Understanding a profit and loss account
Understanding the profit and loss account
The profit and loss account part of the financial statements of a business. For small business owners who run as a sole trader the profit and loss account may be all that is produced, whereby a Limited Company is required to prepare more formal financial statements including additional pages such as a balance sheet, accounting policies and notes to the accounts.
The profit and loss account is a summary of the business trading activities over a period of time (usually one year, unless the business has started, is ceasing or has a short or long accounting period). Important business decisions are often taken by business owners and those involved in the day to day running of the business based on financial statements. They are also a legal and statutory requirement for Companies and should be prepared for sole traders and partnerships in order to assist with the preparation and completion of a tax return.
If a business is looking to raise finance then the profit and loss account may be used as a way of understanding a business, how it is being run and how well it is performing.
Profit and loss account preparation
The profit and loss account should ideally follow the typical format starting with sales/income followed by direct costs, overheads and admin expenses ending with a net profit figure. However this format can range from a very basic version with several lines to a complex version with a number of additional items depending on the type and size of the business.
If the business is VAT registered then the profit and loss account is likely to be shown net of any VAT, also the profit and loss account will only show transactions that are related to the commercial activity of the company, therefore any items such as capital introduced by the owners and bank loans are generally not shown here and as they are considered balance sheet items.
When the profit and loss account is prepared consideration should be made as to how accurate the figures are contained within. Whilst the financial statements may not be 100 % accurate they should be free from material error, by this we mean that the financial statements should be free from any area that would affect an decision making when considering the financial information contained within the accounts.
The profit and loss account is usually split into two distinct areas, the first section being called the trading account. This is because the area up to and including the gross profit line shows only the trading activity of the company, i.e. what the company does to make it’s money.
The remaining area of the profit and loss account below the gross profit line contains the overheads of the business, these are items that are considered not directly related to the trading activity. For example insurance and rent and rates, these items whilst needed will be incurred regardless of the level of trading the business undertakes (to a certain extent anyway).
The first line on a profit and loss account is the sales figure, also commonly known as the turnover of the business. This figure includes all of the sales created by the business regardless of whether the invoices raised for the sales have been paid or not by the customer. It may also include work performed but not yet complete and invoiced depending on the business type.
Cost of sales
The cost of sales line represents the costs incurred to generate the sales made by the business. The same method as with sales applies to the cost of sales, so goods and services received regardless if they have been paid for or not are included within cost of sales.
If the business buys goods to sell then the cost of sales will include such items. The cost of sales will also usually include an adjustment for stock held. Stock held at the end of the year will be adjusted for against the cost of sales and in the same way the stock held at the start of the year. This ensures that only goods used during the year are included against the sales generated. The stock remaining will be included on the balance sheet of the business (if applicable).
Gross profit and the gross profit margin
The gross profit also referred to as the GP or gross profit percentage is the difference between what has been sold during the year and the cost of those sales.
The gross profit margin shows the mark up applied by a business on the goods purchased for sale, and can be compared year on year to highlight any inefficiencies or any market conditions which may be affecting the figure. For example a new competitor may have resulted in a lowering of prices and in term the gross profit margin will have reduced as a result.
Administration expenses / Overheads
The administration expenses and overheads are costs incurred by a business in order for it to run. These items will differ depending on the type of business and therefore may only be several lines or could be much more detailed for larger organisations.
Typically this area of the profit and loss account will include such items as rent, rates, insurance, travel expenses, advertising and wages. Sometimes however depending on the type of business items can be included within administration expenses or cost of sales. For example where the business is a service the wages would more likely be included within cost of sales as this would replace goods purchased.
Finance charges / Other income
If applicable finance charges and/or other income will be shown as a separate item beneath administration expenses.
Interpreting the profit and loss account
One of the best ways to interpret the profit and loss account is to compare like with like or year on year. If the business is fairly consistent then a review of the profit and loss account for comparisons between years can be made. Any unusual differences can be investigated.
Another benefit of interpreting the profit and loss account is to identify any areas for improvement. A look at an increase in sales may identify types of work which are more profitable than others, similarly an increase in costs for a particular item may be worth investigating. If for example insurance is increasing year on year it may be worth investigating to see if costs can be reduced in this area so to increase the overall net profit on the business.
If the information is available the profit and loss account could also be compared with another similar business to identify any comparisons, although often similar business’ are competitors so this is unlikely.
If your business is fairly consistent, look for comparisons with previous years. If there are any deviations from the general trend, ask yourself if you are able to explain them.
In order to help you understand and interpret the figures in the profit and loss account an accountant will be able to assist. Using their knowledge and experience they should be able to identify any areas that could be a cause of concern, items which may draw attention from HMRC. So whilst there may be a cost involved in appointing an accountant the benefits can far outweigh any cost, even more so when considering the tax position.
If you would like to discuss your profit an loss account or accounts with an accountant then complete the enquiry form or contact us.