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Keep your business on track

Accomplish success by understanding your profit and loss statement

By Keith Johnson, CPA

The ability to read and understand financial statements is critical to a business owner’s ability to effectively run an organization, and, in many cases, the difference between a profitable, thriving business and one that will shut its doors.

Financial statements such as the balance sheet and profit and loss (P&L), or income statement, give the practiced reader many clues as to a business’s viability and performance.

Of the two most major financial statements, the easiest for most small business owners to read and understand is the P&L. In its most basic form, the P&L provides a summary of an organization’s activities during a given period of time. Although one year is the most common time period a P&L is prepared for, it can be prepared for a six-month period, quarterly, monthly, weekly, or daily.

The P&L theory

The theory behind a P&L is actually very simple. Essentially, you take all of your income and billings and put it in a big pot. You then subtract what you spent and the result is your net income (hopefully, you will not have a net loss). Your net profit is what the business and owners are taxed on. If you can understand that, you have won half the battle.

Record your income

The first step in reading a P&L is to record all of your income from your business activities, usually your sales. They can be broken out by the different products or services you sell. For instance, a CPA’s P&L could show income from tax preparation, audits, and business consulting.

If you have more than one product or service, the income from each activity should be recorded. The income from the different products or services is summed up to produce gross income. Gross income is all revenues realized by the business.

Subtract your expenses

There are two basic types of expenses which are subtracted from income to get to net income. The first is cost of goods sold. Cost of goods sold are expenses that go directly into your product or service. They include raw materials, labor that went into the product, and other items that are actually in the product.

If an expense is not traceable to the product, do not include it here. Cost of goods sold is subtracted from gross income to produce your gross margin or gross profit. This is an important number as it shows how much money you have left after making your product.

A healthy gross margin may vary by industry, but as a general rule, you want a margin of at least 50% to 60%, if not more. If your gross margin is too small, you will be caught short on paying your operating expenses. You will need to raise your prices or you will have liquidity problems.

The other type of expense is called operating expenses. These expenses are paid, but do not go directly into the product. These expenses may include rent, utilities, phone, insurance, Internet, uniforms, auto expenses, travel, and continuing education. These expenses are just as crucial, but are not reflected into the final product or service.

You need to sum up each expense by account to get total operating expenses. Operating expenses are subtracted from gross profit to get operating profit. Many small businesses will stop here, but there may be small adjustments for nonoperating income and expense, as well as income tax.

Look for oddities

The best way to interpret your P&L is to first look for any expense that sticks out. Are your advertising expenses out of line with your dues and subscriptions? Do you have large bank service expenses? You may need to switch banks. Do you have large travel expenses? You may need to find more effective means of meeting, such as through webinars or conference calls, which may save you money. If one expense dominates your P&L, you will want to do additional research to understand why.

Schedule regularly and keep current

Second, you want to commit to producing P&Ls on a regular basis. Many CPAs will sit down with their clients quarterly to review their financials. By preparing regular and consistent P&Ls over time, you will be able to detect trends and act upon them.

For instance, you may have declining sales. Is it seasonal, or is it something else? Are your payroll expenses out of line? Payroll expenses may be the biggest expense you have. By trending payroll expenses, you will be able to make better hiring decisions. Are your bad debts going up? If so, you may want to implement tighter credit policies. Are your costs of goods going up? You may want to switch vendors or change buying habits. Current P&Ls give a business owner the “eyes” to see their business and project future performance.

In addition to having a firm grip on the pulse of the business, a business owner will find that updated P&Ls will be requested by many different stakeholders in a variety of situations:

•Current P&Ls are used by accountants to prepare the business tax returns;

•They will be required from bankers in credit and lending decisions;

•Vendors may request them to extend credit;

•Government and major purchasers may request them as part of a bidding process; and

•If a business decides to go public and issue stock, P&Ls will be required by regulatory agencies and investors.

Get with a program

The good news is that with a little investment in time and money, you can produce financial statements quickly and easily. Using a small business software program such as QuickBooks, any business owner can prepare P&Ls for any time period desired.

You can also prepare comparative P&Ls to see how your current activity matches up with past performance. The program is relatively inexpensive (about $200 plus tax), easy to learn, almost universally used by accountants, and very forgiving in errors, which you will certainly have while learning the program.

The key is that you must reconcile all of you bank and credit accounts each month. By reconciling all of your accounts, you will ensure all of your income and expenses are recorded and you have all of your information current. Your accountant can help you with this, or various local resources, such as the Chamber of Commerce’s Small Business Center, University of North Florida’s Small Business Development Center, and the Beaver Street Enterprise Center, often have reasonably priced classes to learn how to enter transactions and reconcile.

Having the ability to understand a current P&L means you have the information you need to make timely and critical decisions for your business to not only survive, but thrive.

You will be able to take advantage of opportunities and stay ahead of your competition. Make a commitment to understand your financial statements as a New Year’s resolution and you will likely find 2011 to be a very happy and profitable year.

Keith E. Johnson CPA, is owner of Keith E. Johnson CPA PA in Jacksonville, Fla., a full-service CPA firm providing accounting, auditing, consulting, and tax services to individuals, businesses, and non-profits. He can be contacted at 904-727-0077 or kejcpa@comcast.net.


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