How to read a profit and loss statement — and what the numbers are telling you

Revenue is the income generated by the business. Depending on the business, that might include:

• construction or project revenue
• professional fees
• product sales
• hospitality revenue
• service income
• recurring revenue
• other operating income

The first question is obviously: is revenue increasing or decreasing?

But that isn't enough. A 20% increase in revenue sounds good. If the business had to increase wages, subcontractors and other direct costs by 30% to produce it, the result may not be nearly as attractive.

So rather than stopping at “revenue is up”, ask: what did it cost us to produce that additional revenue?

That takes you to the next part of the P&L.

Direct costs are the costs closely connected with producing the goods or services the business sells. What belongs here depends heavily on the business.

For a construction business, it might include:

• materials
• subcontractors
• site labour
• other project-specific costs

For a retailer, it may include the cost of stock sold. For another service business, direct costs may be relatively small.

The distinction matters because direct costs help us work out gross profit and gross margin.

If revenue increases but direct costs increase even faster, that deserves attention. Possible reasons may include:

• supplier prices have increased
• subcontractor costs have changed
• pricing has not kept pace with costs
• jobs are taking longer than expected
• the sales mix has changed
• discounts are being given more frequently
• low-margin work is making up a larger share of revenue

The P&L identifies the movement. The next job is understanding what caused it.

Gross profit is broadly what remains after deducting direct costs from revenue.

For example (illustrative figures only):

• Revenue: $2,000,000
• Direct costs: $1,200,000
• Gross profit: $800,000

That number on its own is useful. But the percentage is often more useful. In this example, gross margin is 40%.

If the business generated $2 million of revenue last year at a 45% gross margin and now generates $2.4 million at 36%, revenue has grown significantly while the economics underneath the business have weakened.

That can easily be missed if everyone is focused on sales.

Gross margin tells you how much of each dollar of revenue is left after the direct cost of delivering the work.

It can help expose changes in:

• pricing
• labour efficiency
• material costs
• supplier pricing
• project performance
• discounting
• product or service mix

It is particularly useful to compare margin month to month, quarter to quarter, year to year, against budget, and between divisions, services or projects where the accounting allows it.

A movement of a few percentage points can make a substantial difference to profit.

Consider a business with $5 million of annual revenue (illustrative figures only).

• At a gross margin of 40%, gross profit is $2,000,000
• At a gross margin of 37%, gross profit is $1,850,000

Revenue has not changed. But the business has $150,000 less gross profit available to pay wages, rent, administration, finance costs and everything else.

That is why margin can matter more than another headline increase in turnover.

Once gross profit has been calculated, the P&L moves into the costs of running the wider business. Depending on the business, these may include:

• salaries and wages
• superannuation
• rent
• software
• vehicles
• insurance
• marketing
• accounting and legal costs
• travel
• office costs
• subscriptions
• repairs
• administration costs

These costs behave differently. Some are largely fixed. Rent does not automatically fall because sales had a bad month. Other expenses move with the size of the business.

That is why simply asking whether an expense is “too high” can be misleading.

A better question is: why has this cost moved, and is the business getting something worthwhile in return?

For many businesses, wages are one of the largest expenses on the P&L.

If wages move from $900,000 to $1.2 million, that doesn't automatically mean there is a problem. Perhaps the business deliberately hired ahead of growth. Perhaps additional people were needed to increase capacity. Perhaps work that was previously subcontracted has moved in-house.

The P&L gives you the movement. The commercial question is whether the additional cost is producing the result the owners expected. For example:

• Has revenue increased?
• Has capacity increased?
• Have margins improved?
• Is work being completed more efficiently?
• Is the business carrying people ahead of future growth?
• Is the team structure still appropriate?

That's much more useful than simply trying to cut the wage bill because it went up.

You do not need to analyse every small movement in the report. Start with the larger or unusual changes.

If software has increased from $25,000 to $60,000, understand why. If vehicle costs have doubled, investigate it. If marketing spend has increased substantially, ask whether that was deliberate and what the business expected from it. If professional fees are unusually high, there may have been a one-off project.

The P&L is easier to use when you focus on what actually changed.

Eventually you arrive at profit. This tells you whether the business generated more income than expenses over the period.

