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What is a P&L and Why Is It Important?

What is a P&L and Why Is It Important?

Last Updated:  
June 2, 2023
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If you run an ecom brand you probably live and breathe revenue. And for too many, ad spend is the only expense they think about.  

But there’s more to a successful business than just scaling sales to the moon at a (hopefully) reasonable ROAS.

To grow sustainably and cement yourself as a long-term player in the space, you need to know a little more about your business's financial performance.

And the Profit & Loss Statement (or P&L for the cool kids) is one of the best tools to break down your company’s financial performance.

What is a P&L?

The P&L is one of three main financial statements in accounting. The other two are the Balance Sheet and the Cash Flow Statement.

The P&L, in particular, is crucial to understand your business's performance over a period of time.

It breaks down all your company's financial activities every month, quarter, or year.

A (very) simple example

Everything’s better with examples, and accounting especially. So let’s explore by following the story of Lucy, an enterprising young girl who decided to eschew traditional retail and launch Lucy’s Lemons - a direct to consumer bottled lemonade brand for her neighborhood.

In her first month, she sold $100 worth of lemonade.

So her P&L for that month would include $100 in the revenue section.

The bottles (packaging + lemonade) she sold had cost her $20. So her P&L showed $20 as an inventory expense - commonly referred to as Cost of Goods Sold (or COGS if you’re short on time).

She paid Dave from down the street $10 to deliver all the orders. So her P&L also showed $10 as a shipping expense.

She then calculates how much she made using the profit equation:

Profit = Revenues - Expenses.

So for her first month:

Profit = $100 - ($20 + $10)

Profit = $70

That’s the most basic form of a P&L summed up.

Needless to say, a complete P&L is a little more complicated. However, this general structure does not change, and every P&L you encounter will include these essential elements.

P&L vs. Cash flow statement

The cash flow statement shows cash inflows and outflows over a certain period.

This is different from a P&L as it refers to cash in its most liquid form. We aren’t talking about revenues that haven’t yet materialized or expenses that haven’t yet been paid.

For example: Lucy had purchased $200 worth of inventory at the inception of her business due to minimum order quantities. But she only sold $20 worth in the first month.

Her P&L would show a $20 expense. But her statement of cash flow shows that $200 of cash flowed out of the business in the form of inventory purchases.

This distinction is crucial. For ecom brands the importance of cash in the bank cannot be understated.

You might appear to be profitable but if you don’t manage cash correctly you might have a hard time getting your next inventory shipment in to sell.

You need consistent cash flow to function effectively, and a cash flow statement will tell you whether you’re heading in the right direction.

P&L vs. Balance sheet

Your balance sheet shows the status of your company's assets, liabilities, and equity at a specific date.

In plain terms - it tells you what the company owns and owes. It differs from a P&L as it does not cover a certain period of time but a certain point in time.

It is a status report, not a progress report.

So continuing the previous example, at the beginning of the month Lucy’s balance sheet would show $200 of inventory. But at the end of the month, after selling $20 worth, it would show $180 of inventory.

What is included in a P&L?

So we’ve discussed the main elements of a P&L already: revenues and expenses. But these can be broken down into several sub-elements, which makes things more interesting:

1. Revenue

The top line, and most exciting part, of a P&L.

Revenue refers to any incoming funds relating to the sales of goods and services.

Ecom pro tip: splitting revenue based on channels is a helpful way to see where sales are coming from. For example, you may decide to present revenues from online sales separately from wholesale. This is helpful for MER calculations.

It’s also helpful to see the impact of discounts. By breaking down sales into gross sales and discounts separately, you can more clearly see why sales might appear lower in a given period.

2. COGS

The cost of goods sold refers to the cost of the inventory that was sold to generate that revenue.

This can be reasonably straightforward if you buy inventory from a wholesaler or manufacturer, or extremely complicated if you manufacture yourself.

3. Gross Profit

Revenue minus COGS gives you gross profit. This tells you how much you have earned only when considering the direct costs of selling.

It is important to note that this isn’t your final profit number. We haven’t looked at any overhead expenses or other indirect costs of selling.

4. Expenses

Every other expense incurred is included in this section.

We’re talking administrative expenses, advertising expenses, salaries, software costs, and rent - just to name a few.

Businesses often split expenses into different categories with a separate row for each. This can be down to your discretion based on what you find most valuable for your analysis.

