Getting to Grips With Profit & Loss Accounts
Success in business is a numbers game, and getting to grips with those all-important numbers as an entrepreneur is key to everything from HMRC compliance to long-term profitability.
Business accounting may not be the most glamorous aspect of business ownership, but it’s nonetheless crucial to tracking your company’s performance and making informed financial decisions for your business’s future.
Among your business’s most important financial statements is your profit and loss account. If you’ve ever watched entrepreneurs squirm in Dragon’s Den, you’ll be well aware of how crucial this account is to a business’s perceived viability (and the price of not being well-acquainted with its contents).
We’re breaking down the profit and loss account in today’s guide to give small business owners the leg up they need to account with confidence.
Profit and loss accounts: what are they?
Your profit and loss account is a key financial statement, like your balance sheet or cash flow statement.
Otherwise known as your income statement or P&L, your profit and loss account shows your business’s revenue, expenses and net income over a given period.
Together, this data sheds a light on your financial performance and, ultimately, highlights whether you’re generating a profit or loss once all business-related costs have been deducted from your income.
The deducted expenses include things like staff salaries, rent and utilities for your business premises, and the cost of goods sold, to name a few examples.
Assuming the total sales amount exceeds your total costs, your business will earn a net profit. If the reverse is true, your business will suffer a net loss.
Your profit and loss statement will be prepared in one of two ways:
● Cash method: this method is generally used by very small businesses and entails recording your transactions during the period when cash is received (in the case of revenue) and paid (in the case of liabilities)
● Accrual method: this method is more widely used and involves recording cash as it’s earned. In this scenario, even if payment hasn’t yet been received, you’ll record revenue on your profit and loss account whenever a product or service is delivered to a customer
Why do profit and loss accounts matter?
Generating profit is utterly central to business ownership, and it’s your P&L that demonstrates your progress in your profit-driving journey. This makes your profit and loss statement a vital financial account that could be said to quantify your business’s success.
On top of that, accurate profit and loss accounting is crucial to filing accurate tax returns with HMRC.
Beyond that, though, there are a number of key ways that profit and loss reporting benefit your business:
● Internal decision-making: any big business decisions around matters such as office or team expansion, or investment drives, will inevitably be driven by your company’s profit generation (or lack thereof as the case may be). To make sound financial decisions for your business’s future, you need a clear and accurate view of its current financial health. It’s here where your profit and loss account will provide essential insights
● External reporting: when it comes to seeking investment, your P&L will be a key requirement for any analysts or prospective investors who need to establish the financial health of your business before committing any funding. By staying on top of your profit and loss accounting, you can provide comprehensive external reports with ease
● Competitive analysis: another worthwhile measure of your business’s success comes from competitive analysis. With a detailed profit and loss account for your company, you can use this data to compare against other businesses in your industry to gauge your relative success. Where your P&L shows superior performance for your business vs its competitors, this can provide a means of motivation. If your company is falling behind in your industry, this analysis can kick-start a wider review of your business’s financial health to generate an action plan for the future
Profit and loss accounts: a quick breakdown
Your profit and loss account comprises revenue and expenses and makes use of this central formula:
Revenue – Expenses = Net Profit (or Net Loss)
Revenue comes first, followed by a breakdown of your costs (including the cost of goods sold, as well as operating, tax and interest expenses).
Applying the formula, the difference between your revenue and expenses figures reflects your business’s net income (be it profit or loss).
Understanding the terminology
The last step in getting to grips with your business’s profit and loss statement is wrapping your head around the various terminology included.
Equipping yourself with the necessary vocabulary will get you well on your way to accounting with ease. Here are some of the key terms used within a P&L account, along with their definitions:
● Revenue: this figure represents your business’s total sales value in the given period - including accounts receivable in the case of the popular accrual method. Naturally, for an accurate reflection of sales, any returns and discounts should be removed from your sales figure to arrive at the true revenue figure for the period
● Cost of goods sold (COGS): AKA the cost of sales, this figure is the sum total of all costs associated with producing your goods or services. Think material and labour costs, as opposed to promotional costs such as sales and marketing
● Gross profit: this is the figure returned after subtracting your cost of goods sold from your revenue, prior to any operating costs being deducted
● Expenses: your expenses include general and administrative expenses (including staff salaries, rent and utility bills, office supply costs, insurance payments and legal fees and similar), as well as selling expenses (which comprise any sales commission, all marketing costs and any transportation costs incurred through sales activities)
● Earnings before interest, taxes, depreciation and amortisation (EBITDA): this can be considered a measure of your core profit. Depreciation refers to any wear and tear related loss of value for any physical assets on your business’s balance sheet (think office equipment). Amortisation, on the other hand, refers to loss of value for any intangible assets over their useful life - with examples including patents and trademarks
● Interest income/expense: there are two sides to this coin, as interest may be earned via your business bank account or accrued on any business loans taken out. In either scenario, the figure will appear on your business’s balance sheet
● Net profit/loss: this is your business’s true bottom line - the difference between your revenue and expenses
Before we leave you to your accounting, it’s important to stress the value of analysing your profit and loss statements - not only in isolation but over time.
By taking a comparative look at your P&Ls, you can gain valuable insights on how new operating costs are affecting your business’s bottom line and get a sense of how your profitability is growing or shrinking over time. Each new profit and loss account presents a new opportunity to measure, analyse and evolve.
Now that we’ve armed you with the profit and loss know-how you need to account with confidence, you’re ready to get started. But if you’re a little daunted by P&L terminology and the weight of this financial reporting, we’re here to help.
At Arvo, it’s our mission to shoulder the burden of business accounting for entrepreneurs who’d rather spend their valuable time working to scale their business to new heights. Get in touch now to find out how we can take the pressure off when it comes to your company’s accounts.