How NOT to read a Profit and Loss Statement
What you never knew about your Profit and Loss Statement!
Every business needs a measure to make some meaning out of its activities and to assess results. The most commonly used statement for this is the monthly profit and loss statement.
If you missed our earlier posts, you may want to visit Repeat Guest Ratio, Average Length of Stay – 2 Paths to Revenue Growth Nirvana, Table Turnover, Meal Period Analysis – 2 Paths to Restaurant Revenue Growth Nirvana, Market Segmentation Reports – Road Map to Revenue Results and 5 Myths about Financial Analysis, to catch the thread of related posts. Go to Flow of Revenues – Part 1 and 2 here and here.
However, it is unfortunate that most times the profit and loss statement is read incorrectly and worse, decisions are taken based on such erroneous reading.
The following are some of the most common errors:
Revenue and expense items are read individually - Most people including many with a finance background tend to treat revenues and expenses as silos. Their analysis approaches revenues and expenses separately. They do dig deep into these but their analysis is ineffective because they do not see the connection between them. They see the trees but fail to see the forest.
Profitability is a derivative - What does this mean? It means that it cannot be generated on its own, it can only be derived from a comparison of revenues and expenses. This means that profitability is affected by changes in revenues and expenses.Hence, without analyzing what the changes in revenues are and what the changes in expenses are, it is impossible to carry out any analysis and worse take decisions in the operation.
Profit and Loss Statement is only historical - Revenues and expenses recorded in the Profit and Loss Statement are cumulation or aggregation of hundreds of financial transactions during a particular business period, normally a month. As such, these are historical in nature, I.e., they are past events. They only tell you what happened under a certain set of circumstances prevailing at that time.
Tendency to concentrate only on expenses - Everybody who reads a Profit and Loss Statement is paranoid about expenses. They give you the impression that controlling costs (meaning cutting in almost all instances) is the only profit model. Your Performance Appraisal depended on it, your bonus was impacted by it and you were persona non-grata to your boss because he or she did not look good.
Nobody looks at the behavior of revenues and expenses - Scarcely anybody concentrates on the behavior of revenues and expenses. Since the emphasis is all the time on "what happened" or "what is", there is no importance given to "what could be." Even if "what could be" is considered, it is a half baked, hit or miss approach.
The Cause-Effect Relationship analysis is missing - This is the most critical element of the analysis and sadly very few have time for this. Financial Analysis is thoroughly misunderstood to be an analysis of revenues first and then an analysis of the expenses subsequently without leveraging the power behind the relationships between these two. The Funnel Principle of Financial Analysis clarifies the concept of cause-effect relationships.
So, the next time you get your hands on a Profit and Loss Statement, use the following powerful approach:
Ask these questions:
what is the change in revenue compared to the previous period/budget? Is it positive? Why?
what is the change in expenses compared to the previous period/budget? Is it positive? Why?
what is causing the change in revenues and the expenses? Was it some action of yours?
what is the result of the change? Is it positive? If yes, replicate it. If it is negative, course correct.
How can you take action now? What action can you take?
At the end of the day, reading a Profit and Loss Statement is not rocket science. However, it needs some big picture thinking as well as going into details. Such a balanced approach to reading the Profit and Loss Statement will eventually appear to become magical.
