How to read a profit and loss statement: what you need to know

What is a profit and loss statement?

The first thing you need to know about profit and loss statements (P+L statements) is they go by half a dozen different names, just to make things more difficult for you. They may also be called:

  • Income statements
  • Revenue statements
  • Earning statements
  • Operating statements

Understanding P+L statements

Profit and loss statements all follow a simple, standard formula:

Sales – Costs = Profit / Loss

You might notice a similarity with a balance sheet. Like balance sheets, a profit and loss sheet is a way to represent complicated info in a simple manner.

The issue comes when items start being labelled on the P+L sheet. Sales might be referred to as fee income, or revenue. Costs might also be referred to by another name, commonly expenses.

Each of these headings can be broken down further. For example, operating costs could also be subdivided into:

  • Internet fees
  • Cell phone fees
  • Hosting costs

How to organise a P+L statement

Generally, sales is at the top of your P+L sheet. It might also be called Income, Revenue or Fees.

Below Sales is generally Costs, with total Profit or Loss at the bottom.

There are various methods your bookkeeper might use to set out your P+L statement, there might be several subtotals as you read down the statement, but at the end of the day, the basic formula still stands.

Sales – Costs = Profit

On your statement, sales and revenue might be divided into multiple streams. As an example, a gas fitter might have revenue streams for hours worked, emergency call outs and designing heating systems for commercial buildings.

As a business, the decision might be made to split the revenue into these streams to make it simpler to assess the effectiveness of each income source. Either way, below them all they might also be added together in one final line, totalling the revenue figure.

Sales can be broken down in the same manner. Using our tradesman example, there might be categories for materials, transport and marketing costs.

There is no fixed way to break down your sales and revenue streams. It tends to come down to the needs of the business and the methods used by your accountant.

How to break down costs

One of the most common and effective methods to break down your costs is to divide it into two categories:

  • Costs necessary to deliver your service
  • Costs that are not necessary to deliver your service

Costs to deliver your service are generally referred to as COGS, or Costs of Goods Sold.

Using our example, necessary tools and materials that are used to repair and install heating systems would be a COGS for our heating engineer.

If there are no direct goods purchased, for example in a service business, then it is referred to as COS, or Cost of Service. This is the operating price of the people who deliver the service and their transport costs.

Gross Profits

Gross profits, which might also be referred to as Gross Margin, can be represented by the following formula:

Sales – COGS = Gross Profit

Gross profit is how much the business makes after the costs of running the business are taken away from the costs necessary to deliver the product.

Other Costs

If you’ve ever run a business, you soon realise that there are a huge amount of incidental costs, that aren’t associated with directly delivering your product or service.

Example costs are the cost of meeting with clients, costs of outside marketing teams or the actual costs of your accountant.

The term for these costs is Selling, General and Administrative Costs (SG&A)

Adding this to our P+L statement, we come to the following formula

Sales – COGS = Gross Profit;

Gross Profit -SG&A = Profit / Loss

Understanding the meaning of your P+L Statements

Like all statistics, there’s deeper meaning behind the numbers. Once you have an understanding of the parts of your P+L statement, you can watch the changes happen over time, see the ups and downs of your business due to outside effects or the effects of marketing campaigns, and begin to use them to predict future performance.

Using this information, it becomes easier to decide how and where to invest further money and time. Despite the fact that reviewing figures like this generally isn’t the most fun use of your time, understanding your P+L sheets and using that information effectively is one of the best ways to improve your business, for both you and your customers.

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