lose money on every product you sell, increasing volume only deepens the loss.

That’s why having a goal only of increasing sales, without a good understanding of how much it costs to produce those sales, can cause you to reduce your profits or actually lose money.

Monitoring month-to-month changes in the figures on the Profit and Loss gives you valuable information on the direction your business is heading.

Having a budget for your profit and loss gives you even more useful information. Setting up a budget gives you a model of how profitable your business can be and give you a head up about potential trouble. Comparing your actual numbers with the budget tells you if you are staying on track or need to make some changes.

A good reason to be familiar with your profit and loss, and understanding it, is to catch errors in classifying transactions. If you know what a typical month’s profit and loss looks like, it makes it easier to find problems quickly. Errors in the Profit and Loss are very often offset in the Balance Sheet.

I’ve found small business owners very rarely look at the Balance Sheet (which will be described in the next post), and it often contains errors that are offset in the Profit and Loss.

A very typical error that I see results in Sales being roughly double the correct number, resulting in an artificially high net profit. It is offset in the balance sheet in an account called “Undeposited Funds.” The business owner is scratching their head over the inflated sales figure, and, if they even look at the balance sheet, they typically don’t know what the “Undeposited Funds” account is for so they ignore it, figuring it’s some kind of weird accounting thing that they don’t need to worry about.

But this kind of error not only renders your Profit and Loss useless in terms of giving you good information to manage your business, if it goes to your tax preparer and they don’t question it, you will pay significantly more in taxes than you should. It really does pay to be familiar with your financial statements and with what is reasonable and correct!

I’ll go over error detection and how to catch it in the next post about the balance sheet, because there are standard control measures that should be taken regularly that will catch these errors.

Getting familiar with your financial statements takes some time, but once you get familiar with them, a half-hour review each month should give you the insights you need and the opportunity to scan for errors. Well worth it to be able to use the information in these statements to grow your business wisely and strategically!