Financial Management

THE Profit & Loss Account

Aims and Learning Outcomes

Aims To enable students to understand how a profit and loss account is prepared and how it fits with the balance sheet Learning Outcomes After reading this lecture and completing the related exercises, students should:
Understand the terminology used in profit and loss account Be able to draw up a profit and loss account for a sole trader from a list of account balances and explanatory notes Be able to understand and comment on the basic information conveyed by a profit and loss account

Profit and Loss

An organisation run on commercial terms will attempt to make profits by selling goods and/or services at prices that will allow it to cover all the expenses of the business, with a surplus remaining

Revenue or Sales or Turnover is the amount of goods and/or services sold, expressed in monetary term

Expenses are the amounts incurred by the business in purchasing or manufacturing the goods sold, and other expenditure such as rent and telephone charges

Profit and Loss

Profit is the surplus remaining when revenue exceeds expenditure (a desirable state of affairs in a commercial organisation) Loss is the deficit that occurs when expenditure exceeds revenue

The Profit and Loss Account

The profit and loss account summarises the revenue and expenses of an organisation over a period of time normally 12 months. By deducting total expenditure from total income, it shows on the "bottom line" whether your business made a profit or loss at the end of that period. A profit and loss account is produced primarily for business purposes to show owners, shareholders or potential investors how the business is performing. But most of the information is also used by the Inland Revenue to work out your tax bill.

The Profit and Loss Account

Note that Profit and Loss Account is the description that is usually used in the UK; however the term Income Statement is also used , especially internationally

Categories of Commercial Activity

Commercial activities can be broadly classified into three types, as follows:
Trading Manufacturing Service

Categories of Commercial Activity

Trading organisations operate as middlemen. Typically they buy in goods that have been manufactured by another individual or organisation and then sell them on a higher price to someone else Manufacturing organisations are often complex organisations. They manufacture goods that are either sold directly to the public or to trading organisations which they sell them on

Categories of Commercial Activity

Service organisations sell services rather than goods. For example, a solicitor is not concerned at all with the sale of goods. He or she make a surplus out of the provision of professional services Some organisations have a mixture of activities. For example, a commercial tennis club. It sells
annual subscriptions to a range of services such as use of tennis courts and tennis coaching A range of shoes and clothing, that it buys in from all the well-known sports clothing manufacturers

Trading Account
That part of the profit and loss account where the cost of goods sold is compared with the money raised by their sale to arrive at the gross profit This gives a view of the business in terms of sales and viability of profit

Retail trading account for November

Sales Opening stock Purchases

50 000

12 000 30 000 42 000 Less closing stock 15 000 Cost goods of sold Gross profit

27 000 23 000

Yearly Profit and Loss

By law, if your business is a limited company or a partnership whose members are limited companies, you must produce a profit and loss account for each financial year Self employed sole traders and most partnerships dont need to create a formal profit and loss account - the information they complete on the self assessment tax return form amounts to the same thing However, there are key benefits to producing formal accounts. If you are looking to grow your business, or need a loan or mortgage, for example, most institutions will ask to see three years accounts

Keeping accurate records

By law business must keep accurate records of income and expenditure. Keep self-employment records for five years and limited company/partnership records for six years after the latest date your tax return is due Accurate record keeping has important benefits. It:
gives information to manage your business and make it grow enables reporting on profit/loss easily and quickly when required will improve your chances of getting a loan or mortgage makes filling in your tax return easier and quicker helps you or your company avoid paying too much tax provides back-up for claims for certain allowances helps you plan and budget for tax payments prevents interest or penalties for late tax payments helps reduce accountant fees - your annual accounts will be far easier to produce

The basic records you will need to keep are:

a list of all your sales and other income a list of all your expenditure, including day-to-day expenses and equipment a separate list for petty cash expenditure if relevant a record of goods taken for personal use and payments to the business for these for limited companies: a record of money taken out for personal use or paid in from personal funds back-up documents for all of the above You will need the information above to create your profit and loss account

The Profit and Loss Account

The profit and loss statement shows the trading performance of the business and the distribution of profit. Profit is not equivalent to cash in bank
Income Customer sales, profit/loss from sale of tangible fixed assets, non operating income, investment income Expenses Variable (direct) costs, Fixed (overhead) costs, interest paid, depreciation allowance on tangible fixed assets Distribution Drawings/dividends, retained profit

Profit and Loss account Measuring profit

Income

Expenses

The profit and loss statement shows the trading performance of the business and the distribution of profit.

