What is profit and loss statement in business?

In short, a profit and loss statement sets out the itemised details of sales and purchases that have been made by your business. It subtracts the total outgoings from the total income, to show you how much profit (or loss) you have made over a specific period of time. It’s often referred to as ‘the P&L’.

Why is a profit and loss statement useful?

Unlike a balance sheet, which shows a snapshot of your current financial situation at a point in time, a profit and loss statement shows how your company has performed over a specific period – a month, a quarter or a year.

It’s one of the most important financial documents you’ll need for running and growing a successful business. It lets you stay compliant – it helps you to submit accurate accounts at the end of the trading year – and it lets you understand the impact of purchases and sales on trading. In turn, this lets you expand your business, attract more investment, or recruit new members of staff to your team.

Does every business need a profit and loss statement?

If you’re running a limited company, then you’re obliged to produce a profit and loss statement every financial year. Your accountant will need the information to calculate your tax liabilities. Even if you’re working as a limited partnership, however, or as a sole trader, a P&L is still useful. As most P&Ls are produced in a standard format, it enables investors and suppliers to understand how your business is performing.

How do you create a P&L?

Most accountancy software has this function built-in. You can pull off a report detailing your P&L whenever you need the information. But it is still useful to understand the underlying approach to creating the final figure, be it positive or negative. The simplest formula is this one: ‘total revenue – total expenses = profit (or loss)’.

Details of your turnover form the basis of the P&L calculations. That’s the money earned from selling goods or services during a trading year. You will need to use:

• sales receipts

• sales invoices

• credit notes and other sales documentation

Under normal accounting rules, sales and expenses are included in profit when they happen, not when they are actually paid. This means that profits include all credit sales and purchases made within the period, even if they haven’t been paid yet.

Gross profit is calculated by taking the sum of direct costs, things like materials and labour, and indirect costs away from sales made – usually over a 12-month period. Indirect costs are also known as overheads. You can see what your business’s gross profit margin is by dividing the gross profit by turnover, and the net profit margin by dividing its net profit by its turnover. This clarifies how much profit you’re making, overall.

In summary

The P&L is essential for calculating tax liabilities accurately, but also useful to help you compare the profit margins being made from one period to another.

For example, if the profit margins go up from one year to the next, this means that more of the income from sales is staying in the business – perhaps because you’re working more efficiently, putting up prices, or finding savings in your processes. Having a P&L to hand, on a monthly basis, helps you to focus on effective resourcing and the impact of purchases and sales on the overall health of your business.

The profit and loss (P&L) statement (also known as an income statement) is one of the four basic financial statements that presents the revenues, expenses, and net income of a business. In basic accounting, the P&L statement is always one of the first financial statements to be prepared. It measures the performance and profitability of a company and guides business owners in making revenue growth and cost control decisions.

Types of P&L Statements

P&L or income statements are presented using the multiple-step or single-step approach. Regardless of the type, the net income figure stays the same. However, the format heavily impacts the kind of information you can get from the income statement.

Multiple-step P&L Statement

The multiple-step income statement reports income and expenses in two sections: operating and nonoperating.

• Operating: Reports revenues and expenses pertaining to the company’s primary operations, such as selling farming supplies and providing consulting services
• Nonoperating: Reports only the secondary or auxiliary activities of the company, such as rent income or interest income, and shows the extraordinary and infrequent gains and losses that are unrelated to the business’s main activities

This approach to preparing the income statement also uses the function of the expense method, which presents expenses based on its function, such as cost of goods sold (COGS), selling expense, and general expense. Below is an example of a multiple-step income statement from Pym Cosmetics, a fictitious company selling makeup and hair products.

PYM COSMETICS

Income Statement

For the Year Ended December 31, 2022

Sales

Sales revenue

Sales discounts

Sales returns and allowances

$    5,789,487

       (231,579)

       (115,790)

Net Sales

     5,442,118

Cost of Goods Sold

   (3,374,113) 

Gross Profit

     2,068,005

Operating Expenses

Selling Expenses

Sales salaries and commissions

Sales office salaries

Delivery expense

Advertising expense

Depreciation of sales equipment

Telecommunication expense

Postage and stationery

 268,841

 227,481

 179,916

 144,785

     9,005

     7,496

     6,214 

     (843,738)

