12. Mini-Series: Demystifying Your Financial Statements - P&L
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Welcome back to The Accounting Edit Podcast.
My name is Leah McCool with Orca Accounting.
And I'm Aminder Mann with Sequoia CPA.
Today, we are diving into another little mini-series that is purely going to be focused on demystifying financial statements.
So today, we are going to be demystifying your P&L, or your Profit and Loss Statement, also known as the Income Statement.
So we are going to dive into this and really just kind of try and give an overview of what is a Profit and Loss Statement, why business owners should care, key things to look at, and then also common mistakes that you might make when looking at your Profit and Loss, or just anything that you might be doing with regards to what should be on your Profit and Loss, and maybe you're just doing it incorrectly.
So to start off, what is a Profit and Loss?
How would you define a Profit and Loss, Aminder?
And what are some little fun facts about time frame and why it matters?
Yeah, so I think in simple terms, it's a report that you're gonna use to look at what you earned in your business, what you spent in your business, and then what's left over at the end of the day being your Profit at the bottom.
Usually for a time frame, you're looking at it on a monthly basis.
That's how we do it for our clients.
We prepare monthly financial statements, or on a yearly basis, some folks like to look at it at year end, and that's what's used for taxes as well, to look at what was your net Profit at year end.
And P&L is used by your tax preparer to be able to do your taxes as well.
So really, it's like a report card, you could think, or a score card, where revenue is the points you earn, and the expenses are all the fouls or penalties you may take, and then the Profit is where you win or lose the game, depending on if you had a net Profit or you had a net loss.
So that's kind of the way to look at it, and it matters because you want to really look at how your business is doing.
You don't want to just go in guessing.
And so for service-based business owners, I think it's really important that they look at their Profit and Loss Statement on a timely manner, if it's monthly, quarterly, annually, so you know how your business is performing.
And Leah, why should service-based owners really care about their Profit and Loss?
Like, why would someone want to look at this?
Yeah, so I think that really what I would tell someone, if they have never looked at their Profit and Loss in a way where it's actually helping them, it's going to give you confidence in where you are performing well and where you are performing maybe not so well.
And you can really have that confidence of, do you have the margins to be able to hire another team member?
Do you have the money to be able to invest in a website?
And there's definitely something where you can see where in terms of ratios, in terms of your bottom line, in terms of your growth of revenue, it's going to give you that confidence to be able to understand how you are actually performing.
Another way that I think that you should use it is, you can actually see when you are overspending in a certain area of your Profit and Loss.
And an example might be that you are paying for multiple subscriptions to one service, or maybe you are paying more in rent than your business can sustainably grow with.
And so that's something that you are really seeing, okay, compared to how much I'm making, here's what my layout of expenses are, and is this actually draining my business of capital?
Is it really just starving the business and allowing it to not grow?
Other areas include pricing checks.
If you are charging, and this kind of goes into what we'll talk about in a little bit, which is pricing per client or just evaluating how profitable you are per product line or service type.
If you're charging $100 for a service, but then time and materials cost $70 or $80 or $90, then that's, you're really only taking home $10, $20, $30 at the end of the day.
So it gives you that insight into where are my margins performing well, and then where are they actually too small to be actually doing anything productive for my business.
So I definitely think that in the whole picture of this, that all shows internally what you might use, but then externally, bankers and investors and other people that are interested in your financials, they're going to take a look at your profit and loss and see is this sustainable growth.
They're going to be taking everything that you are internally evaluating and actually making their own opinion about it and saying, can you know, should we invest in you?
Should we continue to lend you money based on how you're performing because of that scorecard?
How well are you doing?
Do we want to continue with that?
Yeah, I think those are really good points you highlighted there, Leah.
And just taking a deep dive into the P&L itself, we can start breaking down, what are the key things to look at?
I think the top line that most business owners are familiar with is the revenue, which is the sales or the income that comes in.
And this is all the money that you're getting from your clients.
So this is any sales that you're making.
This is going to be the gross amount that comes into your business.
And it helps you kind of see the patterns of how your business is performing.
If you have seasonality, do you have a busy season?
Or do you have a slow season?
And you kind of look at the patterns year over year, month over month, to be able to see and plan for different types of expenses.
So if you know that you're going to have a slow winter, you can kind of ease up on some of your expenses, pull back so that you can have a better margin to be able to pay yourself through those months or to have enough cash flow to cover that period of time.
So it's really important to understand the seasonality of your revenue.
If you're growing over time, is your revenue increasing month over month?
And a ratio to really look at here is how much revenue are you getting per client or per project?
And so this is really taking your total revenue and dividing it by the number of clients.
So for example, if you had 10 clients and you bring in $10,000, that's $1,000 per client.
And if you're serving them and the cost related to that is $900, you're actually going to be underpriced.
So being able to break down your revenue in a way that you can see it in relation to your expenses is also important.
So you see if your pricing is in line with what it costs to run your business.
And then the next area, Leah, is the cost of sales.
Where, what would a business owner be looking at when they're looking at their cost of sales?
