Reading a profit and loss statement: gross profit, operating profit, and below operating profit

A profit and loss statement answers one question: over a stretch of time, did what we sold exceed what it cost us to sell it? Everything on the page is either part of the "sold", part of the "cost", or a subtotal telling you where you stand between them.

The subtotals are the part worth learning. Each one isolates a different question about the business, and a business owner who can read the four of them separately can diagnose a bad month without help.

What to take away

The subtotals are the statement. Gross profit says whether the thing you sell works, operating profit says whether the structure around it fits, and the bottom line says neither.
Gross margin as a percentage is the most diagnostic figure on the page, because it barely moves with size. When it does move, rule out a coding change before looking for a commercial cause.
The statement is not a cash record, not a list of what money was spent on, and not comparable with another business without knowing how their owner is paid.

The shape of the statement

Here is a small annual statement with invented figures. Nothing here is typical of anything: the numbers exist so the structure is visible.

Statement subtotals at a glance

240,000Revenue
108,000Gross profit
11,000Operating profit
8,000Profit before tax

Line	Amount	What it is telling you
Revenue	240,000	What you sold, in the period you sold it
Cost of sales	132,000	What those specific sales cost you to deliver
Gross profit	108,000	What is left to run the business on
Wages and salaries	52,000	People not directly charged to jobs
Premises	14,000
Vehicle and travel	9,000
Marketing	6,000
Professional fees	4,000
Software and administration	5,000
Depreciation	7,000	This year's share of things bought in earlier years to keep
Total operating expenses	97,000	The cost of existing, whether or not you sold anything
Operating profit	11,000	What the trade itself produced
Interest	3,000	The cost of how the business is financed
Profit before tax	8,000	What is left before the tax computation begins

Subtotal one: gross profit tells you if the model works

Gross profit is revenue minus the costs that only exist because you made those sales: materials, subcontractors, the labor charged directly to jobs, delivery, transaction fees.

Expressed as a percentage of revenue it becomes gross margin: 108,000 on 240,000 is 45% in the example. That percentage is the most diagnostic number on the statement, because it is largely independent of size. Doubling revenue should not move it much. When it moves anyway, one of a short list of things has happened:

Gross profit tells you if the model works

Your prices changed, or your discounting did.
Your input costs changed and your prices did not follow.
Your sales mix shifted toward work that carries a different margin.
You are absorbing rework, waste or unbilled overrun.
Something got coded above the line this period that used to sit below it, which is a chart of accounts question rather than a trading one.

That last one is not a business event, but it looks like one on the report. Rule out the coding change before you go looking for a commercial explanation.

Subtotal two: operating profit tells you if the overhead fits

Below gross profit sit the costs of being open: the people not charged to jobs, the premises, the systems, the professional advice. These are largely fixed in the short term, which is what makes them dangerous: they do not fall when revenue does.

Gross profit consumed by overhead

Gross profit108,000
Overhead97,000
Operating profit11,000

The useful reading is not the absolute figure but the ratio: what share of your gross profit is being consumed by overhead. In the example, 97,000 of 108,000 is consumed, leaving 11,000. That is a business where a modest fall in sales removes all the profit, and knowing that in advance is worth more than any single month's number.

Subtotal three: below operating profit, the business stops being the subject

Interest is the cost of how the business is funded, not how it trades. Gains and losses on selling equipment are the residue of an old decision. Genuine one-off items belong here too, clearly labeled.

Keeping these separate is what lets you compare this year's trading with last year's. A business whose profit fell because it borrowed to expand has a different problem from one whose margin collapsed, and a single bottom-line figure hides which is which.

Three things a profit and loss statement is not

It is not a cash record. Profit can be healthy while the bank empties, and the reasons are structural rather than mysterious: money owed to you by customers, stock on the shelf, loan principal repaid, and money the owner has taken out. Each of those is on the balance sheet rather than here, and the collection side of the first is covered in the accounts receivable guide.

It is not a list of everything money was spent on. Buying a van is not on it; this year's share of the van's cost is, as depreciation. Where that line falls, between something used up and something bought to keep, is set out in the federal guide to business expense resources. Repaying a loan is not on it; the interest portion is. Money the owner takes out for themselves is not an expense at all, regardless of how it feels.

It is not comparable to another business without adjustment. How the owner is paid (salary, dividend, drawings, or nothing at all), moves the bottom line substantially without any difference in the underlying trade. So does whether staff are employed or subcontracted, and whether premises are owned or rented.

Reading a monthly statement

Three columns beat one. This month, the same month last year, and the year to date. A single month contains too much noise; the year to date contains too little urgency.

Four questions, in this order:

Did revenue move, and was it volume or price?These need opposite responses, and the statement alone will not tell you which: you need the underlying sales detail.
Did gross margin percentage move?If revenue is flat and margin fell, the problem is in delivery or pricing, not in selling.
Which overhead lines moved more than the passage of time explains?Annual payments landing in one month are the usual answer, which is why prepayments matter.
What in here happens only once?Name it, and mentally set it aside before you draw a conclusion about the trend.

Traps that produce a wrong conclusion from a correct statement

Traps that produce a wrong conclusion

Timing errors at the period edge.Revenue recorded in the wrong month and its cost in the right one will show as a margin swing across two periods that reverses itself. Check the cut-off before believing a sudden change, using the timing rules in the revenue recording guide.
An empty accrual.A cost incurred but not yet invoiced makes a month look better and the next one worse, which is the failure the expense recording guide exists to prevent.
A miscellaneous account with real money in it.Anything material sitting there is a line you cannot analyze.
Comparing a part-month with a full one, or a period containing four payroll runs with one containing five.
Reading percentages off a tiny base.A line that went from 200 to 600 is up 200% and is still 600.

What a bookkeeper can settle, and what they cannot

Producing the statement, getting the cut-off right, keeping the coding consistent and explaining what moved are bookkeeping. They are all answerable from documents.

What the statement means for the business, whether the trend is sustainable, and how the result should be presented to a lender are advice. So are how it converts into a tax position and which accounting policies apply to your entity.

Tax in particular is not simply the bottom line multiplied by something. The taxable figure is arrived at by adjustments that depend on rules where you operate, and those rules change. The federal tax guide for small business gives a sense of how many of those adjustments there are. Bring the statement to that conversation rather than a conclusion.

Common questions

Why does my accountant's figure differ from the one my software shows?

Because of the adjustments made at the year end: stock counted, costs incurred but not invoiced, amounts paid in advance released over time, and a policy applied to things bought to keep. Ask for the list of adjusting entries. Reading it beside your own books teaches more than the finished statement does.

Should the owner's own pay be on the statement?

In some form, or the profit describes a business running on free labor. How it is recorded depends on the legal form of the business and is worth agreeing once with an accountant, then keeping consistent.

Is a monthly statement worth producing at all?

Yes, if the cut-off is done. Built from the bank feed alone it is a cash summary with a misleading title, and it will show a bad month whenever a large payment happens to land.

What is a good gross margin?

Nobody can tell you that from a page, because the figure depends entirely on where you drew the line between cost of sales and overheads. Your own trend is the comparison that means anything.

Where does an unpaid supplier invoice appear?

As a cost here, in the month the goods or service arrived, and as a liability on the balance sheet until it is paid. The process behind that is in the accounts payable guide.