Running a business is like a money game. To win, you must have profits at the end of any cycle. To win long-term, you need to accumulate profits on an ongoing basis. Your moves are summarized on your Profit and Loss statement (commonly referred to as your P&L statement). The score, the results of your moves, are recorded on the Balance Sheet. Each time you act on a decision, you impact your finances.
Some people call the P&L statement an Operating Statement, or the Income Statement. Income/Outgo statement might be more descriptive because the P&L shows you where your money is going day by day.
When you make a sale (revenue), you must deduct three things: the cost of what you sold, your business expenses (operating expenses) and your interest charges and taxes. Whatever is left is yours, plus or minus.
Remember: revenues do not equal profits. Some people think revenues are theirs to play with, but that’s not quite the case. Unfortunately, you can’t keep it all. That’s the point of it being a Profit AND Loss statement, to give you better insight into what is hovering below the surface and to avoid surprises later.
Here’s how the P&L works:
- Revenues = Gross sales.
- Cost of Goods Sold = What the actual sale cost you.
These costs vary with how many items you sold (e.g. the inventory you bought, the packaging, the delivery charges and the other costs that vary with volume sold). Subtract them from your Revenue to find out your Gross Profit (ie how much you have left) to manage your ongoing operations.
- Gross Profit = money from which you’ll pay your operating expenses.
Whether you sell anything or not, there are expenses you have to pay. Your rent, phone, heat, parking, gas, advertising are examples of the usual costs of operating your business. These costs are deducted from your Gross Profit to leave you with an Operating Profit.
- Operating Profit = the money you can keep, to grow your business.
…or can you? Not quite. After deducting the variable cost of the goods you sold and your fixed operating expenses and interest fees, the tax department also gets its share.
- Net Profit / Net Loss = What is left.
When you show profits at the end of the period, you have choices: buy equipment? Pay off loans? Take dividends? Or keep the cash on hand for later? If it’s a loss, you will want to sharpen your planning pencil for the period ahead.
Either way, your profit or loss for the period is then represented on the Balance Sheet, which shows your cumulative score to date. That score represents how much would be left today if you paid off everything you owe with everything you own. What’s left, the balance, is your ownership, your equity, your profit or loss so far.
Once you understand the relationship between the financial statements, you can make more informed decisions about what to do next to increase your chances of winning the money game.
Before making major business decisions, it’s always a good idea to consult with your accountant or financial advisor, especially now that you can speak their language!