Understanding your Profit & Loss Account – Part 1

Glossary, Management Accounts, Planning,

Following on from last week’s article about An Unreasonable Expectation, I thought I’d explain some of the basics of the Accountancy world, to help demystify what we get up to! I’m going to start with ‘Understanding your Profit & Loss account’.

What is a Profit & Loss Account?

Firstly, it has many different names! These include:

  • Profit & Loss Statement
  • Profit & Loss Sheet
  • P&L
  • Income and Expense Account

They all mean the same thing! A Profit & Loss Account is a summary of the revenue and costs within a business in a period. It could be over a month, or a quarter, but for many businesses is most often seen over a year as part of the end of year accounts.

The result of a Profit and Loss will be either:

  • A Profit – where income exceeds the expenses or
  • A Loss – where expenses are higher than the income received.

The end result is arrived at by taking the costs and expenses of the businesses from the income over the same period.

Why do I need a Profit & Loss Account?

All Limited Companies are required by law to produce a Profit & Loss Account, which feeds into the Corporation Tax Return to calculate the Company’s Corporation Tax liability.

If you aren’t trading as a Limited Company, you will effectively produce a Profit & Loss to create your sole trade accounts. This will feed into your Self Assessment Tax Return and tell you how much tax you have to pay.

The biggest reason to monitor your Profit & Loss account though is to see how the business is performing!

From the Profit & Loss you can show investors, shareholders, managers or lenders that you are making money. It will also show you if adjustments might be needed, for example if expenses are too high.

How can I get a Profit & Loss for my Business?

There is an accepted format for a Profit and Loss Account, which most software can create for you fairly simply.

In its simplest form, a Profit & Loss starts with Gross Income. This is the total of all your sales or revenue in the period. From that you will deduct Direct Expenses, the resulting figure is known as Gross Profit. These are the costs directly attributable to proceeding your goods or services, so raw materials, shipping costs and labour would be examples.

Operating Expenses or Overheads come off next. These include expenses that aren’t directly attributable to the creation of your product, and can be defined as being unaffected by volume of sales in many cases. Examples here would be rent, light, heat, marketing, accountancy fees, as well as any salaries that aren’t directly related to sales.

All of these figures should be excluding VAT.

The end result, in it’s most basic form, is your Profit or Loss for the period. There are many adjustments and tweaks that would be added to the calculation, but hopefully that gives you an idea of what a Profit & Loss Account is, and why it can be so valuable to a business owner.

The key numbers in your Profit & Loss Account.

These can give you a really good insight into how your business is performing, and enable you to identify trends as they emerge.

So what are these key numbers?

  1. Turnover
  2. Gross Profit
  3. Overheads
  4. Net Profit

Let’s look at what each of these numbers are, and why they are important!

1. Turnover

Turnover is the total sales value in any given period. It gives you an indication of the size of the business but it is a mistake to become too focussed on this one!

There is a well worn phrase that says “turnover is vanity, profit is sanity”, and it is well worn for a reason. So many businesses can tell you their Turnover for a period, but when you ask about the profit figure on that Turnover the response is a blank look, yet profit should be the priority.

A business with a high turnover may not necessarily be profitable, and they very often aren’t. This could be because costs could be too high or perhaps management has been distracted by fulfilling the day to day demands of a rapidly growing business. It is possible too that a business can be structured to ‘stack ’em high and sell ’em cheap’, being a low margin business, as Tesco was initially. This should be a conscious decision though!

It is a mistake to chase Turnover without keeping a very close eye on the profitability of a business.

2. Gross Profit

Calculating Gross Profit enables you to see and track how the trading part of the business has done, and is most useful if you can see a trend over a number of periods.
The best way to compare periods is to calculate the gross profit percentage, or gross profit margin, which is obtained by dividing the gross profit by the turnover and multiplying by 100.
There are a range of ways to improve a gross profit margin, including becoming more efficient, increasing prices or focussing your sales effort on products or services that give a higher gross profit.
Knowing your gross profit margin also allows you to compare your performance to other business in your industry. Bear in mind though that different industries would expect to have very different gross margin figures, so don’t panic if yours is very different to another business!

3. Overheads

Also known as Indirect Costs, the overheads of a business are those business costs that are necessary to trade but cannot be directly attributed to a sale. They tend to be fixed rather than variable. Some examples are as follows:

  • Accounting and legal expenses
  • Administrative salaries
  • Depreciation
  • Insurance
  • Rent
  • Water / Heat / Light

Comparing the overheads over time allows you to determine whether you are keeping a tight rein on costs. The best way to do a comparison is to compare the detailed overheads line by line on a regular basis, which can show you the areas you should concentrate on to keep costs under control.

4. Net Profit

Also referred to as the ‘bottom line’, net profit is the amount left over after paying all the expenses of the business. It is also generally the amount on which you will pay tax.

The net profit margin is a more accurate measure of a business’s profitability than gross profit margin. This is because it’s a true indication of the money you’re making, rather than just the money you’re making on your product or service; it takes full account of all of the businesses expenses. To calculate the net profit margin, you simply have to divide net profit by sales (or Turnover) and multiply by 100.

 

Understanding more about your accounts and business numbers does NOT have to be intimidating, and understanding them can make a huge difference, both to your confidence and to your Profits (or Losses…!).

If you have any questions about your Profit & Loss, calculating any of your business numbers, or how to identify or improve them in your business, do get in touch! Once they are related back to your business, these key numbers can become far clearer, and the benefits of tracking them can be substantial.

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