Disclaimer: Please note this article is not financial advice. The purpose of our blog is purely educational, so please consult a professional accountant or financial advisor before making any financial decision.
Most entrepreneurs often think that simply listing down sales and expenses on a notebook is good enough. So when the time comes that they do it, they often feel as if there's something that's not adding up.
Fortunately, there's also a pressing desire for entrepreneurs to really know what's going on in their business operations. So we're giving a slightly detailed focus on a particular financial statement that would tell them accurately how their business is performing—the profit and loss statement.
Overview Profit and Loss Statement
The profit and loss (P&L) statement is the receipt of your entire business at a given point in time. Think of yourself as a shopper. You look at the receipt after paying the cashier to check if the stuff you bought is reflected, especially the bottom part to see how much the change is, if there is any, and if it is correct. A profit and loss statement for a small business provides similar functions.
The P&L, also known as an income statement, is a summary of your business's operations in a given period—usually in 12 months. It shows you how much the business has earned in total through the sale of its products, known as your income statement's "top line.” Afterwards, a deduction from all the operational expenses the business incurred is performed. What’s left is the net profit or your "bottom line."
There are a few differences between a shopping receipt and a small business profit and loss statement. Since the statement records profit and loss, it's uncommon to arrive at an exact zero amount. Your bottom line will either be a positive (profit) or a negative (loss). And whatever the result is will be added or deducted to your equity, just like when you put the change back into your wallet or pull additional bills should you need to pay more.
Now, your income statements are all composed of what’s called nominal accounts.
What Are Nominal Accounts?
Let's say you want pasta for dinner, but you're missing a few things—the pasta and the cauldron. So you go out to buy them.
At the cashier, you pay in cash and then check if what you bought are in the shopping bag—they are. But the receipt is missing one item, so you go back to tell the cashier they forgot to punch in one item. The cashier remained firm and insisted the receipt was correct because they only punch in items classified as a nominal account. That's why you only have the pasta you bought reflected on your receipt.
A nominal account is a temporary account used to record short-term revenue or expense transactions of a business. In the short term, the business will not likely have these transactions reflected on the business for the span of the fiscal year.
Nominal accounts often start with a zero balance and then accumulate recorded transactions. Any remaining balances will be transferred to a real account (permanent) as the nominal account resets back to zero upon opening the next fiscal year's books by the end of the fiscal year.
Your pasta is consumed during dinnertime. Afterwards, you'll have to buy another pack. However, you can cook pasta in the cauldron for years.
To translate into accounting: your pasta falls under an "expense" category, a nominal account, while your cauldron falls under an "assets" category—a real account. Thus, the pasta makes it to the income statement, but the cauldron reflects on a balance sheet.
Here are some examples of nominal revenue and expense accounts that you may have encountered before.
- Income Taxes
Getting insights into how these accounts behave will give you a better understanding of profit and loss statement for small business owners. To understand it further, know the subclassifications for revenue and expense accounts.
Revenue And Cost Classifications
In accounting, not all costs and revenues are treated equally because revenue can come from other sources, and costs are not always predictable. As an entrepreneur, you need to discern these subclassifications so you can better manage them.
In the context of analyzing the profit and loss statement for small business, the simplest classification of revenue you need are the following:
The operating revenue is the money from your business's daily activities. This means the actual selling of the business products.
The operating revenue is considered to be your business's primary income stream. This implies that there can be other streams of revenue that your business can have, and it is classified as non-operating revenue.
This type of revenue is money that is generated from a side activity that is still tied to your business. For example, the business made an investment to another business entity, and it profited, or it rented out a space it owns. This type of revenue is supplementary only and may not sustain your business.
Cost behaves differently depending on where you look for it. But two cost types are present in all businesses.
Fixed costs are the ones that remain the same for a long period. We're saying "long-period" because eventually, all costs change. Fixed costs just happen to be relatively stable in the long term. One example of a fixed cost is payroll. A business can expect to pay the same amount for several years before inflation forces this cost to increase.
Variable cost increases relative to volume. COGS is the perfect example of a variable cost. As you produce more units of your product, the associated per unit cost of production also increases.
Basic Income Statement Analysis
Your income statement can give you more than just a breakdown of revenue and expense. You can also use it as a tool to find out just how profitable your business is. Knowing basic income statement analysis allows you to ask the right financial questions from an external accountant. It will also give you a better understanding of how you can improve your business operations to pump up your net profit.
Here are some of the margins you can calculate to understand your business further.
Gross Profit Margin
The gross margin is calculated by subtracting the business's net sales from the cost of goods sold.
The net sales are the result of all the sales your business has made during the accounting period and deduct the discounts, returns, and allowances from it. On the other hand, the cost of goods sold (COGS) is directly associated with the creation of the product the business sells.
Gross margin is a measure of how much your business gets to keep after it sells its product and pays for the cost of producing it. So if your product is sold at $100 and your gross margin is at 35%, your business gets to keep $35 as capital.
The operating margin measures how much the business gets to keep after all operating expenses, such as payroll, rent, advertising, and depreciation, are considered.
To calculate your operating margin, divide the business's operating income by net sales. Your operating income is the profit your business makes before it pays the tax. Knowing your business's operating margin will let you find out if your business operations are cost-efficient. A low operating margin may mean some expenses are too high at the end of the operation and need to be managed.
Net Profit Margin
The net profit margin is the most important of all the income statement analyses. It is important to do a quick assessment of your business operations in a given period.
The idea of net profit margin (also usually called profit margin) is to account for all the expenses of the business and including interest and taxes, and give you a picture of how much money your business gets to keep from all the money generated through sales.
To calculate the net profit margin, simply divide the bottom line (net profits) to the top line (gross sales) and multiply it by 100. So if your gross sales amount is $100 and your net profit is $50, your net profit margin is 50%. Your business gets to keep half of what it earned after considering all expenses.
Practicing Your Income Statement Analyses With Unloop
Now that you have the rudiments for analyzing your own income statement, all you need is someone to provide it to you. Unloop can do that. Give us a call or send us a message to discuss how we can provide you not just with an income statement but also other financial statements in a timely and frequent manner. We believe that practicing your financial analytical skills constantly will improve your business acumen.