How do I read my profit and loss statement — what is each section telling me and what should I look at first?

What does a profit and loss statement measure, and what can't it tell you?

The statement adds up the business's income and costs between two dates. The AICPA's auditing standard on analytical procedures (AU-C section 520) draws the distinction: income statement accounts represent transactions over a period of time, whereas balance sheet accounts represent amounts as of a point in time. So a profit and loss answers "how did this span go?", not "where does the business stand today?", and one span says little until you compare it with others.

Reported profit is also not cash you can take out. A cash-basis report is no exception: Intuit's help on choosing between cash and accrual says it leaves out any bill you have received but not yet paid. Read net profit as a measure of performance, not as the amount available to withdraw.

What sits in each section, from top to bottom?

A statement runs from top to bottom like this:

• Revenue. This is income from selling goods or services, counted when invoiced (accrual) or when received (cash), sometimes labeled income or sales.
• Cost of sales. This is the direct cost of what you sold, often labeled cost of goods sold.
• Gross profit. The example below marks it as the gross-profit line.
• Operating expenses. These are the costs of running the business, such as rent, office wages and advertising.
• Other income and expenses. The example below labels these other items and shows them just above net profit.
• Net profit. This is the last line, or a net loss when it is negative.

What does an annotated statement look like?

Here is an invented March statement, on the accrual basis, for a landscaping business that bills materials and crew labor to jobs:

Subcontractors sit above the line because they are paid to deliver particular jobs. Advertising sits below because it is spent to run the business, not to deliver any one job.

What decides whether a cost sits above or below the gross-profit line?

Ask whether the cost is part of what you sold. For a business that bills jobs, that puts materials, subcontractors and crew time on jobs above the line, and office, marketing and administration below it.

Placement moves gross profit, not net profit. Shift the 6,200.00 of subcontractors below the line in the example and gross profit rises from 17,600.00 (41.9% of revenue) to 23,800.00 (56.7%), operating expenses rise to 15,700.00, and net profit (7,800.00) stays put. A misplaced cost misstates the figure you would use to judge pricing and job costs. A cost that changes sides between months spoils comparisons too, so keep each borderline cost, such as fuel for job trucks, on the same side every month.

A statement can lack a cost of sales section for different reasons: the business may have no direct costs, or direct costs may have been coded below the line. If you pay for materials, subcontractors or labor on particular jobs, ask your bookkeeper where those costs sit before skipping gross profit. If you have none, skip it and read each operating expense, especially wages, as a share of revenue.

How are gross profit and net profit different, and why can one rise while the other falls?

Gross profit answers whether sales cover the direct cost of delivering them, and by how much. Net profit answers what is left after every cost for the period, including overhead, interest and one-off items. Because operating expenses and other items sit between them, the two can move in opposite directions.

Suppose April brings the same 42,000.00 of revenue, but cheaper materials cut cost of sales to 21,000.00, so gross profit climbs to 21,000.00 (50.0%). The business also adds an office manager (4,000.00) and spends 1,600.00 more on advertising (2,500.00 in all), lifting operating expenses to 15,100.00. After those expenses and 300.00 of interest, net profit falls to 5,600.00 from March's 7,800.00. Gross profit rose while net profit fell. The reverse happens when margins slip but overhead is cut.

Which basis and date range is the report using?

Check these two settings before reading any figure. Intuit's QuickBooks Online help on missing income and expense transactions says the first item to check is how the accounting basis is set for the Profit and Loss report, and that the difference between the bases is how the date is determined for reporting income or expense. The bases treat the same invoice differently:

• Cash basis. Intuit's QuickBooks Online help on choosing between cash and accrual says a cash-basis report counts income or expenses only once you get a payment or pay a bill. A 5,000.00 invoice sent on March 28 and paid on April 10 is April revenue, and a materials bill received in March and paid in April is an April cost.
• Accrual basis. The same help says an accrual report counts income and expenses whether or not the invoice or bill was paid, recording them when you send the invoice or receive the bill. That invoice is March revenue and that bill a March cost.

Once it is paid, each item appears once either way; only the month changes. An invoice that is never paid never appears on a cash-basis report. If you think in bank deposits and the report is on the accrual basis, a strong month may be invoices not yet collected; if you think in invoices and it is on the cash basis, a weak month may be customers paying late.

