Understanding Your Profit and Loss Statement
The profit and loss statement—usually shortened to P&L—is one of the most useful financial reports available to a business owner. So, it is really important that you learn how to read one.
In this article, I’m going to explain the main sections of the P&L, how they work together and what they can tell you about your business.
Don’t worry, I’m not going to blow your mind with accounting jargon. I’m going to explain it in plain English.
What is a profit and loss statement?
A profit and loss statement shows the performance of your business over a particular period. That could be a week, a month, a quarter or a year.
This is different from the balance sheet, which shows what your business owns and owes at a particular moment in time.
Put simply, the P&L is like a movie covering a period of time, while the balance sheet is like a photograph taken on a particular day.
The P&L is made up of five main sections:
- Sales
- Cost of sales
- Gross profit
- Overheads
- Net profit
Let’s look at each one.
Sales
Sales may also be called revenue or turnover.
This is the income your business earns from supplying goods or services to your customers.
If you use traditional accounting, a sale is normally recorded when the work is done and the invoice is raised—not when the customer eventually pays you.
If your business uses cash-basis accounting, the income is generally recorded when you receive the payment.
Cost of sales
Cost of sales may also be called direct costs or variable costs.
These are costs directly connected to making a sale or completing a job. For a trades business, this could include materials, subcontractors or direct labour.
They are described as variable costs because they usually change depending on the level of sales. In theory, if you don’t make any sales, you should incur very little cost of sales.
Gross profit
Gross profit is calculated by subtracting cost of sales from sales:
Sales − Cost of sales = Gross profit
You can also calculate your gross profit margin:
Gross profit ÷ Sales × 100 = Gross profit margin percentage
For example, a gross profit margin of 50% means you have 50p left from every £1 of sales after paying the direct costs of completing the work.
That money then needs to pay your overheads and, hopefully, leave you with a profit.
I’ll talk more about the importance of gross profit margin in another article.
Overheads
Overheads may also be called indirect costs or fixed costs.
These include things such as rent, business rates, insurance, telephone costs, software, accountancy fees and administrative wages.
They are not directly linked to making an individual sale. Many of them still need to be paid even if you don’t make any sales during the month.
Net profit
Net profit is calculated by subtracting overheads from gross profit:
Gross profit − Overheads = Net profit
You can also calculate your net profit margin:
Net profit ÷ Sales × 100 = Net profit margin percentage
This tells you how much profit you are making from each pound of sales after paying the costs of running the business.
A simple profit and loss example
Let’s look at a simple example for a fictional business called Pete the Plumber.
Pete the Plumber: Profit and Loss for May
| May | |
|---|---|
| Sales | £20,000 |
| Cost of sales | (£10,000) |
| Gross profit | £10,000 |
| Gross profit margin | 50% |
| Overheads | (£5,000) |
| Net profit | £5,000 |
| Net profit margin | 25% |
Pete made sales of £20,000 in May and incurred costs of sale totalling £10,000.
This gave him a gross profit of £10,000 and a gross profit margin of 50%.
After deducting overheads of £5,000, he was left with a net profit of £5,000 and a net profit margin of 25%.
That’s all well and good—but was this a good performance or a bad one?
The truth is that, at this point, we don’t know. We need something to compare it with.
Why comparison matters
A point of comparison is simply another set of figures to compare your results against.
You could compare:
- This month with last month
- This year with last year
- Your actual results with your budget
Let’s compare Pete’s May results with April.
Pete the Plumber: May compared with April
| May | April | Difference | |
| Sales | £20,000 | £20,000 | £0 |
| Cost of sales | (£10,000) | (£8,000) | £2,000 A |
| Gross profit | £10,000 | £12,000 | £2,000 A |
| Gross profit margin | 50% | 60% | 10% A |
| Overheads | (£5,000) | (£5,000) | £0 |
| Net profit | £5,000 | £7,000 | £2,000 A |
| Net profit margin | 25% | 35% | 10% A |
The letter A stands for “adverse”, which means the difference had a negative effect on the business. A positive difference may be marked with an F, meaning “favourable”.
Pete’s sales were exactly the same in April and May, but his cost of sales increased by £2,000. As a result, his profit fell by £2,000.
This is something I would want to investigate.
Have material prices increased? Has Pete needed to use more materials? Was there waste or rework? Did he underprice a job? Does he now need to adjust his own prices?
The P&L won’t always give you the answer, but it will tell you where you need to start asking questions.
Small reductions in margins or gradual increases in costs can have a big impact on profit over time.
Putting this into practice
From now on, you should run and review your profit and loss statement every month.
Don’t just look at the sales figure or skip straight to the profit at the bottom. Compare the results with the previous month, the previous year or your budget.
Ask yourself:
- Have my sales gone up or down?
- Has my gross profit margin changed?
- Are any costs increasing unexpectedly?
- Am I making more or less profit?
- What action do I need to take?
Your P&L isn’t just something for your accountant to look at once a year. It is a management tool that can help you understand your business and make better decisions.
If you need help understanding what your figures are telling you, speak to your accountant. A short conversation about the numbers could help you spot a problem—or an opportunity—before it is missed.