Yeah, so really what cost of sales is, is your expenses that are directly tied to what it costs to deliver your service.
Examples of that is any sort of contractors that you have to pay when it comes to delivering your service, any supplies that you have to use in order to produce whatever service that you're doing.
And so that's definitely something where after reducing that from your revenue, then you get what is your gross margin, which is just your revenue minus the cost to produce the service that you are providing.
And that gives you a little bit more insight into actually not what your top line revenue is, but what it costs to, or at least what at a service based level, it will cost you to just earn what you're being paid to do.
So this is definitely telling you, okay, at the end of, you know, after you have your top line revenue, then you have your cost of sales, you get your gross margin, then you reduce that by your operating expenses, and after that, then you have your bottom line revenue.
And that is called net income, net profit, and is showing you what is left after everything.
If it's negative, then that means that you're actually at a loss and you're spending more than you're earning.
But if you have a profit, then that means that you still have profit to, you have extra money left over at the end of what it takes to run your business in a given time period, whether that's monthly, yearly, whatever.
And so it shows you how much realistically did my business make from this time period.
How can that be reinvested into my business?
And this matters because it shows you, am I just breaking even if I'm earning zero at the end of the day?
Am I losing money by running my business?
Or am I actually earning it?
And that ultimately will kind of help guide you in whatever decisions you need to make based on a certain time period.
This all to say, though, that if you're looking at a month, that's not necessarily going to tell you the whole picture.
How does that compare to the last three months?
How does that compare to the last year?
Are there factors that are from seasonality or external things that are affecting this?
And so it's definitely just something to keep in mind as you're looking at a period of performance, as you are evaluating your profit and loss.
Yeah.
No, that's a great point, Leah, that it's not just about looking at the bottom line at a certain point in time.
Yes, it gives you that information, but it's really looking at the trend over a period of time.
That's what kind of gives you those insights to be able to drive a lot of those decisions that you want to make in your business.
And now some common mistakes owners make from looking at their P&L, one can be that they're only looking at their bank balance and not their P&L.
So a lot of times business owners might say, well, I have X amount of sales this month, or I had X amount of revenue this month, why is my bank balance still showing so low?
And that's because they're not taking into consideration the expenses that are hitting their business.
And so if you have high expenses, you may not be as profitable.
And the profit, the net profit is what would roll back into your bank account at the end of the day.
So if you're not looking at your P&L and understanding those expenses, not just the revenue, you could be missing that key piece.
And another one is really separating business from personal.
So a lot of times when business owners do start their business, it's hard to separate different credit cards, bank accounts.
But this is where it's key to start understanding that business expenses should just be on the business side so that your P&L is as clean as possible.
You're not bringing in miscellaneous personal charges that could be throwing off the balance or your expenses.
And so you're getting a clear picture.
So this is why it's really important to separate out business from personal.
And it also allows you to look at the transactions that do come in.
So what we do as accountants is we really look at the classification of all the expenses that are coming in, in your bank account, through your credit card each month.
And part of the review process is to be able to see, are there any items that are misclassified?
Did you put something under a general expense and it should have actually been a cost of sales?
If you're using supplies for your cleaning company and it's related to your direct sale, it should be going under your cost of sales to show you that gross margin rather than putting it as a office supply, which would then be an overhead cost.
So looking at those types of expenses, drilling down and asking the right questions will allow you to see all your ratios more accurately.
And ignoring these...
And another piece is also ignoring trends.
So if you're only looking again, Leah, like you mentioned, at one month in isolation, you're not really seeing the full picture of your business because if you have a slower month and another month that picks up, you may not be seeing the trend of maybe there's seasonality, maybe there's external factors like tariffs kicking into place.
Maybe you need to adjust your pricing based off of those tariffs.
If you're not asking those questions, if you're not reviewing the data, you are not able to make those types of adjustments.
And then another piece is really looking at owner's pay.
A lot of time, you look at the P&L, you look at the net profit and you say, okay, I made X amount this month.
But if you're not looking at it in terms of how much of this am I putting back into my business and how much am I actually going to be taking a distribution or draw on and take home, you're not looking at the net profit just as a isolated amount.
It's not just the total that the business uses, also how much you're taking home as well.
So it's really important to review these things regularly and not wait till tax time.
But are there other mistakes, Leah, that you normally look at on the P&L for your clients?
What does your review process look at on a monthly, quarterly or year end basis?
I think that maybe one of the largest mistakes that I see is people, and maybe it's not even a mistake that they're making actively while recording it themselves, but it's just confusion as to where their actual pay is coming from if they're taking draws or distributions like you said.
And I think that oftentimes they're like, I took this much home, but why is it not showing up on the profit and loss?
Like, is it an expense of the business?
And that's always a conversation where it's, you just have to say that's not an expense, unless if you're running payroll, then that's where those wages would show up.
But any sort of draws or distributions are going to show up on your balance sheet.
And so it's not going to show up anywhere on your profit and loss.
And so that kind of helps guide at least a conversation of, you know, this is what the actual profit and loss is covering.
