Warning: The Profit and Loss Statement Doesn’t Tell the Whole Story!

by Richard Jacobs 22nd of May, 2023

Warning: The Profit and Loss Statement Doesn’t Tell the Whole Picture!

A financial report that shows a business’s revenues, expenses, and profit or loss over a specific period is called a Profit and Loss Statement, otherwise known as an Income Statement.

While the Profit and Loss Statement does provide important information about a business’s financial performance, it is very unlikely to tell the whole story.

A very important consideration is that the Profit and Loss Statement only shows what’s happening within a given time frame, and it doesn't account for cash flow. A company's profitability may not necessarily guarantee financial stability, especially if it is burdened by a substantial amount of debt. This can significantly impact the availability of working capital, leading to cashflow issues, which is a commonly observed concern.

A potential investor ought then to consider the debt profile of the business and consider the following:

Accounts receivable - If customers fail to pay their dues on time.
Accounts payable - If you fail to pay your dues on time.
Seasonal fluctuations - This can significantly impact cashflow. For example, if the business experiences higher sales during the holiday season, it can lead to increased cashflow, but if not managed carefully, could create problems off season.
Economic conditions - Prevailing and potential future such as recessions, pandemics, stock market crashes or simply less access to cheap money through financial institutions.
Capital expenditures - The need to replace old equipment or purchase new equipment for growth.
Debt and interest payments.
Changes in Government regulations - This may include variations in tax laws and obligations.
Management decisions - Such as hiring new employees or investing in new projects.

Profit and Loss Statements only focus on the financials, leaving out other critical data metrics that could impact business performance. Consider –

Customer satisfaction - Collect data to understand how happy customers are with products and services offered.
Return on investment - How much a business earns compared to how much it has invested in its operations.
The percentage of market share and the total sales revenue a business generates for its particular industry is an important indicator of its success.
Net Promoter Score is an important metric that measures a business’s overall customer satisfaction, loyalty, and likelihood to recommend to others.
Customer acquisition cost – How much a business spends on acquiring new customers.
Lifetime value of a customer which is the amount of money that a customer may generate for a business over their lifetime.
The rate at which sales revenue is increasing can indicate a company’s potential for long-term success.
A business’s website traffic and engagement – Visitor frequency, bounce rate, and engagement can tell a lot about its marketing strategy’s effectiveness.
Other considerations might also include overall business culture, customer churn, supply chain and logistics, and/or lease requirements, especially if the business is location dependent.

When making decisions, businesses usually need to take into account the opportunity costs involved. However, many businesses fail to document these costs in detail, resulting in the loss of valuable indicators for decision-making processes.

It’s difficult to assess whether a business choice was the best fit or not, especially when the risk profile of the owner is not known, i.e., risk adverse vs risk taker. Has an owner missed significant opportunity because they are risk adverse? Has this impacted the possibility of resurrecting opportunity in the future?

Certain businesses may need to make significant investments in tangible, intangible, and inventory assets, but the returns on these investments may not necessarily match those of other businesses that don't require such investments. Consequently, while profits may be favourable, the return-on-investment may still fall short of expectations.

It is therefore essential to look beyond the Profit and Loss Statements to make well-informed decisions.

Consider reviewing these other useful documents.

Sources and application of funds.
Cashflow statements.
Employment, supplier, customer contracts.
Industry certification – Hygiene, food, chemical standards.
Lease documents including details of commencement dates, rights of renewals.
Ensure you get a good understanding of staff, roles, costs, experience expertise, personal goodwill of the Owners i.e., is the business dependent on this?

Conclusion

While an Investor will initially review the Profit and Loss Statements to get a rough-cut idea of the business and its financial performance or viability, an astute Investor will review considerably more available metrics to build a much more holistic understanding of the business as a going concern.

It’s in your best interest to ensure all your ducks are in a row and anticipating the information and documents an Investor or Buyer is going to want to see.