Understanding your accounts: The profit and loss account
In this specific article we break down just what a profit and loss account is, how exactly to prepare one and what this means for the business.
Exactly what is a profit and loss account?
The profit and loss account forms section of a small business’ financial statements and shows whether it has made or lost money. It summarises the trading outcomes of a business over a period (typically twelve months) showing both revenue and expenses. On the other hand, a balance sheet is really a ‘snap shot’ of the assets and liabilities of the business enterprise at a particular time.
You may realise of the profit and loss as a video of what has happened on the year and the total amount sheet as a still photograph.
Why are they important?
The financial statements of any business are essential. Key business decisions taken by the owners or managers tend to be in line with the them. The figures are included on documents such as for example taxation statements and finance applications, and will affect relationships with investors, customers and suppliers.
Preparation of the profit and loss account
If you’re VAT registered, your earnings and expenses will tend to be shown ‘net’ of VAT, i.e. any VAT charged/incurred isn’t contained in the profit and loss account.
The profit and loss account only shows revenue transactions which are linked to the commercial activity of the business enterprise. This means income such as for example grants, cash injected by the owners and loans received are usually not shown here Any purchases of significant equipment, loan repayments, drawings, HM Revenue & Customs payments etc won’t be shown either. These things will affect the total amount sheet instead.
The significance of accuracy
The financial statements needn’t be completely accurate, but they ought to be clear of ‘material’ errors. There is absolutely no absolute way of measuring materiality, but loosely speaking, a material error means an error that could affect decision making.
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The trading account
The very best portion of the profit and loss account, up to the gross profit, is known as the trading account. It is because it shows only the direct trading activities of the business enterprise. In this, sits the sales figure and costs of sales.
Near the top of the trading account may be the sales figure – this can include all of the work invoiced, if the invoice has been physically paid by the client or not. It could even include work you have undertaken however, not yet completed (aside from invoiced), depending on in the event that you provide services and this circumstances they’re provided under.
Cost of sales
As its name infers, this represents the expenses incurred to create your sales. So when with sales, any invoices for goods or services you have obtained from your suppliers will undoubtedly be included, whether they have already been paid or not.
You’ll also notice from the example below, that cost of sales includes an adjustment for stock. Any stock that you possess at the time end is not used to generate this season’s sales. Therefore, the stock adjustment excludes the stock at the time end and includes the stock brought forward from the final period. This means that only the stock purchases useful for the existing period’s sales are reflected.
Gross profit and the gross profit percentage
Gross profit is merely the difference in the middle of your sales and cost of sales. The gross profit percentage is probably perhaps one of the most important figures to the business enterprise owner and manager. It shows the sales mark-up and may therefore highlight inefficiencies and pricing issues.
Administrative expenses will be the business overheads. Wages are included under this heading. Wages could be contained in cost of sales or administrative expenses, this will depend on what directly attributable the wages are to the generation of sales and where in fact the owners/managers want to buy shown.
For example, some traders prefer to see their gross profit percentage minus the impact of wages, and for that reason includes wages under administrative expenses instead. Finance charges along with other income are usually shown separately from administrative expenses.
Interpreting and understanding the profit and loss account
If your organization is fairly consistent, search for comparisons with previous years. If you can find any deviations from the overall trend, ask yourself when you can explain them. Search for comparisons together with your competitors and the the business enterprise operates in.
Ultimately, the profit and loss account should tell a tale of what has happened through the year, so you because the business owner/manager are best placed to be sure the profit and loss account shows a genuine reflection of the ‘story.’
An accountant might help one to understand and interpret the figures in the profit and loss account and will highlight the areas that could require further investigation. They’ll also have the ability to identify any ‘anomalies’ which can trigger the eye of HM Revenue & Customs, like a large increase in the expense of repairs or perhaps a dramatic downturn in drawings.
Profit and loss account terms explained
Listed below are the most frequent terms in the profit and loss account you’ll want to understand:
- Net gain: This is your earnings without the cost of goods sold, expenses and taxes.
- Gross profit: That is your total revenue / sales, without the cost of these goods sold.
- Operating profit: This is actually the profit you have after operating expenses (like rent) are deducted from gross profit. It doesn’t include interest or tax deductions.
- Net profit: That is your actual profit. It’s the total amount you’re left with after remaining working expenses are deducted from gross profit.
The digital effect
From April 2019, the united kingdom tax system will dsicover some significant changes. Quarterly reporting, you start with VAT, can be mandatory for several registered organisations. Businesses use HMRC-compatible accounting software to record their data – which HMRC could have usage of. Charities and fundraising work will undoubtedly be exempt, the guidelines will connect with companies turning over £85k or even more.
In the event that you already use electronic accounting software, talk with the provider to see if it’s compatible with the brand new system. Uncertain if your organization is ready? Check out Gov.uk’s section Summary of Making Tax Digital.
For more good business advice
Read our extensive set of business finance pieces, from suggestions about how exactly to pitch for funding, to growth and exit strategy planning. You can even talk with our partner Informed Funding free of charge and exclusive services that will aid together with your funding strategy.
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