This study investigates variation in the phonological development of two-year-old Finnish children (N = 39). Secondly, it examines the relationships between phonological, morphological, syntactical development and later reading skills. Thirdly, it compares children at risk (N = 19) of dyslexia with a control group (N = 20).The phonological development of spontaneous speech data was evaluated in three areas: the amount of the unintelligible speech, attempted and produced words of different length and phonotactics (restricted C1V1C1V1, C1VC1V, CV1CV1 and complex C1V1C2V2). A mean of the most advanced and the weakest fifth (N = 8) was identified in each evaluated areas.The results showed that the variation in phonological development is considerable at age two. In the most advanced fifth, the children’s speech was highly intelligible (96%), whereas in the weakest fifth 75% of the speech was intelligible. The most advanced children attempted both short and long words, whereas the weakest fifth only attempted words with one or two syllables. 35% of targets in the most advanced fifth were phonotactically restricted, whereas the figure was 69% in the weakest fifth. The most advanced children had errors in the length of trisyllabic words (0.3%), whereas the weakest fifth had errors in short and long words (10%). 3% of words produced in the most advanced fifth were phonotactically restricted, compared with 26% in the weakest fifth. The correlations between the different areas of grammar indicated that the level of phonological development predicts the level of morphological and syntactical development. The amount of unintelligible speech and the amount of unintelligible phonotactically restricted words were significantly larger and the amount of attempted trisyllabic words were significantly smaller in the group at risk of dyslexia. The huge amount of phonotactically restricted unintelligible words was a precursor of poor reading skills at age 8 in some individuals, especially if the size of the child’s lexicon was large. These results indicate that a long-term assessment comparing phonological development with the size of the lexicon as opposed to the age of the child is needed in order to determine early precursors of difficulties in phonological development or dyslexia.