How to read a business’s financial statements (Profit and Loss)

Understanding a business’s financial statements (Profit and Loss) is integral to managing a business and before committing to buying a business. There is an abundance of vital information that can gained from the Profit and Loss to assist in making a decision.

• Is it profitable?
• Is it running efficiently? 
• Is each product being sold making money?

Many people get overwhelmed by the numbers but a few quick tips and tricks on what to look for will give an overall perspective on how the business is performing. 

Profit and Loss Statement 

Below is an example of a Profit and Loss statement. We will break it down into sections to analyse how the business is performing.  

Sales‍

Sales are the life blood of any business and this should always be the starting point. Sales represents monies received from items / services sold to customers. 

 Sales in the example appear satisfactory, but there are some important things to consider:

• Always compare sales to the previous years. In the example we can see total sales have decreased compared to the previous year. 
• Examine the source of the sales. We can see that the reduction in sales is coming from lemonade sales, whilst chips sales are trending upwards.
• Consider seasonality. Some businesses operate during a particular season or have high and low transactions depending upon the time of year. Lemonade sales could have been weather dependent i.e. higher sales in warmer months. This anomaly needs to be further investigated to ensure it is not a once-off variable. 

The decrease in sales from 2019 to 2020 are a direct result of the lemonade sales. It is important to understand the operating process for this to ensure it will not continue to trend downwards and whether there are strategies in place to mitigate the risk in the future.

Cost of Goods Sold

Cost of Goods Sold (COGS) represents how much money was spent to sell the items. Typically the more you sell, the higher the Cost of Goods. 

Important things to consider when analysing the Cost of Goods Sold include:

• Align the trend with sales. Total Cost of Goods Sold has increased by $1,000, yet sales have decreased. This will not be sustainable if it costs the business more to buy as a proportion of what they are receiving in sales. 
• Determine product profitability. To improve profitability a business needs to sell products that make money. The cost of producing the lemonade is less than the sales which means lemonades are a profitable product. On the other hand, the cost of chips is more than the sales they make. This brings into question whether it’s still viable to keep selling chips. Options include reviewing the supplier / material to determine whether the costs can be reduced, cease selling the product or maintain it if it is bringing in customers….consider the loss leaders used by supermarkets to bring in customers who then ideally buy other products that have good margins. 

Gross Profit

Gross Profit represents the amount left over after considering all sales and costs to produce/procure the product. In the example, gross profit is positive which indicates it is successful to a degree. Other important considerations which suggests there could be room for improvement are:

• Calculate the gross profit margin (Gross Profit / Total Sales) = Gross Profit %. Calculating the gross profit margin here is imperative as it will determine whether you are maximising profit.  In the example, gross profit margin has significantly dropped which as reviewed before, we are selling more chips which is causing the business to lose money. 
• Compare the gross profit margin to similar industries. This will determine whether the business is operating as efficiently as competitors and whether there is room for improvement. The Australian Taxation Office has a number of benchmarks that you can use to compare your business to the industry norm.

Total Expenses

Expenses represents a business’s ability to operate efficiently. This is especially important during downturns, as these expenses are mostly variable and can be reduced, especially if sales are down. Important things to note are:

• Identify the variable and fixed expenses. Fixed expenses are set and are usually required to operate the business. Variable expenses can be adjusted accordingly and can be reduced if the benefits do not outweigh the costs. In this example, advertising is a variable expense and can be reviewed to determine how effective it is in bringing in sales. The same amount of advertising expense was incurred each year, yet sales have dropped. 
• Are all expenses / invoices included? It is important to ensure that all invoices from suppliers have been recorded. This will give a complete perspective of expenses. 

In the example, the business is running at a profit, however reviewing the Profit and Loss outlines numerous things:

• Sales are trending down, would it continue?
• The chips product is not making a profit. Consideration needs to be given whether to keep selling them.
• How does the businesses gross profit margin compare to competitors? 
• Is the business being efficient in its spending?

Profit and loss reports are one of the primary reports of the financial statements of a business and shows a summary of sales and expenses. Each category (sales, cost of goods sold, total expenses, profit/loss) needs to be analysed to ensure the business is viable and whether it is running efficiently and effectively.

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Disclaimer

This article is provided with the compliments of Alan Dinnie. It is genuinely intended to offer readers information to make better decisions and to give insight into various aspects of business in general, and more particularly related to the sale and purchase and management of businesses. 

All material presented herein is intended for informational purposes only. Information is compiled from sources deemed reliable but may be subject to errors and omissions. No statement is made as to the accuracy of any description. Alan Dinnie makes no warranties or representations regarding the information and excludes any liability which may arise because of the use of this information. This information is the copyright of Alan Dinnie.

Nothing herein shall be construed as legal, accounting, or other professional advice outside the realm of real estate and business brokerage. 

I trust you enjoy the article and that it provides you with useful information.

To your business success