Obviously profit matters. A business needs to generate enough profit to reward its owners, reinvest, deal with tax, service debt and fund what comes next.

But the final profit number should create questions rather than finish the conversation.

• If profit has increased: why?
• If it has decreased: why?
• If revenue increased but profit didn't: where was the additional margin absorbed?
• If profit is significantly ahead of budget: is that sustainable or was there something unusual in the period?
• If profit looks strong: does the cash position support it?

That last question is particularly important.

A business can report a profit and still have very little money in the bank. That surprises a lot of owners.

The reason is that the P&L is measuring financial performance, not simply cash entering and leaving the bank account.

For example, profit may not tell you directly that cash has been used to:

• repay loan principal
• buy equipment
• fund debtors
• increase stock
• pay tax from an earlier period
• make distributions to owners

Similarly, revenue can appear in the P&L before the customer has actually paid the invoice.

So if the business made $400,000 of profit, that does not mean there should be another $400,000 sitting in the bank.

This is why the P&L should be read alongside the balance sheet and cash position. Our guide to reading a balance sheet explains where that difference usually sits.

One month's P&L can sometimes tell a misleading story. There may be timing differences, large invoices, annual expenses, seasonal trading, project revenue recognised at different points, or one-off costs.

Where possible, look at trends. For example:

• Current month versus previous month — useful for spotting recent movements.
• Year to date versus prior year — useful for seeing whether the business is genuinely performing differently.
• Actual versus budget — useful for understanding whether the business is doing what the owners expected it to do.
• Rolling 12 months — useful where monthly or seasonal movements make shorter periods difficult to interpret.

The right comparison depends on the business.

There is an important qualification to all of this. If the accounting information is wrong, the conclusions can also be wrong. For example:

• transactions may be coded incorrectly
• costs may be sitting in the wrong accounts
• revenue may not have been recognised consistently
• payroll may not have been reconciled
• stock may be incorrect
• one-off items may distort the comparison

A beautifully formatted report does not fix poor underlying accounting.

Before making an important decision from the P&L, you need enough confidence that the information is reliable.

For many business owners, a useful starting point is:

• 1. Revenue — what did we generate, and how does it compare with the previous period and what we expected?
• 2. Gross margin — are we keeping the same amount from each dollar of revenue? If not, why?
• 3. Wages and major costs — what has materially changed, and was it deliberate?
• 4. Operating profit — is the core business generating the result we expected?
• 5. Variances — which numbers are significantly different from last month, last year or budget?
• 6. Cash — does the cash position make sense when compared with the reported profit?

You may need additional measures specific to your business, but this gives you somewhere to start.

The usefulness of the report also depends on how it is structured.

A construction business may want to separate labour, subcontractors, materials and project costs.

A hospitality business might focus closely on food costs, beverage costs, wages and occupancy-related costs.

A professional services business may care more about professional wages, contractor costs, utilisation and revenue per employee.

A generic chart of accounts can produce a technically correct P&L without producing a particularly useful management report.

The report should help the people running the business understand how that business actually makes money.

This becomes even more useful where there are several business owners.

One person may believe the business is performing well because revenue is growing. Another may be concerned about wages. Someone else may be focused on the cash balance.

The P&L gives everyone a common starting point.

Instead of “I think we're doing well”, the conversation can become: revenue is up 12%, but gross margin has fallen three percentage points and wages have increased faster than sales — what's driving that? (Those figures are illustrative.)

That is a much better conversation.

There are limits. The P&L does not give you the entire financial position of the business. By itself, it won't tell you everything about:

• how much customers owe you
• how much you owe suppliers
• ATO liabilities
• loans
• assets
• stock on hand
• money owed to or from owners
• the actual amount of cash available
• upcoming commitments

For that, you need to look beyond the P&L. The balance sheet, cash position and sometimes a forecast provide the rest of the context.

Each report answers a different question.

You do not need to be an accountant to get value from a P&L. Start at the top and work your way down.

Look at revenue. Direct costs. Gross margin. Major operating expenses. Profit.

Then compare those numbers with another period or with what you expected.

The most useful question is rarely “what is this number?”. It is “why has this number changed?”

Once you understand that, the P&L stops being another accounting report and starts becoming something you can actually use when running the business.

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