Small business owners often overestimate the profitability of their companies, in large part because it's easy to misunderstand the costs the company incurs on a monthly, quarterly, and annual basis.
When you think about it, this makes sense: There are all sorts of metrics and key performance indicators in a business that are tied to revenue, ensuring you have a solid understanding of what is coming in the door. But there are far fewer motivating factors tied to accurately understanding what is going out.
And therein lies the profitability problem: Profitability measures the extent to which a company’s revenues exceed its expenses and costs. If you only have a firm understanding of revenue, you’re missing a key part of the equation.
How can you fill in the gaps? This is where the profit-and-loss (or P&L) statement comes in.
The P&L statement is one of the “big 3” financial documents businesses rely on to generate key financial insights into the state of their ventures. It summarizes revenues, expenses, gains, and losses over a specific period, usually a fiscal quarter or year. It shows the company's net income or loss by subtracting expenses and losses from revenues and gains. It also provides insights into your operational performance and ability to generate consistent earnings over time.
There are two methods of preparing a P&L statement: the cash method and the accrual method.
The profitability of your business matters – and not just when it comes to bragging rights.
Small businesses often face challenges directly related to profitability issues, including limited capital and cash flow, inadequate financial planning, high debt, limited access to funding, and rising operational costs. All these factors affect the money coming in and out of a business and, ultimately, the bottom line.
Here’s a prime example: A company is in growth mode and is adding clients to its roster frequently. More revenue is coming in the door, and there is more work to do. So, the company starts spending liberally, hiring new talent and investing in assets to support the growth of the business. But, in its focus on growth, the company only looks at revenue, not costs. The result: The business is running at a loss, and nothing is being done about it.
Reviewing the P&L statement would shine a light on this issue, giving the business important insight into key areas of concern. As a result, the owner could decide to scale back on certain areas of growth, reduce existing costs, or acquire additional funding. The P&L statement is not about grinding to a halt; it’s about shifting focus to protect the business over the long term.
In addition to that big-picture insight, the P&L statement can also be used to calculate several key metrics that can give you even more detailed information about your operations and your performance, including:
Financial insight lies at the heart of all sound business decision-making. The P&L statement, along with the balance sheet and the cash flow statement, can provide critical information about your business and help you mitigate risk, improve profitability, and cement your long-term sustainability.
At the same time, it’s important to note that the answers don’t always jump off the page. Finding them requires analysis, asking important questions, and thinking critically. The business owner often lacks the time or financial fluency to add this process to what is already a very full plate.
In these cases, incorporating a seasoned financial expert to your team can streamline the financial analysis and set the stage for more strategic business decision-making. That’s what we do at FocusCFO. We have a team of fractional chief financial officers nationwide who can step into your business and provide the strategic financial guidance you need to propel your business forward.
“In understanding your specific profitability patterns, we can help you uncover where you are making money and where you are not,” says Mark Vernallis, a FocusCFO Area President in the Greater Pittsburgh area. “Understanding costs can make a big difference in the way you think about and operate your business, and this is important in growing your business and becoming more profitable.”
Listen to Mark talk more about profit and loss in this short video: