What’s in a P&L – the Financial Model

The three most important financial reports for a business owner to understand are the Profit and Loss statement, also known as a P&L, the balance sheet and the cash flow forecast.  In this article, I will discuss the P&L, what it means to you as a business owner and how it relates to the financial model for your business.

What is a P&L?

A P&L measures financial performance over a period of time.  The P&L does not show the current financial condition of the business, but rather demonstrates those items that have contributed to its financial position such as revenue, costs of product or service delivery, operating expense, profits and losses.  The balance sheet measures the financial condition of a business as of a specific date.

The Financial Model

Reviewing P&L’s across multiple periods such as months, quarters or even years can provide the business owner with information on the financial model for the business.  Basically, a financial model tells you the percentage of each revenue dollar received that is spent on things like:

  • The cost of providing goods or services;
  • The cost of providing post-sales support;
  • Research and development for new products;
  • Marketing products and services;
  • Selling products and services;
  • Administrative expenses like accounting, human resources and legal and other general overhead items required to support business operations.

When you deduct each of these costs from revenue, the result is the financial statement line called operating income.

Here is an example P&L for a business that grew revenue by $960,000 from 2010 to 2011.  They also increased profits by $593,500.  Part of the increase in profits was simply due to revenue growth, but another large part of the increase was caused by improvements in their financial model in two areas – gross profit and operating expense.   Operating income as a percentage of revenue increased from 9.3% to 12.5% for an increase of 3.2 percentage points.  If the company did not experience improvements in their financial model, profits would have increased by only $89,000 rather than $593,500.

The company increased their gross profits as a percentage of revenue

from 41.3% to 42.5% for an increase of 1.2 percentage points.  This 1.2 percentage point improvement resulted in a gross profit increase of about $156,500 which adds to the increase caused by growth.

The company also decreased their operating expenses as a percentage of revenue from 32.0% to 30.0% for a decrease of 2.0 percentage points.  This 2.0 percentage point improvement resulted in an income increase of $257,700.

As you can see, a P&L provides insight into the financial performance of your business and helps you understand its financial model.  Once you understand your financial model, you can work on identifying ways to improve it and be able to forecast the resulting increase in profit.

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