And maybe this is an area where this is not going to be on the profit and loss.
It's going to be a balance sheet item.
And I would say that really a big one in terms of the profit and loss that I would say that you briefly talked about is not separating business from personal, or at least covering personal items also on your like, or covering business items on your personal cards.
So I have one client who she just hadn't shifted everything over, and there was just so many subscriptions that were on her personal that were being used for business purposes.
And she was going to miss all those deductions.
And it was something where we just had to align and have that conversation of how do we get those, how do we get clarity, how do we get the documentation on those to be able to move them on to her profit and loss.
And ultimately, it was just through a journal entry that we did it, and it was nice and clean and easy.
But it is definitely something where it takes that conversation of that wouldn't happen unless we had talked about it and figured out how to make that work.
And so definitely something that is something where I always advise clients on getting everything on business cards or accounts sooner rather than later, because it really is at the end of the day is going to be where those deductions show up and something where you just want to make sure that you're getting those rights so that when you do file your taxes, then you're getting an accurate picture of what you are actually paying and what's owed.
So yeah, I would say that those are some common mistakes that I see.
Yeah, so true.
I think on the deduction side, if you're not recording it, it's not going to be taken into consideration when it comes to tax time.
So a really good call out there, Leah.
Yeah, yeah, ultimately.
And a lot of times people are, if they're running their own business, then there's a certain point where they start to really lock into, okay, this is what my gross margin is.
And I love when business owners really care about the specifics of everything that we talked about above the bottom line net income.
But there definitely is a learning curve there.
And I think that more experienced business owners, maybe they've been in business for longer, or ones who have just started out with more capital in the beginning, and they have very specific goals for growth.
That's something where I find that they are very excited about that.
And so that's an area where I love to talk to them, because it becomes less about deductions and more about, okay, how do we make this grow?
How do we optimize our business for efficiency and profit and everything?
So definitely something where it's fun to talk.
I love the profit and loss, but it's definitely something where there's a learning curve.
So if some of this stuff is overwhelming to you, then that's okay.
But definitely something that we hope to continue to talk about in a growth mindset sort of way and also touching on deductions and saving at tax time.
Yeah.
And I think it's really important you touched on, Leah, that each P&L is different based on each business owner's different growth trajectory, and each one tells a different story.
And the role we take is really being able to become those storytellers, reinterpret a lot of that data and be able to provide those insights to our clients.
So I think it's really important to understand that your P&L isn't just for tax time.
It's your roadmap for your entire business throughout the year.
So to look at it regularly, pull it up, look at it, and you want to make sure you're looking at sales, you want to look at your expenses, your net profit.
And if it's something you need support with, this is something that Leah and I definitely help support business owners with, not only with just bookkeeping, but on the advisory side, providing that clarity for our clients.
So we're really excited to be working on sharing this mini series.
I know Leah, this is our first one on the P&L, but next time we'll be back with the balance sheet, so we can look at what you own versus what you owe.
And so we're super excited to share that with you next week.
Yes, absolutely.
We're gonna be diving into the balance sheet, like you said, and then the cash flow statement after that.
And so definitely stay tuned, because we are gonna be diving a lot deeper on these statements like we did today.
So thank you so much for listening, and we will see you all next time.
You've been listening to The Accounting Edit, a podcast by Aminder Mann of Sequoia CPA and Leah McCool of Orca Accounting.
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We would love to help you.
You can find Aminder at sequoia.cpa.com or on Instagram at Sequoia CPA.
You can find me, Leah, at orcaaccounting.com or on Instagram at Orca Accounting.
We'll be posting new episodes every other week, so be sure to follow so you don't miss out.
Summary
In this episode, Leah and Aminder dive deep into the significance of Profit and Loss (P&L) statements for business owners. They discuss what a P&L statement is, why it matters, and how to effectively analyze it to make informed business decisions. The conversation covers key components such as revenue, gross margin, and net income, as well as common mistakes that business owners make when reviewing their P&L. The episode concludes with a focus on the importance of understanding financial statements for business growth and future discussions on related topics.
Takeaways
• A profit and loss statement is essential for understanding business performance.
• P&L statements help identify areas of strength and weakness in a business.
• Regularly reviewing your P&L can provide insights into spending and profitability.
• Understanding gross margin is crucial for pricing strategies.
• Common mistakes include not separating personal and business expenses.
• Trends over time are more important than isolated monthly data.
• P&L statements are not just for tax time; they inform business decisions year-round.
• Business owners should be aware of their revenue per client to ensure profitability.
• Effective financial analysis can lead to better investment and growth opportunities.
• The P&L statement is a storytelling tool for business performance.
Thanks for listening!
— Leah & Aminder
Contact
Website: TheAccountingEdit.com
Leah’s Links:
Website: orca-accounting.com
Instagram: @orcaaccounting
LinkedIn: linkedin.com/in/leahmccool
Aminder's Links:
Website: sequoia-cpa.com
Instagram: @sequoiacpa
LinkedIn: linkedin.com/company/sequoia-cpa
