Are you new to business or unsure how to use your profit and loss report? You may be missing out on valuable insights about your business’s financial health. In this post we’ll go through how to use your profit and loss as a tool for managing profitability and take you through the important numbers to monitor and manage. Let’s start with the basics.
What is a profit and loss report?
A profit and loss, also known as an income statement, is a report of your business’s profit position over a period of time (such as the end of a month, quarter or financial year). It differs to a balance sheet which gives you a snapshot of your business’s net financial position at a single point in time. You can read about interpreting a balance sheet here.
The profit and loss report usually has five main components:
- Income (sales/turnover)
- Cost of goods sold (COGS)
- Gross profit (revenue less COGS)
- Expenses
- Net profit (gross profit less expenses)
Keeping a close eye on each of these will ensure you’re maximising the profit potential in your business.
The 5 profit and loss numbers to monitor and manage
1. Sales
The most important part of the income section of your profit and loss report is of course sales. Keep track of how much sales have risen or fallen since your previous report. A pattern of falling revenue may indicate a business is in trouble. Breaking sales figures down into individual products/services or product/service lines will help you see which areas are performing well and which need attention.
2. Expenses
The two main sets of figures in the expenses section of a profit and loss report are:
- Cost of goods sold or variable costs (the costs that fluctuate with the level of output such as materials, labour, commissions, shipping etc). These are variable because they are dependant on the sales you make.
- Operating expenses or fixed costs (the costs that are paid regardless of output such as rent, insurance, advertising etc).
Gradual increases in expenses are normal over time (due to inflation, annual employee pay rises etc) but unexpected spikes should be investigated. You may need to find ways to reduce costs and revisit your business budget to stay on track.
3. Gross Profit and Gross Profit Margin
Gross Profit = Sales – COGS
Gross profit is the difference between total sales and the cost of producing the goods or services you sell. It’s an indicator of a business’s efficiency at using labour and supplies to produce goods or services.
Gross profit only takes into account variable costs and doesn’t include fixed costs.
Monitoring your gross profit will help you:
– set sales targets
– set prices for your product/service
– set budgets for labour costs
– reduce raw materials costs
Gross Profit Margin = (Gross Profit ÷ Sales) x 100
Gross profit margin is gross profit expressed as a percentage of sales. Essentially it shows the percentage of profit you keep from each dollar of sales revenue you generate. For example, a 15% gross profit margin means you keep a gross profit of $0.15 for each $1.00 of sales.
What does gross profit margin tell you? Basically, it’s an indicator of a business’s overall financial health and shows whether the average mark up on your product/service is enough to cover direct expenses and make a profit.
Keep in mind though that gross profit and gross profit margin vary significantly from industry to industry and are best analysed over a number of periods.
4. Operating Profit
Operating Profit = Gross Profit – Operating Expenses
Operating profit is profit generated from core operations. It does not include expenses from interest or taxes. It differs from gross profit in that it takes into account your other expenses as well as COGS.
5. Net Profit and Net Profit Margin
Net profit = Operating Profit – (Taxes + Interest)
Also known as the ‘bottom line’, net profit is the total amount earned (or lost) after paying all expenses. Once you know what your net profit is you can calculate the net profit margin. Expressed as a percentage, it shows what part of each dollar the business earns ends up as profit at the end of the report period.
Net Profit Margin = Net Profit ÷ Total Revenue
As with growth profit margin, this number will vary considerably from industry to industry. Benchmarking is a worthwhile exercise if you’re looking to compare your business performance to others in the same industry.
Summing up
As you can see, your profit and loss report is going to change constantly. You may be in an industry with seasonal variances whereby some months/quarters look healthier than others. Hopefully after reading this article you have a better understanding of what the numbers mean and how you can tease out vital information to better manage your business. We’ve shown you the most important numbers to manage but there are many more insights you can look at to assess the financial health of your business. If it all still seems like financial gibberish, we’re happy to help out.
Further help
- If you’re struggling to make sense of your numbers and need help with management accounting, contact our business improvement specialists for further assistance. You can reach us on (07) 3023 4800 or at mail@marshpartners.com.au.
- You can find out more about working with Marsh & Partners here. As your Absolute.Account.Ability partner we’re on a mission to make your business life better. We’ll help you set goals for your business, devise an Action Plan to make them happen and meet with you regularly to ensure you stay on track.
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