Companies House plans – at some point – to make the submitting of profit and loss accounts for small and micro businesses a requirement.
As we mentioned in our earlier blog, when that actually happens is a big unknown. But it doesn’t matter when that is because it is essential to understand your profit and loss accounts.
The profit and loss account is an important financial statement. And not just because it has to meet any obligations with Companies House in the future.
Understanding the profit and loss account helps business owners assess the health of their company. And when viewed in conjunction with other financial statements – such as cash flow forecasts – gives an overall picture about where the company is.
Understand your profit and loss accounts
Many business owners concentrate on turnover and don’t look too hard at the importance of profit and loss. The profit and loss account (P&L) summarises the trading results of a business over a set time (usually a year) and shows both revenue (money coming in) and expenses (money going out).
If you are VAT registered, income and expenses are usually shown ‘net’ of VAT. That means the VAT charged or incurred is not included in the P&L account.
The P&L account shows only revenue transactions connected with commercial of activity of the company. Income such as grants, bank loans and loans from directors are not typically shown in the profit and loss account. Also, HMRC payments, loan repayments and the purchase of any equipment are not included.
The trading account
The section at the top of the P&L account is known as the ‘trading account’. This shows only direct trading activities of the business. The sales figure and cost of sales is included in this.
The sales figure includes all the work that has been invoiced. These are included whether they have been paid or not. It could include work that you have started but not yet invoiced if you provide certain services.
Cost of sales
The cost of sales represents costs incurred to generate your sales. Any invoices for goods or services received from your suppliers is included – even if your business has yet to pay the invoice.
Included in the cost of sales is an adjustment for any stock you hold. That is because it has not yet been used to generate the sales in that year. Stock adjustments exclude stock at the end of the accounting period and includes stock brought forward from the previous accounting period.
Gross profit and gross profit margin
Gross profit is the difference between your sales and the cost of sales. It is an important figure for business owners as it shows the sales mark-up. This will highlight any issues with your pricing.
These are the business overheads. It can include wages, but they can also be included in the cost of sales. This depends on the amount of wages that can be attributed to the generation of sales and where you want it to be shown.
Charges for finance and other income are normally show separately under administrative expenses.
What does it all mean?
Being able to interpret the profit and loss account is important. In simple terms, you can use previous years’ P&L accounts to look for trends or deviations.
The P&L accounts tell a story of what has happened during the year. They are useful for reflection, whereas the cash flow forecast should be used for planning as it gives the current picture of the health of your business.
Accountants help you to understand and interpret the figures in the P&L account and highlight the areas where you may need to look more closely. HMRC will use the P&L account to spot anomalies such as a big increase in costs or a dramatic drop in profits.
Profit and loss account terms
Here’s all you need to know about the most common terms used.
- Net income: Your income minus the cost of goods sold, expenses and taxes
- Gross profit: Total revenue minus the cost of goods sold
- Operating profit: The profit you have after operating expenses, such as rent, are deducted from the gross profit. This won’t include interest or tax deductions.
- Net profit: This is your real profit. It’s what you’re left with after remaining working expenses are deducted from gross profit.
What if I’m unsure
While it can seem fairly straightforward, interpreting business accounts is a specialist job. If you run a business and want a proactive accountant to help you, then contact our friendly team today.