As a small business owner, you’ll be aware of all the transactions going through your business bank account.
If you’re making regular sales each month then it’s easy to assume your business is also profitable.
But without a profit and loss account it’s impossible to know for sure.
This financial statement is one of the most important documents for keeping an eye on the financial health of your business.
In this article we’ll explain exactly why it’s important, the terms you need to know, and how to read one, so you can use your profit and loss account to make informed business decisions.
Here’s what we cover:
- What is the profit and loss account?
- Why is the profit and loss account important?
- The sections of the profit and loss account
- Definitions for key terms on a profit and loss account
- How to read the profit and loss account
- Profit and loss account vs balance sheet vs cash flow statement
- Final thoughts
What is the profit and loss account?
The profit and loss account is one of the three core financial statements.
It’s generally used alongside the two other types of financial statements: the balance sheet and the cash flow statement.
It’s also sometimes referred to as the income statement, the profit and loss statement, or simply the P&L.
The profit and loss account is compiled to show the income of your business over a given period of time.
It could be for a week, a quarter or a financial year.
More specifically, it shows the net profit or loss your business has made after deducting all business-related costs from the income.
You’ll earn a net profit if the total costs are less than the sales amount, and a net loss if the costs are greater than the sales amount.
This statement is prepared using either the cash or accrual method of accounting.
The cash method is very simple: the business records transactions in the period the cash is received (for revenue) and paid (for liabilities).
This method is usually only used by very small businesses.
The more commonly used accrual method records cash as it’s earned.
For example, if your business delivers a product or service to a customer then you would record the revenue on the P&L, even though you haven’t received payment yet.
Why is the profit and loss account important?
An essential objective of your business is to make a profit. The profit and loss account shows the extent to which it’s been successful in achieving this objective.
It’s also extremely important to help make decisions.
If you have a significant amount of cash going in and out of your business, it’s not easy to determine whether you’re actually making money.
A profit and loss account can help you understand this in more depth.
If you are making a profit, then you can start to consider the next steps in expanding your business, whether that’s new premises, employing more staff, or looking for further investment.
On the other hand, if the business isn’t making a profit, you can take corrective actions to turn this around.
The statement also helps in arriving at the figures required for filing statutory tax returns.
The net profit figure will be the base for calculating how much tax the business will have to pay for the corresponding financial year.
Being able to provide profit and loss accounts over several years is essential whenever you want to borrow funds from a bank or financial institution.
It will help the lender to gauge the earning potential and the stability of the business.
The sections of the profit and loss account
The P&L is made up of two types of transactions: revenue and expenses.
The statement is based on the fundamental equation:
Revenue – Expenses = Net Profit (or Net Loss)
Therefore, all profit and loss accounts are laid out in the same way.
They begin with revenue, also referred to as the ‘top line’. Then, the cost of doing business (including the cost of goods sold, operating expenses, tax expenses and interest expenses) is subtracted from revenue.
The difference is the net profit, also known as net income.
Let’s define the key terms in the order they arise on the profit and loss account.
Definitions for key terms on a profit and loss account
This figure is the total sales for the business over the given time period.
If you’re using the accrual method then it includes the accounts receivable for the period.
Note, any discounts, returns or allowances have to be subtracted from the sales to arrive at the total revenue amount.
Cost of goods sold (COGS)
This is the total direct cost of producing goods, also known as cost of sales.
This includes the cost of labour, materials and overheads directly used to manufacture a product.
All the indirect costs of production, such as marketing and selling expenses, are excluded from this section.
This is the number you get when you take your revenue and subtract your cost of goods sold.
It’s essentially the money you have left over to pay your business operating costs.
Selling, general and administrative expenses
Selling expenses include advertising and marketing costs, sales commissions, and transportation costs to deliver the product or service.
General and administrative expenses are the other indirect expenses incurred in running your premises.
These expenses include rent, staff salaries, utility bills, legal fees, insurance charges, repairs and maintenance, office supplies, etc.
These expenses usually don’t vary with the sales level of your business, so they’re often referred to as fixed expenses.
This stands for earnings before interest, taxes, depreciation and amortisation.
It’s seen as a good measure of core profit, as it eliminates the effects of accounting and financial factors that influence the net profit figure.
Depreciation / Amortisation
Depreciation is the reduction in the value of physical assets on your balance sheet (such as office equipment) over time with usage and wear and tear.
Amortisation is the reduction in value of intangible assets over their useful life.
These are both non-cash expenses.
Interest income / Interest expense
Your business may earn interest income from its holdings with a bank. It will also have to pay interest on its loans.
Both these figures will appear in your profit and loss account.
Net profit / Net loss
The resulting difference between your income and expenses, often referred to as the bottom line.
How to read the profit and loss account
It will be useful for you to compare profit and loss accounts from different accounting periods.
The reason behind this is because any changes in revenues, operating costs and net profit over time are more meaningful than the numbers themselves.
For example, you may have steady revenues but your expenses could be growing at a much faster rate.
Another important way you can extract information from the P&L is by using profit margin analysis.
The profit margin is a ratio of your business’s profit (revenue minus expenses) divided by its revenue, and is always expressed as a percentage.
There are three types of profit margins:
- Gross profit margin
- Net profit margin
- Operating profit margin.
It’s important to note that what is considered a good profit margin varies by industry.
The gross profit margin formula is (Gross Profit ÷ Revenue) x 100 and compares revenue to variable costs.
It tells you how much profit you are generating without fixed costs, otherwise known as your sales mark-up, and can therefore highlight inefficiencies and pricing issues.
The operating profit margin formula is ((Revenue – COGS – Selling, General and Administrative Expenses) ÷ Revenue) x 100.
Because this calculation excludes non-operating expenses such as taxes and depreciation, it tells you how much profit your business made from its core operating activities.
The net profit margin formula is (Net Profit ÷ Revenue) x 100.
This margin illustrates your overall profitability by telling you how much profit is generated from every £1 in sales.
Profit and loss account vs balance sheet vs cash flow statement
The P&L, like the cash flow statement, shows changes in accounts over a set period of time.
The balance sheet on the other hand, is a snapshot showing what the business owns and owes at a single moment in time.
The P&L on its own can’t tell you what value your business holds, and this is why, to get an overall picture of your business performance, you’ll need to look across all three financial statements.
It’s also important to compare the P&L with the cash flow statement.
Under the accrual method of accounting, your business will record revenue and expenses before cash changes hands. So you’ll need to use the cash flow statement to see the actual movement in cash over the period.
The cash flow statement will give you a picture of where you are spending your money, and can help you budget effectively.
The profit and loss account is your key to answering the essential question, is my business profitable or not?
But not only is it crucial to review your current numbers, it’s important to look for changes in your P&L over time.
Armed with this information, you’ll then be able to make informed decisions that will keep your business thriving far into the future.
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