Your profit and loss statement, along with your balance sheet and statement of cash flows, is one of the most important business financial statements. This statement will tell you whether your company is in the black for the year.

If you’re using business accounting software, it’s pretty easy to create a profit and loss statement. However, whether you’re using accounting software or spreadsheets, it’s important to learn the terminology that’s used in a profit and loss statement. That way,  you can use the information in this statement to make your business more efficient.

Use this guide to analyze a profit and loss statement like a pro, and as a reference if you need help preparing one.

Understanding Your Profit and Loss Statement

The first time you look at a profit and loss statement, or P&L statement, you might find yourself scratching your head. There is a lot of unfamiliar information if you aren’t a financial pro. Let’s explore the things you need to know to crack its code.

The first step in deciphering a profit and loss statement is knowing the definition of each of the various parts referenced. Here are the most common terms, and their definitions:

1. Revenue – Revenue includes the total sales that you make, but it also includes money you receive from things like selling property and equipment or receiving a refund on your taxes.
2. Expenditures – It’s not difficult to figure out what information is contained on the total expenditure line, but there are specific types of expenditures you may not be familiar with.
3. Cost of Goods Sold (COGS) – Even though you might sell a cup of coffee for $3, you don’t actually make $3 from the sale. You have to account for the cost of the materials and the time it takes to produce it, which is the cost of goods sold (COGS).
4. Gross Profit – This is the number you get when you subtract the cost of goods sold from your revenue.
5. Operating Expenses (OPEX) – Operating expenses include any costs associated with running your business that are not included in the cost of goods sold. For example: payroll, travel, training, building leases, utilities, equipment purchase, hardware and software, advertising, cell phone, and internet service. The list can get quite extensive, depending on the size and type of small business you operate. Usually, profit and loss statements divide these expenses into descriptive categories.
6. Depreciation. You probably already know that if you drive a new car off the lot, it immediately loses some of its value. This is depreciation, and it doesn’t just apply to cars. Equipment, machinery, and other business goods lose value over time as well, and this can be counted as a loss at tax time.
7. EBIT – This acronym stands for earnings before interest and tax. It’s calculated by subtracting operating expenses from gross profit. Another term for EBIT is operating profit.
8. EBT – This stands for earnings before tax, and this number comes from subtracting both COGS, OPEX, interest, and depreciation/amortization from your total revenue. EBT is a great indicator of business performance and makes it easier to compare you business’s to others if you need to.
9. Earnings Available for Common Shareholders – If your company has investors or if you take a salary from the company, this line is important because it shows net after-tax profit, minus any dividends for preferred shareholders.
10. Owner’s Draw – This is any salary for the business owner which comes out of company revenues.
11. Net Income – Net income, or profit, is the proverbial “bottom line” on a profit and loss statement for small businesses. It’s what’s left after you subtract all your expenses from your total revenue. Hopefully you’ll see a profit, but there is a chance you’ll show a loss, especially if you’re just starting out in business. This is obviously the most important line on the profit and loss statement.

Analyzing Your Profit and Loss Statement

First things first: don’t be intimidated by your P&L statement. Remember a profit and loss is simply trying to look at your sales minus your costs. Of course, it can get more complicated from there.

When you’re looking at your profit and loss, it usually will list sales/revenue/income first (or all the money your business has made), costs/expenses next (what it costs your business to make that money), and end with profit/net income. You’ll see many subtotals throughout, but you are ultimately looking for that profit number at the bottom.

Depending on the details of your business, these categories can be broken out in different ways. For example, you might reference different sources of revenue if your business does generate revenue through different means (e.g. in-store sales and online sales). Think of this is the “top line”of your profit and loss statement.

You’ll also probably break out your expenses (e.g. overhead and materials). Usually you’ll see costs broken out based on the cost of delivering your product or service (COGS), and the general operating costs of the business (OPEX). People start by looking at revenue—COGS to get their gross margin. This gives you an idea of how much you have left over to cover other expenses after you’ve covered the cost of producing your product or service. Your EBIT, also known as operating profit, is the result of gross margin minus operating expenses. Finally, after accounting for interest, depreciation, amortization, and taxes, you’ll get your bottom line.

Your net profit, net income, net earnings—whatever you want to call it—is your bottom line. This shows your business’s profit or loss. If you show a loss, it means you spent more than you earned. If you show a profit, it means you made more than you spent.

In addition to a profit and loss statement, you should also generate a balance sheet and a cash flow statement for your business. These statements will tell you very different things about your business. Together, you can use all three financial statements to get an overall picture of your business’s financial health.

How to Make a Profit and Loss Statement

Now that you know how to read a profit and loss statement for small businesses, you’ll find it is quite easy to figure out how to prepare one.

If you’re not quite ready to take on an accounting software, though, here are the steps you should follow to prepare a P&L statement:

1. Prepare your business’s revenue for each quarter of the year. What were your sales generated for each quarter of that year?
2. Itemize your business’s expenses for each of those quarters. What money did your business spend? Do those expenses count as the cost of goods sold or operating expenses?
3. Subtract your overall expenses from gross profit to get your EBIT per quarter and for the year.
4. Now account for any interest and taxes and subtract these from your EBIT. Interest charges are one of the most complicated parts of the P&L statement, so we suggest reading up more on these non-operating expenses.
5. Determine if your company has operated at a profit or a loss.

As you can see, a simple profit and loss statement is all about answering the question: has my company operated at a profit or a loss over a specific period of time? As your prepare one, you can see how each source you reference brings you closer to an answer.

Profit and Loss Statement Sample

Here’s a profit and loss statement sample that shows you all of the terms we’ve covered so far:

In this sample profit and loss statement, ABC Corporation is operating at a healthy surplus of $252,000 for the year. Most of the business’s revenue comes from in-store sales, and the company’s main expense is payroll. The company can try to increase profits by further developing their online store and by conserving on payroll costs. Depending on the type of business you have, your operating expenses section might have far more expense categories.

Just keep in mind that profit and loss statement samples only show you the finished product. As mentioned above, one of the tougher parts is going to be ensuring your figures are correct on the P&L statement. This is why having accounting software and a great bookkeeper or accountant is essential—they’ll make sure that’s the case.

The Importance of Profit and Loss Statements

P&L statements are very important. In fact, public corporations are required by law to complete them. But aside from obeying the rules, profit and loss statements for small businesses give you the opportunity to review your net income, which is essential for making sound business decisions.

Understanding the insights that profit and loss statements provide can help you operate a more profitable business. Read your profit and loss statement regularly for signs that you are on the right track or for warnings that you might need to make some changes.

Compare and contrast your most recent statements with past statements for a better picture of your current standings and to help make informed decisions in the future. Staying on top of your finances is important when running a business. Regularly referencing your P&L statement will help you do just that.