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!

Your financial statements can be a wealth of information that is useful for monitoring the health of your business and for making business decisions. But only if you understand them and know what to look for! Here’s an overview of the different statements, and information about how to use them and recognize problems will be in upcoming posts.

There are 3 main financial statements for a business:

-Profit and Loss

-Balance Sheet

-Statement of Cash Flows

Let’s look at each of these.

The Profit and Loss calculates the net revenue for a specified period of time—typically monthly, quarterly, or annually. It starts with Gross Revenue (usually from sales), subtracts Cost of Goods Sold (the cost to produce the products that were sold) to get to Net Revenue, and then subtracts Operating Expenses, which are the expenses to run the business. That leaves Net Operating Income. There may also be sections for Other Income and Other Expense if there were any transactions that were not directly related to the business operations, and that leaves Net Income.

The Balance Sheet shows the net worth of the business on a specific date. It’s often called a “snapshot” because it captures account balances at a specific point in time, unlike the Profit and Loss, which captures activity for a period of time (more like a video). It starts with Assets (what you own, and that increase your net worth), subtracts Liabilities (what you owe) and comes up with Equity, which reflects net worth. This includes owner investments and draws, and current and retained earnings. The equation is Assets = Liabilities + Equity.

The Statement of Cash Flows is an often misunderstood statement that explains the difference in the cash balances for a specified period of time. But it’s not set up as “Money In, Money Out”. It starts with the Net Income from the Profit and Loss, and then adjusts for changes to cash balances that are in the balance sheet and not the profit and loss. This includes things like changes in Accounts Receivable and Accounts Payable, changes in loan balances, owner investments and draws, capital equipment purchases and a host of other transactions.

Many business owners look at the Profit and Loss and wonder why the net income figure is so different from their actual cash flow. The Statement of Cash Flows explains this in the “Adjustments” sections.

Final note: The financial statements can be run on either the Cash or the Accrual basis. The biggest difference between the two is in the amounts for Accounts Receivable and Accounts Payable. The Cash basis recognizes income and expenses only when they are paid, so unpaid customer invoices and unpaid vendor bills are not on the Profit and Loss on the Cash basis. These amounts are on the statements on the Accrual basis.

Keep watching for more information on how to understand and use financial statements to manage your business–and how to recognize mistakes!

One of the first things I see coaches urge business owners to do is to delegate tasks that they aren’t good at, and one of the first tasks that is on that list is their bookkeeping.

As an independent bookkeeper, I fully support that advice! BUT—what I often see business owners do is breathe a sigh of relief that they can take that off their plate, and then completely abdicate all ownership in the financial side of their business.

I’ve generated financial statements that never get looked at. I have clients completely stunned to find that they are losing money or, conversely, owe a huge amount of taxes when they have their return done.

Outsourcing your bookkeeping is not the same as outsourcing financial management of your business! A good bookkeeper will record transactions, reconcile accounts, and produce financial statements, but the business owner is the one making the decisions about how to manage the money. That includes setting goals, monitoring results, and getting their taxes taken care of.

A big part of the issue is that business owners don’t know what to look for.  So this week, I’ll be posting a series of tutorials on what the various financial statements are, how to read them, red flags that the business may be in trouble or the books may not be correct, and how to monitor the work your bookkeeper is doing to prevent errors or fraud.

Stay tuned!

We’re at the beginning of a new year, and I’m getting contacted by lots of small business owners whose New Year’s Resolution appears to be “get bookkeeping straightened out.” Usually this is because it’s tax time and they either a) realize they have no idea how to do taxes for their business or b) their tax preparer told them they need to get their bookkeeping straightened out.

Often, these folks are busy running their day-to-day business, following their passion, taking care of customers, paying bills. They’ve rarely, if ever, looked at their financial statements, and if they did, they looked at the Profit and Loss but never at the Balance Sheet. If they did look at the Balance Sheet, they couldn’t make heads or tails of it, either because it’s wildly inaccurate or because they don’t know the purpose of the balance sheet and what the numbers mean.

The main reasons for keeping a solid set of books are a) tax compliance and b) getting information to help make solid financial decisions when running your business.

Tax compliance has a few areas. One is completing the income tax return. Another is tracking payroll expenses and making sure tax payments are made and forms are submitted timely. The same goes for sales tax. It’s also likely that a business needs to file and send out Form 1099s at the end of the year to vendors.

Using the data in reports generated by the accounting system requires a certain amount of financial literacy. Most business owners know the profit and loss statement, but don’t know if it’s accurate or what metrics they should be looking at.

The balance sheet is a mystery to many business owners but it needs to be looked at. The balance sheet is a snapshot (meaning it is looking at balances at one point in time, rather than showing results over a period of time like the profit and loss) of the balance sheet accounts: 1) assets, 2) liabilities and 3) equity. The simplest definitions are that assets are what you own (bank accounts, equipment, accounts receivable), liabilities are what you owe (credit cards, accounts payable, loans) and equity is the difference between the two, or your company’s net worth. The balance sheet accounts should always be reconciled to make sure the balances are accurate. If the balance sheet is off, you can bet your profit and loss is off as well.

The first thing I do when taking on a new client who is scratching their head over their profit and loss, sure it is incorrect but having no idea why, is look at the balance sheet. Obviously incorrect balances are a good clue of where to start looking.

In future posts, I’ll go over some common balance sheet problems and how they affect the profit and loss.