A profit and loss statement is the foundation of understanding the financial health of your company. One look at this document will tell you if a business is making money or losing money, and how the business’s financial outlook has changed over time.
Learn how to leverage this financial statement for your business — from understanding the information contained within it to how (and how often) you should analyze it.
What is a profit & loss statement?
A profit and loss (P&L) statement is a financial document that shows how much a business has spent and earned over a specific period of time — usually a fiscal quarter or year. The statement is used to understand a company’s profitability and identify areas where cost savings can be made.
A P&L statement is also sometimes referred to as an “income statement” or “statement of earnings." The P&L is one of three major financial documents — along with the balance sheet and cash flow statement — that provide a comprehensive overview of a business’s financial health.
Most businesses generate a P&L statement using accounting software like QuickBooks or Xero, which allows them to input income and expenses, and generate a P&L statement at the click of a button.
What is included on a profit & loss statement?
While every P&L differs based on the type of business, there are a few major categories you’re likely to find on most profit and loss statements:
- Revenue. A P&L statement begins with revenue, or the money a business has earned from sales or other activities during the measured time period. Revenue is measured either through cash basis (i.e., recognizing revenue when cash is received) or accrual accounting (i.e., recognizing revenue when it’s earned, regardless of when payment is received). Also note that businesses typically delineate between operating revenue and non-operating revenue. The former is typically recurring revenue generated from core business operations, whereas the latter is inconsistent income such as interest.
- Cost of goods sold (COGS). COGS is what it costs your company to deliver its core service or product. This means direct expenses like inventory, materials, labor, and equipment. It doesn’t include operating expenses like rent and utilities.
- Gross profit. COGS is subtracted from revenue to determine gross profit, or a business’s profit before accounting for operating expenses. A product that has a COGS of $10 but retails for $25 would have a gross profit of $15.
- Operating expenses. These are expenses not related to delivering your core product or service. Common operating expenses include rent, utilities, employee benefits, payroll taxes, sales and marketing, vendor contracts, and professional services (e.g., attorneys and accountants).
- EBITDA. EBITDA stands for “earnings before interest, taxes, depreciation, and amortization.” It’s a good measure of a business’s ability to generate cash flow before taking into account certain non-operating expenses, such as interest on loans, taxes, depreciation of assets, and the reduction in value of intangible assets like patents or copyrights. On a P&L statement, EBITDA is sometimes called “operating earnings.”
- Interest expense. Interest expense refers to interest owed by a company borrowing money, such as through a business loan, line of credit, or business credit card.
- Tax expense. This is the amount the business paid on its income tax for a given year.
- Net income. Once you deduct all expenses from your gross profit, you’re left with your net income, which is the amount of money a company has made after paying off all expenses. This is often referred to as a company’s “bottom line,” and shows its overall profitability.
- Loss. If expenses are higher than the business’s revenue, the business will generate a loss instead of a profit. Losses show how “in the red” (i.e., below profitability) the business is.
Did you know?
In the early stages of your startup, it’s easy to make decisions that seem like they’ll save you time and money, like paying for business expenses with personal bank accounts or neglecting to set up payroll systems because your team is too small. However, some of these decisions can be costly in the long run.
How to analyze a profit & loss statement
Business owners should use a profit and loss statement to understand if their business is profitable or on the path to profitability. Comparing P&L statements quarter-over-quarter and seeing an increase in revenue may indicate an increase in demand for the product or service. A decrease in COGS over a period of time may indicate the business is becoming more efficient. If operating expenses are keeping a business in the red, it may signal to a business owner that they should look to cut costs in some areas.
If a young business isn’t showing a net profit on its P&L, it doesn’t necessarily mean trouble yet. In the early days, businesses have to spend more money to make money. As they achieve economies of scale, ideally their COGS goes down while revenue goes up, and they start to turn a profit.
Horizontal analysis vs. vertical analysis
Vertical and horizontal analysis — also called ratio and trend analysis — are two popular approaches to analyzing a P&L statement:
- Horizontal analysis: This analysis looks at changes over time within a specific line item on the P&L statement. For example, analyzing fluctuations in revenue year-over-year can help a business owner spot trends or seasonal occurrences and optimize the business around them.
- Vertical analysis: This type of analysis considers the size of expense items eating into a company’s revenue over time. When doing a vertical analysis, business owners look to see how they can improve revenue by cutting out unnecessary expenses.
Horizontal analysis is typically used to compare multiple business periods (e.g., FY 2021 vs. FY 2022) to identify trends in revenue and expenses and understand how much you spent vs. how much you had budgeted. Vertical analysis is used to dig into a specific time period to understand where costs can be cut. Financial professionals will usually run both analyses when reviewing a P&L statement, and finance teams often prepare monthly or quarterly flux analyses to explain changes over time and to understand the “why” behind an increase or decrease to an account.
How often should you analyze the P&L statement?
Most businesses generate a P&L statement monthly, quarterly, and during tax season to give them a snapshot of the company’s financial performance. They can then perform a vertical and horizontal analysis to look for ways to maximize revenue. P&L statements are also useful for lenders or investors who want to get a better understanding of the business’s performance and financial health before agreeing to give the business any money.
Understanding profit & loss statements
Profit and loss statements are a crucial piece of the financial puzzle that makes up a business’s performance. Note that interpreting a P&L statement requires a certain level of financial expertise. Business owners typically review their P&L with an accountant or financial advisor before making any decisions based on the information.
Matthew Speiser