The ledger book, finance for managers
The profit and loss statement, read like an owner
You will read a month of a business the way its owner reads it, line by line, down to the one number worth watching.
What you will be able to do
Everything here uses one invented business: a small bakery with two locations. The figures are made up and deliberately round, so the arithmetic never gets in the way of the idea.
Five objectives
- Name every line on a profit and loss statement, and say in plain words what it is telling you.
- Calculate gross margin, and explain why the percent compares two months when the dollars cannot.
- Sort what a business spends into cost of goods sold, operating expenses, and the items that never reach the statement.
- Predict what a five point move in cost of goods does to the bottom line.
- Decide whether a profitable month is enough to act on, and say why profit is not cash.
Why this matters
A bakery can post a profitable month and miss payroll in the same month. Both facts come off the same set of books, and the manager who can read only one of them is the one who signs the wrong lease.
How this works
About eight minutes across nine screens. Nothing is timed, there is no sound, you can go back at any point, and everything works with the keyboard alone: Tab moves between controls, Enter or Space chooses, and the arrow keys move the sliders.
At a glance
- Runtime
- About eight minutes
- Screens
- Nine
- Audience
- Managers without a finance background
- Business
- An invented two location bakery
This is a teaching demonstration and not a substitute for advice from your accountant.
The statement, top to bottom
A profit and loss statement is one long subtraction. Money came in at the top. Costs come off in a fixed order. What survives is at the bottom.
| Line | Amount |
|---|---|
| Revenue | $80,000 |
| Less cost of goods sold | negative −$32,000 |
| Gross profit | $48,000 |
| Less operating expenses | negative −$43,000 |
| Rent and utilities, both locations | $14,000 |
| Salaries and payroll taxes, counter and management | $22,000 |
| Marketing and delivery | $3,000 |
| Insurance, repairs, and supplies | $4,000 |
| Operating income | $5,000 profit |
| Other income and expense: interest on the oven loan | negative −$900 |
| Net income | $4,100 profit |
What this means
Each subtraction answers a different question, and stopping at the wrong line is how managers reach the wrong conclusion. Open any line in the statement to read what that line is telling you.
Revenue
Everything the bakery sold this month, before a single cost comes off: counter sales at both shops, plus the wholesale bread that goes to two cafes. Also called the top line. It says how much business you did, and nothing at all about whether you kept any of it.
Less cost of goods sold
The cost of making the thing you sold: flour, butter, sugar, packaging, and the hourly wages of the people actually baking. It moves up and down with volume. Bake nothing, and most of this disappears. Businesses differ on whether production wages belong here or below; what matters is picking one treatment and keeping it, so this month can be compared with last month.
Gross profit
What the product itself earns, before any of the cost of being open. This is the first honest number on the page. Divide it by revenue and you have gross margin, which is the subject of the next folio.
Less operating expenses
The cost of keeping the doors open whether or not one more loaf sells. These are broken out in the four indented lines beneath. They are the lines a manager usually has the most direct control over, and the lines that quietly grow.
Operating income
The business itself, judged on its own trade, before anything to do with borrowing or one off events. If you only ever look at two numbers, look at gross margin and this one. A business can post a positive bottom line on a lucky sale of equipment while this line is negative, and that business is in trouble.
Other income and expense
Costs and gains that are not the trade: interest charged on borrowing, or a gain on selling off an old mixer. Only the interest on a loan appears here. The repayment of the amount borrowed is not a cost at all, and does not appear anywhere on this statement. That one comes back on screen six.
Net income
The bottom line, and the most over quoted number in business. It is what the month earned on paper. It is not what landed in the bank, and folio seven is about the gap between the two.
Four subtractions, in a fixed order: what the product cost, what the business cost, then what the borrowing cost.
Margin is the number
Gross margin is gross profit divided by revenue, written as a percent. At the bakery this month: $48,000 divided by $80,000 is sixty percent.
It is worth more than the raw profit figure for one reason. Dollars only compare to dollars of the same size. A percent compares anything to anything: this month against last, one location against the other, the wholesale bread against the counter croissant.
The worked example
Take two months at the bakery, side by side. In the second month a large wholesale order lands, so revenue climbs from $80,000 to $92,000. Gross profit climbs too, from $48,000 to $50,600. A manager reading only the dollars reports a good month, because $2,600 more is $2,600 more.
Now the percent. Sixty percent in the first month. In the second, $50,600 divided by $92,000 is fifty five percent. Five points of margin gone. The wholesale order sells at a discount, so every extra dollar of it brought less profit with it than the counter dollars did. Sell enough of it and the business gets busier and poorer at the same time.
| Month | Revenue | Gross profit | Gross margin |
|---|---|---|---|
| Month one | $80,000 | $48,000 | 60.0% |
| Month two | $92,000 | $50,600 | 55.0% |
Revenue up, gross profit up, margin down. All three at once, in the same month.
One month of margin tells you very little. Six months of margin tells you what kind of business you are running, and which direction it is going.
