Making Your Small Business Profitable:
The Profit & Loss Statement
Worry over personal finances is receiving more and more attention as a potential underlying cause of stress for too many of us, and stress appears to be linked to a host of ailments from heart disease and headaches to obesity and diabetes. Far too many small business owners are stressed over their business’ finances–usually because they are struggling to pay their bills, and/or don’t have the funds to grow their business even when it appears as though they are making a profit. These are common business ailments, and fortunately, they are treatable.
My experience from working with thousands of small business owners, is that very few are aware of how critical yet easy it is to understand and use the basic tools of financial management.
Here are five key financial management tools that you need to master in order to realize the full potential of your business:
- Profit & Loss or “P & L” Statement (Income Statement)
- Balance Sheet
- Cash Flow
- Break Even
- Ratio Analysis
P&L tells you how you are doing this accounting period—this month, this quarter, this year.
Balance Sheet tells you how you are doing “to date”—since you started your business–are things getting better, staying the same or getting worse (what are the trends).
Cash Flow tells you how much money (cash) you need to operate your business—monthly/quarterly/annually–can you pay your bills when they are due.
Break Even tells you at what point your bottom line will be zero—not making or losing money–just hanging in there.
Ratio Analysis tells you how healthy your business is and how you compare to other similar businesses in your industry.
Since we opened this discussion with reference to “health,” we’ll use the healthcare industry as an analogy. For example, if you compare financial management to the medical profession, it becomes pretty familiar and easy to understand. You go to the doctor for a check-up and there are a battery of tests and analyses that will help evaluate your general condition. First, how is your health right now–weight, blood pressure, cholesterol, aches, pains, other problems. This is similar to the P&L Statement for business (how are you doing in this current period). Next, how does your current health condition compare to your health history–are you gaining or losing weight, is your blood pressure higher or lower than usual, is your cholesterol still in the safe range, are you experiencing more or fewer aches & pains, etc. Overall, are things getting better, staying the same, or getting worse–this is comparable to the Balance Sheet for business (how are you doing as compared to how you have been doing).
Covering all 5 of these Financial Management tools in one setting may seem overwhelming, so for today we’ll focus on the P&L–we’ll deal with the other four separately in future posts. I’ll get you started, and then you can take it from there.
The basic P&L will look something like this:
Less: Cost of Sales
Less: Operating Expenses
Net Profit (before taxes)
The overarching goal of your business should be to make enough Sales that generate enough Gross Profit to pay for all Operating Expenses, leaving you with sufficient Net Profit to pay your taxes and live the life that you desire.
First, look at your P&L for at least a year–even better for the last three years–and start with the bottom line: Net Profit.
These are the types of questions you need to consider: is your bottom line positive or negative? Are you making money every month throughout the year? Does your Net Profit increase or decrease during certain months? If you have three years of P&L Statements to look over, do you see trends that have developed, and if so, are they consistent over these years? Are you making more money during the summer or winter? Is there a peak or slump during holidays? Look for any and all trends/patterns and make note of these to review later.
Next, look at your Sales. Can you see any trends/patterns, and if so, how do they relate to your Net Profit trends/patterns? Are you selling more during certain months of the year? Are you selling the same stuff throughout the year, or do you have multiple products/services that you offer for different periods or seasons of the year? For example, if you are in the sporting goods industry, you may carry bicycles and skis/snowboards, which are seasonal items, but if you are offering web design, the market may be pretty consistent throughout the year.
Now take a close look at Cost of Sales and Gross Profit.
Cost of Sales (also referred to as Cost of Goods Sold), includes all the costs directly related to producing and selling the products/services that you offer–these are “variable” costs, meaning that they change in relation to changes in the amount of your Sales. The best way to determine if a cost should be included in Cost of Sales is to ask the following: if Sales increase or decrease, will this particular Cost increase/decrease? If the answer is YES, then assign this particular cost to Cost of Sales. If the answer is NO, then put this cost into Operating Expenses (or “fixed” costs/expenses). You don’t have to get this perfectly right–just do the best you can. With practice you will get better and better, and you can always ask your accountant for help if you get stuck.
Gross Profit is the amount that you have left after subtracting your Cost of Sales from your Sales. The numbers (or amounts) for Gross Profit and Cost of Sales are important, but the percentages will enable you to analyze your situation and easily work through different scenarios for making changes to improve your business and profitability.
Here is the simple math to convert dollar amounts into percentages for each:
Cost of Sales (%):
Cost of Sales (in dollars) divided by Sales (in dollars) = Cost of Sales (%)
Example: Sales = $100,000 and Cost of Sales = $40,000
$40,000 divided by $100,000 = 40% (Cost of Sales)
Gross Profit (%) (also called Gross Profit Margin or Gross Margin, but we’re just going to use the term Gross Profit (%) for now):
Example: Sales = $100,000 and Cost of Sales = $40,000
$100,000 minus $40,000 = $60,000 (Gross Profit)
Gross Profit (in dollars) divided by Sales (in dollars) = Gross Profit (%)
So: $60,000 divided by $100,000 = 60% (Gross Profit)
Now review your Gross Profit (%) over the last three years and look for any significant changes–for example, increases or decreases in these percentages. If you sell multiple products and/or services, go through the same process for each product/service individually. Note that while this may sound like a lot of work, it should only take a few minutes, and doing this analysis is crucial for understanding your business at the level of detail that will enable you to make informed decisions that will lead to consistent success and profitability.
Are you making a greater Gross Profit (%) on certain products/services than others? Can you focus on selling more of these (possibly by beginning the selling season earlier and/or extending the selling season for a few weeks or a month)? Are there products/services that you could discontinue (since they are not providing enough gross margin)? Can you charge a little more for some of your products/services? Can you find other suppliers/vendors with better prices/terms? Are there additional products/services that you could offer–possibly with greater Gross Profit (%)? Etc., etc., etc.
To get started, just play around a little to see what happens to your bottom line (Net Profit):
Increase Sales by 20%, but don’t change your Gross Profit (%).
Increase Sales by 20%, and increase your Gross Profit (%) by 10%.
Increase some of your product/service Sales.
Decrease Cost of Sales for some of your products/services.
Don’t worry about how realistic these changes might be at first, just get familiar with how to use these tools. Then you can start seriously analyzing your options and make some decisions and changes that will start moving you closer to your desired goals.
Finally, let’s take a look at your Operating Expenses. These are the fixed costs/expenses (more or less) of running your business month in and month out. Again, your goal is to generate enough Gross Profit to pay all of your Operating Expenses and have enough Net Profit that makes it worth being in business.
Operating Expenses include all the recurring costs of doing business that are not included in your Cost of Sales. Common operating expenses include salaries/wages and related benefits and payroll taxes, rent, utilities, interest expense, insurance, office supplies, travel, etc. As with your variable costs in Cost of Sales, you don’t have to get Operating Costs perfectly right at the beginning, just do your best for now–you will master these things with practice.
Review your Operating Expenses periodically and for each category, and ask yourself if this expense is necessary, reasonable, in line with your other costs of doing business, or is there a better, more efficient alternative. You want to be on the lean side with Operating Expenses, but not too lean to support Sales and Growth. We’ll look more closely at this and determine what range should be good for you when we talk about Ratio Analysis in subsequent discussions.
So, in conclusion, the P&L Statement is a good first stop when reviewing and analyzing your financials. Take a very close look to get a strong and intimate understanding of what’s actually going on in your business under the hood. Then, make changes as needed to steer your business in the right direction.
Very few small business owners are highly motivated to spend time with their financials–their primary focus is usually on getting customers, keeping customers satisfied, making sure that products/services are high quality, etc. Financials are something that the accountant handles.
My advice: It is OK to let your accountant put your business financials together, but you need to understand your financials inside, outside, and upside down. Again, it is not difficult. And from helping thousands of clients over the years to understand and manage their financials, I can tell you that once you learn how to work with your business financials, you will be hooked!
I recommend that you mark your calendar and invest an hour a month (to start with) reviewing and analyzing your financials. After you have this habit established, you can decide if you need a little more time, but don’t spend more than a couple of hours a month on your financials–get in, figure out what’s going on and make course corrections as needed, and then get out and start implementing the changes that you need to keep improving the health of your business.
We’ll look at the Balance Sheet in my next post. Stay tuned–it will be a breeze.