What Is A Profit And Loss Statement? (Formulas And Examples)

By Indeed Editorial Team

Updated 12 September 2022

Published 11 May 2022

The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.

A profit and loss statement is one of the three major financial statements, along with the cash flow statement and the balance sheet, that measures a business' financial performance over a period. It provides information about the ability of the business to generate sales, manage expenses and make a profit. This information can help you as an employee in gauging a business' financial health. In this article, we discuss what a profit and loss statement is, understand its components and find out how to create one to measure the financial performance of a business.

What Is A Profit And Loss Statement?

Understanding the answer to "What is a profit and loss statement?" is essential for an employee to monitor a business' performance and keep a track of its sales and revenue generated. It is a summary of a business' revenue and expenses over a period, which can be a month, a quarter or the entire financial year. This statement provides you with information about the ability of the business to generate sales, manage expenses and make a profit. Together with the cash flow statement and balance sheet, the income statement provides an in-depth look at the finances of a business.

Profit or Loss = Revenue - Expenses

Comparing profit and loss statements of different periods can be really helpful because the change can provide insights about the financial performance than just the numbers.

Related: Basics Of Accounting - Terminology, Principles And Concepts

Profit And Loss Statement Vs. Balance Sheet

This statement highlights the revenue a business generates, the expenses it incurs and the profits it makes over a given period. A balance sheet, in contrast, is a snapshot of the business's assets, liabilities and equity at a single point in time. The balance sheet provides data as on the final day of the fiscal year of the firm. Investors may use the balance sheet to assess the financial strength of a company by comparing its assets against its liabilities.

Why Is A Profit And Loss Statement Important?

Below are some of the reasons why creating a statement is important and can be helpful for an employee and the business they work for:

  • It can indicate the financial health of a business. The profit and loss statement, together with the cash flow statement and the balance sheet, can provide an insight into current the financial status of a business and reveal any issues that employees may be unaware of.

  • It can provide insights to plan for the future. Knowing about the current financial status may help an organisation plan for its future by developing measures to enhance revenue and reduce costs to improve overall profitability.

  • It can help bring in investors and creditors. Investors can refer to the income statement of a business to assess the amount of risk involved in investing in it. If the income statement is healthy, it may attract more investors and creditors which may help increase its profits.

Components Of A Profit And Loss Statement

To understand and prepare a profit and loss statement, it is important for you to understand what it comprises. Below are the most common components that you can find in a profit and loss statement and their definitions:

Total revenue

The total revenue is a business' net income that it receives through its operations. The revenue is the top line of the income statement. If the business sells physical goods, you may mention the revenue as product sales in its income statement. If it provides services, then you may mention it as services rendered.

Related: What Is Revenue? Definition, Types, Examples And More

Direct expenses

Direct expenses are the expenses that a business incurs for selling its goods and services. If it sells physical goods, you may refer to it as the cost of goods sold or the cost of sales. If it provides services, you may call the expenses the cost of services. For example, the money a business spends for buying raw material comes under the cost of goods sold. These expenses are variable and are directly proportional to its sales.

Gross profit

The gross profit is the difference between the total revenue of the business and its direct expenses. It is how much money it makes if it incurs no other expenses apart from direct expenses. Although it is not necessary to include it in the income statement, the gross profit may help you put the expenses into perspective.

Gross profit = Total Revenue - Direct Expenses

A useful metric to analyse the profit at this stage is the gross profit margin. It helps you measure how efficiently the business has been producing and selling its goods and/or services. The formula for gross profit margin is as follows:

Gross Profit Margin = (Total Revenue - Direct Expenses/Total Revenue) x 100 = (Gross Profit/Total Revenue) x 100

The gross profit margin is expressed in percentage.

Overhead expenses

Overhead expenses or indirect expenses are the costs that the business incurs for running. It cannot trace the expenses back directly to the sales. Overhead expenses can be of two types. The first type, known as fixed expenses, are those which remain constant throughout. Examples include office rent, salaries, depreciation and amortisation. Fixed overheads bear no correlation with sales. The second type, called the variable overheads, can loosely correlate with the sales. For example, advertising costs and sales commission.

Operating profit

The operating profit is the profit that the business makes after deducting the overhead expenses from the gross profit. Operating profit measures the net income that the business creates from its operations. This profit does not take interest expenses and taxes into account. That is why operating profit is also called EBIT, short for expenses before interest and tax.

Operating Profit = Gross Profit - Overhead Expenses

Just like the gross profit margin, another useful metric at this stage is the operating profit margin. The formula is as follows:

Operating Profit Margin = (Gross Profit - Overhead Expenses/Total Revenue) x 100 = (Operating Profit/Total Revenue) x 100

The operating profit margin is expressed in percentage.

Net profit

The net profit, also known as the net income, is the final income of the business after deducting all expenses, including taxes and interests. It is the bottom line of their income statement. The net profit is the final and most important line of their income statement because it shows how much profit the business generated during the period.

Net Profit = Operating Profit - (Interest and Tax Expenses)

You can calculate the net profit margin using the formula that follows:

Net Profit Margin = [Operating Profit - (Interest and Tax Expenses)/Total Revenue] x 100 = (Net Profit/Total Revenue) x 100

The net profit margin is expressed in percentage.

Example of a profit and loss statement

Here is an example of what a basic profit and loss statement or income statement looks like:

Year Ended March 31,20212020Total Revenue5,00,0004,00,000Cost of Goods Sold1,00,0001,00,000Gross Profit4,00,0003,00,000Overhead Expenses:

Rent15,00015,000Salaries40,00040,000General and Admin30,00030,000Operating Profit3,15,0002,15,000Interest Expenses25,00025,000Tax Expenses90,00070,000Net Income2,00,0001,20,000Businesses can use the information provided in the statement to calculate useful metrics such as gross profit margin, operating profit margin and net profit margin that can help them gauge their financial health and take necessary measures to improve it.

Read more: What Is An Accountant? Types And Career Advice

Methods For Creating A Profit And Loss Statement

There are two basic methods using which you can create a profit and loss statement:

1. Single-step method

The single-step method calculates the net income by subtracting the total expenses and losses from the total revenue and profits. All revenue line items have a single subtotal, as do the expenses line items.

Net income/profit = (Revenue + Profits) - (Expenses + Losses)

You may use the single-step method when creating income statements for service-based industries and small businesses to determine their net income. This method does not provide a breakdown of expenses by department or gross margin calculations.

2. Multiple-step method

The multi-step method provides a breakdown of the revenue and expenses—it uncouples the operating revenue and expenses from other revenues and expenses. It does so to calculate the operating profit. You may use this method when creating income statements for larger companies to better understand the profitability of their operations. The multi-step method follows the following three-step process:

  • Calculate the gross profit by subtracting the direct expenses from the revenue.

  • Calculate the operating profit/income by subtracting the overhead expenses from the gross profit.

  • Calculate the net income by subtracting the non-operating revenues and gains and non-operating expenses and losses from the operating profit.


Related:

  • What Is Implicit Cost And Explicit Cost? (With Examples)

  • What Is A Financial Statement? (With Importance And Types)

  • What Is Revenue? Definition, Types, Examples and More

  • What Is A Cost Centre? (Types, Importance And Examples)

  • Asset Vs. Expense: Differences, Types And Best Practices


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