How to read a profit and loss statement

business.gov.au describes a profit and loss statement as a financial statement listing sales and expenses, which you can use to work out the gross and net profit of a business. It is also called an income statement.

A balance sheet describes one date, but a profit and loss statement covers a period, such as a month, a quarter or a financial year. business.gov.au says it shows financial performance and profitability over time.

Most profit and loss statements follow the same order, and each line builds on the one above it.

1. Sales, also called revenue or turnover: business.gov.au defines revenue as the amount earned before expenses and other deductions.
2. Cost of goods sold: the total direct costs of producing a good or delivering a service, in business.gov.au's words. For a shop that is mainly the stock it sold; for a builder, the materials that went into each job.
3. Gross profit: sales minus the direct cost of making those sales.
4. Expenses, often called overheads: the costs of running the business that are not part of producing what it sells. business.gov.au gives rent, marketing, utilities and administrative costs as examples of overheads.
5. Net profit: gross profit minus all business expenses, which business.gov.au notes is also known as the bottom line. When expenses are larger than gross profit, the result is a net loss.

Reading it from the top, the cost of goods sold comes off sales first and leaves the gross profit. The overheads then come off the gross profit and leave the net profit. If sales rose the following year but gross profit did not rise with them, the direct costs would be the first place to look.

business.gov.au suggests reviewing your main financial documents regularly and looking for trends or anything unusual. Its list of things to watch includes falling sales, low profit margins and more spending than you budgeted for.

On a profit and loss statement, a few questions help you find them:

• Is gross profit keeping pace with sales? If sales grow but gross profit does not, direct costs may be rising faster than your prices.
• Is net profit small compared with sales? A thin margin leaves little room if sales dip or a cost rises.
• Has any single expense jumped compared with the same period last year?
• Are there one-off items, such as a large repair, that make this period look better or worse than usual?

One profit and loss statement on its own says little. Put it next to the same period last year, or the months before it, to see which way the business is moving. Check that the periods are the same length, and allow for seasons if your busy and quiet months differ.

business.gov.au recommends a financial health check at least once a year, reviewing the profit and loss statement together with the balance sheet, the cash flow statement and the budget.

business.gov.au says your profit and loss statement shows what you earned and spent over time, and you can use those figures to compare your actual results with your budget. The comparison shows where you are over or under budget, so you can adjust your spending or your plans.

business.gov.au suggests setting aside time each month to check your spending against the original budget. In this example, the lower cost of goods sold follows from the lower sales, so the line to ask about is marketing.

A profit on the statement does not mean the same amount is sitting in the bank. If your books use accrual accounting, which business.gov.au describes as recording transactions when they occur rather than when payment happens, a sale counts as income once it is made, even if the customer has not paid yet.

Some spending works the other way. A large purchase or a loan repayment can take money out of the bank without reducing profit by the same amount in that month. Your accountant can advise on how a particular purchase is treated.

That is why the profit and loss statement is read alongside the cash flow statement, which business.gov.au says tracks how much cash you generated over a period, and the balance sheet, which reports your assets and liabilities.