5 Key Areas of an Income Statement (P&L)

So there are five key areas to any good income statement or profit and loss statement. First thing is your revenue and your adjustments. Second category is your cost of goods sold. Third category is your operating expenses. Your fourth category is your operating income and your margin, your operating margin. And then finally, your profit and loss, right? We love the profit and loss. We want to know exactly how much we’re making. So the first section is real simple. It’s your revenue. And all it does, it pulls together all the different revenue streams that you have from all the different models that you used under the revenue worksheet.

So you might have used two, three, four models to actually calculate your overall revenue. Then what we do is we want to take into account any adjustments. Adjustments are things like spoilage, returns, things that would actually adjust revenue so you can get what’s called a net revenue calculation. And that’s important because what we do is simply just take our gross revenue minus our adjustments to get our net revenue– very simple calculation. The next section is your cost of goods sold. Under cost of goods sold, or our COGS section, we’re going to look at all the expenses– all the expenses including staffing and all the other expenses we entered in our expense worksheet to deliver my product or service.

So all we do is we subtract COGS from our net revenue to get what’s called our gross margin. Now gross margin is probably the most important statistic on an income statement or a profit and loss statement. Gross margin basically says, how much money is left over to market, to run my business with G&A costs and to develop my product after I deliver my product. So all it’s saying is is how much does it cost to deliver my product and how much money is leftover afterwards so that I can fund everything else in my business. So why is gross margins such an important statistic for you to know?

Well basically, what it does is it tells you and investors how scalable your business is. So if you have a low gross margin, it actually is going to take a lot of expense in order to deliver that revenue. If it takes a lot of expense to deliver that revenue, then you don’t have a lot left over for marketing and sales and other things that actually are growing the business. That’s what they’re looking for.

So if you have a high gross margin business, this basically means that you have a low cost to deliver that revenue, which is great because all that extra money can actually be dropped either to the bottom line in terms of profit or it can be used to fund product development, sales, and marketing, G&A, and other expenses within your business. So a high-gross-margin business– and you say, Ken, what’s a high-gross-margin business? Well, it really depends on kind of the industry you’re in, but I would say that in things like software, technology, other businesses, things like 80, 90% is a high-gross-margin business. Businesses that are in the 20, 30, 40%– that’s a low-gross-margin business. And average– anywhere between 50 to 70%.

You need that margin in order to run the business. Keep that in mind. I want you to research the gross margins in your industry. Every industry is different, so it’s important that you research and understand how does your industry work. What are the gross margins there? And then where do you fall within those gross margins as well. I also want to make sure that you understand is if your gross margins are too low, your business may not be feasible. You may not have enough money left over to actually do anything with the business. All the money is going into delivering to customers and there’s nothing left over, not only for profit, but not actually to grow the business at all.

And that’s not to be an attractive business for you to even get into. Now I also want you to note that when your business scales, your gross margins actually may look a lot better than when you start because you get things like volume discounts. You have more customers. The more customers you have, the more employees you have, the more efficient, the more specialised you get, the more efficient you get as well. So there’s a lot of reasons why, as your business scales– in fact, almost every business that I see, as they scale their gross margins start to go up.

So what an investor is going to do is they’re going to look at your business more at scale than during the startup phase. So don’t get too worried if you’re like I got 20% or negative gross margins or maybe 20% gross margins as I start, but after the first two years my gross margins are 80%. Well, OK, now I’ve got a really good business. Now keep in mind as well is if you’re a true service business, your gross margins should actually be around 50%. That’s actually how service businesses work. Product businesses are going to be higher into the 60s, 70s, and 80s– 80%.

So you also have to look at the type of business that you have in order to figure this out. Operating expenses and operating margins– operating expenses are all the other expenses in your business that do things like sell and market your product, all your product development costs, and all of your general and administrative costs, so all the other expenses. Not the delivery of your product, but everything else. So what this represents is how much are you investing in the company to grow the company, to scale the company. These are all these activities that actually make the company bigger, make the company grow. And these are the things you want to spend your money in.

So operating margin is the margin or percentage that you have left over after all expenses are actually taken into account that will ultimately inform how– what your profit and loss is. Now, there’s one thing in between operating margin and profit and loss, and that’s taxes. And that’s really the difference– operating margin versus your profit and loss. And the last section of your P&L statement is profit and loss. This is what the statement is all about, right? This is the bottom line. This is where all your revenue minus all of your expenses, and this is what you have left over afterwards.

The important part about this number is this number actually carries over to what we call your cash flow statement because this is the amount of money that you either have in the company– the actual that turns into cash– or the money that you’re losing in the company as well, that’s coming away from the business.