A profit and loss (P&L) account is a statement of the income and expenditure of a business over the period stated, drawn up in order to ascertain how much profit the business made. 'Income" and "expenditure' here mean only those amounts directly attributable to earning the profit and thus would exclude capital expenditure, for example.
Importantly, the figures are adjusted to match the income and expenses to the time period in which they were incurred - not necessarily the same as that in which the cash changed hands.
What is a profit and loss account?
A profit and loss account is an accountant's view of the figures that show how much profit or loss a business has made over a period. To arrive at this, it is necessary to allocate the various elements of income and expenditure to the time period concerned, not on the basis of when cash was received or spent, but on when the income was earned or the liability to pay a supplier or employees was incurred. While capital expenditures are excluded, depreciation of property and equipment is included as a non-cash expense.
Thus if you sell goods on credit, you will be paid later but the sale takes place upon the contract to sell them. Equally if you buy goods and services on credit, the purchase takes palce when you contract to buy them, not when you actually settle the invoice.
What does a profit and loss account not show?
Most importantly, a P&L account is not an explanation of the cash coming into and going out of a business.
MAKING IT HAPPEN
The presence of stock and purchases indicates that the business is trading or manufacturing goods of some kind, rather than selling services.
Where a business holds stock, the purchases figure has to be adjusted for the opening and closing values in order to reach the right income and expenditure amounts for that period only. Goods for resale bought in the period may not have been used purely for that period but may be lying in stock at the end of it, ready for sale in the next. Similarly, goods used for resale in this period will consist parly of items already held in stock at the beginning of it. So take the amounts purchased, add the opening stock, and deduct the closing stock. The resulting adjusted purchase figure is known as 'cost of sales'.
In some businesses there may be other direct costs apart from purchases included in cost of sales. For example, a manufacturer may include some wages if they are of a direct nature (wages of employees directly involved in the manufacturing process, as distinct from office staff, say). Or a building contractor would include plant hire in direct costs, as well as purchses of materials.
How to interpret the figures
A lot of accounting analysis is valid only when comparing the figures, usually with similar figures for earlier periods, projected future figures, or other companies in the same business.
On its own, a P&L account tells you only a limited story, though there are some standalone facts that can be derived from it.
- Was this business successful in the period concerned?
- Was it able to make a profit, and not a loss?
- Was it able to pay dividends to shareholders out of that profit?
However, it is in comparisons that such figures start to have real meaning.
- The gross profit margin of X% was an important statistic in measuring business performance.
- The net profit margin before tax was Y%.
- You can calculate the net profit after tax (the bottom line).
- You could take the margin idea further and calculate the net profit after tax ratio to sales.
- Or you could calculate the ratio of any expense to sales. E.g. the wages to sales ratio.
If you then looked at similar margin figures for the preceding accounting period, you would learn something about this business.
Say the gross margin was 45% last year compared with 46% this year - there has been some improvement in the profit made before deducting overheads. But then suppose that the net profit margin of 8.8% this year was 9.8% last year. This would tell you that, despite improvement in profit at the gross level, the overheads have increased disproportionately. You could then check on the ratio of each item of the overheeads to sales to see where this arose and find out why. Advertising spending could have shot up, for example, or perhaps the company moved to new premises, incurring a higher rent. Maybe something could be tightened up.
Another commonly-used ratio
Another ratio often used in business analysis is return on capital employed. Here we combine the profit and loss account with the balance sheet by dividing the net profit (either before or after tax as required) by shareholders' funds. This tells you how much the company is making proportionate to money invested in it by the shareholders - a similar idea to how much you might get in interest on a bank deposit account. It's a useful way of comparing different companies in a particular industry, where the more efficient ones are likely to derive a higher return on capital employed.
COMMON MISTAKES
Assuming that the bottom line represents cash profit from trading
It does not! There are a few examples where this is the case: a simple cash trader might buy something for one price, then sell it for more; his profit then equals the increase in cash. But a business that buys and sells on credit, spends money on items that are held for the longer term, such as property or machinery, has tax to pay at a later date, and so on, will make a profit that is not represented by a mere increase in cash balances held. Indeed, the cash balance could quite easily decrease druing a period when a profit was made.
Also read:
Reading a Cash-flow Statement
Reading a Profit and Loss Account
Reading a Balance Sheet
Reading an Annual Report
Yield and price/earnings ratio (P/E)
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