7 min read

What is a profit and loss statement?

A profit and loss statement shows how much your business is making and spending over a period of time. You need this to make important financial decisions for your business.

As a business owner, there are plenty of financial reports you should familiarize yourself with to really understand how your company is performing. There’s your balance sheet, your cash flow statement and your profit and loss statement, to name a few.

Your profit and loss statement, often called a P&L or an income statement, is one of the most important reports you’ll need. It measures how much your business is spending and earning over a certain period of time, like monthly, quarterly or annually.

Your profit and loss statement can influence some of your most important financial decisions. Investors and lenders might ask to look at it, too, before doing business with you.

Before you create your profit and loss statement, it’s important to learn when you need it (and why), and how you can use it to make savvy business decisions.

 

Why do I need a profit and loss statement?

Your profit and loss statement isn’t just something you should have, it’s something you need.

It helps business owners see their finances from a bird’s eye view and answer high-level questions, like “Is my business model sustainable for the long run?” and “What direction am I growing?”

You can also answer more pointed questions like these:

  • Where can I reduce spending?
  • What’s bringing me in the most money?
  • What revenue streams aren’t working for me?

Not only is it helpful for you, other people will ask to see your profit and loss statement as well. Investors and lenders will almost always ask to see it before they decide to get involved with your business. Your accountant will also need to see it so they can maintain accurate records and guide you accordingly.

Do new businesses need to create a profit and loss statement?

If you’re just starting a business, you might be wondering, “How can I give investors and lenders a profit and loss statement if I haven’t launched my business yet?”

Well, you can’t — but you don’t need to. Instead, you’ll likely have to provide what’s called a “pro forma statement.” It’s essentially a hypothetical profit and loss statement. You’ll project what your business will make and spend. Investors and lenders will typically ask you to break down your financial projections for each month over your first year in business, though that period could vary.

When you’re creating a pro forma statement, or even a real profit and loss statement, you should be realistic. In some cases, that means underestimating your earnings and overestimating your spending, if necessary.

The steps below explaining how to create a profit and loss statement also apply to pro forma statements, except the latter will have projected figures instead of real ones.

How to create a profit and loss statement

Now that you know why it’s important to create a profit and loss statement, you’re ready to sit down and make yours.

Before you start, decide which time period you want to analyze. The most common and useful periods to look at are monthly, quarterly and annually, but you can use a custom range.

And don’t just list all your major expenses and earnings. Input the smaller miscellaneous costs and revenues, too. Both can add up quickly.

Step 1: List your incomes

List out all your sources of revenue within the period you’re analyzing. There are two types of revenue you can calculate: operating revenue and non-operating revenue.

  • Operating revenue: The money generated directly from what your business provides.
  • Non-operating revenue: The money generated separately from your product or service.

All of a restaurant’s food sales are considered operating revenue, for example. If they sell a piece of their equipment, that’s considered non-operating revenue. Another common source of non-operating revenue is interest earnings from a checking or savings account.

If you provide professional services, like a law firm or marketing agency, your clients’ payments are your operating revenue.

Your total revenue is called your top line — and it’s an important metric your profit and loss statement can help you track over time.

Step 2: List your expenses

After you find out what you’re making, you need to find out what you’re spending.

The first type of expense you should account for is your Cost of Good Sold (COGS). Your COGS is the cost directly associated with making your product or maintaining your services.

Then map out all your other expenses. All the expenses you have to pay that aren’t associated with your COGS are called your operating expenses, or overhead. Some common overhead expenses most businesses have to pay include:

  • Office rent (and other office supplies)
  • Marketing and promotions
  • Business software
  • Bank fees

Not everything can fit on your profit and loss statement — and not everything should be on it. Your assets, liabilities and shareholder equity shouldn’t be on your income statement. Those things belong on your balance sheet.

Step 3: Calculate net income

If you subtract your COGS and overhead expenses from your top line, you have your net income — which is hopefully a positive number. That’s called your bottom line.

Your net income can turn out misleading if you include costs that really belong on your balance sheet, which can turn lenders and investors away. Consulting an accountant or a financial officer can help make sure everything in your profit and loss statement is recorded accurately to prevent that.

How to read your profit and loss statement

Creating your profit and loss statement is the easy part. Analyzing it is the hard part — but the most important one.

The number you’re likely most eager to calculate is your bottom line. That’s an important indicator of your business’ health, but it’s not the whole picture.

A negative bottom line doesn’t necessarily mean your business is doomed. Sometimes business owners plan for or budget for a loss because it’s something they’ll receive a return on investment on. For example, if you’ve just hired new employees, they’ve likely cost you thousands of dollars. But the hope is they make your company more money than they cost in the near future.

The same applies to other sorts of purchases like expensive equipment or a new office space. They might bring your bottom line down, but they have long-term benefits for your business.

You can — and should — also use your profit and loss statement to make informed business decisions. Some examples of scenarios where you might use your statement to do just that include:

  • Laying off employees after a period of lost revenue
  • Creating a budget
  • Switching to less expensive softwares
  • Prioritizing different revenue streams

Common profit and loss statement mistakes

Your profit and loss statement can have a big impact on your business. It sounds simple enough, but small business owners still make mistakes on them. These mistakes are common, but avoidable if you know how to spot them.

  • Making your profit and loss statement too complicated. Amazon’s profit and loss statement is public — and includes plenty of accounts that you probably don’t need. As a small business, yours should look similar to this template from Gusto.
  • Placing accounts on the wrong statement. Many business owners will put an account that belongs on their balance sheet on their profit and loss statement and vice versa. Learning which accounts belong where is important in creating those reports because they can affect your bottom line and ultimately your decisions.
  • Forgetting to run your statement by an accountant. Because so many business owners confuse their profit and loss statements with their balance sheets, you should have an accountant or financial officer look at your statement. They can ensure that it’s accurate and help you analyze the report so you can make important business decisions from it.

The bottom line

As a business owner, your profit and loss statement is one of the most important reports at your disposal. It shows, among other things, your business’ gross profit, net income and cost of goods sold.

This is a tool that can help you decide where to cut spending and find ways to boost profit. It will help you calculate your bottom line, which is your net income. Investors and lenders will almost always ask to look at your income statement before they decide to work with you.

Not to be confused with a balance sheet, your profit and loss statement will help you make major financial decisions. That can help you answer questions like, “Can I afford more employees?” or “What revenue streams are earning me the most money?”

The bottom line is: You should know what your bottom line is, and your profit and loss statement can help you do that. 

Need help creating or reading a profit and loss statement? Schedule a free call with a DiMercurio Advisors team member today to ensure this crucial statement is done correctly.

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