Using Profit & Loss Statements to Analyze Business Health

30A CPA Advises 30A & Metro Atlanta Business Owners: Preparing Your Profit and Loss

To determine the future net worth of your business, a determined and insightful understanding of your Profit & Loss statement (P&L) is essential and critical. At Duluth accounting firm His CPA we have helped critique thousands of Profit & Loss statements to help Gwinnett and Metro Atlanta business owners have useful and informative financial data. Though a balance sheet is a recap of what has happened to a business’s assets and liabilities to date, a P & L, if properly presented/managed/understood is a look into the company’s short as well as its long term viability. A businesses P & L essentially measures how well the business is utilizing company assets, personnel procedures and facilities in its effectiveness of serving customers while keeping a keen eye on profit maximization. By properly gathering and studying one’s operations and its corresponding P & L, one can learn much about a business which is useful for measuring rates of return, detecting both positive and negative trends, taking corrective action, and business valuation.

As with all ratios, care and attention should be given to evaluate them in light of company size, maturity, business climate and industry. Though there are many general rules of thumbs for a variety of different industries, there is no substitution for wise and judicious counsel of a wise and trusted business adviser/CPA. They will help evaluate these and many other nuances which make your particular circumstances, operating overhead and unique niche.

Gross Margin

First in line of the analysis of your business P & L is to carefully evaluate its gross margin. This calculation is done by subtracting the company’s cost of goods sold from sales and by dividing its result by sales. Cost of goods sold is best measured as a percentage and proper care should be exercised to ensure that the periods P & L has properly allocated all direct sales cost to cost of goods sold. Typically most all of these costs will vary proportionally to the amount of product/services sold and delivered. A proper and consistently applied cut-off of accounting data is critical to this evaluation as otherwise the data/margins are unduly skewed to start.

Pretax Margin

What your business nets in dollars and as a percent of sales are an essential part of understanding your business. A business pre-tax margin is determined by subtracting from sales, all cost of goods sold, personnel, sales and operating expenses. Knowledge of this margin is essential as it is a leading indicator of business future assets; liabilities and equity as well as the respective income taxes it/its owners will owe/be required to pay.

Net Margin/Net Income After Taxes

A company’s net margin is what a business has made off of its base operations/business decisions reached during the year. It is what is earned after paying all of a business P & L charges, depreciation, interest and taxes to both the IRS and the respective states in which a business operates. To maintain a clear and adequate understanding of this in dollars, it is prudent to invest the needed time and resources to ensure that one has an adequate overview understanding of how their business is taxed. To that end, it is wise to be aware of several key components:

  • Does the business keep its internal books on an accrual basis and file the tax returns on a cash basis? Are the appending timing differences carefully delineated, documented and understood? For example, business owners might inadvertently neglect to recall that receivables billed and reported in an earlier period when financials are prepared on an accrual basis will have to be reported on a subsequent years tax return when the cash based tax return is prepared.
  • An understanding of the company’s effective tax rate, which is determined by dividing one’s federal and state income tax bill by the related sales for the period.
  • A company’s marginal tax rate, which is the amount of tax that would be due as a percentage and dollars, on any additional profit. This is a critical component as the IRS tax system is graduated, thus requiring more tax, as a percentage to be paid on additional net income.

Interest Expense

There are several hidden risks in acquiring debt that companies need to contemplate before acquiring debt/line of credit. Any of these issues either individually or collectively can cause irreparable damage to your firm’s ability to operate and continue forward. Often business owners who are flush with cash fail to make wise and judicious cash/debt decisions as they are inclined to believe the good times will last forever. Also before making any large non-recurring cash expenditure, care should be exercised to review the proposed transaction with projected cash needs as detailed in the company’s business plan.

Unfortunately, I have witnessed all too often companies spending all of the money they will soon critically need, simply for the lack of proper planning and advisement. An owner will also want to carefully contemplate a proposed line of credit/debt to be sensitive to its flexibility to meet an ever-changing business environment. Attention should be paid to ensuring the debt being requested is adequate as it is always better to have too much credit than too little. Also, the debt provisions should be carefully scrutinized to ensure that all provisions, repayment scenarios, and interest rate calculation and fluctuations are all well understood. Often banks and lending institutions will remove/negotiate several debt provisions in an effort to earn your business.

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