Businesses succeed or fail based on their ability to make a profit. Generate more cash coming into your business than going out as costs, and your business is on solid ground. That’s why understanding your business’s profit and loss account is a critical measure of your company’s financial health.
Profit and loss (P&L) are important indicators to how successfully your business is operating:
Profit – This is the amount of money left over from all income generated by a business, once costs and other expenses have been accounted for. Profit is usually subject to Corporation Tax, but after tax the remaining profit is able to be invested in the business or paid to shareholders or staff in the form of dividends.
Loss – This is where the costs and expenses of operating a business are greater than the amount of revenue a business generates. Costs include staff salaries, service charges such as legal fees, marketing and other expenses that the company pays for.
Small business owners are usually focused on making a profit. The good news is calculating whether a business is making a profit is fairly straightforward.
Profit and loss – example small business calculation
A small business generates monthly revenue of £30,000 selling stationery and office supplies – known as sales. The cost of the goods and other costs directly associated with selling them is £20,000 per month – known as cost of sales. Subtracting the cost of sales (£20,000) from the revenue generated by selling the goods (£30,000) gives the business a gross profit of £10,000.
However, gross profit is not the whole story. Additional costs – known as overheads – such as staff wages, utilities bills, accountancy fees, bank charges, telephony costs and so on also need to be deducted. In our example, let’s assume all overheads amount to £8,000 per month. Subtracting £8,000 from the gross profit of £10,000 gives a net profit of £2,000.
If the costs of running the business were £12,000 per month, this would exceed the gross profit of £10,000. Subtracting £12,000 from £10,000 gives a net loss of £2,000. This would mean the business was losing £2,000 each month. Unless it had access to cash reserves, continual losses could mean the business is unable to operate.
What should be used to calculate profit and loss
When calculating a profit and loss account, not every type of expense or revenue should be recorded. Expenses on assets and cash injections such as loans or loan repayments are usually excluded. Be sure to get professional financial advice before creating a profit and loss account yourself. However, there are several financial elements that do need to be included:
Sales – This is all the money your business made from trading, such as selling goods. It needs to include all sales that have been made even if you are yet to receive payment. For example, a consultancy business might invoice for a project that was completed at the end of a financial year. The amount would be included even if the business has not been paid – outstanding amounts are added to the debtors account on the company’s balance sheet.
Cost of sales – This is any costs directly related to manufacturing, distributing or selling anything your business makes or sells. This can include cost of inventory, postage and packing, transport or materials costs.
Expenses – Known as overheads, these are all other costs your business incurs to operate, such as staff wages, utilities bills, legal fees and premises rent. These should be costs your business has received an invoice for or has paid during the accounting period. Anything not yet paid for but invoiced needs to be added to the creditors account on the balance sheet.
Depreciation – Some assets, such as computers, will depreciate in value over time. These can be removed as assets once fully depreciated. Depreciation times vary depending on the asset but usually three to five years is a typical depreciation timeframe.
What is a profit and loss account?
A profit and loss account – also known as a profit and loss statement – is an official profit and loss calculation of your business over a period of time. Businesses typically prepare profit and loss accounts either monthly, quarterly or annually. The statement details all your businesses transactions, deducting overheads, cost of sales and depreciation from any money your business earned to see if it made a profit.
The crucial part of a profit and loss account is it is for a specific period of time. Accounts also need to be prepared and presented in the same way, no matter if your profit and loss accounts are simple or more complex. Profit and loss accounts are also known as income statements, P&L reports or statements of operation.
How is a profit and loss account different from other reports?
Small businesses usually create several different types of financial reports, including profit and loss accounts, balance sheets and forecasting.
Profit and loss – Profit and loss is used to submit your your company tax return to HMRC and shows the company’s sales, operating costs and any profit or loss the business has made during the financial year. Profit and loss accounts don’t include financial elements such as bank loans or major asset purchases – these are usually reported on the balance sheet.
Balance sheet – This shows a snapshot of everything the company owns, owes or is owned on the last day of its financial year. However, a balance sheet can be created at any stage to understand the value of a business, taking into account money it is owed and any debt or assets it has, such as plant equipment.
Forecast – There are lots of different types of financial reports, from cashflow reports to VAT reports. Forecasting is one of the more common, and shows how the revenue, costs, profit and loss of a business is forecast over the future, such as the next financial year.
Why do small businesses need a profit and loss account?
While creating a profit and loss account requires proficiency in accounting, small business owners would be wise not to put off creating a profit and loss account. HMRC and other financial institutions require a profit and loss account, and if you’re looking to raise money from investors you’ll need to show that your business is profitable. Keeping a profit and loss account also demonstrates good record-keeping, essential if HMRC wanted to review your financial records in more detail.
Pay tax – If you run a limited company you must produce a profit and loss for Corporation Tax report every financial year and submit this to HMRC. It is used to assess your business for corporation tax. If you are self-employed or in a partnership, you don’t have to create a formal P&L but it’s a good idea to do so. Not only does it reveal how your business is performing, the figures in a profit and loss account give you all the information needed to fill in self-assessment forms to calculate income tax.
It’s worth taking time to get the profit and loss account correct. If you make mistake with your P&L when submitting your company tax return, you could be liable for more tax, penalties or interest so it’s important to get these right. There are many online accounting services that will automatically generate a profit and loss account from your bookkeeping records.
Applying for a loan – If you want to take out a business loan from a bank or other high street lender, you’ll typically need to show the profit and loss accounts for your business.
Investors – You also need profit and loss statements when talking to investors or buyers for your business. With annual profit and loss statements, you can show how well your business has been doing since it began operating, allowing investors to see how much of a return they might be able to make from their investment.
Make wiser business decisions – An accurate profit and loss account allows you to make more informed business decisions. It removes the guesswork, providing concrete information that allows you to see how well your business has performed and better plan for future.
What you need to create a profit and loss statement
Creating a profit and loss statement requires accurate bookkeeping and financial records. Keeping accurate financial records is a legal requirement for running a limited company, which means you need to record all outgoings and income. You’ll also need to keep receipts for everything you purchase – from travel expenses to insurance policies – and record all sales and invoices.
If your business is relatively straightforward, you may be able to handle your own financial records. You can use a simple spreadsheet, recording your sales and costs such as overheads. Online accounting software can help, and there are lots of free or cheap cloud-based accounts software that you can access from a computer, tablet or smartphone. Some will automatically generate profit and loss accounts for you. Alternatively, consider hiring a business accountant.
You’ll need to decide the time period your P&L will cover. It doesn’t matter how long the period is – it may differ depending on the nature of your business – but HMRC requires the P&L to cover your accounting period, which is usually a full year.