Some businesses simply get their end of year financial prepared to tick a box and meet their legal obligation giving little consideration to what these figures show. Yet taking a few minutes to understand them can provide you with some great insights into your business. These can inform your decisions and help improve your performance moving forward.
In this blog we look at your Profit and Loss account so provide you with some insight as to what the document can tell you. When your accountant prepares your financials they should take the time to explain them to you, but the more you understand yourself the better.
The Profit and Loss account (now called a Statement of Financial Performance) is among the easiest financial documents to understand. It’s typically presented in two parts.
The top half of the statement reveals the various sources of income the business has received for the period covered, such as a quarter, a half year or a full financial year. After subtracting the cost of producing your goods or services, it shows your gross profit figure.
The bottom half of the account lists all the relatively fixed running costs (business overheads) such as rent, power and communication costs you need to pay each month regardless of sales levels. When these costs are subtracted from the gross profit the result is a net profit figure (before tax).
So far, so simple, but you can learn more.
How well is the business performing?
These two results enable you to work out two key performance indicators (KPIs) that offer important insights into how your business is performing.
The first, your gross profit margin, which is the gross profit expressed as a percentage of sales.
To work this out (if your accounting software doesn’t do this automatically), you divide the gross profit figure by the sales total and multiply by 100 to get the percentage.
Here’s an example:
Gross profit: $80,000
GP %: 80,000 divided by 400,000 = 0.2 x 100 = 20%
Multiplying by 100 allows you to study the gross profit margin as a percentage, so you can easily compare this result with previous margins, irrespective of fluctuating costs or sales levels. Has the margin improved? If not, it’s time to investigate the causes. For instance, has there been an increase in the cost of materials or production labour?
You can now compare your gross margin to those of similar businesses, because turning the result into a percentage overcomes any difference in size. Regardless of whether they are smaller or much larger businesses, it’s the gross profit percentage (GP %) that tells the performance story.
Depending on which sector you operate in, we can help find the average GP percentage for your industry. Your aim should then be to equal the industry average at the least, and preferably do even better. You can also aim to improve on your previous gross margin results.
How profitable is your business?
The net profit margin reveals how profitable your business is when your overhead costs are deducted from the gross profit. It’s worked out using a similar formula.
Net profit: $50,000
NP %: 50,000 divided by 300,000 = 0.166 x 100 = 17%
This KPI empowers you to spot problematic trends before they become disasters. If your net profit margin has fallen, you need to dig for the causes. For example, you may find your marketing costs have blown out with no increase in sales. The lesson here would be to measure your marketing and advertising to see what is actually working, so you can drop any unproductive tactics.
1. Use your gross profit and net profit margins as benchmarks to set improvement goals. Try to improve both on internal benchmarks (your current performance against previous results) and external benchmarks (the average for your industry type).
2. Don’t rely on just an annual profit and loss account. You can’t effectively drive your business forward using a rear-view mirror that reflects dated data – you need more up-to-date figures. Use your accounting software to generate more frequent profit and loss accounts, such as monthly or quarterly statements. These enable you to take prompt action to fix any negative trends before they do serious damage to the business.
3. Remember that you can always get in touch with us to interpret trends in your results and help you take corrective action with your business finances.
If you would like help understanding your businesses financial performance contact us today for a FREE, no obligation, financial review we can compare your financials over the last 3 years and identify trends and opportunities for you to improve your business.
You may also find some useful information in our free resources section.