Profit and loss account: How to understand and use it [Video]
A profit and loss account (or statement or sheet) is, on a simple level, used to show you how much your company is making or how much it is losing.
On that basic level, profit and loss is derived from taking your costs away from your sales. In other words, from what your goods cost you, take away what you managed to sell them for. If you sold them for more, you made a profit. But if you sold them for less, you’ve made a loss.
Now, alongside the cash-flow statement and balance sheet, the profit and loss account (P&L) is one of the most important accounts on which a company is judged. They are usually prepared every year for smaller companies, or twice a year for larger and public companies. They provide the reader with how well the company has done over the year.
For a sole trader, it’s useful as an illustration as to how they are doing and they could be used to support a loan application, for example. And the profit and loss account is usually audited by an external party, such as an accountant.
Distinct levels of the P&L
Now, as with anything that involves finance, the P&L is not purely a simple calculation. It has many distinct levels that give an indication of a company’s situation after certain calculations are made.
To provide an example, first comes the sales, or revenue. This is the money made from selling your goods. Taken away from this headline figure is the cost of sales – literally what is cost to produce the goods. This gives you a gross profit figure (which at this stage could be a loss, of course).
From the gross profit figure, you take away overheads and expenses. These costs are those that are regarded as indirect, so cost of premises and staff, etc. That gives you an operating profit figure.
Arguably, this is the true sense of the company’s profit because it is calculated from the nuts and bolts of the business. But there are a further two levels to go.
From the operating profit, you take any interest charges you might be paying on bank loans or bank charges. This gives you a net profit figure. The final takeaway is tax – what you have paid HMRC. This, finally, is the profit after tax figure.
This is the figure that tells you how much your company has made, after all deductions – in effect, the pure profit. And that can be distributed to shareholders as dividends or poured back into the company.
Words of advice on your profit and loss account
Paul Donno, the managing director of 1 Accounts Online Ltd, has some words of wisdom on how to understand the P&L.
He says: “We’re asked many times about understanding the profit and loss account of businesses. It starts with income – the service you provide or the products you sell, is the top line and that’s your income. And then you take off all your expenses – typically the materials you use, the postage and stationery, telephone using your home as an office, bank charges, HP interest, etc: they all come off the income figure.
“And then you are left with a final figure at the bottom, which hopefully is a profit, or unfortunately sometimes a loss. And that really is what a profit and loss account is.
“As a sole trader, you might know it as an income and expenditure account, so income at the top, expenses underneath, and again, that’s your excess of income over your expenses.”
But, to emphasise the sense of false security a P&L sheet can provide, here’s a warning from Paul: “The difference between profit and loss and cash flow can be huge, so you might be making a lot of profit. Say for argument’s sake you’re making £50,000 of profit, but you night have sitting in your trade debtors, i.e. your customers that owe you money, say £50,000, so you’ve got no money.
“So cash flow is people paying you, and the profit and loss account is the services you have delivered that you may not have been paid on yet, so there is a huge difference between profit and loss, and cash flow. But again, know your numbers – that’s what I would say.”
Need to know your numbers
An accountant would say know your numbers, wouldn’t they, but it’s sound advice. If you’ve ever watched Dragons’ Den, where prospective moguls often unintentionally make fools of themselves in pitches, you’ll have heard the often-used lament of those being sold to, that they don’t know their numbers.
And that can end in two words from the Dragons: “I’m out.”
It’s such an obvious requirement but you hear of people time and time again not knowing what their turnover is, what profit they make and margin they expect. If you don’t know these simple facts about your business, you risk becoming seriously unstuck.
Insights from The Dogfather
We also heard from The Dogfather, aka Dom Makin, who runs a dog boarding and dog day care centre that operates in the south west of London.
He says: “How does a P&L work? That’s when I call in some professional help and a financial adviser comes in a couple of times a year.
“And so if I have got a new venture, if I am expanding into a certain area, if I’ve got a new project, we go through a thorough P&L and we go through everything with a fine toothcomb, looking at the profit and loss, staff, petrol, supplies, building supplies and more.”
And that’s a great note to finish on. If you feel you need help, get some – it could save you a fortune.