At a high level, your P&L statement explains whether you’re profitable or not. The report begins with your revenue then lists your cost of goods sold, operating expenses, taxes, etc., and ultimately culminates with your net profit. Within seconds, viewers of your P&L report will know whether your business made a profit or a loss (hence, the name) and what factors contributed to that result.
If the world is going to put this report on a pedestal, you should at least understand the basics. A good understanding of your P&L report will not only help you communicate your financials, but it will also give you quick insights into your business’s financial health. Armed with these insights, you’ll be better positioned to make sound business decisions at a moment’s notice.
Let’s start from the top down.
P&L Statement Breakdown
P&L statements are most effective when used contextually, and that’s why you’ll often see the financials for multiple years on a single report. If a business has been profitable in recent years but then takes a sudden loss, the report often reveals why. Maybe the company rapidly scaled sales but had to invest in more operating expenses to set the business up for future success. A single year of data won’t tell that entire story.
Revenue is simply the money you bring in as a result of sales. For your business to be profitable, your revenue needs to exceed your expenses.
Cost of Goods Sold (COGS)
Cost of goods sold, or direct costs, refers to the money necessary to make a sale, like materials needed for production and direct labor costs. You wouldn’t include indirect expenses like shipping or marketing fees.
Gross profit is the profit a company makes from sales after you deduct the cost of goods sold. The formula for gross profit: Gross Profit = Revenue – Cost of Goods Sold. Gross profit gives you a quick understanding of how much you’re making off each sale, although it doesn’t include fixed costs and other operating expenses.
Operating expenses are the costs you incur indirectly from the sale of a product. Think of it as the electricity bill for the warehouse, rent, salaries, marketing expenses, etc. This number does not include your COGS.
Net income is all of the money that’s left from your revenue after you’ve deducted your COGS, operating expenses, interest, taxes, and so on. If your expenses exceed your revenue, the negative number is referred to as a loss.
That’s basically all there is to your profit and loss statement, but before you start reading this report regularly, let’s clear up a couple of critical nuances.
Don’t Confuse Profits with Cash
Many businesses fall into the trap of trusting false profits. This mistake can lead to erroneous financial decisions that damage your cash flow and put your business in jeopardy. Profits on your P&L report don’t mean you have cash in the bank. Accountants record sales in the P&L report even if they were sold on account. That means the transaction isn’t cash yet—it’s Accounts Receivable, which is very different from money in the bank.
Your P&L statement doesn’t tell the whole story, which is why you also have balance sheets, cash flow statements, and other financial reports. Take a retail business, for example. In almost every situation, businesses purchase inventory or build products in advance of selling it. And the turnover from purchase to sale doesn’t usually occur within the same month. However, the money spent on inventory won’t show up on your P&L statement until the sale occurs. You can see how ignorance of this fact might cause some flawed financial decisions.
Regularly Check Your P&L Statement
Your P&L statement won’t do you much good if you never check it. Make it a habit to look over your P&L report each month to stay up-to-date on your business’s financial health. If you only analyze it quarterly, you could miss out on important opportunities or discover problems far too late.
Using the P&L report alone won’t give you the whole picture, though. Pair this report with your other financial statements to get a more complete view of your company. By understanding your business financials, you’ll be primed to secure the best financing and make the most informed financial decisions for your business.