Understanding profit and loss reports
A profit and loss report, also known as an income statement, shows the profitability of your business over a specific period. It can cover any period of time, but is most commonly produced monthly, quarterly or annually.
A profit and loss report is a useful tool for monitoring business activity. For business owners, it highlights where their business is succeeding and where it is struggling. Investors will use profit and loss reports to gauge the financial health of a potential investment, or to see what kind of return they are getting on an existing investment.
What's in a profit and loss report?
In general, your profit and loss report will be split into 2 sections:
- revenue — details of all income from your primary business activities (i.e. sale of products and services), any revenue from secondary activities (e.g. bank interest) and any other financial gains
- expenses — details of all expenditure on primary activities (e.g. material and labour costs), any secondary expenditure and any other losses during the period.
The most important part of the revenue section of your profit and loss report is total sales. Secondary revenue and other income can be unpredictable, so to grow your business you should focus on your primary sales revenue.
Note how much sales have risen or fallen since your previous profit and loss report. Breaking sales figures down into individual products or product lines will help you see which products are performing well and which products need attention.
Always look to increase revenue in the period between each profit and loss report. A pattern of falling revenue shows a business in trouble.
The 2 main sets of figures in the expenses section of a profit and loss report are:
- cost of goods sold (i.e. cost of direct labour and any raw materials used to produce your goods or services)
- operating expenses (i.e. cost of indirect labour and any other costs not directly linked to the production of good or services).
Of course, you should look to reduce costs wherever possible. A rising figure for material costs could mean you need to find a different supplier, or find more efficient ways to produce your products. Bear in mind that inflation is likely to cause costs to increase across a market over a period of time, so some increase is inevitable.
Operating costs can be harder to bring down. For example, if rent increases it may not be practical to move to cheaper premises, or the move itself may cost more than the increase in rent. Labour costs can also be complicated, as you cannot usually bring down your wage bill without reducing the number of employees (which may not be possible or desirable).
You should check your profit and loss report for any sudden or unexpected spikes in costs, rather than gradual increases over time (due to factors such as inflation and annual employee pay rises).
How to calculate profit
Using your profit and loss report, you can extract a number of important figures to explain your business's profitability:
- Gross profit = revenue – cost of goods sold — the difference between total sales and the cost of producing the goods or services you sell. An indicator of overall production efficiency and a key figure for setting prices and sales targets.
- Gross profit margin = (gross profit ÷ revenue) x 100 — shows what proportion of gross profit you keep from each dollar of revenue generated (e.g. 20% gross profit margin means you keep a gross profit of $0.20 for every $1.00 of revenue generated).
- Operating profit = gross profit – operating expenses — profit generated from core operations. It does not include expenses from interest or taxes (often called 'earnings before interest and tax' or EBIT).
- Net profit = operating profit – (taxes + interest) — also known as the 'bottom line' — net profit is the total amount earned (or lost) after paying all expenses.
Learn how to use financial ratios to assess your financial performance.