If you’ve run a business, you know the importance of a P&L. If you ever want to run a business, a P&L something you desperately need to understand. A Profit and Loss Statement, or P&L, is one of the most important documents a business uses to operate. The name says it all. This document gives the CEO, owner, board members and CFO information about the company’s ability to turn a profit.
If you ever want to run a business, a P&L is something you desperately need to understand."
Some common names for this financial document include: income statement, profit & loss statement, income & expense statement, financial operations statement, and statement of financial results. They all mean the same thing. This statement tells how profitable a company is.
For this blog post, I’m going to use an example of a peanut butter & jelly sandwich manufacturer. Their name is PB&J Inc.
How to Read it
First is the Revenue or the Top Line. This is the Gross Sales line. If PB&J Inc. sells 100 sandwiches for $2.00 each, their Top Line is $200. Most companies sell more than 1 product. The total sales for all products combined would go into the top line revenue. This number is your total sales.
Everything else on the P&L is subtracted from the Gross Revenue/Top Line.
Next is your cost of goods sold or COGS. These are materials making up the actual product. PB&J uses four materials in their product. Peanut Butter, which they buy for $0.25. Jelly, which they buy for $0.25. Bread, which they buy for $0.10. Plastic Wrap which they buy for $0.05. The total cost of goods sold is $0.65.
Next, some companies will create a ‘net revenue’ line. Gross Revenue minus Cost of Goods Sold. In this case, the Net Revenue would be $2.00 - $0.65. $1.35 per sandwich or $135 on the 100 sandwiches sold.
The next piece of the P&L is the operating expense. These are the things your company uses to run. Some companies break these expenses into multiple sub-categories. For example, if your company has employees, you could have a ‘Labor’ section. This section would include salaries/wages, benefits, worker’s compensation taxes, FICA taxes, etc.
Some other categories could be:
‘Manufacturing’ and for PB&J they might include equipment to make the sandwiches- utensils, space (building rental), utilities, and other manufacturing expenses.
‘Distribution’ which could include any transportation expenses to get the sandwiches to the retailer which could include the payments on a truck, the fuel, and any outsourcing you might do (hired driver, etc.).
‘Marketing’ or ‘Sales Expenses’ could be another section of the expense group. This could be anything from a TV Commercial to a yard sign. It could also include any social media advertising, a website, local newspaper advertisements, or the cost of creating those ads.
‘Travel’ is another large expense, particularly if you are running a small business as the CEO. All of your business travel should be reimbursed by the company to your personal account.
Side note on expensing business travel in a small business. If you travel for your business you should submit receipts to your business for reimbursement. The company paying you for travel is not taxable income if you use your own vehicles. Additionally, your business gets to use it as an expense which reduces the business’s taxable income. We’ll get to that in a minute. Hit me up if you have more questions at email@example.com or on twitter @JeffLeonard12
To recap, we’ve got Gross Revenue of $200. We’ve got COGS of $65. Let’s assume we’ve got operating expenses of $75. Which brings our Operating Income to $60 ($200 - $65 - $75 = $60).
This Operating Income is also known as your Earnings before Interest and Taxes (EBIT). If you have any financial expenses such as interest on debts, depreciation of assets, or insurance, you should list it after the operating income line.
Taxes, Insurance, Depreciation, Net Profit
Next should be your taxes. If you’re paying monthly sales taxes or property taxes you’ll have regular hits here, if you’re only paying quarterly or annual corporate taxes you will hit this line less frequently. However, you can accrue for those expenses monthly so that you don’t forget about them when they hit and destroy those months’ P&L.
Let’s say you’re paying $15 per month in interest and insurance and you’ve got depreciation on assets of $10 for a total of $25.
Now, let’s assume the government is taking 15% in taxes. Here’s the math: $200 Gross Profit - $65 COGS - $75 Operating Expenses - $25 in Financial Expenses = $35 of taxable income. 15% tax is $5.25 in taxes. This leaves you with $29.75.
So, after selling $200 worth of sandwiches, you’re left with a Profit of $29.50 or ~15%.
How to Value it
If you’re going to value a business, you’ll want to see the P&L. You’d want to value the business if you were going to buy it, invest in it, or sell it. Most companies will value themselves based on the annual EBIT. In our example, the EBIT is $60. Depending on the type of company, most will value at 2x the EBIT or up to 4.5x the EBIT. So PB&J Inc. would be valued between $120 (2 x 60) and $270 (4.5 x 60).
Some other factors into the value of the company include:
Customer Diversification - If one customer makes up more than 10% of your base, the value could be reduced. If PB&J has one customer buying 12 of the 100 sandwiches sold, it could see a lower value (still at least 2x your EBIT – closer to $120).
Pending legal action - If you’re being sued for any reason, the value of your company could be reduced. If a competitor is saying you stole their recipe, you could see a lower value (possibly lower than 2x your EBIT).
Product Diversification - If none of your products make up more than 20% of your sales, the value of your company could increase. If PB&J has 8 different jellies and peanut butter selections, and each accounts for 10-15% of sales; then they would see a better value because they can reach a broader customer base (maybe 3x EBIT or $180).
Product life cycle - If your product is early in its life or has “staying power” the value of your company could increase. PB&J is never going out of style, it’s got staying power. If your company produced vinyl records, you could see a reduction in value. If your company produced jet packs, you could see an increase in value.
How to Use it
You’ll also want to use the P&L as the CEO to make decisions. I worked with a business coach a while back. The first thing she tells clients to do is raise their prices. If nothing else changed, but PB&J raised the price to $2.50 per sandwich. The Operating Income (EBIT) would be $110 instead of $60. The net profit would be $72.25 instead of $29.75. An increased profit of $42.50 is quite a jump. Increasing the price by 25% gains a net profit increase of 142%
I don’t highly recommend this strategy unless you know your customers will continue to buy 100 sandwiches. If you raise the price to $2.50 and lose 15 customers in the process, you’ll still end up ahead. But, you will alienate some customers. Net profit would be $40 if you increase to $2.50 and lose 15 customers. Still better than $29.75. Net profit increase of 35%
The next thing I’d do with this P&L is review the COGS. Peanut Butter alone is 18% of the expenses (Expenses are COGS + Operating Expenses). Jelly is also 18%. If you could reduce those prices by 5% each you would increase the Operating Income by $15 (25%). Net Profit would increase to $42.50 which is a Net Profit increase of 43%.
The final step is to review the Operating Expenses.
Labor is 33% of the OpEx. Can overtime hours be reduced? Can headcount be reduced? Doing those things will help reduce the labor expenses.
Manufacturing is 24% of the OpEx. Can the building’s rent be renegotiated? Can cheaper supplies, like knives for spreading jelly, be found? Can knives be re-used instead of discarded after each use; thus, reducing the quantity ordered?
As a good owner, manager, CEO or CFO of your business, review the P&L on a monthly basis. Look for expense reduction opportunities. Look for ways to reduce COGS. Even if the company is making a healthy profit (like PB&J Inc.), review and find ways to improve. In a bind, test out some pricing adjustments and see if you can get a better result.
If you made it this far, I appreciate you. Let me know what you think in the comments or shoot me an email at firstname.lastname@example.org