A profit and loss statement, also known as an income statement, is a financial report that displays your total income, total costs (what you pay to produce your product or perform your service), total expenses (what you pay in overhead), and net income for any given time period.
You can generate a profit and loss statement for any time period, but the most common time frames are monthly, quarterly, and annually.
Why do I need a profit and loss statement?
At its most basic level, a profit and loss statement shows if your business is profitable and if your business model is sustainable. If you have a profit, it means that your business is earning more than it spends. If you have a loss, it means your business is spending more than it earns.
You can use a profit and loss statement to answer overarching questions about your business strategy, such as:
- Do I have enough revenue to cover my costs and expenses?
- Do I have a high return on investment for my expenses?
- Does my business earn enough money to pay me, the owner?
Your profit and loss statement can also give you insights about the details of your day-to-day operations, like:
- Your top earning revenue streams
- Your gross margin (the ratio of your costs of goods sold to revenue)
- Your lowest earning revenue streams
- Your top spending categories
- Where you can reduce your spending
Over time, your profit and loss statement can also show you:
- Your business’s growth over a specific period of time
- The areas of your business impacting its revenue growth
- The areas of your business impacting its profitability
- Sales trends and patterns
Yes! You can get all of this from one little report, which is why a profit and loss statement can be so impactful for small business owners.
How is a profit and loss statement structured?
A profit and loss statement has five sections:
- Costs of Goods Sold (COGS)
- Other Income/Expenses
- Net Income
Here is a profit and loss statement example:
Let’s talk about the first four sections first: income, COGS, expenses, and other income/expenses.
All four of these sections are structured the same way. There’s a line for every income or expense category and subcategory that you use in your business. Each line shows you the total earned or spent in that category for the time period that you’re creating the P&L statement for.
If you use subcategories in your accounting, you’ll also see a subtotal of the subcategories directly under the list of itemized subcategory amounts.
At the very bottom of the income, COGS, and expense sections, there is a total for that section so you can see the total amount you spent or earned.
The final section of a profit and loss statement is your Net Income.
Net Income = (Income – Costs of Goods Sold – Expenses – Other Expenses) + Other Income
If your net income is a positive number, it means that you earned more than you spent and you have profit. If your net income is a negative number, it means you spent more than you earned and you have a loss.
What else should I know about profit and loss statements?
Along with the general “total” lines of the five main sections we just went over, there are a few other “total” lines on a profit and loss statement.
First, under the COGS section, there is a line called Gross Profit.
Gross Profit = Revenue – Costs of Goods Sold
Gross profit shows you how much you actually earned after you take the costs of selling your product or service out of your revenue. Your gross profit is what’s available to put towards operating expenses. (It’s what you can put back into your business!)
The next special “total” line is called Net Operating Income, which is included in the Expenses section of your profit and loss statement.
Net Operating Income = Income – Costs of Goods Sold – Expenses
This is your net income after you subtract your operating expenses and costs from your revenue. Net Operating Income does not include irregular income or expenses. Instead, it’s the money that’s left (or not left) after your day-to-day operations.
Irregular income and expenses—ones not related to your day-to-day operations—are included in the Other Income/Expenses section of your profit and loss statement.
Just like you wouldn’t count a $10 birthday check from your grandmother as part of your monthly income and budget, irregular income is split out on your profit and loss statement. That way, you can easily see and discount uncommon income and expenses and budget around them.
Examples of Other Income are:
- Dividend income
- Interest earned
- Income from investments
- One-time income from an unusual source
Examples of Other Expenses are:
- Reimbursable expenses
- Taxes or penalties
- Depreciation or amortization
- One-time extraordinary expenses (like legal fees)
Pro tip: Your Net Income includes all your expenses for the time period, even the unusual ones. The Net Operating Income line is better for gauging the profitability of your day-to-day operations.
What isn’t shown on a profit and loss statement?
A profit and loss statement only shows your income, costs, and expenses. Assets, liabilities, and equity do not appear on the report.
Assets can include:
- Purchases of furniture, equipment, machinery, tools, and vehicles
- Money lent to others
- Security deposits paid
Liabilities can include:
- Credit card payments
- Loan payments
- Sales tax payments
Equity can include:
- Owner distributions
- Money invested by the owner
Many people confuse profit with cash that’s available to spend, but the two are not the same! That’s why it’s important to understand what’s not included in your profit and loss statement.
You can have profit and still have negative cash flow, especially if you have a lot of liability payments or need to take owner distributions. If you see a profit on your report, don’t assume that all that money is available for you to spend!
How do I prepare a profit and loss statement?
A profit and loss statement can be prepared using a digital bookkeeping program like Xero. (Some programs will call the profit and loss report an income statement. Whatever it’s called, the report will be structured the same and can be run for any time period that you specify.)
You can also hire a bookkeeper to prepare this report for you.
If you don’t have a bookkeeper or a digital bookkeeping program, then you can prepare your own by using this profit and loss statement template.
Add lines for all your income, costs, expenses, and other income/expense categories and then add up the categories in each section. At the very bottom, create a line for net income and subtract your costs, expenses, and other income/expenses from your revenue. Voila—you’ve created your very own profit and loss report!
And that’s it! Getting to know your profit and loss report will help you understand the big picture—and the tiny details—of your business finances.