What a P&L Tells You

Why does this thing have so many lines?

You already know the basic profit equation, and everything here is a different version of it.

\[\text{Revenue} - \text{Expenses} = \text{Profits}\]

Then you see a real income statement, with three periods across the top and a lot of different rows, and it looks a lot more complex.

Do not panic. It is simple as long as you hold on to revenue minus expenses equals profits.

Revenue is always at the top. That is why we call it the top line. At the bottom is net profit. Everything in between is different ways of subtracting off costs, with subtotals along the way that lead to that final number. We break things out into categories so there is a stepwise way to do this.

The first thing we subtract is all the costs and expenses that have to do with the good or service we are producing. That is the cost of goods sold, which is in fact what the name says. Revenue minus those costs - not all the costs, those costs - gives gross profit. That is a rough big profit number, a gross approximation, and what it tells you is how profitable the product or service itself is.

We still have expenses left. There is more than the expense of creating the product. There are the other activities of running the business, so we can market and get those goods out to people. Even though the accountant’s time is not directly in whatever widget we are selling, we still need that person to run the business. Subtract those operating expenses - marketing, rent, the rest - and we get EBITDA, which stands for earnings before a handful of things: interest, taxes, depreciation and amortization.

Depreciation and amortization come next. This is the part we are not actually paying in cash, but it is an expense to be recognized in the period. Subtract it and EBITDA becomes EBIT, earnings before interest and taxes.

Interest is not running the business. It is financing the business. You might have a loan and you have to pay interest on it, so subtract that and give the number another haircut down to earnings before taxes.

The last step is that businesses are taxed on their profits. Subtract the tax expense and you get net profit. That is the bottom line, and it is called that because it is at the bottom.

What you see is a complex table, and all it is is a repackaging of the simple equation. We slice up the expenses in a particular way. The reason we do that is to get snapshots of what profits are once we account for different parts of the business: for creating the product, then for operating, then for the implied costs that are not cash out of our pockets, then for financing, then for tax.

What can you tell without the name on it?

Hand someone a profit and loss statement with the company name stripped off and they can tell you a surprising amount.

Look at the revenue number. How big is it? Is this a Fortune 500 company or a mom-and-pop shop? Is there a cost of goods sold, and how substantial is it? That tells you whether this is a company that actually makes something. Manufacturers make things, so you see a cost of goods sold and a gross margin. Others are retailers or resellers, not adding a lot of value, taking a small margin on top of the stuff they buy. How thin that margin is is good evidence about what kind of business it is.

Then the other operating expenses. How big are they, and what is the split among them? Do they spend a lot on marketing, because this is the type of business where one of your biggest expenses is finding and retaining customers? Do they carry a large headquarters overhead, or is it relatively light? Small decentralized companies might not have much headquarters at all, whereas a business that requires coordination across many locations probably does.

Look at depreciation. If it is high, they have a very large asset base - lots of equipment, heavy expensive machinery. If it is light, they are relying mostly on things that do not depreciate, on expenses incurred in the period, often in the form of human talent.

Two retailers, same industry, opposite businesses

Even within one type of business, you get very different margins and very different models.

A luxury brand does not sell very much, because the goods are expensive and only a few people come in. It has to spend heavily on marketing to maintain a strong brand presence around prestige. Low volume has to come with high margins, because those margins support all that other operating spend - marketing, administration, brand management - which is expensive. So you see large gross margins, and often large margins generally.

Now contrast that with a big-box retailer selling brand-name goods. They are selling things people already know about, already branded. Their whole value is aggregating a lot of the stuff you need for your house and making it ready. They do not have to spend much on branding or on capturing customers, because we already know who they are. Given how much of this rides on volume, they can get away with thin gross margins - a little markup on what they buy - and still make it work economically.

Both are retailers. What each has to be good at is completely different. The luxury retailer has to be good at marketing, using that extra margin to establish itself as something of prestige. The big-box retailer is playing a volume game: get a lot of customers through a lot of products efficiently, ordered, stocked, and coming off the shelves over and over. Being efficient is how you win.

What a margin already tells you

Suppose I tell you a company’s gross margin is 70 percent, and nothing else.

That is a lot of money left to run the rest of the business beyond the cost of the product. If it is a manufacturer, it is probably a high-premium, difficult-to-make thing - it commands that premium because it is valuable and very few people can do it.

If it is a retailer, it is because there is a very high cost of getting these customers. Maybe there are not many of them. Maybe they are luxury buyers, or think about a product only a very specific kind of surgeon ever needs. These are people whose time is valuable, who are difficult to find, and a lot of money has to be spent reaching and convincing them.

Now say the gross margin is 10 or 12 percent instead. That points at a commodity good. Lots of people have it. In the case of a retailer, you are reselling somebody else’s stuff, an object any retailer can carry. You cannot mark it up much, because others will out-compete you. You are not doing much beyond buying the stuff and making it available, and that is not a lot of value added, so it is not a lot of margin for you.

Creating value, and capturing it

To have a business you have to create value. To survive you have to capture some of it too.

Creating value is about supplying a good or service where the cost of doing it is lower than the value you produce. You make something of a certain value, and the costs that go into producing it have to come in under that.

