Demystifying Your Accounts - Part 3 The Profit & Loss Account

... back to syllabus

4 Oct 2013

If you want to keep an eye on the finances of your company, there are two key financial statements you need to be familiar with: The Profit & Loss (P&L) and the Balance Sheet. We’ll deal with the Balance Sheet in Part 4 but for now lets cover the mighty P&L.

Typically, you will see a P&L covering a year, a quarter or a month. But you can prepare them for any period of time. Whatever, the P&L will show the profit or loss and how it is derived over this particular time period. Typically, a P&L will be prepared on an “accruals” basis - ie, a sale or expense will appear in the P&L when it is incurred, as opposed to a “cash” basis in which the sale or expense is shown when paid.

A P&L will look something like this:

A little explanation is required for each of these headings:

SALES: For a service business or one which raises invoices for sales, this is the total invoiced in the period REGARDLESS OF WHETHER THE INVOICES HAVE BEEN PAID OR NOT. For a retailer or cash trader, this will generally be the total revenue taken in for the period.

COST OF SALES: Simply, this is what you paid for whatever you have sold. If you are a retailer, this will be the cost of your stock. If you are a manufacturer, this will be the cost of the materials you purchased to produce your goods. Generally, CoS will be adjusted for stock to reflect the value of the stock or materials sold in the period.

GROSS PROFIT: This is Sales less Cost of Sales. It is the entity’s profit before the application of operating overheads, expenses and other costs. Gross Profit (and the gross profit margin) is important as it reflects the core profitability of a business.

EXPENSES (or operating costs, overheads): These are the costs incurred by the entity which are not cost of sales. In the example above, we have shown only five types of cost but there are many others. Much like sales, the expenses will be shown on an accruals basis, which means they will appear whether they have been paid or not. In some instances, they will appear even if they have not been invoiced. This is known as an “accrual”.

In small businesses, financing costs (interest) will be normally be shown in expenses. Larger entities will often charge financing costs after Net Profit but we prefer to keep it simple. (It’s important to note that only the interest element of a loan or HP repayment is an expense against profit. The capital repayment part shown in the Balance Sheet as a reduction in liabilities.

Gross Profit less Expenses = Net Profit before tax.

NET PROFIT BEFORE TAX: This is the fabled “bottom line”. Its how much profit the entity has made before tax is applied to it. Net profit is one of of the most closely followed numbers in an entity’s finances, as ultimately it defines how successful it is.

Next time we'll discuss the Balance Sheet. And we'll also put up a jargon-buster as there are a lot of terms that will probaby be unfamiliar to you.