Key takeaways
- A profit and loss statement (P&L, or income statement) lists revenue, then subtracts costs in layers: cost of goods sold, operating expenses, interest and tax.
- Gross profit = revenue − cost of goods sold. Operating profit = gross profit − operating expenses. Net profit is what is left after interest and tax.
- Count revenue and costs in the period they belong to, not when cash moved, if you want the P&L to show how the business really performed.
- Owner drawings, loan repayments and stock you bought but have not sold are not expenses on a P&L.
What a profit and loss statement shows
A profit and loss statement covers a period of time, usually a month, a quarter or a year. It answers one question: after paying for what it sold and what it costs to run, did the business make a profit, and how much?
It is different from a balance sheet, which is a snapshot of what the business owns and owes on one date, and from a cash flow statement, which tracks money in and out of the bank. A business can show a profit on its P&L and still run short of cash, for example while waiting for customers to pay.
Lenders, investors and landlords often ask for one, and in the US the same figures feed Schedule C of a sole proprietor’s tax return. Even if nobody asks, a monthly P&L is the quickest way to see whether prices, costs and margins are moving the right way.
The structure: five lines that never change
Every P&L follows the same order. Each line subtracts one layer of cost, and the profit figure after each layer tells you something different.
- Gross profit shows whether your prices cover the direct cost of what you sell.
- Operating profit shows whether the business as a whole pays its way, before financing and tax.
- Net profit is the bottom line: what the business earned for its owners in the period.
Revenue − Cost of goods sold = Gross profit Gross profit − Operating expenses = Operating profit Operating profit − Interest = Profit before tax Profit before tax − Income tax = Net profit
Step 1: work out revenue
Revenue is everything you earned from selling goods and services in the period. Start with total sales, then subtract refunds, returns and discounts you gave. The result is net revenue, and it is the figure the rest of the statement is measured against.
Leave out sales tax or VAT you collected for the government: it was never your money. Also leave out loans you received and money you put into the business yourself. Both raise your bank balance, but neither is revenue.
If you invoice customers, count a sale in the period you did the work or delivered the goods, even if the customer pays later. That is the accrual method. Very small businesses often use the cash method instead and count sales when the money arrives. Either works, as long as you use the same method every period.
Step 2: subtract the cost of goods sold
Cost of goods sold (COGS) is the direct cost of the things you sold in the period: stock bought for resale, raw materials, packaging that goes out with orders, and direct labour if you make products. Service businesses with no stock often have little or no COGS.
Count only the cost of what you actually sold. Stock still on the shelf at the end of the period is an asset, not a cost. The standard way to work this out is from your stock counts.
Cost of goods sold = Opening stock + Purchases − Closing stock Gross profit = Net revenue − Cost of goods sold Gross margin % = Gross profit ÷ Net revenue × 100
Free toolProfit margin calculatorStep 3: list your operating expenses
Operating expenses are the costs of running the business that do not go into a specific product: rent, wages and salaries, advertising, software, insurance, phone and internet, accounting fees, and payment or marketplace fees. Group them into a handful of clear lines rather than one line per receipt.
Large purchases that last for years, such as equipment, vans or computers, are not expensed in one go on a P&L. Instead their cost is spread over their useful life as depreciation. Check your tax rules too, since tax law can let you deduct some purchases faster than you depreciate them in your own accounts.
| On the P&L | Not on the P&L |
|---|---|
| Sales, minus refunds and discounts | Sales tax or VAT collected |
| Cost of stock you sold | Stock still unsold at the end of the period |
| Rent, wages, software, advertising | Money the owner takes out (drawings) |
| Interest on loans | Repaying the loan itself |
| Depreciation of equipment | The full price of equipment in the month bought |
Step 4: interest, tax and the bottom line
Subtract operating expenses from gross profit to get operating profit. Then subtract interest on any loans or credit lines. Only the interest goes on the P&L; the part of each repayment that reduces the loan balance does not.
Whether income tax appears depends on how the business is set up. A US C corporation pays its own tax at a flat 21% federal rate, so that tax is an expense of the business. In a sole proprietorship, partnership or S corporation, profit passes to the owners and is taxed on their personal returns, so the business P&L usually stops at profit before tax.
Net profit margin % = Net profit ÷ Net revenue × 100
Worked example: an online homeware shop for one year
A small online homeware shop, set up as a C corporation, sold $120,000 of goods in the year and refunded $3,000. It started the year with $8,000 of stock, bought $48,000 more and had $9,200 left at the end, so its cost of goods sold was $46,800. It paid $900 of interest on a business loan.
- The 60% gross margin says the shop’s pricing is healthy: each $100 of sales leaves $60 to cover running costs.
- Wages are the biggest operating cost at 20.5% of revenue, which is the line to watch if sales slow.
- If the owner had taken $20,000 out of the business during the year, net profit would still be $13,351. Drawings come out of the profit; they do not reduce it.
| Line | Amount | % of revenue |
|---|---|---|
| Sales | $120,000 | |
| Less refunds and discounts | −$3,000 | |
| Net revenue | $117,000 | 100% |
| Cost of goods sold ($8,000 + $48,000 − $9,200) | −$46,800 | 40.0% |
| Gross profit | $70,200 | 60.0% |
| Rent and storage | −$14,400 | 12.3% |
| Wages | −$24,000 | 20.5% |
| Advertising | −$6,000 | 5.1% |
| Payment and platform fees | −$3,500 | 3.0% |
| Software | −$1,800 | 1.5% |
| Insurance | −$1,200 | 1.0% |
| Depreciation | −$1,500 | 1.3% |
| Operating profit | $17,800 | 15.2% |
| Interest | −$900 | 0.8% |
| Profit before tax | $16,900 | 14.4% |
| Income tax at 21% | −$3,549 | 3.0% |
| Net profit | $13,351 | 11.4% |
Reading your P&L: what to look for
One P&L on its own tells you little. Its value comes from comparison: this month against last month, this year against last year, and your margins against your own targets.
- Show every line as a percentage of revenue, as in the example. A cost that grows faster than revenue shows up straight away.
- Watch gross margin first. If it falls, prices, discounts, supplier costs or the sales mix have changed, and no cut in overheads will fix that for long.
- Compare operating profit with the cash in the bank. If profit is rising but cash is falling, look at unpaid invoices and stock levels.
- Keep monthly statements in one file so you can see seasonal patterns. Many small businesses earn most of their profit in a few months.
