GAAP accounting standards may seem intimidating, but they're an important step in helping startups lay a solid financial foundation. Why GAAP for startups? Learn more here.
June 22, 2020
Not sure exactly what to look for when reviewing your startup's Profit & Loss Statement (P&L) or Income Statement? You've come to the right place.
In this article, we'll take a close look at what makes up the P&L statement, how to read one, and things to consider when analyzing yours. This article is the first installment in our series of articles demystifying the most common financial reports startups will encounter.
Before we dive in, let's quickly review a few key assumptions which impact the content of this article.
This article is based on the use of the accrual accounting method, which tracks money not in terms of cash inflows or outflows but in terms of when it is earned or due; as opposed to the cash accounting method, which books expenses and income when cash exchanges hands.
At Zeni, we use accrual accounting method for all of our customers and recommend it to startups and small businesses because it gives you a more accurate overview of your business’s financial health, allows for strategic business decisions and the ability to scale and prepare for exit scenarios such as mergers/acquisitions or initial public offerings.
Plus, the accrual accounting method is required for businesses earning $5 million annually in revenue or businesses that report financial statements to outside parties, such as investors, per the generally accepted accounting principles, or GAAP.
This article was written to provide those with limited exposure to financial statement a working understanding of the profit and loss statement. If you’re concerned with something in your financial statements, make sure to seek help from an experienced bookkeeper or accountant.
Now that we're on the same page, let's get started.
A profit and loss statement (P&L) provides a summation of the revenue, cost of sales, gross margin and expenses that a company incurs during a specified period of time, usually across a month, quarter, or year. The P&L, also referred to as an income statement, profit and loss report, statement of operations or statement of earnings, is the most common financial report for businesses of every size.
It’s also what investors and bankers analyze before making decisions about investing or lending funds, so it’s critical that companies maintain accurate P&L statements in accordance with GAAP for an at-a-glance look at your company’s financial health. The P&L statement is also home to the ubiquitous “bottom line,” which is ultimately your revenue (the “top line”) minus the cost of business operations.
A standard P&L statement is broken down by:
A standard P&L grouping of expenses typically includes*:
- General and Administrative
- Research and Development
- Sales and Marketing
- Interest income
- Income taxes
- Foreign exchange gain or loss
*At Zeni, our goal is to make understanding business finances easier for founders, which is why we break down operating expense groupings by expense type, such as:
These groupings makes it simple to look at your startup’s P&L statement to get a sense of what your rent costs are, what your salary expenses look like, and other common (but pivotal) questions about your company’s financial health.
If a P&L statement summarizes the revenues, costs, and expenses from a specified time period, what information does a balance sheet and cash flow statement provide?
The next installments in this three-part series address these two other types of financial statements, so stay tuned. (Want these blog posts to land in your inbox? Subscribe to the Zeni blog here.)
Once you have your P&L statement in front of you, you’ll begin reading it with the top line, which contains your revenue for the time period. Your top line can also be used to measure your progress against the revenue goals you’ve set for your company. The bottom line contains your net income (or loss) and shows whether or not you were able to turn a profit during the timeframe your P&L statement covers.
If something’s not cohesive between the top line and the bottom line, investigate the rest of the statement for inconsistencies. Focus on the fluctuations, investigate where needed and make improvements for future months.
Commonly referred to as the “top line,” the revenue component of a P&L shows you the money earned by the company for a specific time period.
Revenue is total sales by the company's primary business operations. The revenue section should separate the various revenue streams such as software sales, hardware sales and services. This allows the user to easily review the health of each segment.
It's important to track different sales categories so you can get a clear understanding of which service lines are affected by decreases, among other things. This is of critical importance for startups. You should require this from your accountant or bookkeeper—tell them explicitly that you want to see this information.
The Zeni Dashboard enables founders real-time visibility to their revenue, cost of sales and gross margins by business segment via the Revenue Insights report.
As with all reports on your Zeni Dashboard, use Compare Mode to view changes to your revenue, COS and gross margin over a selected period time, and click through to view transaction level details directly.
Depending on the industry you’re in, the cost of sales (COS) line may also be referred to as cost of goods sold (COGS). Regardless of the term used, COS are the costs incurred to support the company's product lines and/or services.
