This article was written by Jo Nockels, Training and Communications Manager of TaxAssist Accountants, the UK’s largest network providing tax and accountancy advice and services specifically for small businesses.
So you could think of the profit and loss as a video of what has happened over the year; and the balance sheet as a still photograph.
The financial statements are very important. Key business decisions taken by the owners/managers are often based on the financial statements. Furthermore, the figures are included on documents such as tax returns and finance applications, and can affect relationships with investors, customers and suppliers.
Preparation of the profit and loss account
If you are VAT registered, your income and expenses are likely to be shown ‘net’ of VAT, i.e. any VAT charged/ incurred is not included in the profit and loss account.
Also, the profit and loss account only shows ‘revenue’ transactions that are connected with the commercial activity of the business. This means income such as grants, cash injected by the owners and bank loans received are generally not shown here, and any purchases of significant equipment, loan repayments, drawings, HM Revenue & Customs payments etc won’t be shown either. Such items will affect the balance sheet instead.
The financial statements needn’t be 100 percent accurate, but they should be free from ‘material’ errors. There is no absolute measure of materiality, but loosely speaking, a material error is defined as an error that would affect decision making.
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The trading account
The top section of the profit and loss account up to and including the gross profit, is referred to as the ‘trading account’. This is because it shows only the direct trading activities of the business.
Sales
At the top of the trading account is the sales figure – this will include all of the work invoiced, whether the invoice has been physically paid by the customer or not. It may even include work you have undertaken but not yet completed (let alone invoiced), depending on if you provide services and the particular circ*mstances they are provided under.
Cost of sales
Cost of sales should, as its name infers, represent the costs incurred to generate your sales. And as with sales, any invoices for goods or services you have received from your suppliers will be included, whether they have been paid or not.
You will also notice from the example below, that cost of sales includes an adjustment for stock. Any stock that you hold at the period end has not been used to generate this year’s sales. Therefore, the stock adjustment excludes the stock at the period end and includes the stock brought forward from the last period. This ensures that only the stock purchases used for the current period’s sales are reflected.
Gross profit and the gross profit margin
Gross profit is simply the difference between your sales and cost of sales.
The gross profit margin is probably one of the most important figures to the business owner and manager. It shows the sales mark-up and can therefore highlight inefficiencies and pricing issues.
Administrative expenses
Administrative expenses are the business overheads. You will note that in the example below, wages have been included under this heading. Wages can be included in cost of sales or administrative expenses, it depends on how directly attributable the wages are to the generation of sales and also, where the owners/managers want it shown. For instance, some traders like to see their gross profit margin without the impact of wages, and therefore will include wages under administrative expenses instead.
Finance charges and other income are normally shown separately from administrative expenses.
Interpreting and understanding the profit and loss account
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.
Also, look for comparisons with your competitors and the industry the business operates in.
Ultimately, the profit and loss account should tell a story of what has happened during the year, so you as the business owner/manager are best placed to make sure the profit and loss account shows a true reflection of this ‘story.’
An accountant can help you to understand and interpret the figures in the profit and loss account, and can highlight the areas that may require further investigation. They will also be able to identify any ‘anomalies’ which might trigger the attention of HM Revenue & Customs, such as a large increase in the cost of repairs or a dramatic downturn in drawings.
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FAQs
Profit and loss accounts show your total income and expenses, and also shows whether your business has earned more income than it has spent on its running costs. If that is the case, then your business has made a profit. The profit and loss account represents the profitability of a business.
What is profit and loss account answer in one sentence? ›
A part of the final accounts which is prepared on the basis of indirect expenses and indirect incomes of the business concern to ascertain net result of the business done in the accounting year is called Profit and Loss Account.
How to understand balance sheet and profit and loss account? ›
A Balance Sheet gives an overview of the assets, equity, and liabilities of the company, but the Profit and Loss Account is a depiction of the entity's revenue and expenses. The significant difference between the two entities is that the Balance Sheet is a statement while the Profit and Loss account is an account.
How do you solve profit and loss statements? ›
How do you calculate P&L?
- Net Sales (or revenue) – Cost of Sales (or Cost of Goods Sold) = Gross Profit (or Gross Margin)
- Gross Profit – Operating Expenses = Net Operating Profit.
- Net Operating Profit + Other Income – Other Expenses = Net Profit Before Taxes.
- Net Profit Before Taxes – Income Taxes = Net Profit (or Loss)
What is the Profit and Loss Percentage Formula? The formula to calculate the profit percentage is: Profit % = Profit/Cost Price × 100. The formula to calculate the loss percentage is: Loss % = Loss/Cost Price × 100.
How to prepare a P&L and Balance Sheet? ›
Here's a general step-by-step guide to creating a profit and loss statement:
- Choose a reporting period. ...
- Gather financial statements and information. ...
- Add up revenue. ...
- List your COGS. ...
- Record your expenses. ...
- Figure your EBITDA. ...
- Calculate interest, taxes, depreciation, and amortization. ...
- Determine net income.
The three golden rules of accounting are (1) debit all expenses and losses, credit all incomes and gains, (2) debit the receiver, credit the giver, and (3) debit what comes in, credit what goes out.
What are the rules for profit and loss? ›
In the case of profit, the selling price is always more than the cost price. Profit = Selling Price - Cost Price. Similarly, in the case of loss, the cost price is more than the selling price. Loss = Cost Price - Selling Price.
How do you read a profit and loss statement for dummies? ›
The report is divided into two sections: income and expenses. Your total revenue is listed under the income section, while your total expenses are listed under the expenses section. To calculate your net profit or loss, simply subtract your total expenses from your total revenue.
Which comes first profit and loss or balance sheet? ›
The balance sheet contains everything that wasn't detailed on the income statement and shows you the financial status of your business. But the income statement needs to be tallied first because the numbers on that doc show the company's profit and loss, which are needed to show your equity.
Use these seven steps to help you read and analyze a P&L report:
- Define the revenue. ...
- Understand the expenses. ...
- Calculate the gross margin. ...
- Calculate the operating income. ...
- Use budget vs. ...
- Check the year-over-year (YoY) ...
- Determine net profit.
It is a financial statement that provides a snapshot of how much your company is making (revenue) compared to how much is being spent (costs and expenses). Simply put, your P&L shows your business's revenue minus costs and expenses, typically over a specified period. The outcome is your net profit or bottom line.
What is a Profit and Loss Account with an example? ›
The profit and loss (P&L) statement is a financial statement that summarizes the revenues, costs, and expenses incurred during a specified period. The P&L statement is one of three financial statements that every public company issues quarterly and annually, along with the balance sheet and the cash flow statement.
How to calculate the profit? ›
However, the method varies according to the given values. When the selling price and the cost price of a product is given, the profit can be calculated using the formula, Profit = Selling Price - Cost Price. After this, the profit percentage formula that is used is, Profit percentage = (Profit/Cost Price) × 100.
What is a simple explanation of profit and loss? ›
Your business's profit (or loss) is the difference between your income and your expenses. Put simply, that's the amount that comes into your business and the amount that goes out.
What are the 3 steps to calculating profit & loss? ›
To calculate the accounting profit or loss you will: add up all your income for the month. add up all your expenses for the month. calculate the difference by subtracting total expenses away from total income.
What is the rule of profit and loss account? ›
Profit & Loss Account shows the net profit or loss earned by the company. Calculations in the Profit & Loss Account would be as follows: Add all revenue earned over the accounting period. Add all expenditures made throughout the accounting period.