Administrative Expenses 

Officers' salaries expense

Office salaries

Legal and professional expense

Utilities expense

Building depreciation

Office equipment depreciation

Postage and stationery

Miscellaneous office expense

 197,432

 177,300

   23,721

   22,375

    17,401

    15,978

      7,745

      3,004  

    (464,956)  

Income from Operations

Other Revenue and Gains

Dividend revenue

Interest income

Rent income

Other Expenses and losses

Interest expense

Loss on sale of equipment

  85,000

  12,000

  20,000

  278,631

      2,034 

    759,311

     117,000

    (280,665) 

Income Before Tax

Income Tax

    595,646

    125,086

NET INCOME

$  470,560

Earnings per share

$       2.353

Single-step P&L Statement

The single-step approach reports all revenues and expenses as a lump—it doesn’t classify these items by function or operating vs nonoperating. It uses the nature of expense method, reporting expenses by type, like utilities, instead of functional purpose. If we convert the income statement above using the single-step approach, it should look like this:

PYM COSMETICS

Income Statement

For the Year Ended December 31, 2022

Revenues

Sales

Dividend revenue

Interest income

Rent income

$    5,789,487

          85,000     

          12,000    

          20,000

Total Revenues

5,906,487

Expenses

Cost of Goods Sold

Sales discounts

Sales returns and allowances

Sales salaries and commissions

Sales office salaries

Delivery expense

Advertising expense

Depreciation of sales equipment

Telecommunication expense

Postage and stationery

Officers' salaries expense

Office salaries

Legal and professional expense

Utilities expense

Building depreciation

Office equipment depreciation

Postage and stationery

Miscellaneous office expense

Interest expense

Loss on sale of equipment

 (3,374,113)

    (231,579)

    (115,790)

    (268,841)

    (227,481)

    (179,916)

    (144,785)

        (9,005)

        (7,496)

        (6,214)

    (197,432)

    (177,300)

      (23,721)

      (22,375)

      (17,401)

      (15,978)

        (7,745)

        (3,004)

    (278,631)

        (2,034)  

Total Expenses

(5,310,841) 

Income before tax

Income tax

$   595,646

$    125,086 

NET INCOME

$  470,560 

Earnings per share

$         2.353

Uses of a P&L Statement

For small businesses, the income statement can be a useful financial statement to assess their performance in implementing short-term and long-term goals:

• Evaluate past performance: You can use the income statement to evaluate your performance in achieving business objectives. For example, if your goal is to increase sales by 20%, you can compare the current year’s P&L statement with the previous year’s statement to assess if you achieved this goal.
• Predict future performance: You can use income statements of the past years to perform a trend analysis. By looking at how income and expense moved through the years, you can predict growths and declines by looking at changes in income and expense amounts.
• Assess the relationship between future cash flows and revenues: While the income statement uses the accrual basis, you can still use this statement to assess the relationship of revenues with cash flow. For example, you can compare income from operations with the operating cash flow in the cash flow statement. In this comparison, you can analyze the speed at which operating income becomes cash.

Learn more about small business bookkeeping and how a bookkeeping system can help your business organize accounting information.

Analyzing the P&L Statement

There are two ways to analyze the P&L statement: common size analysis and year-over-year (YoY) analysis.

PYM COSMETICS

Income Statement

For the Years Ending December 31

2022

%

2021

%

% Δ YoY

Sales

Sales revenue

$   5,789,487

100.00%

$   5,347,895

100.00%

▲ 8.26%

Sales discounts

      (231,579)

-4.00%

      (359,913)

-6.73%

▼ -35.66%

Sales returns and allowances

    (115,790)

-2.00%

    (177,550)

-3.32%

▼ -34.78%

Net Sales

Cost of Goods Sold

   5,442,118

 (3,374,113)

94.00%

-58.28%

   4,810,432

   2,948,795)

89.95

-55.14%

▲ 13.13%

▲ 14.42%

Gross Profit

2,068,005

35.72%

1,861,637

34.81%

▲ 11.09%

Operating Expenses

Selling Expenses

Sales salaries and commissions

(268,841)

-4.64%

(268,841)

-5.03%

▲ 0.00%

Sales office salaries

  (227,481)

-3.93%

 (130,315)

-2.44%

▲ 74.56%

Delivery expense

  (179,916)

-3.11%

(111,698)

-2.09%

▲ 61.07%

Advertising expense

  (144,785)

-2.50% 

   (97,421)

-1.82%

▲ 48.62%

Depreciation of sales equipment

    (9,005)

-0.16%

     (8,400)