COS/COGS has both direct and indirect or OCOGs (other cost of goods sold). Direct cost of sales are costs incurred to produce the company's product lines and or services. OCOGs may relate to product warranties, hosting overhead or labor allocations.
It can be difficult to determine whether expenses can be classified as COS/COGS, especially as it relates to identifying labor splits and support (this is particularly pertinent to software companies). Expenses like royalties, order processing, and sales commissions are considered OPEX, while hosting expenses may be split between COGS and OPEX, depending on the structure of your business.
The money you spend to run your business is considered your operating expense (OPEX). Generally, everything that isn’t part of your revenue or COS lines on your P&L is part of your operating expenses, but there are exceptions — we explain this further below in the "other expenses" section.
Some common operating expenses include:
The Zeni Dashboard provides real-time insights into your operating expenses; expenses are organized by expense groups, such as Salaries and Benefits or Sales and Marketing, making it easy to zero in on key categories and transaction level data related to those expenses. Plus, using Compare Mode, Zeni customers can compare change over time in each expense group for a more granular, actionable view of their company's operating expenses and trends.
Operating Profit or EBIT Calculation: Revenue - COS - Expenses (excluding tax and interest)
EBITDA Calculation: EBIT + Depreciation + Amortization
Operating profit shows your company's profit from business operations, before excluding interest and taxes. Operating profit is often referred to as EBIT, earnings before interest or tax, or EBITDA, earnings before interest, tax, depreciation or amortization.
Operating profit is a key metric to investors as it highlights how well a company is being managed; it reflects the company's total revenue (demand) and expenses (efficiency). The founders and executive management team play a key role in ensuring these expenses and trends are in accordance with the business plan.
When you have an expense that doesn’t neatly fit in the OPEX line, it will likely show up on your P&L under Other Income/Expenses or Non-Operating Expenses. The expenses categorized as non-operating generally relate to interest income/expense, other income/expense and foreign exchange gain or loss, to name a few.
Net Income Calculation: Revenues - COS - Expenses (all types)
Net income (or loss) is well-known by its other name, the bottom line. The bottom line on your company’s P&L shows the total amount of revenue less the COS, OPEX, and all other business expenses.
Hopefully, when you settle in with your P&L statement, your accountant, and a fresh cup of coffee, you’ll not run into any nasty surprises that indicate major problems. But you’ll also want to keep a sharp eye out for possible red flags that may not jump out at you. Here are some issues to keep your eyes peeled for:
A P&L statement has a range of uses, all depending on the reader’s intent. Aside from providing an overview of revenue and expenses, a P&L statement can be used to calculate metrics and set and monitor monthly, quarterly, and annual goals.
When it comes to calculating metrics, there’s a lot of information that can come from one P&L statement. Among the most commonly encountered include:
A P&L statement can also be used to view and analyze trends, though the right software can make this significantly easier. Using Compare Mode in the Zeni Dashboard makes it easy to view changes in areas like travel, ad spend, and marketing expenses by week, month, quarter or year, so you can stay on top of your finances and make informed business decisions accordingly.
Finally, a P&L statement is used for setting and monitoring monthly, quarterly, and annual goals. Use your P&L statement to perform a budget to actual variance analysis (frequently referred to as a “budget vs. actual”) for forecasting, performance evaluation, and identification of gaps in operations.
Variances between your P&L statements and your cash flow occur because accrual accounting recognizes revenue in the period in which it was earned, not necessarily billed or collected, and records expenses when they were incurred (again, not necessarily when you were invoiced or when you paid it). Thus accrual accounting enables you to view trends more accurately.
Anything looks intimidating when it’s laid out in a spreadsheet, but P&L statements don’t have to be. It’s your data, so make the most of it by taking the time to understand your financial statements. That’s why we created this series of articles— because we believe that financial literacy for founders and business owners is critical for startup success.
For more information, subscribe to the Zeni blog to receive the next two installments of this series — which break down the Balance Sheet and Cash Flow Statement in a similar manner — directly in your inbox. Or, if you’re ready to get started managing your financials with a state-of-the-art finance firm that empowers its team of finance experts with the latest artificial intelligence and machine learning technology, start your onboarding process today.