How to understand the P&L
Updated: Mar 4, 2020
From the perspective of an owner or entrepreneur who never looks at their profit and loss statements as they do not simply understand them, just because it seems complicated and downright difficult to understand. But for any business to grow and succeed, the most important financial statement for you to look at is the profit and loss statement. So here are some basics that will help you to understand your P&L.
What does a P&L do? It tells you whether your business is doing it right and if your company is making profits or loss. It begins with a summarized form of your company’s revenue, lists down in detail your costs and expenses, and finally shows the net profit or loss.
All P&Ls are based on a very simple formula, sales – cost = profit. It really is that simple. Everything else is a matter of breaking down sales or costs into more detail and adding subtotals. Sales are typically shown at the top of the P&L. Costs are shown just below sales and profit is right at the bottom underlined in bold. You may see a number of subtotals as you look down the column, but it is still sales - costs = profit.
The first line on any income statement or profit and loss statement deals with revenue. The exact wording may vary, but you can look for terms like "gross revenue," "gross sales," or "total sales." This number shows the total sum of money a business brought in during the time period covered by the income statement.
The 2 main sets of figures in the expenses section of a P&L Statement are:
Cost of Goods Sold (COGS) and Gross Margin (GM)
Cost of goods sold (COGS) are the direct expenses incurred by the company to produce goods, this includes direct labor costs and raw materials. Direct expenses are the expenses which include the materials costs used to create the goods and direct labor costs used to produce the goods.
Sales - COGS is known as Gross Profit (or Gross Margin). This is the money the business earns after it subtracts the cost of delivering its product and/or services. It is also the money needed to cover other costs associated with running the business while generating a profit.
Companies with high gross margin represent high profitability because those companies have paid low prices to generate high revenues for their products or services
Other costs of the business are not associated with the production of widgets. These costs may include staff salaries, the cost of hiring accountants who produce the P&Ls and even the president’s compensation fee. These costs are most often referred to as selling, general and administrative costs (SG&A). In addition to this, the P&L is now broken down into two parts: Sales - COGS = gross profit, and Gross Profit - SG&A = Profit.
When you look at your company’s P&L, you should only want a business to generate more sales if it is going to benefit you in some capacity over the long-run. After all, if you're an investor or owner, it's your hard-earned money that is at risk in the business.
It may take a little time for you to get down with the basics of understanding P&L, but it will give you peace of mind that your business is on the right track.