Today, we are going to talk about one of the most important reports, a report all of your potential investors will want to see and pore over. The statement that answers the question: are you making money or are you losing money? What statement is this?
Statement of Profit & Loss.
Or something else.
Like a moody teenager stuck in a permanent identity crisis who changes the spelling of their name on a weekly basis (although without the dramatic hissy fits) the Statement of Profit & Loss goes by many different names, varying based on location, accounting standards, current practice or auditors’ preference. You may see Statement of Operations, Income Statement, Profit and Loss Account, Statement of Financial Performance, Earnings Statement and so on and so forth. For short, you’ll often see it referred to as a “P&L”. I’m going to use that going forward for the simple reason that it’s short. J However, no matter what it is called, the goal of the P&L remains constant: to show whether you earned money or lost money of a set period of time.
So, where to start?
Let’s break down that last sentence. It has three components.
- Earned money.
- Lost money.
- Set period of time.
Earning money means that your revenues, the amount of money you earned over the set period, was greater than your expenses, the costs that you incurred in earning this money. In this case, your business has a net profit and is profitable.
Losing money means that your expenses were greater than revenues. In this case, your business has a net loss and is not profitable.
Set period of time means that the P&L includes activity for a defined time period, say a month, a quarter or a year. One starts at zero, track all of the revenues and expenses for that period, and at the end of the period, you stop and write that number down. When you start a new period, you start from zero. For more on dates and time and how both tie into your financial statements, see here.
In graph format, your financial statements look a bit like this:
Great! So what’s with all the sections in the P&L? Why not just have three lines—“revenues”, “expenses” and “income or loss” or even “making money or losing money”— and call it a day?
That’s an excellent question! The answer is that the person reading the financial statements—be that management, a lender, an investor or even you—needs to know more. Not all income and expenses are created equal and lumping all of the revenues and all of the expenses together in one line isn’t going to be all that informative. On the simplest level, we want to be able to break out your operating income and expenses from operations from your non-operating income and expenses. At the same time, we also need to understand what is going on in your operations in order to assess whether it is going well or not and whether you are working well or not.
Wow, that was a lot. Can you break it down a bit?
Let’s start with breaking down your operating income and expenses from your non-operating income and expenses. And for that, we need two definitions.
Operating income and expenses are revenues and expenses that are directly related to the core operations of your business. On the revenue side this includes the amount you earn from the sales of your company’s products and services. On the expense side, this includes the amounts you pay in order to provide those products and services and to run the business. Running your business will include everything from product development, to your sales and marketing, to your customer support team, to your legal advisors and accountant, and so on.
Non-operating income and expenses are not directly related to the core operation of your business. You may earn them or pay them as part of doing business, but they aren’t really part what you do. The most common type of non-operating income and expense are interest income and expenses. For example, if you take a loan out to fund your business development, the interest you are paying is incidental. Unless you are a finance company that borrows and lends money, borrowing money isn’t your business. You’ll also find unusual or non-recurring items in this section, such as obligations under a lawsuit or costs related to discontinuing a business line.
The final breakout between what is considered operating and what is considered non-operating may vary based on where you are located and under what the accounting rules you report.
Why is it helpful to differentiate between operating and non-operating revenues and expenses? If I want to understand your business, I need to be able to see the results on a standalone basis. How much did you actually sell? How much did it cost you to run the business itself? Yes, I need to understand your financing costs as well, but those aren’t part of your core company identity, if you will. Theoretically, you could find another source of funding and run the business quite well without debt. On the flip side, perhaps you just did a round and have a nice pile of cash, and have invested it until you need it. Once you do use that money—as you are planning on doing—and the investment income disappears, will your sales income be able to support the business?
Beyond that, it’s not enough to just know “operating expenses”. You need to know what type of expenses. What is going on in operations? How is the company functioning? Is the company charging enough for its products or services? Where is it investing its efforts and resources? As such, instead of just shoving operating expenses into one giant lump, these will be broken out by categories, such as cost of goods sold, research and development, sales and marketing and general and administrative.
An analysis of expenses by categories can provide you and others a lot of information on your company. Think of it as seeing the forest instead of the trees. Here are some examples.
- If your company manufactures robot teddy bears, you are going to want to be able to parse out how much it cost you to manufacture the toys that you sold this year (“cost of goods sold”)….
- You will then want to compare your cost of goods sold to how much you sold the toys for (“sales” or “revenues”) before deducting all the other costs of running the business (“gross profit”).
- If you are an R&D startup, your investors might be want to know how you are managing the funds they invested. Are you keeping your eye on the prize and focusing on your research and development efforts (“R&D expenses”)? How has that spend translated into results?
- You’ll want to track your sales and marketing costs against your revenues. Are increases in your marketing spend resulting in an equivalent increase in sales?
- An unusually large amount in G&A might indicate that you are a company that likes to blow its money on fluff prioritizes the creation of a fun work environment for its employees. J
And so on and so forth.
Wait… my financial statements don’t look like that!
It’s fine! Just as the name of the statement can vary from place to place, so can the standard format. Your P&L might class the various expense types into several categories as in the examples I’ve given above. In other cases, your P&L might have sales at the top and then a list of expenses broken down by use: salaries, rent, consultants, computer expenses, and so on. In other cases, you may have both. The “official” P&L will be in a summarized format but the footnotes will include a detailed schedule breaking down the expenses by use.
Is that it? I remember seeing other categories on our financial statements….
Gosh, no, there’s so much more! The truth is that this is an article that I’ve been trying to write for months now, ever since audit season when I had financial statements on the brain. But every time I did, I got bogged down in detail. I kept on ending up with an article roughly the length of my old accounting textbooks. In the end, I opted for (relative) brevity for short, in part because I just must get this blasted article done. For more detail, I recommend:
Investopedia has a nice article on Understanding the Income Statement.
Accounting Coach has a six part post on Income Statements
The Balance has a series of articles on Income Statement Analysis