Most small business owners don’t do much with their Profit and Loss Statement beyond glancing at the bottom line because they don’t know what it’s telling them. That’s understandable. Financial statements aren’t exactly intuitive to the untrained eye.
In this article, we’re going to train you to understand and read a Profit and Loss Statement, just like one of our Bench bookkeepers.
What Is a Profit and Loss Statement?
The P&L summarizes your business’s revenues, costs, and expenses for a specific period (and yes, there’s a difference between costs and expenses!). A P&L might cover a month, a quarter, or a year. Sometimes, it will also compare one period with an earlier period to see how you’re tracking over time.
A P&L essentially tells you if your company is profitable.
Practical Things a Profit and Loss Statement Can Show You
You can use a Profit and Loss Statement to help you decide:
- If you can afford to hire new employees or move to a bigger location
- If you have enough money to pay your taxes
- If your current growth strategy is effective
- If you’re making enough profit to pay back outstanding loans
- Which areas of your business generate the most profit and which generate the most costs
Essentially, a Profit and Loss Statement can provide insight on your revenues and expenses that may not be apparent until you see them summarized in black and white. But to get there, you need to know how to read it.
Understanding the Profit and Loss Statement
Every Profit and Loss Statement contains four basic components:
- Revenues: The total income generated by the sale of goods or services from the company’s main operations.
- Costs: The direct cost of producing the goods or services sold by the company, such as materials and labor.
- Expenses: The costs incurred by the business to generate revenue, other than direct costs of producing the product or service.
- Net income or loss: A measurement of the total revenues left over after paying all expenses. If the company has net income, it can use that money to save for a rainy day, invest, pay off debt, or distribute profits to shareholders. If the company has a net loss, it will need to tap into savings, receive additional investments from shareholders, or get a loan to cover the shortfall.
Now that you know the four basic components, every P&L follows the same simple formula:
Revenues – Costs – Expenses = Net Income or Loss
Sample Profit and Loss Statement
Let’s look at a P&L for Blake’s Brake Repair, a fictional company, to see what that might look like in the real world.
The P&L from your company may look different from this one because:
- Your company may use the term “sales” instead of revenues
- Your company may use the term “costs” instead of expenses
- Your company may use the term “net profit” instead of net income
- Revenues and expenses may be broken down into more detail and include subtotals
Don’t let these differences throw you. The P&L may look more complicated, but if you remember that every P&L follows the same basic formula, you’ll know how to read it.
How to Analyze a Profit and Loss Statement
Knowing that Blake posted a profit in November and that he made more this November than a year ago is useful. But where a P&L really comes in handy is using the information it contains to evaluate the financial strength of the company.
You can use a P&L to:
1. Compare Month-Over-Month or Year-Over-Year Numbers
For example, looking at the P&L above, we see that Blake posted a profit of $25,000 for the month of November 2019 compared to a profit of $19,000 for the same period in 2018.
That’s good news! However, Blake could also look at each number, line-by-line, to look for variances.
For example, revenues increased while the cost of goods sold decreased. Typically, when sales go up, so do direct costs. So why are costs down? Maybe Blake negotiated a better deal with his parts supplier, so the variance makes sense. But if the difference is surprising, Blake might want to investigate the reason.
2. Calculate Metrics
Metrics are a good way to objectively track the health of your business. Here are three that you can calculate using a Profit and Loss Statement.
Gross Profit Margin
Gross profit margin indicates how much of your revenue is profit after factoring in direct costs.
Gross profit margin = (revenue – cost of goods sold) / revenue
Net profit margin
Net profit margin tells you what percentage of your revenue was profit. Unlike the gross profit margin, it takes into account all expenses, not just direct costs.
Net profit margin = (revenue – costs – expenses) / revenue
Operating Expense Ratio
Operating expense ratio tells you what percentage of your revenues goes toward paying expenses other than direct costs.
Operating expense ratio = total operating expenses / revenues
For example, if Blake wanted to calculate his metrics for November 2019 based on the P&L above, his results would look like this:
Gross profit margin = (revenue - cost of goods sold) / revenue
($105,000 - $12,000) / $105,000 = 89%
Net profit margin = (revenue - costs - expenses) / revenue
($105,000 - $12,000 - $68,000) / $105,000 = 24%
Operating expense ratio = total operating expenses / revenues
$68,000 / $105,000 = 65%
Looking at the metrics above, Blake can see that 89% of his revenue is profit after paying direct costs, 24% of his revenues are profit after taking into account all costs and expenses, and 65% of his revenues go toward paying operating expenses.
3. Compare Your Numbers or Metrics to Industry Benchmarks
Knowing your own numbers and metrics is useful, but how do you compare to the competition? Industry benchmarks can provide an answer.
Benchmarks are industry standards that represent the average of key numbers collected from many different businesses in your industry. They’re an excellent tool for measuring your company’s performance against similar businesses.
Once you’ve calculated metrics for your company, compare them to the standards in your industry. If your ratios are pretty close to or better than industry benchmarks, you know you’re on the right track. If not, you may want to dig into the reasons your results are different and perhaps consider changes in how you run your business.
You can usually find benchmarking data through a national industry association, your local chamber of commerce, or even the U.S. Census.
A Profit and Loss Statement Can Help You Understand Your Business
If you’ve been filing your Profit and Loss Statements away without reading them, it may take a while to get comfortable reviewing the numbers. Once you do, however, you’ll realize your P&L is a useful tool for running your business successfully.