Profit and Loss Accounts - Simply Put!

Before you get started

A Profit & Loss Account (P&L) is one of the four key pieces of financial information for any business.

Understanding a Profit and Loss Account is essential for anybody owning or managing a business. A P&L is not something for you to ask your Accountant to do and then allow it to be consigned to a drawer.

This Marstan Guide takes you through the basics of a P&L and explains the various components and terminology of a set of accounts.

Before you embark upon this exercise of understanding, make sure you have read our Marstan Guide which shows how the P&L relates to other key pieces of information. This can be found in:

• Business Finance - Simply Put!

What is a Profit & Loss Account?

A Profit & Loss Account is a statement of your trading activities for a given period (e.g. a month, a financial quarter or financial year) which records the income earned by your business and the cost which you have incurred in running your business.

The amount you have earned is usually called “Turnover”.

The figures for Turnover and Costs make it very simple to calculate profit as follows:

If you can keep this simple principle in mind, it is easier to deal with the other refinements which we will refer to later such as: gross profit; net profit; interest; work-in-progress; depreciation; profit before tax etc. Do not be concerned about these at this stage. They may seem very technical at the moment, but they are as simple as Profit & Loss Accounts when taken in context.

What do I need to know about Turnover?

Remember – Turnover is the amount you have earned in the business for a given period of time (say, a month, quarter or full financial year).

There is a distinction between what the business has earned and what payments it has received. In a year’s accounts there will be a number of different types of transactions in your list of earnings and they will fall into one of three categories:

1. Goods or services that you supplied near the beginning of the period which may have been invoiced to your customer and have been paid.
2. Goods or services you have supplied a little later which may have been invoiced to your customer and not yet paid. These are debtors and will be on a list totalled in your income statement because the money was earned in the period, even if the cash has not yet been received.
3. Goods or services which you supplied so recently that you have not yet invoiced the Client for them. This is called Work-in-Progress. These may include projects which you are 50% of the way through and will not bill until later. Half will be credited as Income to one financial year and the other half will be credited as Turnover to the following financial year.

The total of these three items will be your Turnover.

What is the difference between Gross Profit and Net Profit?

There are two main types of cost:

1. Direct Costs

   These are directly related to how much it costs to produce the goods or services you are providing to the customer. The more you sell, the higher this figure will be. (No problem, providing you are making a profit!) For example, if you produce more goods or services, you will need more staff or equipment.

   These direct costs are often known as the “Cost of Sales”.

2. Overheads/Indirect costs

   These relate to the overheads (like running the buildings whether you are producing or not).

If you deduct the Direct Costs from the Turnover you arrive at Gross Profit:

Net Profit is arrived at by deducting the indirect costs from the Gross Profit:

How is my tax calculated?

Tax is a liability to be paid by the business. Obviously, the way in which the business is taxed varies according to the type of organisation (sole trader, partnership or company) and where it operates. Essentially, most systems calculate tax on the Net Profit. This is the amount which the business has earned after it has paid all its costs.

Net Profit is often called PBIT (Profit before Interest and Tax).

When the tax has been deducted from the Net Profit (PBIT) you will arrive at the Actual Profit.

What is Interest?

Interest is received according to the amount of cash you have in the business or paid according to the amount you have borrowed from others to finance the business.

This is not necessarily related to the costs of your production and is, therefore, an item of indirect cost rather than direct cost. As a result, it is one of the Indirect Costs to be deducted from Gross Profit in order to arrive at the figure for Net Profit.

What is Work-in-Progress?

Work-in-Progress is the value of work done but not yet invoiced. Work-in-Progress is a simple concept, but one which appears to cause a great deal of confusion by people in business.

The best way to illustrate it is by example.

The financial year of a company is 1st January to 31st December.
They take on a 3 month commission to carry out some consultancy work and produce a report at the end. The terms of their contract are that they will deliver the report at the end of the assignment and then they can invoice. The programme is as follows:

• 1st December 2008 - Start the work
• 28th February 2009 - Complete the work
• 5th March 2009 - Invoice for the work
• 5th April 2000 - Receive payment

When the company produces its accounts for the 31st December 2008, it includes within its turnover for that year the value of 1 month of the work. It will be shown as “Work-in-Progress”.

Remember: Work-in-Progress is the value of work done but not yet invoiced. IT HAS NOTHING TO DO WITH WHEN THE PAYMENT IS RECEIVED.

When an invoice is issued it comes off the list of Work-in-Progress and gets added to the list of invoices for which payment is awaited (often referred to as a ‘Debtors List’ – more about that later).

What is Depreciation?

When you own an asset (e.g. a building lease, equipment, computers or company vehicles) you will have bought or leased them and the value will be included on your Balance Sheet.

When a year has elapsed, the value of many assets will go down. For example, if a car or computer has a 5 year life, one way of calculating it would be to show its value being reduced by 20% over each year on the Balance Sheet and the difference between the value now and the value year is effectively recorded as an expense, named “Depreciation”.

This gives a truer picture of the real value of the assets in the business and, of course, the depreciation costs will be offset against the tax which you should pay.

Appendix - Profit & Loss Account

Downloads

• Profit and Loss - Working example.xls (28 KB)