Find the basis on the report itself: look at the header and footer, then the report's settings, and ask whoever produced it if it is not shown. In QuickBooks Online, Intuit's help on choosing a method says you can customize an individual report to use a different accounting method and compare the results. That help puts the choice of Cash or Accrual under the report's Accounting method setting (also under Customize, General), and Intuit's help on the profit and loss comparison report notes that some reports look different in the classic view and the new enhanced experience. In Zoho Books, Zoho's undated Business Overview Reports help says the Report Basis filter, among the report's Customize options, selects the accounting method for the report.

Then check the dates. A range ending today covers only part of a period: Zoho's undated Business Overview Reports help describes its Month to Date, Quarter to Date and Year to Date filters as showing data from the beginning of the period up to the date you run the report. Put a half-finished month beside a full one and revenue appears to collapse, so compare only complete spans of equal length, with the period's bills and invoices entered.

In what order should you read it each month?

Run this routine each time a statement arrives:

1. Read the header and footer. Confirm the business, the date range and the basis (from the report settings, or from whoever produced it, if not printed), and that every comparison column covers an equal, complete span, because every figure below depends on them.
2. Scan for bookkeeping signals. Look for the patterns in the table further down before interpreting anything, because they distort every total and percentage beneath them.
3. Check revenue against earlier periods. Revenue is the base for every percentage, so know whether and why it moved before judging costs.
4. Check gross profit as a percentage of revenue. This tests pricing and direct costs, and you can skip it only if the business has no direct costs.
5. Work through operating expenses. Take the largest lines first, then any line whose share of revenue changed, since overhead does not shrink when sales do.
6. Look at other items. Set interest and one-off gains or losses aside before judging the trend.
7. Read net profit last. It is the sum of everything above, so it means something only once you know what drove it.

Which comparisons make a figure mean something?

A single column cannot tell you whether a number is good, bad or normal. Two comparisons turn it into information:

• Against earlier periods. Use last month for the latest change and the same month last year to allow for seasons; Intuit's help on the QuickBooks Online profit and loss comparison report offers a previous-year option showing the same period and dates last year.
• As a share of revenue. A cost that keeps pace with sales keeps its share; a rising share means it is growing faster than sales, even in a month when revenue grew.

Year-to-date through the last complete month, against the same span last year, smooths out one odd month; Intuit's help says its QuickBooks Online comparison report defaults to the current year-to-date, so set the report period to end at the last complete month.

How do you tell a bookkeeping problem from a business result?

The AICPA's analytical-procedures standard, written for auditors, lists specific unusual transactions or events, accounting changes, business changes, random fluctuations and misstatements among the conditions that can cause relationships among figures to vary. Ask first what happened in the business and whether anything changed in how the books or the report are set up (the basis, the range, or where a cost is coded). A small movement with neither cause may be ordinary fluctuation; if a large one stays unexplained, suspect the books. These presentations point that way:

A suspense account is different: AccountingTools defines it as an account that temporarily stores transactions whose proper account is uncertain and classifies it as a current asset or current liability, so it sits on the balance sheet and any income or cost parked there is missing from this statement. AccountingTools also says all suspense items should be cleared by the end of the fiscal year, otherwise the statements issued contain unidentified transactions and are therefore incorrect. Checking that balance belongs with reading the balance sheet.

Dozens of tiny lines, or one catch-all expense line, point to a chart of accounts that needs reworking.

What should you open behind a line that looks wrong?

Open the transactions that make up the line. Intuit's QuickBooks Desktop help on a profit and loss that does not match a sales report says to double-click to quick zoom on the amount in question, and Zoho's undated Business Overview Reports help says you can click on any account in the report to view its detailed summary. In other systems, run the account's transaction detail or general ledger for the same dates and basis as the statement.

Then ask of the transactions, or of your bookkeeper:

• Does each transaction belong to this kind of income or cost?
• Is any transaction in twice?
• Is any dated in the wrong period, or missing from this one?
• Would the figure look normal on the other basis, or over a full period?

If the transactions are right, the figure is a business result and the question becomes what changed. If one is coded to the wrong account, correcting it is a separate task with its own question.

What does the profit and loss leave out, and where do you find it?

It leaves several questions to other reports:

• How much cash is free to take out. The profit and loss cannot tell you, and why profit and the bank balance differ is a separate question.
• Whether you hit your plan. That needs a budget set in the books and compared with actual results.