Assessing a Profit and Loss Account

Typically, a company issues profit and loss statements every month, and includes year-to-date figures and figures for the previous year, enabling comparisons to be made.

Income and expenses are entered into the account at the time they are incurred, which is not always when payments are made or received. For example, income will be recorded according to the date on the invoice, not the date that the customer pays. This also applies to credit—so if a company sells (or buys) goods on credit, the sale is recorded when the contract is set up, not when cash finally changes hands.

Expenses that appear on a P&L account are restricted to those directly related to achieving those sales. So wages, advertising costs and delivery/transportation are included, as is depreciation of property and equipment. Other costs—like capital expenditure—are not included.

P&L accounts can be presented in a basic single-step format:

This separates operating and non-operating revenue and expenses, and also shows gross profit. Whichever format they choose to use, companies must present their figures using Generally Accepted Accounting Principles (GAAP), which stipulate how revenue and expenses should be tracked for tax purposes. They also make it easier to compare different company statements. In some countries, receipts, revenues, and sales may be known collectively as turnover.

Here is a very simple multiple-step P&L:

• Net sales—total value of the sales for which the company sent invoices during the period in question.
• Opening and closing inventory—the value of stock held at the beginning and end of the period. This is never the selling price, but the cost of the stock or its value once realized (if this is lower).
• Purchases—direct costs, like goods and raw materials, which vary directly with sales. Capital items are not included, and neither are overhead costs like rent.
• Cost of goods sold—the opening inventory, plus purchases, minus closing inventory. This reflects the fact that goods purchased for resale during the period in question may not have been sold yet, and so form part of the inventory remaining at the end. Similarly, there will be goods in the opening inventory that were purchased during the previous period. In some sectors, other direct costs may be included here—for example, plant hire in the case of a building contractor.
• Gross profit—net sales minus cost of goods sold. This shows how much the business has made directly from the product or service it sells, before expenses, overhead and taxes are deducted. When expressed as a percentage ratio, this is also known as the gross profit margin (GPM). In this case, the GPM is 166:250, or 66.4%. As with most financial ratios, this figure is most meaningful when compared with previous financial periods, or with other companies in the same sector.
• Other overhead—expenses that stay fixed (rather than direct costs that vary with sales), like rent, salaries, insurance and interest payments, legal and professional fees, and office supplies.
• Net profit before tax—gross profit minus other overhead, before any tax is paid.
• Tax—although tax won't have been paid yet, it is due on any profit made during the period in question. Because tax is complicated (for example, certain rules may change, or there may be under or overpayments from previous periods to take account of), the figure here may not be the actual amount due.
• Net profit after tax—this is what's meant by the bottom line. A company is free to do what it wants with this amount, whether it's reinvesting in the company or rewarding investors with dividends.
• Dividends—payments to shareholders. A company can decide how much it wants to pay out, as long as the total dividends do not exceed the total available profit—which is this year's net profit after tax, plus any retained profit brought forward.
• Retained profit—how much profit is left after shareholders have received their dividends.
• Retained profit brought forward—all the retained profits that have accumulated over the years, since the company was formed.
• Retained profit carried forward—retained profit plus retained profit brought forward. The total will form the new figure for retained profit brought forward in the next accounting period.
• Earnings per share—Public companies may also report income as earnings per share, which is net profit after tax (net income) divided by the number of shares outstanding.

On its own, a P&L account reveals only limited information—it becomes much more meaningful when compared with previous periods or with other companies in a similar business. There are some basic things to derive however—such as whether the company made a profit or a loss, or whether it managed to pay dividends to shareholders.

It's also important to bear in mind that a single month's figures may be unrepresentative, particularly for a business with an income that fluctuates with the time of year. Retail is a good example of this, where sales tend to be higher towards Christmas.

It's helpful to turn some of the figures into ratios, to make relevant comparisons. For example, in this case, net profit margin before tax in relation to sales was 81:250, or 32.4%. After tax, it was 64.8:250 or 25.9%. Other useful ratios might highlight particular expenses. For example, the wages to sales ratio here is 60:250 or 24%.

By comparing such figures with previous accounting periods, managers might discover that the cost of wages has gone up, or that the net profit margin has dropped in relation to the gross profit margin. Further analysis might reveal the cause—such as a particular marketing campaign, or new pay structures for the labor force. The information can then be used to support future planning and strategy.

Return on capital employed (ROCE) combines a company's P&L account with its balance sheet. The formula is net profit (either before or after tax) divided by stockholders' funds—thereby measuring the efficiency and profitability of the company's capital investments. The more efficient the company, the higher the figure is likely to be.

In most cases, a company's profit is not simply about cash sales—although there are a few exceptions (such as a trader who simply buys something for one price and sells it on for more). In fact, a company's cash balance may bear little relation to its actual profit because of factors like buying and selling on credit, purchases intended for long term use, or tax due to be paid later.

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