TL;DR:
A profit and loss statement (P&L) starts with revenue and subtracts costs in stages until it reaches profit.
Gross profit = revenue − cost of goods sold; net profit = what is left after all other costs.
Margin = profit ÷ revenue, so you can compare a month to a month or a business to its past self.
Someone hands you a one-page report full of lines like revenue, cost of goods sold and operating expenses, and asks whether the business is doing well. A profit and loss statement, also called an income statement, answers one question: over a period of time, did the business earn more than it spent? Once you know the order of the lines, it reads like a short story.
When you need to read one
You meet a P&L when you run a business, join a team that reports numbers, apply for financing, or buy or sell something. It covers a period such as a month, a quarter or a year, and you should always check which period you are looking at before you read a single number.
The order of the lines
Revenue (sales): The money earned from selling things or services in the period, at the top. Some statements show it as sales or income.
Cost of goods sold (COGS): The direct costs of what you sold: materials, the goods themselves, or the direct labor to make them. It is only the costs tied to the sales above.
Gross profit: Revenue minus COGS. It shows whether each sale makes money before the overhead of running the business.
Operating expenses: Everyday costs that do not depend directly on each sale: rent, wages, marketing, software and the like.
Operating profit: Gross profit minus operating expenses. It is the profit from running the business itself.
Interest, other items and tax: Costs of borrowing and other items, then income tax where it applies. What is left at the bottom is the net profit, often called the bottom line.
Names differ between companies and countries, and what goes under cost of goods sold versus operating expenses can vary. If something is unclear, ask the person who prepared it or your accountant what is included.
Worked example: a simple P&L with example numbers
A small shop reports one quarter. All figures are invented for the example.
Line | Amount |
|---|---|
Revenue | 48,000 |
Cost of goods sold | −28,800 |
Gross profit | 19,200 |
Rent | −6,000 |
Wages | −7,500 |
Marketing | −1,500 |
Other costs | −1,200 |
Total operating expenses | −16,200 |
Operating profit | 3,000 |
Interest paid | −400 |
Net profit before income tax | 2,600 |
First verify the arithmetic. Gross profit: 48,000 − 28,800 = 19,200. Operating expenses: 6,000 + 7,500 + 1,500 + 1,200 = 16,200. Operating profit: 19,200 − 16,200 = 3,000. Net before tax: 3,000 − 400 = 2,600.
The statement stops before income tax because how and whether tax applies depends on the business type and place. A real P&L would show a tax line, and your accountant can tell you what it should be.
Turn the lines into margins
A profit of 2,600 means little without knowing the sales behind it. A margin divides a profit by revenue, so you can compare periods of different sizes. Each calculation is shown here:
Gross margin:
19,200 ÷ 48,000 = 0.40, so 40 cents of every dollar of sales is left after the direct costs.Operating margin:
3,000 ÷ 48,000 = 0.0625, or 6.25 cents per dollar.Net margin before tax:
2,600 ÷ 48,000 = 0.0542, or about 5.4 cents per dollar.
In a spreadsheet, with revenue in B2 and gross profit in B4, the gross margin is =B4/B2, then format the cell as a percentage. Do the same with the other profit lines. Percentages are only a formatting choice; the underlying number is always profit divided by revenue.
What the example tells you
Each sale earns a reasonable amount over its direct cost (40 cents per dollar), but running costs take most of it. Wages and rent together are 13,500, which is more than two thirds of gross profit:
13,500 ÷ 19,200 ≈ 0.70.Small changes matter. If revenue and COGS stayed in proportion and sales rose by 1,000, gross profit would rise by
1,000 × 0.40 = 400, while the fixed running costs might not change at all.A thin net margin means little room for a bad month. One more unexpected cost of 2,600 would erase the quarter's profit.
Questions to ask of any P&L
What period does it cover, and is it the same length as the one I am comparing against?
Are the numbers on a cash basis (when money moved) or accrual basis (when earned or incurred)? A P&L often differs from the bank balance for this reason.
Which line changed the most from last period, and why?
Is anything unusual hiding in Other costs?
Does profit match cash? A profitable business can still run short of cash, as our guide to a cash flow forecast shows.
Mistakes to avoid
Reading profit as cash in the bank. They are different measures.
Comparing a month with a full year.
Judging a business on one period. Look at several in a row.
Ignoring the notes or assumptions the preparer gives you.
General information only: This explains how a P&L is laid out. It is not accounting, tax or investment advice. Check with a professional before making decisions based on financial statements.
Doing it faster
Always read in the same order: period, revenue, gross profit, operating profit, net profit, then the three margins. If you are looking at a report on your screen and a line makes no sense, DuckyHelper can look at it with you and explain the terms out loud while you stay in the document.
Frequently asked questions
What is the difference between gross profit and net profit?
Gross profit only subtracts the direct cost of what you sold. Net profit subtracts everything else too, such as rent, wages, interest and tax.
Is a high margin always better?
Not by itself. A high margin on very few sales can earn less in total than a lower margin on many. Look at the profit amount and the margin together.
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