The first thing to know about a profit and loss statement is that it’s a lot like Sean “Puff Daddy” Combs. (Or does he just go by Diddy now?)
A profit and loss statement, like producer and businessman Mr. Combs, goes by more than one name—and can do more than one thing. Sometimes it’s referred to as an income statement or an earnings statement. For the cool kids, it’s simply a P&L.
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So what is it, exactly? A P&L is a financial statement or report that tells a narrative about your business over a specific period of time.
The language of business is numbers. The story of any company, regardless of its size, can be told through financial reports. And if you aren’t looking at your numbers, you’re straight-up Sandra Bullock in Bird Box, floating down a river with a blindfold on.
In this article, I’ll show you an easy (and visual) way to understand your profit and loss statement.
Where you’ll see a P&L in the wild
In my nerdy bookkeeping world, a profit and loss statement appears at the sound of a swoosh and the push of a button. The accounting software does all the hard work of reporting for you and it’s seriously magical.
Having quick access to these reports is a big reason why bookkeeping software is so important for business owners.
It’s totally possible to create your own P&L (in the same way it’s totally possible to make make home-made Skittles). But between the two options, there is a clear and easy choice.
Depending on the number of transactions you have, generating your own P&L may take a lot of time and effort. You first need to manually add up transactions from your bank and credit card statements and then organize it all in a spreadsheet.
With this method, it’s too easy to make mistakes. You can’t really look at the underlying data easily if you wanted to re-sort it or if you needed to reference it.
For example, let’s say you reported $1,000 in meals in February, and come August you want to see more details about each transaction.
- With bookkeeping software, you can simply expand on that number to see all the transactions.
- With manual reporting, that’s likely not the case.
Using bookkeeping software is light years ahead of an analog report.
So how do you read a P&L statement?
Profit and loss statements generated in bookkeeping software are standardized, which means, once you know how to read one, you can read them all.
You’ll generally have these three categories:
- Revenue: Income, like from sales
- Cost of goods sold, or COGS: Your direct costs
- Operating expenses: Overhead
Each category can be further broken down into subcategories.
At the top of the P&L, you’ll have a breakdown of your business’ revenue sources and the total amount of revenue for the period. Remember, revenue is the amount of income you’re bringing in from sales during a specific timeframe.
Direct Costs or Cost of Goods Sold (COGS)
Right below that, you should have a breakdown of your direct costs. If you sell products, direct costs will be called cost of goods sold (COGS).
The cost of goods sold is how much you pay to buy the thing you’re selling. These costs tend to vary because how much you buy depends on how much of those items you sell.
Different industries will have different costs of goods sold. For example, a business that resells musical instruments will have a higher cost of goods sold than a business that sells life coaching. And a business that sells services and products, like a computer store that does repairs, might fall somewhere in between.
It’s important to look at the cost of goods sold expressed as a percentage of your total revenue because then your numbers are relative, which means you can compare them to other periods or to benchmarks for your industry.
You can find this by dividing the total COGS by the total revenue.
Here’s an example.
Let’s say your gross revenue is $25,000 and your COGS is $7,500.
$7,500 / $25,000 = 0.30.3 x 100% = 30%
In this example, your COGS is 30% of your total gross revenue. In other words, it costs you 30% of your revenue to buy the product you’re selling.
Looking at COGS expressed as a percentage can help you easily compare your costs to your industry standard, understand what your costs and revenues would be if you were looking to expand, and can also help you keep an eye on costs from period to period.
Next, you’ll have gross profit. Gross profit is what’s left over from the revenue earned after you subtract the cost of goods sold and before you account for all your operating expenses.
The gross profit is the amount of money left over that you can use to run your business, so it’s important to make sure you have enough.
Gross profit can also be expressed as a percentage of total revenue by dividing it by total revenue.
If your gross revenue is $25,000 and your gross profit is $17,500, then your gross profit is 70%.
