THE NATIONAL BANK OF NEW ZEALAND

Solution Guide
Understanding your Profit and Loss statement

FROM NATIONAL BANK BUSINESS BANKING

June 2004

The Profit and Loss statement offers you an important means of monitoring the progress of your business. Its therefore important that you understand how it works. This guide offers a simple explanation of its structure and how you can use the Profit and Loss statement to better manage your business.

The Profit and Loss (P&L) statement and the Balance Sheet are the major financial documents most familiar to all small business people. Of the two, the Profit and Loss statement is easier to understand because its format is simpler. (The related Solution Guide, Understanding your Balance Sheet should be read in conjunction with this guide.) Purpose of the P & L statement The Profit and Loss statement goes under several different names. It is sometimes referred to as an Income and Expenditure account or (to use the more modern terminology of international accounting) a Statement of Financial Performance. As these names indicate, its main purpose is to list all your income, then all your expenses. The difference between the two represents

either the profit you have made for the period or the loss, allowing you to assess your performance.
How often is it produced?

Every business produces a Profit and Loss statement and a Balance Sheet at least once a year for the purpose of submitting the annual tax return. This is actually its main purpose. The P & L statement typically features two vertical columns of figures: one for the immediate financial year, and one for the previous year. This enables you to compare this years income and expenses with last years. Under manual accounting systems, this yearly P & L statement was the norm for many businesses. But modern accounting software allows you to produce statements at the click of the button. There are good reasons for producing a P & L

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statement more often than once a year. The more frequently you can monitor the progress of your business, the more opportunity you have to take action if you spot trends that need to be corrected. For example, you may notice that certain

expense items have increased significantly since the previous P & L statement. So a quarterly or monthly P & L statement is of more use to you than a yearly account.
Structure of the Profit and Loss account

Heres a typical example:

Acme Furniture Company Ltd Profit & Loss Account: 2003 Tax Year 2003 Sales Less: Cost of Sales Production expenses Postage and packaging Total cost of sales Gross Profit Other income Interest received Gross income Less Expenses Accountancy fees Bad debts Electricity Telephone Vehicle expenses Office expenses Depreciation Shareholders salaries Total Expenses Net Profit (before tax) 1,250 500 1,200 1,450 7,500 12,560 3,245 60,000 $87,705 $67,545 1,190 250 1,180 1,400 4,650 12,200 3,680 55,000 $79,550 $29,915 35,000 3,500 $38,500 $151,500 2,500 1,250 $155,250 25,000 2,000 $27,000 $108,000 570 895 $109,465 $190,000 2002 $135,000

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Note that two lots of expenses are deducted from the income of the business. In broad terms, these two categories are: 1. The direct costs of producing your goods or services. These are categorised as Cost of Sales or Cost of Goods Sold (CoGS). For example, if you make wooden garden furniture, you have to buy in timber, glue, paint, screws, etc. Note that many service businesses (such as a financial consultancy, for example) wont have any Cost of Sales or CoGS, because they sell only time: they dont buy in raw materials to process and sell. 2. The fixed expenses (or overheads) of running your business. These two categories contain totals that are assembled from your financial records. For example, the Office Expenses total might include a variety of expenses such as stationery, tea and coffee, stamps, etc.
Why are these two expense categories separated?

raw materials. Separating out these costs allows you to keep an eye on the ratio between Sales and Cost of Sales. The lower you can keep your Cost of Sales in relation to Sales, the more profitable your business is likely to be. For instance, if the price of timber rises markedly because of shortages in the market, youll notice your Cost of Sales increasing in relation to sales. This should prompt you to take some remedial action such as raising your selling price to compensate for the increased cost of your raw material. The second category of expenses is referred to as Fixed expenses because the expenses represent the relatively fixed costs of running your office and business premises - your overheads. Whether you manufacture one chair or 1,000 chairs, you still have the costs of keeping your business open. You have to pay rent, electricity, telephone and other office overhead costs. Nevertheless you want to keep an eye on your fixed expenses (or office overheads) as a percentage of total sales. For example, if it costs you $20,000 to run your office, and your sales are $200,000, your fixed expenses represent 10% of sales. If you can increase your sales next year to $300,000 but still keep your office expenses at $20,000, your fixed expenses will now be only 6.67% of sales - a more efficient

Separating these two cost categories enables you to monitor the performance of your business more effectively. This is because the first category is variable, the second is fixed. The Cost of Sales is a variable expense because it will vary according to sales. If you sell more chairs, youll need to buy in more

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achievement that will be reflected in your bottom line (your Net Profit figure). Separating out the fixed expenses also allows you quickly to see if there have been any unusual increases. For example, postage costs may have jumped considerably. The comparative figures (this years postage expenses versus last years) give you an opportunity to investigate and remedy any costs getting out of hand.
Categorising expenses

past three months) would only take into account the actual cash transactions into and out of your business. In other words, any income and expenses not yet shown in your bank statements for that three-month period are ignored. (Many businesses prepare their GST returns, for instance, on this cash or payments basis). By contrast, an accrual based report includes:

Creditors that you owe money to, but you havent yet paid. Debtors who owe you money, but havent yet settled the bill.

