The Profit and Loss Statement
The Profit and Loss Statement is one of the most important tools a business owner has. You can, and should, use the information within it when working out how to improve your profitability. The profit and loss statement is also called the ‘Income Statement’ or the ‘Statement of Financial Performance’. Although it can be prepared for any period of time (a year, a month, or even a week), for tax reasons, a business needs to prepare one for each financial year.
A profit and loss statement shows:
- The total amount of money you have made during the year,
- The expenses involved in making that money, and
- The profit your business has made.
Components of the Profit and Loss Statement
The profit and loss statement contains the following components:
- Revenue (income). This is the money your business earns. Usually this is from selling products and services, but it can also include income from things like investments and renting out assets.
- Cost of Goods Sold. This is the money your business paid for the products it sold during the reporting period, as well as any costs directly involved in making products or providing services. It includes all ‘direct costs’ involved in providing a product or service, such as the costs of raw materials, freight, and sales commissions. It may even include the wages paid to employees to make products or provide services. This is called ‘direct labour’. However, most wages and salaries are more often ‘fixed costs’ and are included as expenses instead.
- Gross Profit. This is calculated by subtracting cost of goods sold from revenue. It shows how much money is available to cover the general costs of running your business and to make a profit.
- Expenses. These are the other costs your business has, in addition to the cost of goods sold. The amount of these costs is not directly linked to the amount of sales you make – for example, you will pay the same amount for your mobile phone data plan, even if your sales increase. They are therefore called ‘indirect costs’. Examples include overheads such as lease payments and power, administration costs such as accountancy fees and phone bills, selling expenses such as advertising, and financial expenses such as bank fees.
- Net Profit (the bottom line). This is what you have left after taking away all costs from all income. It is calculated by subtracting expenses from gross profit. You’ll pay tax on this income – the profit you get to keep after all the taxes are paid is called ‘net profit after tax’.
The process of calculating profit and loss is shown in the following figure.
Profit and Loss Forecasts
You can also prepare a forecast of a Profit and Loss Statement for the upcoming year to estimate how much profit or loss you think your business will make over this time. Forecasts are particularly useful when you are intending to grow your business or make changes to it, as these will help you to work out how many extra sales you need to make to cover the costs associated with growth. This is all part of a ‘break-even analysis’. Forecasts are also useful for estimating how much you need to save for your tax bill.
The Impact of GST on Profit
Whether or not GST has an impact on your profit depends on whether you are registered for GST and if you are able to claim back the cost of any GST you pay to other businesses. In terms of sales revenues:
- If you’re registered for GST, you must charge 15% GST on all your sales. However, when preparing your profit and loss statement, you do not include this GST in your sales figures. GST is passed on to the IRD – it is not revenue for your business.
- If you’re not registered for GST, you don’t charge any GST on your prices. This means you simply show all money from sales in your profit and loss statement. You don’t have to worry about subtracting GST from your sales income to work out your revenue.
In terms of costs, many (if not all) of the businesses you buy supplies from will be GST registered. This means there will be GST included in the prices you pay them. This will affect your cost of goods sold and the expenses part of your profit and loss statement:
- If you’re registered for GST, you can ‘claim back’ the GST you pay. This means that GST is not an expense for your business. As a result, the cost of goods sold and expenses amounts shown in your profit and loss statement will have GST subtracted.
- If you’re not registered for GST, you will not be able to claim back any GST you pay. This means that GST is an expense for your business. The cost of goods sold and expenses amounts shown in your profit and loss statement will include GST paid. This reduces your profit.
How Should I Use my Profit and Loss Statement?
The Profit and Loss Statement can give you guidance of areas in which you can improve your profits as well as your profitability. It provides you with the figures you need to work out how many products or services you need to sell in order to make the profits you want, and can be used to figure out the impact on profitability of any business decisions you make.
You can get this information by:
- Identifying your largest expenses.
- Comparing the revenue, expenses, and profit amounts on your profit and loss statement from year to year to see which amounts have increased and decreased.
- Calculating ratios such as the gross profit margin and wages to sales ratio, and then comparing these ratios from one year to the next.
- Comparing ratios to industry benchmarks.
- Comparing amounts to your budget for the year.
Prepare a monthly budget for the year and use this to guide your spending. Then, through the year, use your accounting software to produce a profit and loss statement for each month. Compare this with your budget and check to make sure you are not paying for anything your business does not really need. Monitoring actual expenditure on a monthly basis will make it easier to get back on track if your expenses are getting out of control.