The Profit and Loss statement is one of the essential financial statements used by investors, accountants, and business owners (the other essential financial statements being the Balance Sheet and Cash Flow Statement). It is used to analyze how profitable a business was during a specific time interval. The Profit and Loss statement is sometimes referred to as the income statement, P&L, statement of income and expenses, or the statement of operations.
The Profit and Loss statement is the most important report for business owners, analysts, investors or potential investors for two main reasons:
- The Profit and Loss statement shows a business’ operating profitability; and
- It serves as a valuable guide in anticipating how a business may perform in the future.
The Profit and Loss statement is based on a fundamental accounting equation (Income – Expenses = Profit) and is designed to show the profitability of a business during a specific period of time. Profitability is not to be confused with Cash, and the Profit and Loss statement is not to be confused with the Cash Flow Statement. This is because the Profit and Loss statement does not show cash receipts nor does it show cash disbursements (money in or money out). Please see Cash Flow vs. Profit under Cash Flow Management for an example that explains this better.
For Business Owners and Managers
Profitability is the primary goal of all businesses. Increasing profitability is one of the most important tasks of business owners and managers. As a result, it is important for business owners and managers to think of the Profit and Loss statement as a progress report for their business. By doing so, business owners can make critical business decisions and track the results of their decisions.
EXAMPLE:
Misty owns a boutique, retail store. She is presented with a unique advertising campaign by a local marketing firm. The advertising campaign will cost her $10,000 and will be directly focused at her ideal target market. Misty thinks this advertising campaign will be great for her business, but she wants her accountant to look it over first.
Her accountant, Lynea Paradis, looks at Misty’s Profit and Loss statement and determines her Advertising to Sales ratio is slightly lower than that of similar retail stores. Lynea also prepares a Profit and Loss Forecast that includes the cost of the advertising campaign as well as a Cash Flow Forecast and determines that as long as the advertising campaign increases weekly sales by 3%, Misty will recoup her $10,000 investment in 6 months. Misty and her accountant thus determine that this is a solid investment in her business. Misty can now review her sales growth weekly to ensure she made the right decision.
As you can see, measuring profitability and projecting future profitability is critical to the success of any business. By evaluating the Profit and Loss statement, Misty’s accountant was able to determine that the advertising campaign made financial sense.
The Profit and Loss statement can be analyzed in a couple of ways:
Comparing Profit and Loss statements over a number of periods reveals trends in profitability to help identify a business’ strengths as well as emerging problems.
Financial Ratios created from the Profit and Loss statement can be compared to industry benchmarks to help evaluate a business’ performance and efficiency relative to similar businesses.
For Lenders and Investors
A business’ ability to operate profitably is crucial. A business that operates profitably (their bottom line indicates net income) has demonstrated its ability to use borrowed/invested funds successfully. As a result, lenders and investors are more willing to loan or invest more funds to the business. On the other hand, a business that does not operate profitably (their bottom line indicates a net loss) has demonstrated an inability to use borrowed/invested funds successfully. Therefore, lenders and investors would be more hesitant to loan or invest any more funds to the business.