Profit and Loss Statement definition

What is a profit and loss statement

A profit and loss statement is a financial report that provides a summary of an organisationís revenues, expenses, and profits and losses over a specified time period. The term is used synonymously with a profit and loss account, income statement, statement of operations, statement of financial results or an income and expense statement.

What is a profit and loss account?

A profit and loss account shows an organisationís revenue and expenses over a certain time period; usually a month, quarter or fiscal year. It displays the story of its trading and, fundamentally, whether the business has made a profit or a loss.

Profit and loss statements show the total income and expenses, and whether the income earned is higher than what was spent on running costs. The business has made a profit if this is the case. The income comes from sales, bank interest and other income like the online filing incentive. Expenses or running costs may be directly linked to sales, such as buying the products or service to sell to customers, or they could be general administrative expenses, such as paying your accountantís wages or buying office stationery. These expenses are taken away from the income to provide the profit over the particular time period.

The profit and loss account is helpful in showing a companyís capability of generating sales, managing its expenses and creating profits. It is formed based on accounting principles including revenue recognition, matching and accruals, which makes it differ to a cash flow statement.

Whilst the profit and loss account shows the profitability of a business, it canít show whether it is running out of cash as it builds stock. To gain this insight you will need a balance sheet.

Cash in the bank isnít the same as profit.

Weíve established that the expenses taken away from the income provides the profit. But this isnít the same as the cash in bank due to there being non-cash items in the profit and loss account. The organisation might not have been paid for all of its sales; the sales figure in the profit and loss statement is for the sales invoiced in that period of time (the invoices with dates covered in that period). Therefore, money received through invoices belongs on the balance sheet.

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How is the profit and loss account structured?

A profit and loss account is required for all businesses registered at Companies House (the UKís registrar of companies and the executive agency and trading fund of the government) by law as part of their financial accounts.

The main categories that make up the profit and loss account include the revenue (sales); cost of goods sold; administrative costs; marketing and advertising costs; technology costs; interest expense; taxes; and net income.

What wonít you find in the profit and loss account?

In the profit and loss account you wonít find anything that the business owns or owes, as these are known as Ďassets and liabilitiesí and belong on the balance sheet. This is another reason why cash in the bank canít be called profit, as it is also affected by non-profit and loss items, like buying capital assets. These are pieces of equipment that will last for more than a year and, again, as these are something that the company owns, they are found on the balance sheet.

Profit and Loss Account Example

To get a better idea of what a profit and loss account would look like, have a look at an adaptation of an example provided by Business Accounting Basics:

Sales

£

£

Hardware

100,000

 

Consultancy

20,000

 

Total Sales

 

120,000

Cost of Sales

 

 

Cost of Goods sold

50,000

 

Direct labour

10,000

 

Total cost of sales

 

60,000

Gross Profit

 

60,000

Overheads

 

 

Salaries

30,000

 

Car and Travel

1,200

 

Rent, rates, power and insurance

3,000

 

Telephone and stationery

2,000

 

Advertising

500

 

Business Entertainment

100

 

Bank interest and loans

100

 

Bank charges

200

 

Legal fees

500

 

Depreciation

200

 

Corporation Tax

5,000

 

Total Overheads

 

42,800

Profit/Loss

 

17,200

How useful is a profit and loss account?

Apart from profit and loss accounts helping you gage an understanding of how your business is doing, they are also helpful in other ways. For instance, the tax that your business pays, whether thatís income tax or corporation tax, is calculated on its profits. But these profits need to be adjusted for tax, as expenses such as business entertaining need to be added back. So, itís important to put costs in the right categories when sending your bills and expenses to accounting services.

Benefits

For anyone who is interested in the financial health of a company needs to be able to understand financial statements, and the profit and loss statement comes under this umbrella. The importance of information displayed in this type of document should not be underestimated.

Profit and loss accounts are instrumental in helping investors and creditors establish the past and predict the future performance of the organisation. They also use it to determine its capability of generating future cash flows.

It is a handy tool for management as it clearly shows the costs which relate to sales during the particular period. It could turn out that you are selling goods at a 50 percent higher cost than what you are buying them for. However, once all of the overheads are taken into account, you are actually losing money. Therefore, a profit and loss account allows you to review the pricing, sales and costs to assess how figures can be improved in the future.

Limitations

With that being said, the information in profit and loss statements has a few drawbacks. For example, things like brand recognition and loyalty are relevant but are not reported because they cannot be reliably measured. Also, some numbers are based on the accounting method used, just like how inventory level is measured using FIFO or LIFO accounting. Finally, some numbers depend on judgements and estimates. For example, the depreciation expense depends on the estimated useful life and salvage value. Therefore, bear these factors in mind when analysing your profit and loss account.

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