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Understand Your P & L

Written by: Bill Boyer

Article Overview: While cash flow is the most critical financial measure for small businesses, it is imperative that the P & L us fully understood

Understand Your P & L

You must understand your Profit and Loss. It is imperative to analyze, monitor and manage your cash, but the profit and loss statement must also be analyzed to understand the impact that revenue and expense levels are having on the company results. To over-simplify, profits are a major contributor to cash, and losses use cash.

Most current accounting packages have versatility that allow the statements to be formatted in different ways to facilitate your analysis of the statements. Most profit and loss systems generally present sales and cost of sales to calculate a gross profit or gross margin. The cost of sales is generally the material cost coupled with the cost of preparing or producing your product or service for sale. The cost of sales should fluctuate as your sales fluctuate. The gross margin is generally followed by sales, administrative, and financing costs, which may be fixed, or may change independently of sales . The descriptions and groupings of accounts can be modified to suit your individual business needs, and to give you as much (or as little) detail as you prefer. "Big-picture" statements can help you identify trends; detail statements can help you analyze the reasons for the trends.

The presentation of the numerical results can also be modified. Commonly, the first column lists the actual numerical results for the most recent period. The next column often shows the year to date results. It is also fairly common to have a column next to each set of numerical results that calculate the percent to sales. If not, ask your accountant or bookkeeper to add these. This is a very important tool.

In addition to concentrating on the actual numerical results, analyze using the percent to sales column. Compare the current period percentages to the year to date results. Any percent that is different from the year to date percent should be reviewed to understand the variation. It is also useful to compare the current percentage to the percentage of the prior year total results.

The first element you should review is sales, as that is the basis for the percentage calculations. Be sure you understand why it is changing. This may be simple as it could just be a function of changes in volume. But if your sales mix includes many different categories, it could be pricing variations. For example you could be selling two unique products, one at a much higher selling price than the other. Sales could increase on the higher price one resulting in sales gains for the year, but sales on the lower price item could be decreasing and that may not initially be recognized. And this lower price item could be the most profitable.

The next element you should review is the cost of sales. The reasons for variation from period to period could be complex. Be sure to review with your accountant or bookkeeper the costs that make up this number. This is one category where there seems to be more variation in categorization in accounting. Often it is more than just the cost of the materials from your supplier accumulated in this number. Freight may be a part of the number; in today's economy it is becoming a much more significant item. Maybe freight should be considered individually. You and your accountant will have to make the judgment call on those items.

Normally the next line in the statement is the gross margin or gross profit. It is the calculation of sales minus the cost of sales. This is probably the most difficult to analyze. Have selling prices kept pace with the cost of the product? Have there been changes in the mix of products or services sold? Are you selling more low-margin products and fewer high-margin products?

Finally, review the results on all the other items listed on the profit and loss. It is normal to have variations in costs and percentages from period to period; however, these variations should "smooth out" when looked at over a longer period. If they don't, there may be a trend developing which needs to be investigated.

You must be able to understand why there are changes in these percents in order to take action to manage these costs or take other actions to offset their impact. This is critical for a well run business. But first you must identify what is changing - and you can't do that without an intimate knowledge of your profit and loss statement.

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Article Tags: coaching, consulting, cost of sales, inventory, management, profits, small business



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