3 Red Flags to Avoid in Your Business P&L

Can you say for certain you know exactly what is going on in your P&L (or Income Statement)? If not, you may need to take a deep dive to uncover any red flags that may be hindering business growth. When red flags go undetected, you are faced with many negative side effects, from overpaying on taxes to halted business growth, making analysis of any red flags a priority. 

Red Flag #1: Decreasing Profit and Margins

The first indicator that something is wrong with your P&L is when you notice decreasing margins. Common margins that appear on the P&L include cost of goods sold to sales, operating income to sales and net income to sales. These 3 ratios make comparison easier from period to period. When you analyze your P&L, you should look at these margins to uncover any major mistakes. If you were expecting a loss, these ratios will be negative, but if you feel like you had a solid month or year, the numbers should be increasing or around the same place as the prior period. Steady declines can foreshadow business continuity issues as it indicates the business is consistently losing money and generating decreasing profits. There are a few steps you can take to mitigate the risk including:

Analyzing seasonal trends - If your business is seasonal, say a lawn care business, your margins will have extreme differences between quarters. You want to be sure you are analyzing the prior year figures to fully determine your business standing. It may not be a big deal when margins decrease at the end of the year if your business seasonal margins are increasing from the prior year.

Cut out unnecessary expenses – Small businesses tend to spend a majority of their time growing their business without going back to the basics and cutting out unnecessary expenses. For example, unused magazine subscriptions and software programs should be canceled if they are not providing any benefit to the business. This can increase your margins and put more money back into your pocket at the end of the day. 

Increase prices – Inflation is increasing at rapid speeds, leading to necessary price adjustments. There are two main ways to improve the bottom-line number, also known as net income: increase revenue or decrease expenses. Your sale prices need to be adjusted to match inflation levels and as your expertise grows. You should not be charging customers prices from 5 years ago.

Red Flag #2: Unproportionate Expenses

After you review margins for any big red flags, you need to dive deeper into the P&L and look at expense categories. Ideally, expenses should be increasing or decreasing proportionally compared to sales. Say sales increased by 2%, you would then expect to see the cost of goods sold increase by 2% as well. You should be able to explain any large outliers, such as a new software program added or higher supplier fees. Unexplained costs can have a significant impact on the bottom-line number, which is often what you pay taxes on, making it essential that everything is recorded properly. Having comparative P&Ls, which is two periods side by side, is a great way to begin analyzing expenses. Some large expense categories to perform analysis on include:

Cost of Goods Sold – A major red flag on the P&L is when cost of goods sold increases unproportionally compared to sales. With the recent pandemic, many construction companies saw the cost of materials dramatically increase. To mitigate the risk of losing money, these companies raised sale prices to keep costs proportional. If you were one of the few companies who did not raise prices, you should reconsider because of the effect it can have on net income.

Wages – Similarly, wage expenses also need to be analyzed. An increase in wage expense and a decrease in the bottom-line number indicates that employees were not as efficient. To fix this issue, implement new productivity policies and incentives to motivate employees to improve their work speed while maintaining quality. 

Repairs and Maintenance – Repairs and maintenance may seem like a miniscule account to analyze, but many small businesses struggle to comprehend when certain items need to be capitalized and reported on the balance sheet. Any expense that improves the property, such as adding a sidewalk, should be capitalized.

Red Flag #3: Reduced Advertising Expense

Unfortunately, many businesses struggled to grow with the increased competition in recent years. Technology has made it incredibly easier for new entrants to gain market share, leaving existing businesses struggling to maintain a strong customer base. As a result, small businesses need to focus additional efforts on their advertising strategy to remain competitive and profitable. If you notice advertising expenses decreasing between periods, it may be time to adjust your overall strategy. According to a Deloitte study, 73% of businesses have ramped up marketing strategies since the inception of the pandemic (Veenstra, Deloitte). Almost 3 out 4 businesses have altered their strategies, making it important that you are too. Here are some advertising strategies to ramp up sales and market share:

Channels – Advertising channels include radio, print, television, and social media. If you are only using one of these channels, consider adding another one. Social media is a powerful tool that should be used by all businesses regardless of industry. Social media apps, like Tik Tok, Instagram and Twitter, should all be utilized to reach Millennials and Gen Z customers. 

Audience – The audience you are tailoring your marketing strategy to also should be evaluated on a regular basis. If you are consistently reaching customers aged 40-60, it might be time to increase advertising expenses to expand the group you aren’t reaching. 

Incentives – Incentives are another great way to rework your advertising and marketing strategy. Offering new customers a special incentive, like 10% off or free shipping, can lead to a steady customer down the road. Discounts are a small price to pay for repeat customers who will eventually pay the full sale price, boosting the strength of your P&L.  

Why Should I Care About an Accurate P&L?

According to recent studies, 48% of small businesses define success as achieving a profit (Xero). Achieving a profit is founded on strong accounting policies, such as accurate reports. Having an accurate P&L goes well beyond comparing growth between periods. The P&L net income is what you eventually pay taxes on. If expenses are inaccurate, you could end up paying too much in tax. Due to the significant burden accurate report production can have on your busy schedule, many businesses turn to an outsourced accountant. Outsourced accountants can provide you with all the tools necessary to achieve business growth, from bookkeeping to report creation, all with reduced expenses compared to hiring an in-house accountant. Reach out to Basis 365 today to discuss the benefits we can provide you. 

Sources

Veenstra, Jennifer. “The CMO Survey: Rising to meet the challenge.” Deloitte, 2021, https://www2.deloitte.com/us/en/pages/chief-marketing-officer/articles/cmo-survey.html. Accessed 18 December 2021.  

Xero. “T-Minus Five: Report reveals more than half of US small business owners surveyed give themselves five years or less to make it or break it.” Xero, 2021, https://www.xero.com/content/dam/xero/pdf/media-release/tipping-point-making-jump-self-made-usa.pdf. Accessed 18 December 2021.