Decoding Profit and Loss Statements for the Self-Employed

Being a small business owner often means wading through a number of reports. One of the most common (and useful) is the profit and loss statement, or P&L statement. The humble P&L gives a bird’s eye view of your business’s income and expenses, empowering you to make more informed decisions about your next move. 

In this article, we’ll break down what you need to know about P&Ls and walk through how to get the most out of yours. Let’s get started!

What is a profit and loss statement?

A profit and loss statement for self-employed people is a report that shows your business’s revenue and expenses over a given period. The P&L statement breaks down your revenue streams and various expenses, enabling you to calculate your gross profit and net income. This breakdown offers a clearer picture of your business’s performance. 

You can create a profit and loss statement manually by gathering and organizing all the needed data points. Many accounting platforms can also automatically produce one for you, saving time.

Key components of a profit and loss statement

• Revenue: Revenue represents your business’s income. For maximum benefit, break out your revenue by type (for example, products versus services) and subtract any refunds given to customers. 

• Cost of goods sold (COGS): COGS refers to the direct expenses of producing your goods or services. These include the costs of materials, labor, storage, and anything directly tied to the products or services sold. 

• Gross profit: Gross profit is your revenue minus COGS. It indicates the profit generated by each item sold, but keep in mind that this is not your actual profit—that comes later.

• Operating expenses: Operating expenses are the basic, ongoing expenses that your business incurs to stay up and running—things like rent, utilities, and some salaries (such as for administrative staff) fall under this category. You may hear these expenses referred to as SG&A (Selling, General, & Administrative expenses), or broken down into more granular buckets like S&M (Sales & Marketing), R&D (Research & Development), and G&A (General & Administrative).

• Net income: Net income is your bottom line—the amount your business actually earned during a given period. The formula is straightforward: subtract operating expenses from gross profit to obtain net income.

How to create a profit and loss statement

Creating a P&L may be time-consuming, but the steps are relatively straightforward:

1. Gather financial data

Start by collecting all revenue and expense data for the desired time period. You can create a profit and loss statement for any period you like: monthly, quarterly, annually, or year-to-date. It’s obviously much easier to gather the needed information if you keep good accounting records. In fact, creating accurate P&Ls is one of the reasons these records are so important to begin with. If your records are incomplete or inaccurate, the P&L won’t reflect the reality of your business, which won’t be helpful.

2. Organize the data into categories

Next, categorize your data. Although you ultimately want to determine total revenue, breaking it down by item or distinguishing between products and services can provide valuable insights. Similarly, separate your expenses into COGS and operating expenses, further categorizing them to gain a quick overview of your spending on rent or payroll. Manually combing through each line of data can take a long time. Accounting software makes this task much more manageable by automatically categorizing and grouping related items. 

3. Calculate gross profit and net income 

With all your data organized, you can now get to the heart of the profit and loss statement—calculating your profit. 

Calculate gross profit

To calculate your gross profit, you must add up all of your revenues. Then subtract all your direct expenses to get your total cost of goods sold. Finally, subtract these two numbers to get your gross profit.

Here's a (very simple) example: Let's say your business sells bracelets. You sold 1,000 bracelets over the last month for $10 each. That gives you a total revenue of $10,000. 

Each bracelet costs $4 to make—this covers the cost of materials and labor. This means your total cost of goods sold on those 1,000 bracelets is $4,000. 

This gives us $10,000 - $4,000 = $6,000 gross profit on the month’s bracelet sales.

Calculate net income

Now that we have our gross profit, we can use it to calculate our net income or loss. To do this, take your gross profit and subtract all of your operating expenses. 

To continue our example, we had $6,000 in gross profit. Let’s say our operating expenses consist of $1,000 in rent and $1,000 in administrative expenses like salary and office supplies. 

This gives us $6,000 - $2,000 = $4,000 net income for the month.

Note that it is definitely possible to end up with a negative number for net income. This would indicate that your business operated at a loss, and you’d need to either increase revenue or decrease expenses to compensate. 

How to interpret a profit and loss statement

Now that you know how to create a P&L, let’s explore how to interpret what it’s showing you.

Revenue

The revenue section of a profit and loss statement typically breaks down into categories. You'll find revenue numbers for each category and a total revenue figure that combines all categories across your business. Having income broken out by category is essential because it helps you understand how each area of your business performs. For example, if you sell both a one-time purchase and subscription for a service, you can see which brings in more money. Based on these figures, you might then decide that one of them isn't worth continuing.

Cost of goods sold

The cost of goods sold (COGS) breaks down the direct cost of creating the products or services in the revenue section. Knowing your COGS is helpful because it shows you how profitable the individual items you're selling are. A high COGS may indicate there's room to improve the profitability of a given item or service. For example, you might find a better deal on materials or streamline the manufacturing process to reduce costs.

Gross profit

Gross profit measures the profitability of your sales before factoring in the overall costs of running your business. Your gross profit can give you a sense of how much your operating expenses are impacting your overall profitability. 

Operating expenses

Operating expenses, also known as SG&A, encompass the costs necessary to run your business on a day-to-day basis. Unlike COGS, your operating expenses aren’t directly tied to revenue-generating items. A P&L usually breaks down operating expenses by category, helping you understand where your business allocates the most funds. In many cases it’s staffing, but marketing and advertising costs are often a large expense, too.

Net income

Your net income represents your business's bottom line. A positive number indicates profitability, while a negative figure indicates that your expenses exceeded your earnings, resulting in a loss. To address a negative net income, you'll need to explore options to increase revenue or reduce expenses. You want to see a positive number here—if it’s negative, you’ve spent more than you earned and your business is losing money. If it’s positive, congrats—you’re profitable!

Using profit and loss statements for decision making

Leveraging your P&L to make decisions puts you at a significant advantage. Financial challenges often contribute to small businesses’ failure, due to a lack of clarity on how much revenue is generated. Your P&L makes this very clear and can help drive decisions in a number of areas:

Budgeting and forecasting

A profit and loss statement is an excellent tool for planning your next month, quarter, or year. Looking at historical data, you can anticipate your business's performance in a given period, allowing you to create informed budgets. Did you learn that revenue increases during summer and operating costs increase during winter? You can cover the winter expenses and balance your cash flow. Alternatively, you can make a plan to reduce winter expenses, increasing your overall profitability and reducing the pressure during those months.

Making informed business decisions

An accurate P&L is also a fantastic tool for crucial business decisions, such as when to hire (or hold off on hiring), how to price products and services, and which areas to focus on for company growth. Suppose you want to hire a new employee or contractor but discover you're already spending a significant amount on the payroll. In that case, hiring may impact your net income excessively so you might delay hiring. 

A P&L can also inform pricing strategies. For instance, if you notice that your products' COGS is high and gross profit is low, you might raise the price of the products or find a more affordable supplier to counter this.

Tax planning

Your profit and loss statement can also aid in tax planning. Quarterly P&L reviews can help you estimate your tax payments and identify potential tax deductions when filing your taxes. This can go a long way towards easing the anxiety many small business owners feel around taxes, and depending on the size of your business, an experienced accountant might be helpful here.

Get more from your accounting

A profit and loss statement can be one of your most powerful tools as a small business owner. However, creating one can be a lot of work for someone already keeping many balls in the air.

Found can help you keep tabs on your business with business purchases made with your Found card, or imported from your banks, credit cards, or payment apps. With auto-categorization, you’ll always have access to up-to-date expense, income, and profit and loss reports. Access these reports in the app, or export them at any time. Try it for free today!

This material has been prepared for informational purposes only.