Once you have created it, the question is capture, and the mechanism is price. You created value of a certain amount and now you set a price. It has to be below what the customer values, or they would not buy. But there also has to be room between the price and your cost, so the producer captures something too.

In the good case you have created enough value that the customer keeps some of it and you keep some of it. The price splits the pie. You have to capture enough to sustain the business - enough to pay all your costs and leave a sufficient profit - while staying below what the customer thinks it is worth.

Both sides can fail. If the price the market will bear is too low, given how customers value it or what the alternatives are, you cannot capture enough to sustain operations, and the business does not last. And if you produced it at a cost so high that you have to price above what any customer will pay, they will not buy, and you cannot capture anything either.

Heavy SG&A and no profit: growing, or bloated?

Some things you can diagnose straight from the statements, or at least know where to start looking.

Imagine a company with heavy SG&A that is not profitable. Is that bad?

It depends, and you need the context. It could be a company that is new and growing, where the revenue growth has not arrived yet but will. They are building capacity in sales and administrative muscle to handle a much larger business they expect to grow into.

That is a very different story from a company that is not growing and is bloated, where the cost is a stone weight dragging it down and keeping it from being profitable. That business is making money on its product or service, and then once you layer in all the sales and administrative cost, it is unprofitable. The prescription is entirely different: the SG&A is too big for the size of the business and you have to ask whether it can be reduced.

This is not something you can tell from the financial statements alone. You have to know something about the context and about what the future is expected to look like, to know whether a symptom like that is a concern or exactly what you would expect.

All the way down to one unit

Unit economics takes the whole business and breaks it down.

A business sells a product or a service, and in the end it does that for many, many customers over and over. So one of the building blocks is the single transaction, or the single customer. What do the economics look like there? Take a lemonade stand. For one cup of lemonade, how much am I making? That is how we reduce a big complex business to one unit of what it does and analyze the economics at that point. It tells us whether the company is profitable as this scales up, and whether it will stay profitable as it scales further.

There are limits. You can have good unit economics and still lose money.

For a given product, think about all the costs traceable to that one thing - for a cup of lemonade, the cups, the lemons, the sugar, the water - and then what you sell it for. There is a big margin between the two. But there are other costs: hiring people, running the stand, other fixed costs. You have to sell enough volume that all those margins add up and pay for the costs that cannot be traced down to the unit.

So even when it looks like you are making money on every single unit you sell, you can still lose money in aggregate, because all that margin collected over too few units does not cover the rest.

Where you can see a proxy for unit economics is in the part of the statement tied closely to product. Cost of goods sold is usually traceable to specific products. If you know your volume, divide total revenue by volume for average price, and divide total cost of goods sold by volume for approximate unit cost. The difference between those, scaled across all units, has to cover everything that sits below the gross margin line.

The fingerprint

A profit and loss statement is a signature of the kind of business it is.

A product-driven business creates most of its value by making a distinct product. Revenue has to exceed the cost of goods sold - everything it took to make the thing. The gross margin is telling you how much value you are creating: how distinctive you are at making this, how much customers value it. Then, having made a great product, you still have to market it, talk to customers, service them, and distribute it. That is the operating expense below the gross margin line. You can see which is which.

A retailer does not make product. Its cost of goods sold is what it buys from others, so the gross margin is what it makes on the sale after subtracting what it paid. Again the question below the line is what it spends to run the business, reach customers, and keep things moving.

A marketing-driven business has an offering that is understandable enough, and the work is finding customers, convincing them to buy, and continuing to service them. The cost sits not in the product but below the gross margin line, in sales and administration, because a lot of money goes into making sure people know who you are.

A service business carries no inventory, so there is no high cost of goods sold - it is not buying something to sell, or buying materials to make something. It sells the hours of the people who work there, and those hours very often appear in SG&A. The margins look completely different, because selling expertise is not the same shape as selling a product.

If this were your business

Managers have a small number of degrees of freedom. If you wanted to improve profits, what could you actually do?

Fundamentally you raise revenue or you lower cost. On revenue there are two levers.

Sell more units. Hold prices constant and find more customers who want your product, which requires figuring out who they are, where they are, and what it costs to identify and sell to them.

Raise prices. This means convincing customers your thing is worth more to them than they are currently paying. Is there justification for that?

On cost, the questions are whether there are things you buy that you could buy cheaper, and whether there are things you buy to provide the good or service that you do not have to buy at all. Some of that lives in cost of goods sold, where the question is whether you can grow the gross margin. Some lives below it, in sales and administration, where the question is whether you can still run the business on a lower cost base.

How do you choose? Try a one percent change in each - volume, price, each type of cost - and see where it has the biggest impact. You can take everything on the profit and loss statement and ask: if we moved this by a small amount, what would change the most?

Then ask what it would take to do it. In a very competitive market, raising prices is hard; in a less competitive one it may be easy. It also takes little effort to change a number - raising a price is an administrative change, not a change in behavior or supplier relationships. Buying something cheaper, or stopping buying it, means renegotiating and changing how you work.

So it becomes a comparison. What is the biggest benefit available from putting my attention here, and what cost or inconvenience would I face to make progress on it? Between those two, you prioritize the levers differently.

© 2026 Eric Lin. All rights reserved. This chapter is provided for students in BUSI 170 - please do not repost or redistribute without permission.