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How to Create a Profit & Loss Statement for Small Businesses

Finance
Article
10/04/2019

Are you making or losing money? To know how your business is doing, you need to track your financial progress by reviewing a profit and loss statement. This lets you see whether your business is profitable and growing, or whether it's losing money and needs to make changes.

Here, we'll walk you through how to create a profit and loss statement (P&L) for small businesses, explain how to read a profit and loss statement, and provide a P&L example as an easy-to-follow guide. Familiarizing yourself with these fundamental practices is a crucial step to getting your small business on the path to profitability.

What is a profit and loss statement?

A profit and loss statement details a business's income and expenses over a defined period. The P&L is also referred to as an income statement, statement of profit, statement of operations, and a profit and loss report. Regardless of the term used to describe this financial statement, it is a snapshot of a business's revenue and expenses over a specific period. Typically, a P&L is made at least quarterly and annually, but they can be done more frequently.

Balance sheet vs. profit and loss statement

A P&L is not the only financial statement essential to understanding how your business is performing. Balance sheets are also very important, listing the company's assets and liabilities, as well as the owner's equity, as of a set date (e.g., December 31). The balance sheet shows, among other things, whether a business is too leveraged (i.e., has too much debt). And it's helpful to maintain a cash flow statement, which details the money going in and coming out of the company so that it can be sure there are sufficient funds on hand to pay bills when they come due. Of all these financial statements, however, the P&L is considered to be the most important because it shows the ability of a business to make a profit.

The preparation of the P&L and any other financial statement is fairly straightforward. And if the business has an accounting system, it can track revenues, expenses, assets, and other key numbers as they occur and generate these reports at the touch of a button.

How often are profit and loss statements calculated?

Typically, profit and loss statements are prepared on a monthly, quarterly, or annual basis (quarterly and annual statements are advisable). When applying for a small business loan, companies will often need to produce several years of profit and loss history, if available. Similarly, when a company is seeking investors, or a business owner wants to sell, interested parties want to see P&Ls for a number of years to detect the direction in which the business is moving.

For tax law purposes, there's no requirement to generate and submit a P&L to the IRS. However, the tax return itself is the P&L, reflecting the income and expenses of the company for the year. There are, however, differences between the P&L and the tax return because not all expenses are deductible on the return (e.g., only 50% of business meals are deductible on the tax return, while 100% of these expenses are reductions on the P&L).

How to read a profit and loss statement

Reviewing revenues and expenses by line item and comparing amounts to prior periods helps identify positive or negative trends in the business. To begin, it's important to know the company's accounting method: whether it reports on the cash basis (which generally means income is reported when received and expenses reported when paid) or accrual basis (which generally means income and expenses are reported when all the events needed to fix the amount have occurred with reasonable certainty). The accounting method affects how income and expenses are taken into account on the P&L. Once you know this, you can begin to look at the line-by-line entries on the P&L.

Key components of a profit and loss statement for small businesses

The P&L is comprised of two main parts: the income earned during the period of the statement and the expenses in the same period. These two parts are broken down in the various entries relevant to your business. Not every P&L will have the same lines.

1. Revenue

Revenue is reported first on a profit and loss statement for small businesses and includes all income items. This entry on the P&L may be referred to as sales, gross receipts, fees, or any other term to describe the company's operating revenue. Operating revenue is typically broken out from non-operating sources of income, like interest.

Again, the accounting method affects when revenue is reported on the P&L. When using the accrual method of accounting, revenue is reported when earned, at the time of sale, even if payments have not yet been received. If the cash method is used, revenues will be recorded when payment is received. To increase the accuracy of reported income, gross sales may be adjusted based on past experience of customer returns or refund requests by setting up an allowance and netting it against revenues.

2. Cost of goods sold (COGS)

A company that sells goods must figure the cost of goods sold (COGS). This is essentially the cost of inventory or materials used to create products, which is then subtracted from the sales to determine the actual revenue (gross profit) from the sales. For example, a company that carries a $20 item in inventory and sells it for $100 would have $100 in revenue, but after taking the $20 of COGS into account would report $80 in gross profit.

3. Expenses

The expense portion of a profit and loss statement for small businesses encompasses any expenditure made to operate the business. These can include:

  • Advertising costs
  • Employee salaries, benefits, and payroll taxes
  • Interest expenses
  • Office supplies
  • Payments to vendors or contractors
  • Professional fees for accountants, attorneys, etc.