$17,500 / $25,000 = 0.7 0.7 x 100% = 70%
Once again, it’s important to look at this number expressed as a percentage so you can make your data relative for comparing your gross profit to the industry standard.
This will help you predict how this number may change when revenue and/or your cost of goods changes, along with monitoring any big changes in the amount over time.
Then there are the operating expenses, commonly (and coolly) written as OPEX. Sometimes these business expenses are also referred to as overhead. They are generally fixed, meaning they’re the expenses associated with running your business day to day.
Here are some examples of operating costs:
Yes, you should also understand your operating costs expressed as a percentage of your gross revenue. Similar to gross profit, this percentage will help you compare your costs to industry standards so you can see how you’re doing compared to other companies in your space. This will give you a starting point when making predictions about expanding or contracting your business.
Let’s say you spent $10,000 on OPEX, and you had $25,000 in gross revenue.
$10,000 / $25,000 = 0.40.4 x 100% = 40%
That means operating expenses are 40 percent of your gross revenue.
Using the equation above, you can express any line item in terms of percentage of gross revenue. This can help you understand a particular cost from a different perspective.
For example, let’s say your business spent $12,000 on marketing in the same month it earned $25,000. That’s 48 percent of revenue that went towards marketing. ($12,000 / $25,000 = 48%.)
Looking at the cost in terms of percentage of revenue can help you see the cost relative to your income.
The bottom line
At the bottom of your P&L, you’ll have your net profit or net loss. This is also called net income, net profit margin, profit margin, and net profit ratio. All of these terms refer to the amount that’s left over after you subtract your operating costs from your gross profit.
If you have trouble remembering net vs. gross, think about a net at the bottom, catching whatever is left over.
And yes, in addition to looking at the bottom line in terms of real dollars, looking at it in terms of a percentage of total revenue helps you make that number relative so you can make comparisons.
Let’s calculate the percentage where $7,500 is net profit and $25,000 is the gross revenue.
$7,500 / $25,000 = 0.30.3 x 100% = 30%
Net profit or net income in this example is 30% of gross revenue.
Why is net profit important? Looking at the percentages over time can help you measure your company’s growth rate.
Here’s how to find the growth in net profit period over period.
Let’s say the prior month’s revenue was $23,000. Use this equation to find the percentage change from the prior month to the current month.
(Most current period – Prior period) / Prior period
($25,000 – $23,000) / $23,000 = 0.08690.0869 x 100% = ~ 8.70% growth
Now that you can read a P&L, what else is it useful for?
1. To make forwarding-looking decisions using backward-looking data
If you’re trying to grow your business, the P&L is a great place to start to make predictions based on history.
- How much has revenue grown month over month, quarter over quarter, and year over year?
- Can you predict how much revenue will grow over the next year or three years?
- What does this mean for staffing and production?
2. To collect data on experiments you’re running in your business
Your profit and loss statement can verify whether a new line of business is actually profitable. You can see how a new revenue stream trends, or how an increase in marketing spending impacts sales.
3. To make sure you’re on target within your industry
A P&L can help you see where your business is in terms of profitability compared to the industry standard. If you’re lagging behind, diving into the P&L might help answer questions like:
- Are you paying too much for production or cost of goods?
- Are your monthly operating expenses too high?
- Or maybe your prices for your products and services are too low?
Browse through these resources for financial standards and benchmarks within your industry:
- Start with your industry associations. They might provide consolidated industry data and financial benchmarks.
- Biz Stats provides “free business statistics and financial ratios” and is pretty easy to navigate.
- The IRS’ Corporation Source Book and the U.S. Census Bureau’s Economic Censuses have extensive information, but they can be overwhelming to sift through
4. To make sure your business is profitable
At first, getting to know your P&L might feel daunting (or maybe depressing if the numbers aren’t pretty).
But without it, you have no way of really knowing how your business is doing compared to competitors, if you’re making progress, and if you’re on the right track.