Profit and Loss Basics

Profit is the excess of income over expenses. If you buy something at $2 and sell it for $3, your profit is $1. If you sell it for $1.50, your loss is fifty cents. You know that.

Your business is planning to make a profit. However, you also want to know if it is operating at a loss, and why, so you can make adjustments. That's just good business.

For now, you want to ensure that your business is planning to be profitable. You want a document that shows you and your investors where the income is expected, what expenses need to be paid, and how much profit is left over. Both now and in the future, you will rely on the income statement to keep you informed.

Income Statement

An income statement is a financial document that shows how gross income (income before expenses) is converted into net income (income after expenses). Gross income or revenue is sometimes called the top line and net income is the bottom line. Because the statement considers profits and losses, it is also referred to as a profit and loss (P&L) statement. Seemingly to make business more confusing, some entrepreneurs and accountants refer to an income statement as an operating statement or an earnings report. There are slight differences between these reports, but the terms are often used interchangeably. For consistency, use the most accepted: income statement.

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Following are examples of two income statements for start-up businesses to illustrate the components.

The first example is a Projected Income (Profit and Loss) Statement for a product business (from Appendix A):

This income statement estimates gross revenue as the total of sales. If a business derives income from nonsales sources, it will be listed here as well. Some businesses opt to break down sales more, showing where sales are expected by department or category of product or service.

The cost of goods sold is the cost of buying any raw materials and producing finished goods. In retailing, the cost of goods sold (COGS) is the purchase price of wholesale products, such as store inventory. Depending on the business, the cost of preparing inventory for resale may or may not be included in COGS. Instead, some businesses refer to it as cost of sales (COS). COGS will be covered in more detail later in this chapter.

The gross margin, as defined in Chapter 12, is the relationship of the profit to the cost. A widget with a wholesale cost of $6 is sold at a retail price of $10. Calculate: (10-6) / 10 = 40%, the gross margin. Your income statement can document the gross margin for your business. Gross margin is discussed later in this chapter.

The operating expenses are then listed. In the example, the business sells a product and the expenses include sales, general, and administrative expenses. Your business plan may include more or less detail, depending on size. Operating expenses are described in more detail below.

Finally, the income statement shows how much the business sets aside for depreciation and to pay interest on debts. Depreciation is the reduction in value of an asset due to age.

The bottom line on the example income statement shows projected net profits for the first three years of operation. They are projected because they haven't happened yet. Once the business is established, income statements will include actual net profits.

A projected income statement—and most other financial statements in your business plan—are also referred to as pro forma. Pro forma is Latin for “as a matter of form.” Pro forma can also refer to reports that exclude unusual and nonrecurring expenses, such as transactions that adjust the purchase or sale of business property, but this definition is rarely used in small business.

Variation

The second example is for Acme Time Management Consultants. As you can see, it is a service business and doesn't calculate costs of goods sold because goods (products) aren't sold; advice, measured in time, is sold. In addition, the business planners decided to develop monthly projections for the first year. Note that both income and expenses are well detailed, which makes tracking the source of losses easier.

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