Profit and loss accounts are one of the staple pieces of paperwork for business owners and managers – a simple and effective barometer of success internally, handy for securing investment, and legally required for incorporated companies.
They should be relatively simple to compile, especially if you keep good records throughout the year.
Andrew Subramaniam, partner at chartered accounts HW Fisher & Company, explains: "A profit and loss account is a record of the income and expenditure that a business has generated over a specific period and either shows a profit (income exceeding expenses) or a loss (where expenses exceed income).
"Usually you would only include the income and expenses relevant to the business activity. If you were compiling a profit and loss account for your household, for example, you would probably include things like council tax, utilities and water rates, but would not include the cost of a takeaway."
Depreciation is also often shown in accounts. This is the cost of any large items of equipment, machinery or vehicles that have been bought to last several years. The cost of these items is spread over a number of years, a proportion showing in the accounts each year.
A simple profit and loss account would typically show income or turnover at the top and list expenses and costs below.
Subramaniam says: "Typically these costs would be arranged in groups rather than listing every single item. A good example of this is print, postage and stationery. Rather than listing all your stamps, paper, pens and envelope purchases individually you can group them into a handy single heading."
Deciding on expense groupings early on will help keep the accounts tidy, and tracking income and expenditure by group will help simplify the process.
Subramaniam says: "Making a detailed note of every transaction is time-consuming but can be rewarding if there is an unexpected result.
"Depending on the purpose of the accounts, the level of detail will vary, with typically the date being recorded along with the type of expenditure and of course the value itself."
Subramaniam adds: "I would suggest that good books and records are kept from the outset which should be updated on a regular basis. Avoid lumping large costs into the same headings as this can be misleading.
"Choose the headings and selection of items going into these headings carefully as you need to be able to identify what is in here. Don't be afraid of having lots of headings if you need to analyse where your main costs are."
How often do accounts need to be compiled, and who needs to see them?
"Businesses usually have to produce them at least once a year for the year in question to comply with the relevant tax legislation," says Subramaniam.
"However, many companies produce quarterly accounts to measure their financial progress during the year and if results are not as expected you would then review the business to see what action and measures should be taken.
"In addition, banks usually like to see these before lending money to companies or businesses. If a business is going to be sold, then the profitability is usually a key point in negotiating the sale price."
Subramaniam adds: "Understandably this sort of financial information is regarded as quite private so unless absolutely necessary most sole traders and individuals are reluctant to share this information. All companies, on the other hand, must publicly list their accounts at Companies House where for a small fee these are available for all members of the public to see."
It is important to note that the figures do not necessarily represent cash you have actually received or paid.
John Hoskin, founder of online accountants Cleveraccounts.com says: "The sales figure is all the sales you have made for which the customer has received the goods or services, even if your customer has not paid the bill yet, and your costs will include all the amounts you should have incurred in the period, even if you've not physically paid for them yet.
"If you buy some stock and sell it on at a profit, but you have not yet paid your supplier, the cost would still be included in the profit and loss account, to match with the sale you have made. Equally, you may not have paid an electric bill that relates to the last period covered by your account but the full cost of electricity for the period is still included."
Hoskin adds: "A profit and loss account can be used to monitor how much money the business is making, before or after certain costs, and ratios can be used to determine how profitable the business is.
"For example, net profit divided by sales gives the net margin percentage. This is the ratio of profits to sales made, and the higher the percentage, the more profit you are making per £1 of sale, and so the more profitable the business is.
"Along with the absolute profit (or loss) earned, ratios like this are important as they show how large a business's profits are in relation to its sales and costs. A very small margin indicates that even though the profit could be large, it is only a very small percentage of the sales or costs incurred and so a small increase in costs could push the business in to a loss. A large percentage margin indicates a more robust position."
Sales, costs and ratios of this type can also be tracked over time, to see how the business is doing and what trends it is experiencing, such as growing sales and reducing margins.
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