Explaining the Profit and Loss Account

Profit

The Profit and Loss account, or P&L, for a business contains valuable information about how well it’s doing. It partners with the Balance Sheet as one of the most important reports that a business can produce.

In its most simple form the P&L tells you how much you have sold, how much you have bought and how much profit (or loss) you have made over a specific period of time.

What a profit and loss account will not do

The P&L is a relatively easy document to understand which is why it’s the first one that many people look at when assessing the health of a business.

But it’s important to understand its limitations. The P&L will not tell you about the underlying health of the business, such as how much money it owes or is owed and what the value of its assets are.

The P&L will show you whether a business is making a profit but not whether it’s generating cash. If that appears to be a contradiction, it’s not, because a business might sell lots of goods at a good margin, but if it fails to collect payment from its customers that profit is worthless.

Companies that are profitable on paper can still suffer major cash flow problems. That’s why every business, from start-ups to established firms, needs to carefully plan where the cash is going to come from to buy stock, to pay wages and to settle outstanding tax bills.

Different types of Profit & Loss Account

There are many different ways for preparing a Profit and Loss account. Limited companies are obliged to submit a set of accounts to Companies House every year and they must be prepared in a certain format and are referred to as statutory accounts.

But many businesses often put together a different P&L for use by managers or directors and this can be put together in a different way. The layout used is one that suits the needs of the readers and can form part of the organisation’s internal management accounts.

Every P&L shows the performance of a business for a specific period of time. It could be a week, a month or a year. Statutory accounts are usually prepared once a year while management accounts often cover a particular month or number of months.

The main sections of a Profit and Loss Account

Most P&L accounts are put together in a similar way although the detail of what’s included in each section may vary from one business to another.

1. Turnover

Turnover, or sales, is the total value of what you’ve sold during the period covered by the P&L account net of VAT. It might be broken down into different types of product, helping you to see which items sell better than others.

Other income received by the business, such as bank interest or money received from the sale of assets, is not included in turnover because it does not represent income from your main trading activity.

2. Cost of Sales

These are the costs that are directly related to the sales you have made, so it includes raw materials or stock you have purchased to resell. It may also include the cost of creating the items that you sold, including the cost of staff time if you are selling services.

3. Gross Profit

This is the sum of Turnover minus Cost of Sales. It tells you how much profit you are making directly from your sales.

4. Other Operating Costs

These are all the other costs associated with running a business, such as the rent and rates on your premises, accountancy and legal fees, and depreciation. These costs cannot be directly linked to your sales and may not change very much even if your sales figures were to change significantly.

5. Net Profit

This is the Gross Profit minus the Operating Costs. You could think of it as the true profit of your business because it’s made up of all the income and all the costs. This isn’t quite the profit that you’ll pay tax on, because taxable profit is calculated slightly differently, but it’s probably close to it.

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