Move the levers
Four things drive this statement. Move them and watch the whole page answer. The sliders take arrow keys, Home, and End.
The four levers
| Line | Amount |
|---|---|
| Revenue | $80,000 |
| Less cost of goods sold | −$32,000 |
| Gross profit | $48,000 |
| Less operating expenses | −$43,000 |
| Operating income | $5,000 |
Gross margin
60.0%
Sixty cents of every dollar survives the baking.
Operating income
$5,000
Profit for the month.
Prompt one: find a price and a volume that pay for the month
Leave the two cost levers where they are and work the top of the statement. Operating income has to clear zero on price and volume alone.
Prompt two: move cost of goods by five points
Set the cost of goods slider anywhere, then check. You will get the same statement five points worse and five points better, side by side, so you can see what five points is actually worth in dollars.
Classify the line
Ten things that happen at the bakery in a month. Decide where each one lands. Three of them never touch this statement at all, and those three are the ones worth the argument.
Flour, butter, and the bakery boxes
The store manager’s salary
A new deck oven, bought outright for $18,000
Rent on the second location
Paying back $1,400 of the amount borrowed for the oven
The owner taking $3,000 out of the business for herself
Fuel for the van that runs bread to the wholesale accounts
Everything rung up at the counter on a Saturday
The card processor’s fee on every counter sale
The bread still on the shelf when the month ends
Item 1 of 10
Answered 0 of 10.
Profit is not cash
The month you just read showed $4,100 of net income. In the same month the bakery’s bank balance fell, and the owner could not make payroll without dipping into savings. Both of those things are true, and neither is an error.
The statement records a sale when the sale happens and a cost when the cost is incurred, not when the money moves. Money moves on its own schedule. Three gaps do most of the damage, and all three are timing, not trickery.
One: a customer who pays in forty five days
A cafe takes $9,000 of wholesale bread on the fifth. The sale is revenue in this month’s statement, in full, that same day. The cash arrives seven weeks later. Every dollar of that sale is profit on the page and nothing in the account. Money billed and not yet collected is called receivables.
Two: flour sitting in the storeroom
The owner buys $6,000 of flour at a bulk price on the twentieth. The cash leaves that day. On the statement, none of it is a cost yet. Flour is inventory, an asset, until it becomes bread that somebody buys. Its cost lands in cost of goods sold over the next two or three months, in pieces, as it is baked and sold.
Three: a year of insurance paid in one month
The annual premium is $7,200, and the insurer wants all of it in March. Cash out, $7,200, in one month. On the statement it is $600 a month for twelve months, because that is the period the cover applies to. In March the bakery pays $7,200 and expenses $600.
Add the three together
$9,000 sold and not collected, $6,000 of flour bought and not yet baked, $6,600 of insurance paid ahead of the months it covers. Against $4,100 of profit.
The month was genuinely profitable and the account genuinely went down, and the statement is the wrong document to have asked. That question belongs to a cash flow statement, which is a different page in the same set of books.
Every one of the three is timing. Nothing here is an error, and nothing here is hidden. It is the same money, counted on two different clocks.
Profit is an opinion about timing. Cash is a fact about a bank balance.
The decision
The owner has read the month, seen $4,100 of net income, and wants to sign a lease on a third location next week. The reason given, in full, is that we made money last month. A build out will take about $60,000, most of it in the first sixty days. You are the manager she is asking.
What do you tell her?
The margin check
One last look at the month, drawn to scale. Every bar is the same month you started with, and the scale is honest, which is the lesson.
The month as a chart
| Step | Change | Running total |
|---|---|---|
| Revenue | $80,000 | $80,000 |
| Cost of goods sold | negative −$32,000 | $48,000 |
| Gross profit | no change | $48,000 |
| Operating expenses | negative −$43,000 | $5,000 |
| Operating income | no change | $5,000 |
| Other: interest on the oven loan | negative −$900 | $4,100 |
| Net income | no change | $4,100 |
Three quick reads
1. What is the gross margin on this month?
2. Which single bar takes the most away from revenue?
3. Cost of goods rises five points, to forty five percent of revenue. Nothing else moves. What happens to operating income?
Question 1 of 3
What to take away
Five things to look at first, on any statement
- Revenue, and whether this is one month or a trend. One month is an anecdote. Three is a direction.
- Gross margin as a percent, not gross profit in dollars. The percent is the only figure that compares across months, locations, and products.
- The two or three largest operating expense lines, each as a percent of revenue. That is where the money quietly goes, and where a manager can actually act.
- Operating income, not net income. It judges the trade on its own, before borrowing and one off items flatter or spoil the picture.
- The cash question the statement cannot answer. What is sitting in receivables, in inventory, and in costs paid ahead. Then go and read the cash flow statement.
And one habit worth more than all five: before you accept any figure, ask what period it covers and what is included in it.
Where you landed
- Classify the line: not answered yet.
- The decision: not answered yet.
- Three quick reads: not answered yet.