A profit and loss account is a statement of a business’ financial performance for a specified period, usually a year. It contains information on the sales, purchases and then displays a net profit or loss for the time span under consideration.
The usefulness of a P & L statement is very evident by its function as the primary indicator of how well a business has performed.
Many new small businesses focus on cash levels as their primary benchmark of whether the business in doing well, but as can be seen in the article profit versus cash; this is not the better model to assess wellbeing.
Accounting for amounts due but as yet unpaid and expenses paid in advance provides a clear picture of actual gains or losses in a given year.
Components of a Profit and Loss Account
A profit and loss accounts has several components or sub-sections where the various categories of income and expenses are shown. It is not usually mandatory to display sections where the business has not entries and the documents can to a certain extent be tailored towards the business it is reporting on.
Sales and Income
Sales and Income is the first component or section of the profit and loss account and display, either as one figure or as several entries, the total amounts earned in the year. A business will be encouraged to show each of its distinct areas of sales if it would be useful to the reader to demonstrate that their income is derived from differing products, geographical locations or some other separator.
Where several categories are shown, a sub-total of all of these is displayed.
Cost of Sales
Costs of sales are those direct and often variable expenses which are matched to the provision or manufacture of the items sold. A simple example would be where a builder records the expenses of paying for bricks, cement and direct labour as the cost of sales in their business.
Also included in this section are stocks which are held at the end of the period. These have been purchased but not yet used and therefore in order to match their costs to the period in which they are actually sold, they are deducted from the purchases figure.
Costs of sales will therefore represents the expense incurred by the business in producing the goods or services which they have sold in the year.
Gross profit (GP) is a simple calculation of deducting total income from the cost of sales amount. In some situations there might be a gross loss where the expenses exceed the amount of sales.
This is a very unhealthy position for the business to be in as they have spent more on creating the product or service than they have earned from selling it.
Typically, a gross profit percentage can be calculated by dividing the GP by the total sales figure.
Distribution Expenses and Costs
Distribution costs are generally those which are incurred in the transportation and delivery of the business’ products and services to the customer. In additional, direct selling costs, such as sales person wages and commission may be included here as they are intrinsically related to moving the products and services from the business to the customers.
Due to the nature of some businesses, for example, one which does not sell physical items, their might not be any expenses which fall within this category. In such cases distribution costs may be omitted from the profit and loss account altogether.
This profit and loss section largely comprises indirect costs such as administrative salaries and expenses relating to the use of electricity, water, gas and other utilities. Businesses would want to keep the sums in this category to a minimum as they are overhead expenses and not directly related to production or selling.
Typically, businesses will seek to minimise administration expenses by finding alternative and inexpensive means of providing the functions usually housed in this category.
Other Income and Expenses
Other income and expenses on the profit and loss account would comprise sundry items incidental to and separate from the business activities. Examples would be interest received or paid on the business bank account and depreciation and amortisation.
Net Profit or Loss
Often the last item on the performance statement is the profit or loss earned in the year. Where the figure is positive, the business has at least to a certain extent had a successful year and made a net gain by earning more money than it incurred.
A net loss on the other hand is indicative of expenses being too high and or income being too low. A loss for a business start-up in its first year might not be cause for alarm as set-up costs will be shown but these are unlikely to be repeated in future periods.
Nevertheless, a loss in any period of trading does warrant analysis and reflection so that the entrepreneur has a clear understanding as to why the results are as stated and that problems areas can be identified and corrected with the minimal delay.
The profit and loss account for a business provides a useful summary of performance and provides confirmation or otherwise that the different aspects of its operations are proceeding as planned.
Overtime, the profit and loss account, when compared to previous years results can highlight trends and discrepancies which might require further analysis.
The earlier the figures can be compiled after the financial year end, the greater will be the value they will provide and the more relevant they will be.
Relevant and timely management information including the profit and loss account is an important component of managing a small business start-up and ensuring that the results it produces are in accordance with the business plan.