Sometimes the dividing line between fixed expenses and variable expenses is not absolutely clear. For example, if the monthly power bill shoots up from $200 to $800 because youre running extra shifts to complete some furniture orders, should that increase be shown as a variable cost of sales? Similarly if the (reasonably steady) delivery truck expenses suddenly increases significantly because youre delivering more sold items, under which category should this go? These are judgement calls that you can decide with the help of your accountant. Notes on the Profit and Loss statement
The P & L statement is accrual based

In other words, the Profit and Loss statement includes (for the chosen period):

The total income (whether received or not). The total expenses (whether paid or not).

What the P & L statement leaves out

The Profit and Loss statement doesnt include:

Any personal items. Any capital items. Any loans or repayment of the loan principal (the capital portion of the loan).

The Profit and Loss statement is accrual based, not cash based. Heres a simple explanation of the difference. A cash-based report for a fixed period (for instance, the

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What the P & L statement also includes

Expenses to Sales ratio

The interest on a business loan, since this is an expense item. Depreciation on capital items.

Are your expenses increasing out of proportion to any increase in business? Discover this by dividing your Total Expenses by Annual Sales. For example: Total Expenses: Annual Sales: $87,705 $190,000

Ratios to monitor The whole purpose of financial statements is to help you manage your business more effectively. This is why its important to understand the P & L statement, and to use it in running your business. Here are some of the ratios specific to the Profit and Loss statement that you can usefully monitor:
Gross profit margin

Ratio: 87,705 divided by 190,000 = 0.46 or 46% (i.e., you incurred $46 of expenses for each $100 of sales). You should look at the expense ratio particularly if your net profit is on a downward trend. Always aim to keep your expenses as low as possible and under control in relation to previous years. Even if the business is doing well, a deteriorating expenses ratio can signal that youre letting expenses creep up unnecessarily. In other words, your grip on the reins of the business is slipping. The message is that you can always cut some fat from business expenses, with very pleasing results at your bottom line: your Net profit. Other ratios include Wages to Sales, a ratio that will determine whether wages are increasing or decreasing in proportion to the increase in sales. You can also pick any particular expense that you wish to monitor, such as Advertising to Sales. This ratio would enable you to measure the effectiveness of your promotions. For more help on this topic, ask your Business Banking

This ratio shows whether your average markup is sufficient to cover all expenses and show a profit. Simply divide Gross Profit by Annual Sales and multiply by 100 to get a percentage. For example: Gross profit: Annual Sales: 100 equals 80%. You should aim to achieve at least an equal or higher percentage than similar businesses in your industry. A low margin - especially in relation to industry norms could indicate you are under-pricing. A high margin could indicate over-pricing if business is slow and profits are weak. $151,500 $190,000

Ratio: $151,500 divided by $190,000 = 0.8 x

THE NATIONAL BANK OF NEW ZEALAND, PART OF THE ANZ NATIONAL BANK LIMITED

Manager for the Solution Guide: Checking the health of your business which deals with financial ratios in more depth. Resources Related Solution Guides include: Checking the health of your business

Depreciation made simple Developing excellent business systems Pricing strategy made easy Tax made simple Understanding working capital Understanding your Balance Sheet

Further information:

To talk to someone about your business banking needs call 0800 16 88 88 and we will put you in touch with the Business Banking Manager nearest you or visit www.nationalbank.co.nz/business

DISCLAIMER: THIS MATERIAL IS PROVIDED AS A COMPLIMENTARY SERVICE OF THE NATIONAL BANK OF NEW ZEALAND, PART OF ANZ NATIONAL BANK LIMITED ("BANK"). IT IS PREPARED BASED ON INFORMATION AND SOURCES THE BANK BELIEVES TO BE RELIABLE. ITS CONTENT IS FOR INFORMATION ONLY, IS SUBJECT TO CHANGE AND IS NOT A SUBSTITUTE FOR COMMERCIAL JUDGEMENT OR PROFESSIONAL ADVICE, WHICH SHOULD BE SOUGHT PRIOR TO ACTING IN RELIANCE ON IT. TO THE EXTENT PERMITTED BY LAW THE BANK DISCLAIMS LIABILITY OR RESPONSIBILITY TO ANY PERSON FOR ANY DIRECT OR INDIRECT LOSS OR DAMAGE THAT MAY RESULT FROM ANY ACT OR OMISSION BY ANY PERSON IN RELATION TO THE MATERIAL. THE NATIONAL BANK OF NEW ZEALAND, PART OF THE ANZ NATIONAL BANK LIMITED 2004 THE NATIONAL BANK OF NEW ZEALAND, PART OF ANZ NATIONAL BANK LIMITED. ALL RIGHTS RESERVED.