Understanding your accounts: The profit and loss account
Understanding your accounts: The profit and loss account
In this article we break down what a profit and loss account is, how to prepare one and what it means for your business.
What is a profit and loss account?
The profit and loss account forms part of a business’ financial statements and shows whether it has made or lost money. It summarises the trading results of a business over a period of time (typically one year) showing both the revenue and expenses. In contrast, a balance sheet is a ‘snap shot’ of the assets and liabilities of the business at a particular point in time.
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.
Why are they important?
The financial statements of any business are important. Key business decisions taken by the owners or managers are often based on the them. 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.
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 typically not shown here Any purchases of significant equipment, loan repayments, drawings, HM Revenue & Customs payments etc won’t be shown either. These items will affect the balance sheet instead.
The importance of accuracy
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.
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. Within this, sits the sales figure and costs of sales.
At the top of the trading account is the sales figure – this will include all 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 circumstances they are provided under.
Cost of sales
As its name infers, this represents 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 are the business overheads. Wages are 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 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 can explain them. 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.
Profit and loss account terms explained
Here are the most common terms in the profit and loss account that you need to understand:
- Net income: This is your income minus the cost of goods sold, expenses and taxes.
- Gross profit: This is your total revenue / sales, minus the cost of those goods sold.
- Operating profit: This is the profit you have after operating expenses (like rent) are deducted from gross profit. It doesn’t include interest or tax deductions.
- Net profit: This is your actual profit. It’s the amount you’re left with after remaining working expenses are deducted from gross profit.
The digital effect
From April 2019, the UK tax system will see some significant changes. Quarterly reporting, starting with VAT, will become mandatory for all registered organisations. Businesses will use HMRC-compatible accounting software to record their data – which HMRC will have access to. Charities and fundraising work will be exempt, the rules will apply to companies turning over £85k or more.
If you already use electronic accounting software, check with the provider to see if it is compatible with the new system. Not sure if your business is ready? Head to Gov.uk’s section Overview of Making Tax Digital.
For more good business advice
Read our extensive list of business finance pieces, from advice on how to pitch for funding, to growth and exit strategy planning. You can also speak to our partner Informed Funding for free and exclusive services that will assist with your funding strategy.
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