For example, you may choose to separate marketing expenses into ad spend on PPC platforms vs other marketing activities. This additional transparency lets you see exactly where your advertising money is going.

For example, if Lucy started paying Steve from next door $10/month to talk to his soccer teammates about how Lucy’s Lemons is the only drink that quenches his thirst after a win, she might want to see that on a separate Influencer expense line rather than lumped in with her Google Ads & Facebook Ads.

Shipping costs are another source of pain for ecom brands. So that’s often a good one to have as a separate line item to check how these costs have stacked up over time.

5. Operating Profit

Gross profit minus expenses give you operating profit. Judging by its name, you can deduce this tells you exactly how profitable your brand’s operations are.

This ignores interest expenses and taxes. The idea is to focus on what a business’s operations can generate, independent of how it was funded.

For example, Lucy could have started her business using an angel investment from her grandpa or an interest-bearing loan from her dad.

One method would show an interest expense on her P&L and thus a lower net profit. But her operating profit would be the same in either case.

6. Interest Expenses

Any interest payments on loans or credit cards are included in interest expenses.

7. Tax Expenses

This one is self-explanatory. Death and taxes. It’s got to be done.

8. Net Profit

The bottom line of a P&L. This is the culmination of all our previous sections.

We have found the net profit earned by the company over a certain period.

The P&L is complete.

Why is a P&L important?

So this sounds like a lot of work. Why even bother learning about and putting together a P&L?

Understanding your annual performance

You can’t improve your ads if you don’t look at performance and the same goes for the rest of your business.

A P&L breaks down your performance and gives you an insight into how things have gone from a financial perspective.

Maybe after looking at revenue figures, you realize a particular sales channel hasn’t performed to expectations.

Maybe your advertising costs are going up without a proportional increase in revenue.

Maybe your shipping costs are unsustainable in the long run.

A P&L allows you to judge your performance and identify areas of improvement.

Project your future performance

Short-termism is a thing of the past. In an unstable macroeconomic environment, businesses must be prepared for what’s to come.

You can project future performance by looking at the historical data in your P&L and extrapolating each revenue/expense line item. This can help you to forecast where the business will be in 3, 4, or 5 years.

Not only that, but once you have your projections, you need to regularly compare them to the actual performance in your P&L. That’s the only way to know how reliable your forecasts are and improve them over time.

External users

Companies might be required to have a P&L to keep investors or banks happy.

A P&L also provides a degree of confidence that you are calculating your taxes correctly.

And if Lucy wants to one day sell her business to big lemon, she’ll need to have strong historical records of her performance to make a case that the business is healthy and worth buying.

Analyzing your P&L: how do you do it?

Like any data, financial statements are pointless if you don’t analyze and apply them to make better business decisions.

There are two main ways to analyze the data you’ve compiled.

Horizontal analysis

Also known as trend analysis, this is where you look at a particular line item and judge how it changes over time.

This allows you to identify patterns, detect issues, and project future numbers.

For example, Lucy might look at sales figures over a few years and notice that there is a seasonal increase every summer due to a correlation between heat and thirst.

She could act on these findings by increasing investments in inventory and marketing at the beginning of the summer.

Vertical analysis

We can also make judgments by looking at a P&L from top to bottom.

Vertical analysis consists of calculating the relative size of specific line items compared to the company’s revenue.

For example, Lucy might notice that shipping expenses are 10% of her revenues and decide that she should get that down by increasing the minimum order size to be eligible for free shipping.

2-D Chess

If you want to get extra value out of the analysis you can combine the two. Look at an expense as a % of revenue over time.

That means that you can compare how reasonable the change in an expense is from one period to another as a function of the change in revenue.

For example, Lucy might notice that her sales doubled from $10K in October to $20K in November thanks to her Black Friday promo.

But her Gross Profit % decreased from 80% to 40% indicating that she might have been too aggressive with her discounting strategy.

Or perhaps she notices that her Influencer expense as a % of revenue is increasing month over month, which could indicate that it’s not as effective in increasing sales as she had hoped.

Final Thoughts

In the land of ROAS and MER, P&Ls aren’t the sexiest topic to cover, but they are one of the most necessary.

Hopefully, you now have a better appreciation for, and understanding of, the P&L. And can put this knowledge to use making sure your brand is healthy and set up to dominate into the future.

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