-0.16%

▲ 7.20%

Telecommunication

   (7,496)

-0.13% 

     (6,500)

-0.12%

▲ 15.32%

Postage and stationery

   (6,214)

-0.13% 

     (7,118)

-0.13%

▼ -12.70%

  (843,738)

14.57%

 (630,293)

-11.79%

▲ 33.86%

Administrative Expenses

Officers' salaries expense

   (197,432)

-3.41%

   (187,362)

-3.50%

▲ 5.37%

Office salaries

   (177,300)

-3.06%

   (200,142)

-3.74%

▼ -11.41% 

Legal and professional expense

     (23,721)

-0.41%

     (27,463)

-0.51%

▼ -13.63%

Utilities expense

     (22,375)

-0.39%

     (20,447)

-0.38%

▲ 9.43%

Building depreciation

     (17,401)

-0.30%

     (17,600)

-0.33%

▼ -1.13%

Office equipment depreciation

     (15,978)

-0.28%

     (15,998)

-0.30%

▼ -0.13%

Postage and stationery

      (7,745)

-0.13%

       (7,941)

-0.15%

▼ -2.47%

Miscellaneous office expense

       (3,004)

-0.05% 

       (1,179)

-0.02%

▲ 154.79%

   (464,956)

-8.03%

    (478,132)

-8.94%

▼ -2.76%

Income from Operations

   759,311

13.12%

   753,212

14.08%

Other Revenue and Gains

Dividend revenue

    85,000

1.47%

   30,000

0.56%

▲ 183.33%

Interest income

    12,000

0.21%

     6,000

0.11%

▲ 100.00%

Rent income

    20,000

0.35%

   15,000

0.28%

▲ 33.33%

   117,000

2.02%

   51,000

0.95%

▲ 129.41%

Other Expenses and losses

Interest expense

   (278,631)

-4.81%

 (172,553)

-3.23%

▲ 61.48%

Loss on sale of equipment

    (2,034)

-0.04%

   -          

0.00%

   (280,665)

-4.85%

   (172,553)

-3.23%

▲ 62.65%

Income Before Tax

    595,646

10.29%

   631,659

11.81%

▼ -5.70%

Income Tax

  (125,086)

-2.16%

   (132,648)

-2.48%

▼ -5.70%

NET INCOME

$  470,560

8.13%

$  499,011

9.33%

▼ -5.70%

Earnings per share

$       2.353

$     2.495

▼ -5.70%

To analyze the sample income statement analysis above, we can use both ways:

• Common size analysis: With this method, you state income and expenses as a portion of total sales rather than just large figures. For example, you can look at the difference between the gross profit margin of 35.72% and operating profit margin of 13.12%. We can analyze these two by investigating why operating expenses ate 22.6% of gross profit. Is the business using too many resources? Are there unnecessary expenses in the business’s operations? These are just some of the points of analysis you can derive using the common size approach.
• YoY or trend analysis: Here, we compare the same line item but at different periods to see whether it increased or decreased. Take a look at the % Δ YoY―read as “percentage change year-over-year”―column in the example above. We can see that 2022 saw an 8.26% increase in sales revenue. While that is good, it’s also worth noting that 2022 net income decreased by 5.70%. Even with a considerable increase in sales, why did the profit margin decrease? A possible explanation for this is rising costs. If you look at the cost of goods sold and selling expenses above, it’s up by 14.42% and 33.86% in 2022, respectively. Now, you can dig deeper into why COGS and selling expenses are rising. Is it because of internal factors, such as spoilages and unexpected overhead costs, or external factors like rising inflation and rising oil prices?

Limitations of a P&L Statement

A P&L statement can help you measure profitability and performance. However, it cannot provide a 100% prediction or explanation. The primary limitation is that the income statement uses the accrual basis of accounting, which does a good job of matching expenses with the revenues they generate but doesn’t provide information on whether your business is generating sufficient cash flow.

The secondary limitation is the use of estimates and accounting methods. For example, depreciation expense only estimates the useful life of an asset. Moreover, some companies may choose different depreciation methods for different classes of assets. Other companies with similar assets might estimate the useful lives differently, making the income statement incomparable.

Bottom Line

The profit and loss statement is the primary statement that every business owner must examine to assess if the business is operating efficiently, such as getting high revenues at the least possible cost and time, and effectively, such as achieving revenue goals that put the company at a better position. However, always proceed with caution when analyzing the income statement because it has its limitations as well.