How to Read an Income Statement (P&L), Line by Line

The top line: revenue, and what it leaves out

Revenue is what the business billed customers during the period. The roaster sold $600,000 of coffee last year. Two details matter before you read any further.

First, most businesses use accrual accounting, which records a sale when the coffee is delivered, not when the money arrives. A café that took delivery in December and paid in January counts toward December. Second, revenue is usually reported net: returns, refunds and discounts come off before the number you see. The roaster refunded $12,000 of damaged shipments, so its revenue line reads $588,000.

Read revenue next to the prior period, never alone. $588,000 is good news if last year was $400,000 and a warning if it was $750,000.

Cost of goods sold and gross profit

Cost of goods sold is what it cost to make or buy the specific things that were sold: green coffee, bags, labels, and the wages of the person running the roaster. Subtract it from revenue and you get gross profit. The roaster's cost of goods was $330,000, which leaves $258,000.

Divide gross profit by revenue and you have the gross margin, here 44%. That's the share of every sales dollar left to pay for everything else the business does, and it says more about the business model than any other line. A software company keeps most of each dollar at this point, because another copy of the product costs almost nothing to deliver. A grocer keeps a much thinner slice, because every sale carries the cost of the goods on the shelf. Neither is wrong, but they need very different sales volumes to survive.

Watch the gross margin over time more than any single year's figure. When it slips from 44% to 39% while revenue climbs, the business is usually discounting to win volume or absorbing a supplier's price increase it hasn't passed on.

Operating expenses: the cost of running the place

Below gross profit come the operating expenses: rent, salaries for everyone who isn't making the product, marketing, software, insurance, the accountant. For the roaster these total $190,000.

Where a cost lands, above or below gross profit, is partly a judgment call, and businesses make it differently. One roaster counts its delivery driver in cost of goods; another counts the same driver as an operating expense. That's why comparing two companies' gross margins can mislead. Compare gross profit and operating income together, since the total can't hide in the split.

Depreciation usually sits in this block too. The roaster bought a $70,000 roasting machine three years ago. Accounting doesn't charge the whole price to the year of purchase; it spreads the cost across the machine's useful life, $10,000 a year in this case, and that yearly slice appears here. No cash leaves the business when the line is recorded. The cash left three years ago, when the machine was bought. That gap between the expense and the cash is one of the main reasons profit and cash drift apart.

Operating income, interest, taxes, and the bottom line

Gross profit minus operating expenses is operating income, often called EBIT (earnings before interest and taxes). For the roaster: $258,000 minus $190,000, or $68,000. It's the cleanest test of whether the business itself works, because it ignores how the business is financed and what it owes in tax.

Financing costs come next. The roaster pays $8,000 a year of interest on its equipment loan, leaving $60,000 before tax. After an illustrative $13,000 of income tax, net income is $47,000. That's the bottom line, and 47 out of 588 is an 8% net margin.

You'll meet one more subtotal constantly: EBITDA, which is operating income with depreciation and amortization added back. For the roaster that's $78,000. Lenders and buyers like it as a rough measure of the cash the operations produce before any spending on new equipment. It flatters equipment-heavy businesses, though. The roasting machine will need replacing someday whether or not this year's statement shows a line for it.

Four questions to ask of any P&L

Is the gross margin holding? Growth that arrives with a shrinking gross margin was often bought with discounts, and it tends to stop when the discounts do.

Are operating expenses growing slower than gross profit? If they are, the business gets more efficient as it grows, which is what scale is supposed to do. If overhead grows faster, every new dollar of sales is worth less than the last.

Is anything a one-off? A gain from selling a van or a lawsuit settlement can move net income by more than a year of normal trading. Good statements break these out. When they don't, the notes usually explain them.

Does the profit turn into cash? The income statement can't answer this on its own. Set it beside the cash flow statement: a business reporting $47,000 of net income while its bank balance fell is tying money up in inventory or unpaid invoices, and the balance sheet will show where.

Key takeaways

• An income statement is a subtraction: revenue, less the cost of what was sold, less the cost of running the business, less interest and tax.
• Gross margin describes the business model. Operating income tells you whether the business itself makes money.
• Depreciation is an expense with no cash leaving that year, which is one reason reported profit and the bank balance move differently.
• Read every line against the prior period; a single year's figure rarely means much alone.

Frequently asked questions

Is a P&L the same thing as an income statement?

Yes. Profit and loss statement, P&L, statement of operations and income statement are different names for the same report: revenue and expenses over a period, ending in net income.

What is a good net profit margin?

It depends on the business model, because the model decides how much of each dollar can survive to the bottom line. Compare a business with its own history and with companies that sell the same way before calling a margin good or bad. A thin margin on a high-volume business can produce more total profit than a fat margin on a small one.

Is EBITDA the same as cash flow?

No. EBITDA leaves out the cash spent replacing equipment, the cash tied up in inventory and receivables, and the cash paid in interest and taxes. It's a useful rough measure of operating earnings and a poor substitute for the cash flow statement.