Profit and Loss Statement Definition
A profit and loss statement is a financial report that provides a summary of an organisation’s 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 organisation’s 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 accountant’s 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 company’s 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 can’t 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 isn’t the same as profit.
We’ve established that the expenses taken away from the income provides the profit. But this isn’t 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 UK’s 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 won’t you find in the profit and loss account?
In the profit and loss account you won’t find anything that the business owns or owes, as these are known as ‘assets and liabilities’ and belong on the balance sheet. This is another reason why cash in the bank can’t 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 that’s 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, it’s 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.