What is a profit and loss statement and why do you need one for your business? Our content partner Opportunity Fund shares expert insights on lending with this Q&A about P&L statements.
by Ashlyn Smith | Jul 13, 2017 | Finance, Management, Resources |
Q: Why should business owners create a P&L statement?
A: Profit and loss statements are used to help business owners keep track of what is going on in their business and prove to lenders they can afford a loan. Having cash in the bank doesn’t always tell the full story. An owner can have a lot of cash in the bank, but that may be because they are not paying their rent or not paying all of their taxes. There’s no way to really tell without proper financial statements.
Owners need to know their numbers. They should know their monthly/quarterly/annual sales and expenses. This helps owners track trends in their profits and spending. You need to know when and where to make adjustments before you’re running a deficit. Without a P&L, neither the business owner nor a lender will accurately know if the business is actually making money in the long-term.
Q: How does a P&L work with other financial documents? What’s the difference?
A: The P&L, Balance Sheet, and Cash Flow Statements are all interrelated. For example, the net income from the P&L is reported in the equity section of the balance sheet. If a business owner prepares the P&L on a cash basis versus an accrual basis, then cash flow from operating activities (i.e. cash from sales and cash paid to vendors or employees) would be included in the cash flow statement. Even if it may seem redundant, all of these financial documents paints a complete, detailed picture of how your business is doing.
Q: How will preparing financial documents help me get an affordable loan?
A: Besides a tax return, a profit and loss statement is the only other document that can tell a lender how the business is doing. Lenders need to be able to determine if the business is generating enough cash flow to pay the business expenses plus the proposed loan payment. Without a P&L, lenders won’t be able to calculate if the business is able to support a loan payment. If a lender doesn’t ask to see financial statements, chances are high that they are preying on you with an unaffordable loan that will cripple your business.
Q: What makes a stellar P&L statement stand out?
A: The more detailed, the better. Lenders want to know the source of the sales revenues. These type of details help lender truly understand the operations of the company. P&Ls that only show total sales and total expenses, with no itemization, are not really helpful. Here are a few examples of good itemization:
- For a restaurant: breakdown your revenues from food sales versus liquor, beverages, or other merchandise.
- For a service company: breakdown your revenues from ongoing contracts versus one-time customers.
- In general: it’s important to itemize your expenses so that lenders can see detailed cost of goods sold (COGS) and operating expenses like rent, payroll, and advertising. It’s also good to note if there were any one-time expenses included on the P&L, like legal fees related to a lawsuit or start-up costs for a new product line.
From a lender’s perspective, accrual based accounting is better than cash based accounting because it’s a more accurate way of recording when revenues and expenses are recognized instead of paid. Discuss this with your accountant to see if this is possible for your business.
Q: What mistakes do borrowers make when preparing their financial statements and can borrowers avoid those mistakes?
A: The biggest mistake that small business owners make with their financial statements is taking a hands-off approach. It’s understandable that small business owners are busy, and financial statements may not be their core competency. Many owners just pass along information to their bookkeeper or accountant and leave it up to that person to take care of all the financials. However, it’s important to take the time to understand what the numbers on the statements mean. You should learn how to read the financial statements to decipher things like how products are selling period-over-period, how product pricing may compare to expenses, and how expenses are trending each period.
Another big mistake small business owners make is only creating financial statements once a year. If you are only tracking revenues and expenses on a yearly basis, it’s hard to keep track of things because you are referring to outdated information. For instance, if adjustments to pricing need to be made or if the rental contract needs to be renegotiated, it’s difficult to know what adjustments to make if you don’t know and track the company’s numbers.
Q: How do I get started?
A: Start by having a discussion with your accountant or bookkeeper. Collect your records of sales and expenses, calculate net income, and fill out a formatted document that will cleanly show your net income.
For a detailed guide on creating a P&L statement, check out this handbook by Zions Bank: