FINANCIAL LITERACY • 23 JULY 2021 • 2 MIN READ

What exactly is a profit and loss statement?

SECTIONS

What makes a profit and loss account the most useful financial statement?

Who uses a profit and loss account?

Components of a profit and loss statement

Interpreting your profit and loss statement

Before we say anything – let’s establish that a profit and loss account is known by a few other names:

Income statement
P&L statement
Statement of income

It’s one of the critical financial statements that every business must prepare at the end of each financial year to assess financial health and calculate taxable income. Collectively, these financial statements cover assets, liabilities, revenue and expenses. Whereas the balance sheet covers the asset and liability components, the profit and loss account handles revenue and expenses.

What makes a profit and loss account the most useful financial statement?

By reporting on income and expenses, the statement calculates a business’s net profit.

In addition, it breaks down income and expenses to a granular level. Accountants and business owners can use these details to identify opportunities for optimisation. They’re able to analyse:

The cost of sales (or manufacturing expenses)
Operating expenses
Non-deductible expenses
Financial expenses
Selling and administration expenses
Non-cash expenses

Who uses a profit and loss account?

A range of users are interested in the profit and loss account. It’s important that they check it alongside the balance sheet to make sure the business has cash and positive equity.

Those interested in your profit and loss account include:

Accountants – when preparing an income tax return
Banks – to see whether the business is making enough profit to repay a loan and interest
Potential investors – checking how profitable the business is
Shareholders or potential investors looking at companies listed on the stock exchange – will the company declare a dividend from its profits?
Management – comparing the actual figures against their budget
Business owners – investigating unusually high expenses and also forming their budget for the coming years

Components of a profit and loss statement

Income

Also known as sales or revenue, income can come from:

Selling goods
Providing services
Clients reimbursing certain expenses
Earning interest

Cost of Sales / Direct Costs

These expenses relate directly to the sale of goods or services*.

Opening stock
Purchases of goods (products to sell)
Purchase of raw materials (for processing, then selling)
Purchases of materials (materials used in the construction industry)
Freight and packaging – bringing materials and goods to you, and delivering to customers
Commission paid to salespeople
Contractors and subcontractors
Maintenance of factory plant and machinery (the more units produced, the more maintenance is required)
Wages for factory workers (if they’re based on units produced, rather than per hour)
Closing stock

* Not all businesses will have a cost of sales section. It’s usually only applicable when you’re selling goods or performing work that involves raw materials (e.g. construction). Those in the service industry are likely to exclude this section and only have expenses of an operating nature.

Gross Profit

After deducting any costs of sales from income, you have the gross profit. This should be enough to cover operating expenses.

Operating Expenses

These are costs that generally remain consistent, no matter the level of sales.

Advertising
Bank fees
Computer and IT expenses
Insurance
Interest
Office rent
Power
Printing, postage, and stationery
Professional fees (legal, accounting, consulting)
Telephone and internet
Salaries
Staff expenses

Non-cash Expenses

Depreciation of property, plant and equipment
Gains or losses on the sale of assets
Certain accountant adjustments, which may include: reimbursing a director or shareholder for using part of the home as an office, adjusting for any private portion of business expenses

Non-deductible Expenses

These are business expenses that can’t be deducted from taxable income:

A portion of entertainment expenses
Certain legal expenses
Fines and penalties
Income tax

Net profit or loss

The non-deductible expenses cannot be claimed as tax deductions, but they are still business expenses. After taking those into account, we arrive at the net profit or loss.

Interpreting your profit and loss statement

Sales

Without sales, your business cannot pay its employees (including you). The whole point of being in business is to make money (net profit), so sales should be the centre of your attention. Sales should cover all business expenses and provide the owner with a reasonable return.

However (and it’s a big ‘however’), more sales don’t necessarily mean more profit. Ask yourself these questions:

Have your sales increased or decreased over the years?
If you hire an extra contractor or employee for $45,000 a year, are you getting at least that back in additional sales?*
Are you pricing your product correctly?
Are some products selling better than others, and if so, why?
Do you receive a higher margin on certain products?

* Or does the extra person mean you can reduce your own hours, let you have more free time, or allow you to focus on other business areas? Remember – your time is also valuable and mustn’t be discounted.

Cost of Sales*

If you’re paying for an extra contractor or employee, you should see either an increase in sales by at least the same amount, or your own workload should lessen, or a combination of the two.

With your purchases – if these increase but revenue doesn’t, what’s happened with the items you bought?

Xero is able to track categories for income and expenses if you’d like to determine the profit on individual projects or jobs. Xero can provide a Profit and Loss Account for each job. From here, you can see if you’re pricing each job correctly – you may have an idea of the profit in your mind or jotted it down somewhere, but have your workings taken into consideration all costs?

* Some businesses may not have any cost of sales, such as those providing services

Gross Profit*

Gross profit is important. Very important.

It’s calculated by taking your sales from operations (don’t include any interest or one-off items), then deducting your cost of sales.

Gross profit should be able to cover your operating expenses.

* Some businesses won’t have gross profit, such as those providing services; in these circumstances, gross profit is just sales/revenue.

Non-cash Expenses

We’re not saying ignore these when analysing your profit and loss account, but the business often has no control over non-cash expenses. They include:

Depreciation – this may not be a true reflection of your assets’ loss in value because we use the maximum deduction allowed by Inland Revenue
Home office expenses – this is an expense calculated only because Inland Revenue allows a deduction for business owners using part of their home for business purposes
Motor vehicle reimbursement – similar to home office expenses, we only adjust your financial statements for tax purposes
Depreciation recovered – this pops up in your profit and loss account when the business sells a fixed asset for more than its book value; it’s purely arbitrary as it directly related to depreciation
Loss on disposal of assets – this is the opposite to depreciation recovered and happens when the business sells a fixed asset for less than its book value
Shareholder salary – this is an adjustment made by your accountant as a means of allocating company profit
Bad debts – considered to be a non-cash expense because you’ve recorded the sale as income but won’t receive payment; we don’t want you paying tax on income you’ll never receive

Operating Expenses

our focus on operating expenses should be looking at trends (comparing against past years) and unusual items. If you have Xero’s profit and loss account on your screen, click into the expense and you’ll see the listed included there.

Comparing your actual figures against your expectations (and understanding any variances) will provide great insight into your business.

Net Profit

Your net profit is the gross profit less non-cash and operating expenses. From reading other sections in this article, you’ll be understanding that the bottom line itself doesn’t provide any insights – you need to compare against previous years, and see how accurate (or realistic) your budget/forecast has been.

Sole traders and partnerships: Your net profit would be the equivalent of receiving wages – is it enough for you to live on? What changes would you need to make?

Companies: Take into consideration any PAYG-paid wages you receive from the company, dividends you receive, and your net profit. As with the sole trader, are you happy with that as income?

Where has my profit gone?

You’ve made a net profit, but don’t see it reflected in your bank account – business or personal. You ask yourself – I’ve made a profit, but where’s the money?

It’s such a common question that we’ve created a blog specifically on the topic. You’ll find explanations of various reasons, including: