Having put time and money in starting a business and building a customer base, you’re ready to sell. One of the prerequisites of selling your business is the preparation of financial statements. Clearly organized and constructed statements help potential buyers decide whether it’s worth investing in your company or not. Plus, they offer a historical snapshot of your financial position over a given period. Of all the financial documents and statements that you need to prepare, the profit and loss statement is perhaps the most important. And this is why: it shows whether your business is profitable and growing, or whether it’s operating at a loss and requires some changes.
Not too familiar with this financial statement? No need to worry. In this post, we break down everything you need to know about a profit and loss statement. By the time you finish reading, you’ll be well on your way to creating one for your own business.
What Is A Profit and Loss Statement?
A profit and loss statement (also referred to as P&L or an income statement) is a financial document that summarizes your expenses, revenue, and net income over a specified period.
Buyers usually demand that businesses share P&L statements for a whole year, but you can also evaluate your profit and loss monthly or at the end of each quarter. The short-term statements tell you whether you need to improve your profits by cutting expenses or increasing revenue. With yearly statements, both you and potential buyers can recognize trends, such as net income being higher in Q4.
A profit and loss statement also comes in handy when applying for a loan or seeking investment. By looking at it, bankers, investors, or potential partners can get an accurate picture of your business’s health, how it’s performing and whether it’s capable of generating profits over the long term. The statement will highlight if any losses are sustainable or likely to cause problems. Put simply, your P&L statement helps lenders and investors determine how likely you are to pay back interest and dividends.
Another advantage of preparing a profit and loss statement is that it reflects the taxes you’ll need to pay to the government. Many entrepreneurs consider tax filing to be a complicated endeavor. Yet if you prepare a profit and loss statement, preparing your tax return could be less stressful.
What Goes into a Profit and Loss Statement?
A typical profit and loss statement has six key components:
- Cost of Goods Sold
- Gross Profit
- Operating Expenses
- Earnings Before Interest and Taxes
- Net Income
Here’s a breakdown of each:
Revenue is the sum of all the money your business generates, primarily through the sale of products or services. It can also be a breakdown of different revenue sources, highlighting the income you receive from advertising, sponsorships, direct sales, etc. Revenue is the first entry you must add on your profit and loss statement. Revenue stats for online businesses are the easiest to obtain. If you have an ecommerce store on Shopify, for instance, you can view sales reports to gather information about your revenue.
2. Cost of Goods Sold (COGS)
The next thing to look at on your profit and loss statement are your cost of goods sold. Your COGS is how much it costs to source the products you sell. Cost of Goods Sold can consist of purchasing, packaging, and shipping costs. If you sell services, COGS will mostly be labor costs, though it can include other expenses, such as marketplace fees. What’s interesting about COGS is that it only accounts for direct costs, i.e., expenses that you can exclusively attribute to the sale of a product or service. You should exclude marketing, rent, internet bill, and all other indirect expenses from your calculation.
3. Gross Profit
Gross Profit is the amount left after you subtract the cost of goods sold from your revenue.
Gross Profit = Revenue – Cost of Goods Sold
By calculating your Gross Profit, you should be able to figure out your Gross Margin, an indicator of competitiveness. Here’s how to calculate it:
Gross Margin = Gross Profit / Revenue
Gross Margin is usually expressed in percentage form. Having a high Gross Margin is crucial for small to medium businesses. A healthy percentage indicates that the business has unique products, good brand loyalty, or other competitive advantages that enable it to operate at a higher margin.
4. Operating Expenses
Operating expenses are costs associated with your day-to-day business operations. The expense items could vary, depending on the type and size of the business you own. For example, many online businesses are run from home, and the owners do not hire employees for the business. That said, this section of your profit and loss statement can still get extensive because of various marketing costs. Make sure to put any advertising expenses under marketing, including the cost you incur in running Facebook and Google ads.
Your operating expenses may also include software and other resources necessary to run your business. Assuming you own and plan to sell a Shopify eCommerce website, one cost is the recurring subscription fees you pay for the apps installed in your Shopify store. Make sure to include this in your profit and loss statement to set realistic expectations on running costs.
Other operating expenses might include your internet bill, license fee, hardware repair cost, and insurance expense.
5. Earnings Before Interest and Taxes (EBIT)
EBIT is the profit your business makes after paying its operating expenses. This includes your income before you deduct your taxes and financing costs. Calculating EBIT helps deliver a more accurate view of your company’s operational performance as it sets aside expenses that don’t result from operations. A high EBIT figure indicates to lenders and investors that you have good baseline strength and the means to cover your business’s debts. And as EBIT eliminates the effects of legal and financing obligations, it gives prospective buyers a clearer and rawer view of your business’ value.
6. Net Income
Net income (or net profit) is the last item on your profit and loss statement. It shows how much money is left after you subtract all your expenses, interests, and taxes from your total revenue. Your net income can be positive or negative based on whether your business spent less or more than it earned. If you’re just starting in business, your P&L statement’s bottom line may show a negative figure. This is normal and is not a cause for concern. Potential buyers know that it can take a while for new businesses to break even and reach a point where they’re earning a net profit consistently.
Net profit could also vary based on the trends from your profit and loss statement – whether there’s an increase/decrease in expenses or an increase/decrease in revenue. Internal factors such as shifts in operating procedures or changes in product suppliers, and external factors such as competition, seasonality, and changing consumer behavior can all bring changes in your net income.
What Doesn’t Appear on a Profit and Loss Statement?
A P&L statement only highlights your costs, expenses, and income. You can’t include your equity, assets, and liabilities on this financial statement. Equity is the value attributable to your business and is the difference between your assets and liabilities. Assets can include things like the purchase of tools, furniture, office supplies, etc. Liabilities are debts that you owe to another company or lending institution. Examples include loans, sales tax payments, credit card payments, etc.
Profit and Loss Statement Example
To help you visualize your P&L statement, we’ve created this profit and loss statement example for a hypothetical business – a Shopify toy store selling fuzzy stuffed animals.
Business Name: Little Cuddle Toys
Period: June 30 2020 – June 30 2021
|Cost of Goods Sold||($50,000)|
|Other Marketing Costs||$7,000|
|Utilities (internet, phone, etc.)||$2,200|
|Shopify software and apps||$70|
|Total Operating Expenses||($25,270)|
|Earnings Before Interest and Taxes||$44,370|
|Taxes (assuming a 13.3% tax rate)||($5,901)|
As you can see, the store has earned a net profit of $38,469 for the year. If this business has a profit and loss account for the prior year, you can compare its figures to see whether the business is stagnant, growing, or declining. For example, if its 2019-2020 P&L statement shows a net income of $25,000, whereas its 2020-2021 P&L statement shows a profit of $38,469, it’s clear that it’s growing. Maybe it spent more on advertising or introduced a new line of products that became an instant hit with consumers.
When making year-over-year comparisons, try to identify the reasons behind the rise or fall in your net income. Ask yourself:
- Did I spend more on advertising, or pick a new marketing strategy for my business?
- Have I changed any supplier? Does the new supplier charge more than the previous one?
- What caused the increase in operating expenses? Does this make sense for my business?
Answer these questions to get a better sense of your profit and loss statement.
Also, consider comparing your P&L statement to a competitor’s. Doing so can help you identify new opportunities to increase revenue and cut costs. For example, another business might be selling products via both online and retail sales channels. Adding the missing channel to your business should help boost sales.
How to Create a Profit and Loss Statement?
The easiest way to create a profit and loss statement is to use online accounting software such as Xero or QuickBooks. Software like this makes it easy to create accurate P&L statements. And you also get to set specific parameters like the date range, whether to exclude an entry, and more. Some accounting software even automates the process of uploading your P&L statements to your sales listings.
For example, Xero offers a dedicated Shopify app that Shopify business owners can use to integrate their orders in Xero’s accounting software, after which they can quickly generate a profit and loss statement. Beyond that, Xero provides an option to export the P&L statement to a website marketplace. Assuming you own a Shopify store yourself and want to sell your business through Exchange, you can use software like Xero to export your P&L statement as a PDF and upload it to the financial documents area of your Exchange listing.
If you prefer doing things manually, you can use a profit and loss template instead of software. Tools like Google Sheets and Excel come with pre-formatted P&L templates. You can also download free templates from Corporate Financial Institute and similar websites. Look for options that are prefilled with formulas so that you just enter your revenue and expenses to calculate your profit and loss.
You can also consult a bookkeeper to help you with managing your income statement. The benefit of doing so is that you avoid the common P&L mistakes that business owners make. For example, some businesses write a manual check and list it as an expense in the profit and loss statement. An error like this could lead a business to under calculate its net income. Posting a check requires a balance sheet entry since it doesn’t affect the bottom line of a company’s profit and loss.
A profit and loss statement is a valuable document for small businesses. A well-organized P&L can help you discover a lot of information about your operations, find opportunities for improvement, and measure your growth over time. As a seller, a P&L statement allows you to counter any buyer’s objections to your business valuation. Rather than providing vague answers to questions about your asking price, consider creating a profit and loss statement to support your demand. Getting the best price for your business is a matter of presenting definitive figures as it is of your revenue model and luck.