Net Profit
Drawings or dividends

Increase in assets

Retained profit

Profit and loss for a Sole Trader

The profit and loss account of a trading business splits into two parts:
First, the profitability of buying and selling processes are shown in the trading account, to arrive at a figure of gross profit, and then All other expenses of the business are deducted to arrive at a net profit

The basic layout of the profit and loss account is as follows:

sales Less: cost of sales Gross Profit Various expenses

Net Profit

-(--) -(--)
--

Trading account

Example
Marry has a shop that sells cookers. For the sake of simplicity we will assume that she sells only one type of cooker at a price of 195 each. She buys all the cookers from one manufacturer at a cost of 135 each. Each cooker therefore produces a profit of 60. if Marry bought and sold only one cooker the basic trading account information would be as follows: Marry: Trading account Sales of cooker 195 Cost of goods = Less: cost of cooker 135 Cost of sales Profit 60

Example
Naturally, if marry is trying to make a profit out of her business she will hope and expect to sell more than one cooker. If she sells 100 cookers during the course of the month of May 20X2 her trading account will be as follows: Marry: Trading account for the month ending 31 May 20X2 Sales: 100 cookers@195 19500 Less: cost of sales(100 cookers@135) 13500 Gross profit 6000

Self-Test Question
Jules sells leather bags from his market stall. The bags are all to the same design but are produced in a range of different colours with slightly different fastenings. During the month of December 20X5 he sells 66 bags at 23 each. He has bought the bags for 14.60 each. Show Juless trading account for the month.

Movements in Stock
In most trading businesses a stock of goods has to be held at all times, so that
Goods can be displayed and There are enough items in stock to satisfy potential demand

Mary has found that she needs to have at least 5 cookers on display at any time in order to show minor differences in styling to her potential customers. Also she needs to have a further 20 cookers in stock to cope with the potential demand. Stock is replaced when necessary in order to ensure that there are always at least 25 cookers on the premises. The factory from which she orders guarantees rapid delivery so Mary does not have to keep a large amount of stock on the premises. At 1 June 20X2 Mary has 30 cookers in stock. During June she sells 76 cookers. She orders 35 cookers which was delivered on 10 June and a further 40, delivered on 24 June. How many cookers does Mary have in stock at 30 June? In order to answer this question we can construct a stock movement account

Mary: Trading account for the month ending 30 June 20X2

units
14820
4050 10125 14175 (3915)

Sales: 76 cookers @195

Cost of sales: Opening stock: 30 cookers @135 Add: purchases: 75 cookers @135 Less: closing stock: 29 cookers @195

76
30 75 105 (29) 76

Cost of sales: 76 cookers @135 Gross profit for month

(10260) 4560

Calculating cost of sales

Most of the businesses have periodic stocktaking, usually to coincide with the date at which the accounts are drawn up Stocktaking allows businesses to
keep track of stock Identify those items are not selling Disposed of any item damaged items found Generally make sure that there have not been any significant losses poor accounting or theft

Stocktaking identifies the quantities of stock and its cost At the date of the profit and loss account and balance sheet, a valuation of stock is established Purchases in the period are calculated from delivery records and invoices

Calculating cost of sales

Because the stock value at the beginning and the end of the accounting period are established, and the total purchases are known, it is easy to calculate the cost of sales as follows: Opening stock -+ Purchasing -- Closing stock (--) Cost of sales --

Example
Marys accounting year ends on 31 October. In respect of the year to 31 October 20X2 she will need information about: Opening stock on 1 November 20X1 Closing stock on 31 October 20X2 Purchases for the whole year.

Example
At November 20X1 her opening stock value was 4725 At 31 October 20X2 her closing stock value was 6480. During the year she received total purchases of cookers of 153 900. She sold 986 cookers at the normal selling price of 195 and a further 141 at 175 in a special Christmas promotion This is all the information that is needed to calculate Marys gross profit for the year.

Mary: Trading account for the year ending

31 October 20X2

Sales
986 cookers @195 141 cookers @175 192 270 24 675 216 945

Cost of sales
Opening stock at 1 November 20X1 Add: purchase during year Less: closing stock at 31 October 20X2 4725 153900 158625 (6480)

(152 145)

Gross profit for year

64800

Calculating Net Profit

The basic layout of a profit and loss account is as follows: Sales -Less: cost of sales (--) Gross profit -Various expenses (--) Net profit --

Typical Business Expenses

Expenses could include the following: Cost of premises: rental, business rates, insurance, electricity, gas, water and repairs. Selling costs and costs of distributing goods: haulage costs, delivery services, costs of sales staff salaries and commissions. Administrative costs: telephone, stationary, administrative staff salaries, accountants and legal fees, computer costs. Finance costs: bank charges and interest on loans.

Gross profit analysis

Gross profit is an important element in judging how well or badly a business has performed. However, one isolated figure has little significance on its own. We need to make comparison at least two figures. Comparing two consecutive years If the gross profits in 20X1 and 20X2 are 57300 and 64800, respectively, the increase in gross profit is 64800 - 57300 = 7500 Percentage increase = (7500/57300)*100=13.1%

Gross Profit Margin

Gross profit margin is a way expressing, by means of a percentage, the relationship gross profit and sales. Gross profit margin simply shows gross profit as a percentage of sales. Gross profit margin (%)=(Gross profit)/Sales*100

Net Profit Margin

Net profit margin is a way of expressing , by means of a percentage, the relationship between net profit and sales Net profit margin(%) = (Net profit/sales)*100