Accounting for some expenses requires understanding asset depreciation. Some purchases, such as office equipment, must be capitalized as an asset and written off over the useful life of the item. For example, if a $1,000 computer is purchased (and no accelerated write-off is used to account for the purchase for tax purposes), it would be reported over five years. Each year the profit and loss statement reflects 20 percent of the cost for the computer, or $200 in expense.

Non-operating expenses, such as interest and taxes, are often broken out separately from operating expenses for illustrative purposes.

4. Gross profit

Gross profit is the difference between the revenue or gross receipts and the cost of goods sold. If the company is a service business without inventory, then the gross profit and the gross receipts are the same amount.

5. Net profit or loss

After calculating any taxes due and subtracting them from pretax income, the net amount will equal a company's profit or loss for the period. When trying to compare companies in different industries and tax situations, or if exact numbers aren't yet available, net profit or loss is often equated to the earnings before interest, taxes, depreciation, and amortization (EBITDA).

Examples of P&L statement analysis

A quick glance at a P&L shows whether the company is making or losing money. But delving deeper can reveal much more. This is important when creating a comparative income statement, whether comparing a single business's performance over multiple accounting periods or comparing one company's performance to another (something an investor would do).

There are different ways to analyze a P&L:

Horizontal analysis

This type of analysis is also referred to as series analysis. It looks at changes over time within a particular line item. For example, figure the percentage that revenue increases year over year for a five-year period. It helps you see patterns, such as cyclical occurrences. It helps you detect red flags (e.g., that COGS is too high).

Vertical analysis

Vertical analysis, also referred to as common-size analysis, looks at the relative size of expense items to the company's revenue. For example, how much is a company spending on marketing or research relative to its revenue, and how is this trending over time?

How to create a profit and loss statement

Creating a P&L can be as simple as pressing a button if you regularly and accurately record your income and expenses in your accounting system. The accounting system generates your P&L on command. If you want to create a P&L manually, it's a little more complicated and time-consuming. You can use a template, such as the P&L example from the Small Business Administration, to create one. Generally, you will want to do the following:

Gather important information

To create your P&L manually, you need to gather all relevant information. This includes items of income and expenses. This information can be derived from invoices, receipts, credit card statements, and bank account transactions.

Build a profit and loss statement

The basic P&L is a periodic one. Startup businesses that don't have past performance to use in preparing a P&L create a pro forma P&L. Thus, the pro forma P&L is merely a projection of what they expect to earn and to spend, and is needed if a startup is seeking capital via a loan or with investors.

To create a basic P&L manually, take the following steps:

  1. Gather necessary information about revenue and expenses (as noted above).
  2. List your sales. You can break them down into subcategories of sales if necessary or helpful for your business.
  3. List your COGS.
  4. Subtract COGS (Step 3) from gross revenue (Step 2). This is your gross profit.
  5. List your expenses. Create categories for each type of expense. Don't include interest on business debt here; it will be accounted for later on.
  6. Subtract the expenses (Step 5) from your gross profit (Step 4). This is your EBITDA.
  7. List interest on business debt and subtract from EBITDA (Step 6).
  8. List taxes on net income (which usually has to be estimated because a return typically hasn't been filed when a P&L is being prepared) and subtract this from the balance left in Step 7.
  9. List depreciation and amortization and subtract from the balance left in Step 8.

After completing Step 9, you have your P&L.

P&L example

Let's take the case of a part-time home-based specialty cake-maker. His revenue for the year is $5,000. His COGS (flour, eggs, etc.) is $800. His other expenses include boxes for the cakes, car expenses to deliver the cakes, advertising, and insurance. His P&L for the year ending 12/31/XX would be as follows:

Revenue = $5,000

COGS = $800

Gross profit = $4,200

Expenses

Boxes = $100

Car = $400

Advertising = $800

Insurance = $1,200

Total = $2,500

EBIDTA = $1,700

Taxes (no loans or depreciation/amortization of assets) = $375

NET PROFIT = $1,325

You can use this P&L example to see the net profit margin. Divide net profit by revenue. In this example, the net profit margin is 26.5 percent ([$1,325 ÷ $5,000] x 100).

If this baker has a P&L for the prior year, he can compare his business performance to see whether sales are growing year over year, expenses are lower than in previous periods, or there are other changes that indicate he must do things differently.

The bottom line

Small businesses are focused on their bottom line. To make sure you have control over your business finances, maintain and review your P&L. Use expense management tools to improve your P&L and help keep your business on the path to profitability.

Barbara Weltman is a tax and business attorney and the author of J.K. Lasser's Tax Deductions for Small Business as well as 25 other small business books.
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