Are you distorting your business’ profit and loss statement?
Posted on 5th April 2023 at 10:11
Are you distorting your Profit and Loss statement without even realising it?
Are you distorting your business’ profit and loss statement?
Your business’ Profit and Loss Statement is a crucial KPI. However, it is often misunderstood, underused, or distorted.
We’ll start with the basics and then look at what could be going wrong with your profit and loss calculations.
What is a Profit and Loss Statement?
Your profit and loss statement is a financial record of what your business has spent and earned over a selected period of time. The statement will show your revenue, minus expenses and losses.
The resulting figure is either your final profit or your final loss.
So, your profit and loss statement provides valuable insight into the financial health of your business: whether you are able to successfully generate income through sales, manage expenses and sustain a healthy profit margin.
When is a Profit and Loss Statement Used?
At a minimum, your accountant will generate a yearly profit and loss statement to meet HMRC requirements, potentially to minimise tax or support other financial goals.
Some businesses produce a monthly profit and loss statement to keep an eye on the top and bottom lines – with maybe one or two items in between.
So usually, and mistakenly, profit and loss statements are just put together to meet reporting requirements. However, they can, and should, be used to help you make decisions in your business. To do this successfully, your profit and loss statement needs to be free of distortions.
Mistakes which distort your Profit and Loss statement
The profit and loss statement of two identical businesses can look quite different, depending on how they treat different items of expenditure.
This means distortions can occur. There are two common distortions in a typical owner-manager profit and loss statement: the way owners treat their own salary and the way gross margin is calculated.
If you really want to build a business that will scale, you have to avoid these distortions to see the true profitability of the business.
The owner income distortion
It is common for owners to take a mix of salary and dividends. It’s even more common for owners to pay themselves below the full market rate. Both of these things can distort the profit and loss statement, leading to an incorrect picture of the company’s true profitability.
That 20% profit you think you’ve made? In reality, if you had to pay someone else the market rate to do your job then you may have made a much lower profit.
Not only will this distortion impact your assessment of the business, but it will impact the decision-making in the business. The steps and effort you put into increasing profitability will be very different if you think you are making a 15% profit than if you realise you are only making a 3% profit.
If you are paying yourself less than the market rate, it is wise to have two versions of accounts: one which shows your profit and loss with the reduced compensation you are taking, and one which shows your profit and loss if you were to be paid market rate.
This is also vital if you ever want to scale your business to the point of selling it. A buyer will need to think about paying someone to replace you and will need an accurate picture of how this impacts profit and loss, and the EBITDA (Earnings Before Interest, Tax, Depreciation and Amortisation).
The gross margin distortion
Gross margin is a company's gross profit divided by its sales. It represents the amount earned in profit per pound of sales. Gross margin is stated as a percentage.
Here’s an example calculation:
You buy a widget for £5.
You spend £2 on labour customising the widget.
You sell the customised widget for £20.
Your cost of goods sold (COGS) is £7.
Your gross margin is 13/20 or 65%.
The trouble with this standard calculation is that we have mixed costs of goods sold and labour – so we can’t measure and work on the efficiency of our labour.
Here’s how you should redefine Gross Margin (Real Revenue): revenue minus all non-labour direct costs.
If you are a service company and you subcontract some of your direct labour then this is effectively a cost of goods sold and should also be taken off the revenue to give your gross margin.
For example, if you’re an accountant and you subcontract the bookkeeping for my clients, this should be treated as a cost of goods sold. However, this should only apply where subcontracted costs of work are linked directly or ‘vary’ according to the sales/ work done with clients.
If you subcontract general admin then this is a fixed cost, not a variable cost linked to the client work, and would not be included here.
Using your profit and loss statement to set targets
Once your profit and loss statement is free from owner salary distortion and you have used the redefined gross margin calculation, you can set more accurate profit targets.
You should focus on gross margin and net profit rather than sales in order to support improved financial decision-making.
An accurate profit and loss statement is also essential if you’re thinking of scaling your business. If you are not at 15% profitability then scaling up is risky – certainly taking on more staff would be perilous.
The focus should be to prove that you can get to 15% with what you have. Then you can add staff, which will drop your profit margin back to 10%. At this point, you’d be focused on getting back to 15%... and repeat.
This approach to profit and loss ensures your business focuses on efficiency and productivity – not spending or investing its way out of trouble. You first ensure that the profitability is there and you’re operating efficiently, before investing in the next stage of growth.
Examining profit and loss is just one element of your business’ wider strategy for managing cash. If you want to know if your business’ cash habits are strong enough for success and to take your business to the next level, take our FREE Level Up Your Cash Habits Scorecard now. You’ll get a personalised report and a free copy of our highly-rated book: The Entrepreneurial ScaleUp System (only pay P&P). Here’s the link: https://cashhabits.scoreapp.com/
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