What Is a Profit and Loss Statement? Its Importance and Examples

A profit and loss statement is a key document that shows a company’s revenue, expenses, and net income for a given period of time. It provides details about your business’s financial health and can be very valuable for making decisions.

However, many small business owners have never made or analysed a profit and loss statement before, and approaching one for the first time can be confusing,, especially if you’re not using an accounting software platform to track all of your financial data. In this guide, we’ll explain what a profit and loss statement is, how to read one and show you how to create your own.

Key Takeaways

• A profit and loss statement shows your business’ revenue, expenses, and net profit or loss in a given period of time.
• Profit and loss statements are important for businesses because they make it easy to track changes in financial health. They also simplify business taxes and are required to get a business loan.
• You can create your own profit and loss statement using accounting software, Excel, or a word processor.

What Is a Profit and Loss Statement?

A profit and loss statement is a financial document that breaks down your business’s net income over a set period of time. It shows key financial metrics like your revenue, cost of goods sold, and operating expenses.

Many businesses choose to prepare a profit and loss statement monthly, quarterly, or annually since it makes it easy to monitor changes to your business’s profitability over time.

You may hear profit and loss statements referred to by several different names. They’re also called income statements, P&L statements, earning statements, statements of profit, or statements of operations.

Profit and loss statement example

The best way to understand how profit and loss statements work is with an example. Here’s a simple P&L statement for a small business.

Gross profit is defined as your revenue minus your cost of goods sold—that is, the cost of any raw materials or labour that went into producing and delivering your products. Operating profit is your gross profit minus all of your business’ operating expenses. Your net profit is your operating profit minus any interest you pay on debt and any taxes your business pays.

Your profit and loss statement can be as detailed as you need. For example, you can break down revenue to show income from different product lines, business locations, or even specific customers. You can also break down operating expenses into categories like advertising, office supplies, travel, payroll, and insurance. These breakdowns are very important for analysing your P&L statement and drawing insights about your business.

How To Analyse a Profit and Loss Statement

There are two main ways that you can use a profit and loss statement to gain insights into your business’s financial health.

First, you can conduct a time series analysis to see how line items in your profit and loss statement have changed over time. For example, you can monitor how revenue from a specific product line has increased or decreased year-over-year for the past several years. You can also evaluate how different expense categories have changed in size over months, quarters, or years.

Second, you can conduct a common-size analysis. This involves calculating each expense line item as a percentage of your business revenue. The benefit of common-size analysis is that it enables you to see how specific expenses are growing or shrinking over time relative to your business’ revenue.

While these analyses are useful on their own, profit and loss statements are most helpful when analysed alongside other financial reports.

For example, cash flow statements show how money moves through a business and give more detail about where revenue and expenses are coming from. Balance sheets offer a snapshot of a business’s assets, including cash on hand, capital equipment, debt, and more. Analysing all three of these documents together is the best way to get a complete picture of a business’s financial performance.

It’s also worth noting that you can compare profit and loss statements not just over time within the same company but also for the same accounting period across two companies. This is helpful if, for example, you want to compare your business’ finances against a peer company in the same industry.

Why Do You Need a Profit and Loss Statement?

Profit and loss statements serve several important purposes for small businesses.

First, maintaining profit and loss statements over many months, quarters, or years allows you to monitor changes in your business’s financial performance. You can easily see whether your net income is growing or shrinking and what the key drivers of those changes are. Profit and loss statements provide important information to make data-driven decisions about the future of your business.

Another reason to use profit and loss statements is that they simplify your business taxes. Much of the tax information the government requires from businesses is the same data that’s reported on an income statement. So, if you already have an up-to-date profit and loss statement, you’ll be ready to submit your tax returns.

Finally, P&L statements are very important for any outsiders looking at your business and trying to understand its financial position. Most banks require several years’ worth of profit and loss data before they will issue a business loan. Potential investors or buyers will also want to see detailed financial statements before they decide on buying into your business.

How To Make Your Own Profit and Loss Statement

Making your own profit and loss statement is straightforward, especially if you already use accounting software to keep track of all your business’ revenue and expenses. In fact, many accounting platforms have built-in tools that enable you to generate a custom P&L statement in seconds.

However, you can also create a profit and loss statement on your own using Excel or a word processor. We’ll break down the process into five steps.

Step 1: Choose your accounting method

There are two methods you can use to account for revenue and expenses when building a profit and loss statement: the cash method and the accrual method.

The cash method involves counting revenue when it reaches your business—that is, when a customer makes a payment and money lands in your business bank account. Similarly, expenses are counted when you actually pay bills and money leaves your account.

The accrual method counts revenue and expenses when they’re accrued rather than when they’re paid. For example, using the accrual method, revenue is counted when you deliver work and invoice a client—which could be days or weeks before you actually get paid. Similarly, expenses are counted when you make a purchase, even if you charge the item to a credit card instead of paying for it right away.

The cash method is simpler in most cases since you can just check your bank account to see when income and expenses should be counted. However, some businesses with inconsistent cash flow may prefer the accrual method because it offers a clearer view of business activity in a given period.

Step 2: Calculate your revenue

Your business’ revenue includes all income earned by your business for any purpose. Revenue can come not only from sales to customers but also from interest on cash in a savings account or selling off old equipment.

It’s a good idea to break any non-sales revenue into its own line in your profit and loss statement. This means you can easily track changes in sales over time. You can also break sales into several line items for different products or services your business offers.

Step 3: Determine your cost of goods sold

Your cost of goods sold is the direct cost that went into any products or services your business sold to customers. For example, if you purchase a product from a manufacturer for £7 and then sell it to a customer, your cost of goods sold for that product is £7.

Cost of goods sold should also include direct labour costs for a product or service you sell. What counts as a ‘direct’ labour cost is up to you, but in general, this should only count employee pay that can be attributed to a specific sale.

For example, if you pay an employee hourly to paint a house, you can include their wages in your cost of goods sold. However, if you pay an employee hourly to manage your store, their wages should not be included in your cost of goods sold since they can’t be directly attributed to any single sale. You’ll include labour expenses that aren’t counted with your cost of goods sold as part of your operating expenses in the next step.

Subtract your cost of goods sold from your revenue to determine your business’s gross profit.

Step 4: Calculate your expenses

Your business expenses include everything your business pays to operate. This includes indirect labour costs (like salaries and benefits), advertising expenses, equipment purchases, insurance premiums, utility payments, and more. You can decide which expense categories are important to your business and break them into their own lines for more detailed analysis.

Make sure you don’t double-count expenses that have already been included in your cost of goods sold. In addition, you typically don’t include interest payments on debt or tax payments in this part of your income statement. That’s because these aren’t operational expenses. Tracking them separately is important for understanding how your business’ spending on operations is changing over time.

Once you have tallied up all your expenses, you can subtract this sum from your gross profit to determine your operating profit.

Step 5: Add your interest and tax payments

Finally, add line items for any interest payments on debt and any tax payments. Subtract these lines from your operating profit to determine your business’ net profit or loss.