As a startup, your ability to understand a small business profit and loss statement will go a long way in determining the financial health of your business. That’s what will let you know how much money you’re making, versus how much you’re spending.

Startups don’t succeed on the intrinsic merit of their ideas. They succeed based on their ability to consistently make a profit. That’s why, along with learning how to write a good business plan, entrepreneurs should also learn how to understand a profit and loss statement.

What is a profit and loss statement?

A profit and loss statement or account is an official document that shows the profit and loss calculation of your business over a specific period. It could be for a month or a quarter, although the most important statement tends to be for a full financial year.

The profit and loss statement will calculate all your business transactions, cost of sales, overheads and depreciation. There are two crucial things to understand about profit and loss statements:

They are always for a specific time frame, usually for a year.
They will be presented in the same format, irrespective of the size or complexity of your business.

Why does your small business need a profit and loss statement?

Your small business, if it’s a limited company, would need a profit and loss statement for existing regulations and potential financial needs.

Regulatory obligation: Regulatory and financial institutions like the HMRC require you to create a profit and loss statement.

Tax assessment: All limited companies need to create one to help determine their corporation tax.

Loans: If you would like to apply for a loan from a bank or any other financial institution, they would need to see your profit and loss account.

Investments: Any potential investor in your startup would require it to understand the financial state of your business.

Informed decisions: With a profit and loss statement, you would know what aspects of your business need to be improved, what projects are generating revenue and what needs to be better managed.

Self-employed individuals and those in a partnership are not required to create one but it would also help them to make better business decisions.

What is the purpose of a profit and loss statement?

A profit and loss statement records and summarises all the financial transactions and changes in the values of your business assets. Put simply, it shows how you performed financially over a year. Other than the overall financial health of your startup, it will also encourage you to be financially wise about all your decisions.

While hiring an accountant is the traditional practice, startups can also use accounting software tools for documenting sales, overheads and expenses with proof. These apps will also automatically generate profit and loss statements and calculate your taxes.

Understanding a small business profit and loss statement

To understand a typical profit and loss statement, you need to know the terms that appear on it:

Revenue: Incoming money from the total sales of your products or services. Even if you haven’t earned revenue but have made the sale, you need to include it here.

Cost of goods sold (COGS): This is the cost your business incurs to make the product or service. These would include the cost of raw materials and payments for labour.

Gross profit: You work out your gross profit by subtracting your COGS from your revenue. It’s also referred to as gross or operating margin.

SGA (selling, general and administrative expenses) or OPEX (operational expenditure): This is what it costs your business to market, deliver and sell your product or service. It also includes the cost incurred in managing the company and all other expenses related to the functioning of your office.

Depreciation: This calculates the loss of value of your assets including machinery, hardware etc.

Earnings before interest and tax (EBIT): The earnings before applying the necessary taxes. You get it by deducting your SGA or OPEX from your gross profit.

Earnings before interest, tax, depreciation and amortisation (EBITDA): This calculates EBIT, taking into account depreciation and amortisation.

Net income: This is the profit or the total income your business will have once revenue, interests, taxes and expenses are calculated.

In short

While you might be busy with several other things while launching your startup, understanding a profit and loss statement should be a top priority. It will enable you to financially assess all your decisions and objectively analyse how your business is performing across functions.