This article is for owners of businesses turning over somewhere between $2 million and $5 million who receive a monthly profit and loss statement and want to read it the way an adviser does. It covers the order we read one in, what the report cannot tell you, and the five numbers worth carrying in your head so you can tell how the business is travelling before the report arrives.
When a new client sends us their profit and loss statement, the first ten minutes go to three lines on the page and two figures that sit outside it. Everything else on the report is detail that helps explain those five.
Gross margin is the first line we look at
Gross margin is revenue less the direct cost of producing what you sold, expressed as a percentage of revenue. For a retailer that is the landed cost of stock. For a manufacturer it is materials, direct labour and freight in. We read it first because it moves with every pricing decision, supplier change and discount you give, and because small movements carry large dollar amounts.
A business turning over $4 million at a 41% gross margin earns $1.64 million to pay for everything else. At 38% it earns $1.52 million. The three points cost $120,000 a year, and the report will show a reasonable result either way because sales may have grown in the same period.
We compare the margin against the same month last year and against the rolling twelve months. A single month can swing on the timing of a large stock delivery or a year-end stocktake adjustment, so the trend over twelve months is the figure we trust.
Overheads make sense as a share of sales
Below gross profit sit the overheads: wages for staff who do not make the product, rent, software, insurance, vehicles and professional fees. Reading these as dollar amounts tells you very little in a growing business, because every line will be larger than last year.
We divide each major overhead by revenue. Wages including superannuation is usually the largest, and with the super guarantee now at 12% it can rise as a share of sales without anyone being hired. If total wages were 22% of revenue two years ago and are 26% now, the business is paying $160,000 more a year on $4 million of sales to deliver the same work.
Net profit before the owner's pay
The third line is net profit, adjusted so that the owner's own salary, super and any personal costs run through the business are shown separately. An owner's pay can be structured differently from one year to the next, and a profit figure that moves because a director took a larger salary in June says nothing about how the business performed.
With the owner's pay added back, you can see what the business earns as an asset. That is the figure a buyer, a bank or an investor will look at, and it is the one we track through the year.
What a profit and loss statement leaves out
The report records income when it is earned and costs when they are incurred. Cash arrives on a different timetable. A strong month on the profit and loss statement can sit alongside a tight bank balance when customers pay on 60-day terms, stock has been bought ahead of a busy season, loan repayments are falling due or a quarterly BAS is about to be paid.
So the two figures we look at outside the report come from the balance sheet and the bank. Our article on cashflow viability goes further into why a profitable business can still run short of cash.
The five numbers worth knowing by heart
A business owner in the $2 million to $5 million range can carry five figures in their head and know, within a few minutes, whether anything needs attention.
- Gross margin percentage, for the last twelve months and for the latest month.
- Wages including super as a percentage of revenue.
- Net profit before the owner's pay, as a dollar figure for the year to date.
- Debtor days, which is trade debtors divided by annual sales, multiplied by 365. It tells you how long, on average, customers take to pay.
- Break-even revenue, which is total overheads divided by gross margin percentage. It is the monthly sales figure at which the business covers its costs.
Break-even revenue turns the other four into a single monthly target. A business with $1.4 million of annual overheads and a 40% gross margin needs $3.5 million of sales, or about $292,000 a month, to break even. If a quiet month comes in at $260,000, you know the gap before the report tells you.
Making the monthly report earn its place
A profit and loss statement is only as useful as the coding behind it. Costs posted to the wrong account, stock purchases expensed in one month and capitalised in the next, or a missing accrual for a large supplier bill will each move the margin by a point or two and send the conversation in the wrong direction.
The reports we suggest show the month against the same month last year, the year to date against budget, and gross margin by product line or location where the business has more than one. Accounting software can produce all of this once the chart of accounts and tracking categories are set up for it.
The Australian Government's guide to setting up a profit and loss statement on business.gov.au includes a free template, which is a useful reference if you are setting up reporting for the first time.
Questions we are asked
What is a profit and loss statement?
A profit and loss statement shows the income a business earned and the expenses it incurred over a period, usually a month, a quarter or a year, and the profit or loss that results. It records amounts when they are earned or incurred, which is why it can differ from the movement in the bank account.
How is a profit and loss statement different from a balance sheet?
The profit and loss statement covers a period of time and shows performance. The balance sheet is a snapshot on a single date and shows what the business owns and owes, including cash, debtors, stock, loans and creditors.
How often should I review my profit and loss statement?
Monthly, within about ten working days of month end, works well for a business in the $2 million to $5 million range. Reviewing it quarterly leaves too long between a problem appearing and anyone acting on it.
What is a good gross margin?
It depends on the industry and the business model, so the more useful comparison is your own margin against last year and against your plan. A distributor and a specialist manufacturer can both be healthy at very different margins.
How do I work out my break-even revenue?
Divide your total annual overheads by your gross margin percentage. With $1.4 million of overheads and a 40% margin, break-even is $3.5 million a year, or about $292,000 a month.
Reading yours together
If you would like a second set of eyes on your profit and loss statement, our Finance Hub team can work through it with you, set up the reporting so the five numbers come out each month, and tell you what we see in the first ten minutes. Book a time with us and bring your last twelve months.
