The profit and loss account – a video of your business efficiency
One of our jobs as financial directors is to train business owners and managers on the fundamental foundations of finance. By understanding the 3 different core statements/reports that make up a set of accounts – and the jargon that goes with them – you’ll become much more confident in your ability to translate the figures, and realise that accounts aren’t really quite as complex as they can first appear.
Over this next series of posts, we’ll explore the language you’ll come across in your accounting processes and the 3 key documents your finance department or accountant will put together for you to keep you updated on your position and prepare for annual filing.
The profit and loss account is another term that has alternative names you may hear, such as:
Income and expenditure
Statement of profit and loss
We say this is the ‘video’ of your business, as it tells the story of how operationally efficient your business was in the 12 month accounting period, by showing all the invoices in and out, to show revenue raised and costs incurred.
The document will open with the following text at the top: “This is the profit and loss account of [company name], for the year ending [last date of the year’s accounting period]”.
The profit and loss account calculations work like this:
Show your revenue – money generated from products or services i.e. your turnover/revenue/sales
Show your cost of sales i.e. the direct costs of things you’ve sold such as materials and manufacturing costs – service businesses may not have any cost of sales
Subtract your cost of sales from your retained profit – this figure is your gross profit
From your gross profit, subtract your overheads – the resulting figure is your operating profit i.e. the profit you’ve made from your operations. This is also sometimes referred to as PBIT or EBIT - Profit Before Interest And Tax/Earnings Before Interest and Tax, because you show interest and tax below this line in your accounts.
You can also work profit out as a percentage of the sales revenue figure - this is called your margin.
Margins and overheads
So your gross margin is your gross profit ÷ the sales revenue as a percentage.
For a manufacturer this may be, for example, 50%, while in service industries it may be 95 or 100%. For example, you’ve sold £100, your cost of sales was £50, which gives you a gross profit of £50. That gross profit divided into the £100 is 50% = your gross margin.
The same applies for your operating margin, but you need to take off your overheads – these are generally indirect costs such as:
Essentially, if it’s not directly linked to producing or manufacturing a product, it will be an ongoing cost the business incurs on a regular basis.
So if you’ve made £100 in sales, with a £50 cost of sales and overheads of £25, you’re left with an operating profit of £25. So 25 ÷ 100 = an operating margin of 25%.
Your overheads also include your depreciation charge for the year. So you need to add up all the depreciation calculated on your fixed assets for the year and move it from the balance sheet into your profit calculation. However, you’re not allowed to include depreciation in your tax calculations because it’s too subjective.
Your net profit is the figure you have left after all tax and interest has been deducted, and overall, your profit and loss account will show you how your business has performed operationally over the year or period, and whether you’ve made any money .
This is really only the basics of this element of your accounts – it’s also worth knowing about amortisation, EBITDA and many other more complex nuances of your calculations. If you’d like to explore this in more detail, please drop us a line
to learn more about our fantastic training courses.