How to read your profit and loss statement

The profit and loss statement is the report business owners look at most, yet many read only two numbers: total sales at the top and profit at the bottom. Everything in between tells you how the business makes its money and where it leaks. Learning to read the whole report takes a little practice, and it is one of the most useful skills an owner can have. This guide walks through each part and the questions worth asking.

What the profit and loss shows

The profit and loss, also called the income statement or P&L, shows the business's income and expenses over a period, such as a month, a quarter or a year. The difference between them is profit or loss.

Two points are easy to miss:

It covers a period, not a moment. The balance sheet is a snapshot on a single date. The P&L shows what happened between two dates.
Profit is not cash. On the accruals basis, income is recorded when it is earned and expenses when they are incurred, not when money changes hands. A profitable month can still leave the bank account lower. That is why a cash flow forecast is a separate and necessary tool.

The structure, line by line

The layout varies with your software and chart of accounts, but most follow this order.

Revenue

Revenue, also called sales, income or turnover, is what the business earned from its main activities, shown without GST if you are registered. If revenue is broken down by product, service or location, you can see which parts of the business are growing.

Other income, such as interest, government grants or a gain on selling equipment, is often shown separately. Keep it separate in your mind too: it may not recur.

Cost of sales

Cost of sales, also called direct costs or cost of goods sold, covers the costs that rise and fall directly with what you sell. For a retailer, it is mainly the cost of stock sold. For a trade business, it may be materials and subcontractors. For a service business, it may include the wages of staff who deliver the work.

Gross profit and gross margin

Revenue minus cost of sales is gross profit. Expressed as a percentage of revenue, it is the gross margin. This is often the most important number on the page, because it shows how much of each sales dollar is left to pay for everything else.

As an example, a business with revenue of $1,000,000 and cost of sales of $600,000 has gross profit of $400,000, a gross margin of 40%. Every additional $100 of sales at that margin contributes $40 towards overheads and profit.

A falling gross margin is an early warning. It might mean supplier prices have risen and have not been passed on, discounting has crept in, the sales mix has shifted towards lower-margin work, or jobs are running over budget.

Operating expenses

Operating expenses, or overheads, are the costs of running the business regardless of sales volume: rent, administration wages, insurance, software, marketing, motor vehicles, professional fees and so on. Continuing the example, if overheads total $300,000, the business makes $100,000 before interest, depreciation and tax are considered, depending on how your report is laid out.

Look at overheads both in dollars and as a percentage of revenue. A cost that grows faster than sales is worth a closer look.

Depreciation and interest

Depreciation spreads the cost of equipment, vehicles and other assets over their useful lives. It is a real cost, but not a cash payment in the period. Interest is the cost of borrowing. Some reports show these separately, which lets you see operating profit before financing and asset decisions.

You may also hear the term EBITDA: earnings before interest, tax, depreciation and amortisation. It is widely used when businesses are valued and compared, because it strips out financing and accounting choices.

Net profit

What is left after all expenses is net profit. In company accounts, income tax may then be shown to arrive at profit after tax.

A note on owners' pay

How the owner is paid affects the P&L, and it varies with the business structure:

Sole traders and partnerships do not pay themselves wages. Money taken out is drawings, which does not appear in the P&L. The profit shown is the owner's return for their work and investment.
Companies may pay directors a salary, which appears as an expense, or the owner may take money in other ways, such as dividends, which do not.

This matters when comparing your business with others, assessing whether it is genuinely profitable, or valuing it. A business that shows $150,000 profit but relies on an owner working sixty hours a week for no salary is not the same as one that pays a manager to do that work. Buyers and their advisers adjust for this, a process often called normalisation. If you are thinking about buying a business, it is one of the first things to understand.

How to read it well

Compare, do not just read

A single P&L tells you little on its own. Put it beside:

the same period last year, to allow for seasonality
the previous month or quarter, to see trends
your budget, to see whether you are on track

Look for movements that you cannot explain. Either something has genuinely changed, or something has been miscoded. Both are worth knowing.

Work in percentages

Convert key lines to a percentage of revenue: gross margin, wages, rent, marketing and net profit. Percentages let you compare periods of different size and spot creeping costs.

Check the one-offs

Separate one-off items, such as an insurance payout, a large repair or a grant, from ordinary trading. They can make a weak period look strong or the reverse.

Ask whether it is complete

A P&L is only as good as the books. If supplier bills have not been entered, depreciation has not been recorded or income has been coded to the wrong period, the profit figure is wrong. A regular month-end close is what makes monthly profit figures reliable.

Questions to ask each month

Is revenue in line with what I expected, and which areas grew or shrank?
Has gross margin held up? If not, why?
Which overheads moved most, and are those changes intended?
Are there one-off items affecting the result?
How does profit compare to cash in the bank, and why are they different?

Revenue tells you how busy you were. Gross margin tells you whether that work was worth doing. Net profit tells you whether the business, as a whole, is paying its way.

How we can help

If you would like help understanding your profit and loss, or setting up monthly reports that answer the questions you care about, we can work through them with you. Learn more about our accounting services or contact us.

This article is general information only and does not take into account your circumstances. Speak to a qualified adviser before acting on it.