Inside a business: how to read a profit and loss statement
The profit and loss statement, or P&L, shows whether a business earned more than it spent over a period such as a month, quarter or year. Read from the top down, it tells a story about pricing, costs and efficiency that every owner, manager and lender should be able to follow.
The structure, line by line
Every P&L follows the same basic order, even when the labels differ. Each line subtracts another layer of cost from what customers paid.
- Revenue: sales for the period, net of returns and discounts.
- Cost of goods sold: the direct cost of what was sold, such as ingredients, materials or merchandise.
- Gross profit: revenue minus cost of goods sold, and gross margin is gross profit divided by revenue.
- Operating expenses: rent, payroll, marketing, utilities, insurance and depreciation.
- Operating income: gross profit minus operating expenses, the profit from running the business itself.
- Interest and taxes: the cost of borrowed money and the income taxes the business owes.
- Net income: what remains after everything, the bottom line.
EBITDA and its limits
EBITDA stands for earnings before interest, taxes, depreciation and amortization. Lenders, buyers and analysts use it to compare operating performance across businesses with different debts, tax situations and equipment ages, and loan agreements often set limits tied to it.
Critics caution against relying on it, for good reasons. Depreciation reflects equipment that will eventually need replacing, and interest and taxes are real cash costs. EBITDA is not defined by generally accepted accounting principles, so companies calculate it differently, and adjusted EBITDA can exclude almost anything management calls unusual. Treat it as one view of operations, never a substitute for net income or cash flow.
Profit is not the same as cash
The P&L covers a period of time. The balance sheet is a snapshot of what the business owns and owes on a single date, and the cash flow statement tracks the cash that actually came in and went out. Under accrual accounting, revenue counts when it is earned and expenses when they are incurred, not when money changes hands.
That gap explains how a profitable business can still run out of cash.
- Customers pay invoices weeks or months after the sale.
- Inventory ties up cash before it sells.
- Loan principal payments reduce cash but are not expenses on the P&L.
- Equipment bought with cash leaves the bank account at once but reaches the P&L gradually through depreciation.
- Fast growth demands more inventory and receivables before the new sales are collected.
Common-size analysis
A common-size P&L shows every line as a percentage of revenue, which lets you compare months, years or similar businesses even when sales change. Suppose sales grew 10 percent but payroll grew 25 percent: both dollar figures look like growth, but the common-size view shows payroll rising from 30 percent of revenue to about 34 percent.
Build the common-size view monthly, and compare each month with the same month a year earlier to account for seasonality. Trade associations and lenders sometimes publish typical ratios for an industry, which make useful rough reference points.
A worked example: a hypothetical coffee shop
Imagine a coffee shop with $500,000 in annual sales. Every figure here is made up to show the mechanics.
As you read the lines below, remember what a P&L leaves out: loan principal payments are not expenses, and new equipment is expensed only gradually through depreciation, so the shop’s bank balance can grow much more slowly than its profit.
- Cost of goods sold, from coffee, milk, food and cups, is $150,000, leaving gross profit of $350,000, a 70 percent gross margin.
- Payroll is $175,000, or 35 percent of revenue.
- Rent is $45,000 and other operating costs are $45,000, 9 percent each.
- Depreciation on espresso machines and furniture is $15,000, or 3 percent.
- Operating income is $70,000, or 14 percent, and EBITDA is $85,000.
- After $10,000 of interest and $15,000 of income taxes, net income is $45,000, or 9 percent.
Find the break-even point
Break-even analysis splits costs into variable costs, which rise with each sale, and fixed costs, which stay roughly the same whatever you sell. The share of each sales dollar left after variable costs is the contribution margin, and it pays down fixed costs until profit begins.
In the coffee shop example, treat cost of goods sold as the only variable cost and the rest of operating expenses as fixed, a simplification. Each sales dollar then contributes 70 cents, and fixed operating costs total $280,000, so break-even sales are $280,000 divided by 0.70, or $400,000 a year. At an average ticket of $8, that is 50,000 sales, or roughly 960 a week, and actual sales of $500,000 leave a $100,000 cushion.
Use the P&L to set prices and control costs
When a cost rises, the P&L shows how far prices have to move. If the coffee shop’s ingredient costs rose 10 percent with prices unchanged, cost of goods sold would grow by $15,000 and operating income would fall from $70,000 to $55,000. Recovering that takes a price increase of about 3 percent, assuming customers keep buying at the same rate.
Use contribution margin to judge new spending. A $1,500 monthly marketing campaign needs about $2,143 in extra monthly sales just to pay for itself at a 70 percent contribution margin. Review the P&L every month against your budget and the same month last year, and ask why any line moved by more than a point or two of revenue.