Typically the Profit and Loss account (now more correctly called a Statement of Financial Performance) is one of the easier – if not the easiest – financial document to understand by small business owners. It’s typically presented in two parts.
The top half of the statement states the different forms of income received by the business for the period stated by the report, such as a quarter, half year or full financial year. After subtracting the cost of producing your goods or services, it shows your gross profit figure.
The bottom half of the account lists all the relatively fixed running costs (expenses) such as rent, power and communication costs you need to pay each month regardless of the sales obtained. When these costs are subtracted from the gross profit the result is a net profit figure (before tax).
More can be learned from the Profit and Loss account, often in conjunction with two key performance indicators (KPI's), thus allowing you to know the following:
How well is the business performing?
Gross Profit Margin: the gross profit expressed as a percentage of sales.
To work this out (if your accounting software doesn’t do this automatically), you divide the gross profit figure by the sales total and multiply by 100 to get the percentage.
Here’s an example:
Gross profit: $80,000
Sales: $400,000
GP %: 80,000 divided by 400,000 = 0.2 x 100 = 20%
By converting the GPM to a percentage you can easily compare this result with previous margins, not taking into account fluctuating costs or sales levels. If it has improved or not, you are able to see what changes may've had the effect. For example, has there been an increase in the cost of materials or production labour?
Your GPM can also be compared to similar businesses now that the result is a percentage as this overcomes any differences in size. It doesn't matter if they are a smaller or much larger businesses, it’s the gross profit percentage margin that tells the performance story.
Your overall aim should be to at least equal to the industry average, and preferably do even better. You can also aim to improve on your gross profit margin results from previous results.
How profitable is your business?
Net Profit Margin: reveals how profitable your business is when your overhead costs are deducted from the gross profit.
It’s worked out using a similar formula. For example:
Net profit: $50,000
Sales: 300,000
NP %: 50,000 divided by 300,000 = 0.166 x 100 = 17%
This KPI allows you to identify negative trends before they become something potentially worse. If your NPM has fallen, you need to investigate the cause. For example, you may find your marketing costs have skyrocketed but there was no result in sales. Therefore, the lesson here would be to look at your marketing and advertising to see what is actually working, so you can drop any unproductive tactics.
Three tips
- Use your gross profit and net profit margins as benchmarks for future improvement. Try to improve both on internal benchmarks (your performance against previous results) and external benchmarks (the industry average).
- Don’t rely on just an annual profit and loss account. You need more up-to-date and frequent figures. Use your accounting software to generate more frequent profit and loss accounts, such as monthly or quarterly statements. These enable you to take prompt action to fix any negative trends before they do serious damage to the business in the future.
- Remember you can always get in touch with us to interpret trends in your results in order to take correct action.