Sound financial management starts with a proper set of books, and that begins with the accounting cycle.
The cycle starts by identifying and capturing every financial transaction the business makes over a period, typically a month. That includes money received and spent, customer billings, amounts owed to vendors, and adjustments for non-cash items such as depreciation of fixed assets. This part of the process is essentially bookkeeping.
What bookkeeping produces is the raw material for accounting. The accounting process takes that information and shapes it into financial reports for two distinct audiences:
- External users — most recognizably, the IRS, along with lenders and investors.
- Internal users — the owners and managers who rely on these reports to make sound business decisions.
A good accounting system can produce a wide range of reports. Most of these reports are interrelated and most useful when read together, but in this article, we’ll focus on the one most owners reach for first: the Profit and Loss statement.
What Is a Profit and Loss Statement?
The Profit and Loss (also known as an income statement, statement of operations, or simply P&L) is a summary of financial information over a period of time, normally a month and/or a year, although, if used properly, it can be for any period of time depending on the needs of the business.
Ideally, a P&L is most powerful when it shows activity for each month throughout the year and a year-to-date total.
Modern accounting software can produce P&Ls in many formats, and most allow you to export the data into a spreadsheet for further analysis. For the example below, we’ll keep it simple: current month and year-to-date.
Here’s a sample P&L, along with reference points.
Accrual Basis vs Cash Basis
Before discussing how to read the P&L, it is important to note that there are two ways to prepare the report: on an accrual basis and on a cash basis.
- Accrual Basis: Put simply, the accrual basis, a generally accepted accounting principle used when reporting to external users, also recognizes income when earned, not received, and expenses when incurred, not paid.
- Cash basis: Cash basis is acceptable for internal reporting, but it is not always a proper reflection of what actually happens in a business. It’s the opposite for tax preparation. The cash basis recognizes income when received, not earned, and expenses when paid, not incurred.
Unless the entity is a true cash business, the accrual basis is the best method for providing meaningful information to support sound business decisions. Tax law allows the use of either method, but that is beyond the scope of this discussion.
For more information, please check with your professional accountant, such as a Certified Public Accountant (CPA) or tax professional.
In this discussion, we assume the accrual basis.
How to Read a Profit and Loss Statement
1. Sales
The Sales line item, also known as income or revenue, represents the total sales for the company for the specified period, in this example, for the month of December and Year-to-Date. It represents all cash sales and all invoices presented to customers for later payment (also known as accounts receivable) for the appropriate period.
2. Cost of Goods Sold
The Cost of Goods Sold line item represents the direct costs incurred to generate a sale. This depends on the type of business and the owner/manager’s preferences. In a manufacturing business, it is typical to see direct materials, direct labor, and maybe even an allocation of overhead.
In a retail business, you might see the cost of purchasing items for resale. Here we also have outside services, which may be contractors whose work is necessary to produce income.
Again, the exact line items will vary, but the concept is to attempt to associate the direct costs of making a sale.
3. Gross Profit
The Gross Profit line item is arguably the most important on the P&L. It shows the profit generated from a sale.
In our example, the December gross profit is 42 cents per dollar of sales (it costs 58 cents to produce); year-to-date, it’s 51 cents per dollar (costing 49 cents).
Why does this number matter so much? Three reasons.
1. It informs pricing decisions. Gross profit tells the owner what the market is currently bearing and where there may be room to adjust prices up or where margins have quietly eroded.
2. It signals business viability. A negative gross profit means it costs more to make a sale than the sale brings in. In that situation, selling more only digs the hole deeper. Healthy gross profit is the foundation on which everything else sits.
3. It reveals trends over time. Comparing periods reveals fluctuations that warrant closer examination. In our example, December’s gross profit is meaningfully lower than the year-to-date average, a gap worth investigating. Common culprits include rising costs that haven’t been passed through to pricing, a change in product mix toward lower-margin items, or a bookkeeping error (which can happen even with the best systems and the best people).
The Bottom Line on Gross Profit
Gross profit is where a business is made or broken. The goal is straightforward, even if executing it isn’t: sell your product for the highest price the market will allow, keep the cost of producing it as low as possible, and then sell a lot of it. What’s left is what the business has to work with, the pool of money that covers every other expense on the page below it.
4. Expenses
Expenses are the costs of keeping the business open. Unlike cost of goods sold, they generally don’t move with sales. Rent happens whether you sell 10 units or 10,000.
The specific line items should be tailored to the business, but the ones shown here are fairly standard. The most common mistake is using too much detail.
You don’t need separate line items for airfare, hotels, and rental cars unless each is significant on its own. A single “Travel” line is usually enough, and if a number ever looks off, modern accounting software lets you drill down to see the underlying detail. The same logic applies to office supplies. The amount you spend on paperclips isn’t going to make or break the business, so it doesn’t need its own row.
One exception is meals and entertainment. These should always be tracked separately because they aren’t fully deductible, and breaking them out now makes tax time considerably easier.
Monitoring Expenses Against a Budget
Tracking expenses is one thing; monitoring them is another. The most effective way to monitor is to build a budget and compare planned spending against actual results, line by line, each period. Budgeting is a topic in its own right and beyond the scope of this article, but it’s worth noting that the P&L is the backbone of the planning, direction, and control required by budgeting.
5. Net Operating Income
This is self-explanatory. It represents the profit or loss from day-to-day operations.
6. Depreciation
There are other items that should be shown on a P&L that occur but aren’t really a function of day-to-day operations. The most obvious one is Depreciation.
Depreciation accounts for the wear and tear of fixed assets, such as buildings, equipment, and furniture, the cost of which is spread over more than one year.
When a piece of machinery is purchased, under generally accepted accounting principles, it must be capitalized (shown as an asset) rather than expensed immediately. The cost is then recognized monthly over the life of the machinery, typically five or seven years, and each monthly amount is shown as depreciation.
For example, a machine costing $60,000 with a life of five years would be depreciated at $1,000.00 per month and shown as an expense on this line. Typically, a business will have several such assets, and the monthly depreciation for each one will be accumulated on this line.
7. Net Income (Loss)
The net income or loss of the business is the sum of all income and expense items.
In this case, there is a loss for the month but a profit for the year. Obviously, a business wants to make a profit so that it can continue on to fulfill its purpose. The owner/manager should always keep an eye on this bottom line, but the components described above tell the real story.
Meaningful Reports Make Real Impact
Bookkeeping systems can generate dozens of reports, but the value comes from getting the numbers right and knowing what to do with them. A business owner should consult an accounting professional, like a CPA, to ensure the books are accurate, meaningful reports, such as a profit and loss, are being prepared, and the results are analyzed to keep the business on track financially.