Understanding your profit and loss statement
Your profit and loss statement (P&L) provides valuable insights into your business. Can you read and interpret them? If not, these steps will get you started.
A P&L usually covers a financial year, and allows you to report on income and expense figures for the current month, the year to date (i.e. the period from July 1 to the current month), or for another period you define, such as the last three months.
A P&L is generally broken into three main areas: sales, costs, and expenses; each of which is sub-totalled as you work your way down the page. The report will also contain your gross profit and your operating profit.
Sales figures or income
If you invoice your customers, by default the figures in the P&L will be reported on an accrual basis, meaning the report covers what you’ve invoiced, not what you’ve collected. However, most accounting systems will also allow you to run a P&L on a cash basis when required.
Note that these figures are always exclusive of GST because GST is never your money, it’s just a tax you’re collecting on behalf of the government.
Cost of goods sold (COGS) or direct costs
These are the costs that vary directly with your sales. For example, if you sell 10 new computers to a client for $1,200 each (excluding GST) your sales income would be $12,000. If those computers had cost you $700 each, your COGS would be $7,000.
"If your gross profit percentage is declining over time you’re likely to feel it in terms of reduced net profit and a worsening cash position. "
If you sell services rather than goods, your direct costs will include your wages, salaries or subcontractor expenses for the period.
Gross margin or gross profit (GP)
The difference between your sales income and your total direct costs is your gross margin, or gross profit, GP. In the computer example above, the GP would be $5,000. That is, $12,000 minus $7,000.
It can be useful to calculate your gross profit percentage (or GP%), which is just your GP divided by your sales and them multiplied by 100. In the example above, the GP% is 41.7%. That is, $5,000 divided by $12,000, multiplied by 100.
This calculation helps you to understand how your business is performing. For example, if your GP% is declining over time you’re likely to feel it in terms of reduced net profit and a worsening cash position.
Want more articles like this? Check out the financial management section.
These are the items that typically don’t vary as sales vary, and include rent, marketing expenses, insurances, admin salaries and so on. I see many P&L’s where the expenses are listed in alphabetical order, but I strongly recommend creating some subtotals so you can see totals by each type of expense. For example, total salaries and related costs such as super, training costs, workers compensation and payroll tax. Having these subtotals will help you see the big picture, rather than just worrying about the detail.
Your operating profit is your GP less your expenses. As with GP, it can be very helpful to also calculate your operating profit as a percentage so that you can keep track of changes in your profitability.
Your P&L may also include a few other lines such as non-operating income and expenses, but for most practical purposes, you can focus on the operating profit line.
Your P&L is a yardstick that you can use to develop your budgets (and then report future P&Ls against that budget) or track trends in your business over time. But it can only be used in that way if you run the report, spend time analysing it, and then take action.
Have you experienced business benefits from reading and responding to your P&L? If so, please share them in the comments.