P&L 101: What are Profit & Loss Reports and how to read them?
13 Jul 2020 | 05.20 AM

P&L 101: What are Profit & Loss Reports and how to read them?

Adam Adam Frederico

The P&L report is a window into your business – you need to see how your money comes in and where it is spent. The main premise is to understand how your business either earned a net profit or loss and how to modify your strategy. Love it or hate it the Profit and Loss Report is like a scorecard of a company and if you can read it well, the P&L can help your company grow sustainably.

Profit and Loss Reports are used to track a business’s total revenue and total expenses in a specific period of time, usually prepared monthly or quarterly. They are very useful since they show a business’s net profit (or loss), which can indicate the strength of a company’s operations and sales strategy.

The main categories that could be found on the P&L include:

  • Revenue (or Sales)
  • Cost of Goods Sold (or Cost of Sales) – COGS
  • Operational Expenses
    • Selling, General & Administrative (SG&A)
    • Marketing and Advertising
    • Technology
    • Interest Expense
    • Taxes
  • Net Income (Profit)

There are three main sections of a P&L statement: revenues, COGS, and Operational Expenses. Any listed line item on a P&L goes under either revenue or an expense account, and all these items determine the bottom line.

To go a little deeper, there are a few types of profit:

01. Gross Margin = Revenue – COGS

Gross Margin is a company's profit before operating expenses. It is important because it reflects the core profitability of a company before overhead costs and shows the financial success of a product/service. It is also used to calculate the Gross Margin Ratio which is found by dividing Gross Margin by Total Revenue. Calculating gross profit margin allows you to compare similar companies to each other and to the industry as a whole to determine relative profitability.

02. EBITDA (Earnings Before Interest, Tax, Depreciation & Amortization)

This is a metric that closely resembles free cash flow for most businesses. By looking at earnings and adding back interest, tax, and depreciation expenses, the company can see what could be available as cash. Since depreciation and amortization are non-cash items, they do not have to do with the health of your business’s cash flow. Therefore, EBITDA is a good way to gauge cash flow.

03. Net Profit

This is the ultimate measure of the profits of a business. Taking your revenue and subtracting COGS and all operational expenses result in a number that is your net profit.

Now let’s try to read the P&L statement of Mike’s Bike Shop:

<ul>
 <li>To find the Net Income, we simply subtract expenses from revenues.</li>
 <li>To find the Gross Margin, we subtract COGS from Revenue -> $27,600 - $10,200 = $17,400</li>
 <li>To find EBIT, we subtract Interest Expense and Tax from Net Revenue -> $27,600 - ($10,200 + $500) = $16,900</li>
 <li>To find EBITDA, we subtract depreciation from EBIT -> $16,900 - $1,000 = $15,900</li>
</ul>
  • To find the Net Income, we simply subtract expenses from revenues.
  • To find the Gross Margin, we subtract COGS from Revenue -> $27,600 - $10,200 = $17,400
  • To find EBIT, we subtract Interest Expense and Tax from Net Revenue -> $27,600 - ($10,200 + $500) = $16,900
  • To find EBITDA, we subtract depreciation from EBIT -> $16,900 - $1,000 = $15,900

One important thing to keep in mind is the difference between an income statement and a balance sheet. Imagine Batman and Robin for a second: they make a formidable team because each brings a complementary skill to their crime-fighting endeavors. Financial statements of a company work just like them – they are different, but each complement one another to see the bigger picture. The income statement shows you how profitable your business is over a given period, while the balance sheet gives you a snapshot of your assets and liabilities. Together, they make a strong financial duo.

Understanding the income statement is essential for all businesses to analyze profitability and growth. Luckily, the basic equations underlying income statements are easy to break down and all statements are organized in similar ways.

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