Reading your own profit and loss

Many owners receive a profit and loss statement every month and read one line: the bottom one. The rest of the report explains that line, and it answers questions the bank balance cannot. Here is how we walk clients through theirs.

The shape of the report

A profit and loss statement, also called an income statement, covers a period of time: a month, a quarter, a year to date. It starts with what you earned, subtracts what the work cost, then subtracts what it cost to keep the business open. Here is a simplified example for a small contractor:

Start with gross profit

Gross profit is revenue minus the costs that rise and fall with the work: labor on the job, materials, subcontractors. In the example, every dollar of revenue leaves 35.5 cents to pay for everything else. That percentage, the gross margin, is the most useful figure on the page, because it tells you whether the work itself is priced correctly.

Watch the margin from month to month. A falling margin with steady revenue usually means one of three things: prices have not kept up with costs, jobs are running over estimate, or costs are landing in the wrong period. The third is a bookkeeping question, and it is worth ruling out first.

Then overhead

Overhead is what it costs to stay open whether or not there is work: rent, office staff, insurance, software. It tends to move slowly, which makes it easy to stop reading. Compare each overhead line with the same period last year. Small increases across several lines add up, and they are easier to address one at a time.

Dividing total overhead by the gross margin gives a rough break-even revenue. In the example, overhead of 96,100 at a 35.5% margin needs about 271,000 of revenue over the six months before the business earns anything.

What the report leaves out

A profit and loss statement is different from a cash report, and several things that move money never appear on it:

• Loan principal. The interest on a loan is an expense. The principal repayment reduces a liability on the balance sheet.

• Equipment purchases. A truck or a machine is recorded as an asset and expensed over time through depreciation.

• Owner draws and distributions. These are payments to owners out of equity. In a sole proprietorship or partnership they are not business expenses at all.

• Sales tax collected. It belongs to the state and sits on the balance sheet until you remit it.

This is why a profitable month can end with less cash in the bank. Read the profit and loss next to the balance sheet, and the gap usually explains itself.

Cash or accrual

Check which basis the report uses. On the cash basis, revenue appears when the customer pays and expenses when you pay them. On the accrual basis, revenue appears when you earn it and expenses when you incur them. Accrual reports show the result of the work done in a period. Cash reports show what moved through the account. Many owner-run businesses keep books on one basis and file taxes on another, and your accountant can print either.

Ten minutes a month

When the report arrives, read it in this order:

1. Revenue compared with last month and the same month last year.

2. Gross margin, and the reason for any change of more than a point or two.

3. Each overhead line compared with last year.

4. Operating income, and what it means for cash once loan payments and draws are counted.

Write down the questions and send them to whoever keeps the books before the next report arrives.