Introduction to the Basic Profit and Loss
The basic profit and loss or P&L statement is one of the main accounting statements.
The Profit and Loss shows a business’s financial performance over an accounting period. The accounting period can be any length but is usually a month or a year.
At the end of a period, any revenue accounts are transferred to the credit of the profit and loss account, and any expense accounts are transferred to the debit of the profit and loss account. The statement now shows the revenue minus the expenses for the period resulting in either a net profit or net loss.
It is sometimes called an Income and Expenditure Statement, particularly for a non profit making organisation.
What should a basic Profit and Loss look like?
The layout of a Profit and Loss for a company for annual reporting purposes is legally defined. However, for management account purposes the layout should be in the format most useful for managing the business.
A typical and useful format for management is shown in the example below. The level of detail for each item will depend on your business, and who is using the information. For example, sales could be broken down by product category, or overheads could be broken down into multiple lines such as rent, wages, light & heat etc.
|Cost of sales||45,000|
|Profit before tax||10,000|
This format clearly identifies the main function of a profit & loss and that is to show that:
What the Basic Profit and Loss does not show
The profit and loss has nothing to do with cash. It does not show how a business earned or spent its cash.
For example, if on the 1st January a business pays rent of 12,000 for the year, the cash flowing out of the business is 12,000. However, the monthly profit and loss account for January would only show a charge of 1,000 (12,000 / 12 months), as this represents the charge for that month.
The need to understand the basic Profit and Loss?
The basic Profit and Loss is important for many reasons:
- Management should use the Profit and Loss to identify whether the business made a profit for the period. The important figure is the final line Profit before tax. It should also use it to establish % relationships between expenses and sales, to spot trends in operating profit ratios, and for comparison of actual results against a budget.
- They are used by Suppliers to decide on whether credit is given as they identify the profitability of your business.
- Bank Managers utilise the profit and loss as they base their lending ratios on certain aspects of it, for example Interest cover = Profit before interest and tax / Interest paid is used to determine whether the profit the business is making is sufficient to cover the interest payments on their loan.
- The basic profit and loss is used by investors to decide whether to invest or not and at what price. For example they will look at the profits before tax to establish their likely return on investment.
Any number of people could be using your profit and loss to make decisions about your business. It is important that you have an understanding of what information the profit and loss is providing and what that information is telling you.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.