The profit and loss statement is a financial report that shows whether you’re making or losing money. You need to have one — and accountants love them — because they neatly lay out your incomings and outgoings.
The trouble with P&Ls is that they’re just numbers without context, and people tend to skip down to net profit. For your own business, when a problem pops up and you aren’t quite sure how to address it, you need to know what the numbers are telling you before you can troubleshoot.
Let’s look at how to read your profit and loss statement to identify problems and fix them.
Understanding Profit & Loss: Gross > Operating > Net
Your profit and loss statement is a document with three main components: your gross profit, operating profit, and net profit. Each number tells a story about your business and contains key insights, if you know how to read them.
Gross profit: Revenue vs COGS
Revenue is everything your business earned from core activities — selling goods and services — during a defined period. Beneath that, you also have cost of goods sold (COGS). When totalled, revenue and COGS leave you with gross profit.
The best way to interpret this gross profit is to find your gross profit margin, which is the percentage of your revenue leftover after paying COGS. High margins tend to be better, but margins are also industry-specific, so it’s essential to compare like with like. If your margin narrows, the likely culprits include rising COGS, procurement costs, supplier changes, or a failure to raise your prices.
Beyond your gross profit margin, it’s important to compare your profit growth and revenue growth. Here is how the two affect each other:
- Revenue up, gross flat → cost issue
- Revenue flat, gross down → price or cost issue
- Revenue down, margin holds → volume/selling issue
Operations: The architecture of your business
Your operating expenses (OpEx) are the indirect costs of doing business, outside of COGS. Think of it as your overheads like rent, utilities, and wages. Subtracting OpEx from your gross profit leaves you with your operating profit.
Beware of making too many cuts at this layer, since it’s wiser to spend smarter (not less). For instance, look at the growth rate of your expenses vs revenue. This will show whether your revenue is growing in line with your costs.
In your audits, put your operating costs into two baskets: infrastructure and productivity. Infrastructure is necessary for your business to function; without it, your business will struggle to stay open. For example, a cafe needs a physical location to operate. Productivity is slightly more abstract, as its benefit is in the execution of something. For instance, accounting software can save you valuable time doing admin, so you can focus on other parts of your business.
Infrastructure and productivity aren’t mutually exclusive. Some costs affect both: rent (infrastructure) for a corner cafe may be high, but the location (productivity) is worth the price given the number of customers it brings.
Net profit: What you owe
Net profit is the last layer to interpret. It is your total revenue minus everything that costs you money, including obligations that come with running a business, like interest on debt, taxes, and asset depreciation.
If your net profit isn’t strong, there are no easy fixes. You can’t change your tax rate unless you earn less revenue — which is counterintuitive. This leaves you with interest, i.e. what you pay on your business debts. If your debts have stacked up, try consolidating loans (limiting the number of loan institutions you use) and refinancing for better interest rates to become more efficient with your debt.
Asset depreciation can reveal a disconnect between your profit and cash flow, as depreciation is a non-cash expense that sits in your gross and operating numbers.
Interpreting your profit and loss statement
Making sense of your P&L requires comparison to prior business history, budget vs actuals, and your own industry competitors. It’s not just an annual report to discuss with an accountant: you need to view it month by month to stay on top of any problems.
These are the key concepts that help you interpret your profit and loss statement:
- Margin trends over time: Compare your margin trends to see how your numbers are tracking. Do dips occur seasonally, or is the downturn holding steady?
- Industry comparison benchmarks: Not all industries share the same profit margins. In footwear retail, the gross margin is 41-49%, whereas cafe hospitality is 60-67%. Do this across your layers, and find outliers which can point in the right direction.
- Budget vs actuals: Set your budget targets and track your plans against actual performance. A good rule of thumb is to use variance thresholds to highlight deviations outside of acceptable numbers.
Compare your numbers with the ATO’s specific industry benchmarks resource tables. Benchmarks help businesses without prior business history see how they stack up.
Marty’s Cafe P&L statement
Let’s see how this all works with Marty’s profit & loss statement for his cafe. Click on the button to reveal each layer of Marty’s P&L:
Mastering profit & loss statements
Profit and loss reports are more than just your bottom line. Comparison, context, and going through each layer of profit are the best ways to interpret the numbers, since these tools help you realistically identify issues as they arise. With practice, reading your P&L can give you the insights needed to run your business profitably.
