Profit and Loss

Profit and LossTogether with the balance sheet and cash flow statement, the profit and loss statement forms a business’s key financial documents.

Cash is the lifeblood of a business and these statements, with the help of financial ratios enable the business analyse its financial condition and ensure that it has enough funds to survive and thrive and make informed financial, investment and management decisions.
 

Profit and Loss Statement

In the following sections, we’ll start from the basics to understand the definition of a P&L statement and then consider an example to understand how a P&L statement is created and analysed.
 

What is a profit and loss statement?

Also known as the income statement, the Profit and loss statement is the first financial report based on which all other statements are prepared. It is a report card for the business. It reflects a business’s profitability or financial performance, offering a snapshot of its income and expenditure and its profits during a specific time period.

Profitability matters to a business’s existing and future lenders and investors, its stakeholders, competitors, regulatory bodies and everyone associated with it.If the company is not profitable, it will show a net loss and will not be able to qualify for credit from lenders.

If the company is profitable and shows a net income, it shows its ability to make use of the funds borrowed and invested efficiently.

Income statements are usually prepared monthly, quarterly and annually and answer the following questions:

  • Are sales high or low?
  • What is the gross profit? How much money is available to the business after costs?
  • What are the expenses for the time period covered by the statement?
  • What are the increases and decreases in net income?
  • How much money is available for expansion?
  • How much money is left for the owners?
  • How much money is available to repay loans?

The profit and loss statement is based on the simple formula:

Income (-) Expenses = Net profit

The net income is derived from deducting the total expenses from the total income, showing how profitable the business is and is an indicator of the efficiency of its operations.

When the income is more than the expenses, the business is said to have made a profit. When expenses are more than the income, the business would have made a loss.

The information contained in the profit and loss statement makes it a valuable tool that helps identify expenses and analyse the rationale behind them, allowing tighter control so that steps may be taken to being more profitable.

The Profit and loss statement reveals how much cash has been spent and earned by the business for a given time period, along with the related costs and expenses. It reflects the profit or loss for that period.

While the P&L shows revenues, expenses, gains and losses, it does not list money received and money paid out.

Unlike the balance sheet, which shows the business’s financial position at a specific point in time, the P&L statement relates to a specific time-frame: three months, six months or 12 months.
 

Profit and loss account format

The profit and loss statement format is based on the complexity of the business’s operations. Businesses usually choose between two formats for the P&L statement. These are:

  • Single-step, where there is one category for income and one for expenses. This has its limitations as it cannot compute financial ratios.
  • Multi-step, where the expense account is further sub-categorized into various heads, allowing the business to calculate its gross profit, net income and operating income.

Whichever format is used, income is always at the top of the statement before expenses.

The job of a P&L statement is to add up sources of revenue and deduct expenses related to the revenue, showing the company’s financial progress during the particular time period.

The statement begins with the total revenue from sales of products and services followed by operating expenses related to the production of goods and services for the accounting period.

Depreciation (wear and tear in assets such as machinery, furniture, tools) is calculated and subtracted from the gross profit. Depreciation is the process of spreading the cost of the assets over their lifespan.

Interest income and expenses are then added and deducted from operating profits to find out profits before income tax. The next step is to deduct income tax from the operating profits before tax to arrive at net profit or losses, as applicable.
 

How to prepare a profit and loss statement

The following profit and loss formulas sum up the income statement:

  • Gross margin = net sales – cost of goods sold
  • Net operating profit = gross margin – operational expenses
  • Net profit before tax = net operating profit + other income – other expenses
  • Net profit / loss after tax = net profit before tax – income tax

It is important to note here that companies in the service industry have comparably simpler income statements as they do not sell goods and therefore, do not maintain inventory of goods. Businesses in the merchandising sector that buy and sell goods but do not manufacture them have more complex income statements as they must report purchase and sales.

Manufacturing companies have the most complex profit and loss statements as they have both production and sales to report. They must maintain a system that monitors manufacturing costs from the point of production to the point of sale. Because of this, they must use the inventory cost flow equation for raw material, the work in process and finished goods to compute the cost of raw materials used in production, cost of goods manufactured and cost of goods sold.

  • Raw materials in production relates to the cost of direct and indirect materials.
  • Cost of manufactured goods is the cost of goods ready for sale in finished good inventory.
  • Cost of goods sold is the cost of goods sold and no longer in inventory.

Based on the following profit and loss statement example, let us look at how to prepare a profit and loss statement for a manufacturing company.
 

Profit and Loss Statement Example

 

Sample Profit and Loss Statement for ABC Manufacturing Company Ltd.

For the quarter ended March 31, 2014 | All values in Rs.

NET SALES 300,000
Cost of goods sold:
     Beginning inventory − 85,000
     Material purchased − 150,000
     Shipping − 45,000
Cost of goods available for sale 280,000
     Less ending inventory − 90,000
COST OF GOODS SOLD − 190,000
GROSS PROFIT 110,000
Operating expenses (Selling, Administrative, and General
Expenses):
     Salaries and Wages − 52,000
     Rent − 10,000
     Electricity − 4,000
     Other Expenses − 6,000
     Local Taxes − 3,000
     Depreciation − 1,000
     Repairs − 2,500
Total operating expenses − 78,500
Profit From Operations 67,500
     Other income + 5,000
     Other expense − 1,000
Net Profit Before Taxes 71,500
     Provision for income tax − 25,500
NET PROFIT AFTER INCOME TAX 26,000

 

Notes on how to prepare a profit and loss statement

Begin with the heading. The heading of the statement is critical as it shows the company’s name, statement title and the time frame relating to the report.

The basic information required to construct a P & L Statement is as follows:

  • Net sales
  • Cost of goods sold / cost of sales
  • Operating expenses including Selling, general and administrative expenses
  • Other income and other expenses

 

Net Sales

Net sales is the total sales during the period, which in this case, is 3 months including January, February and March 2014, minus returns and sales discounts. Returns will vary depending on the nature of the business and the allowance is usually 2% of total sales. Discounts reduce the actual total sales based on prices paid by the customers vis-à-vis catalogue prices.

Under Net Sales, enter net sales minus returns and discounts.
 

Cost of Goods Sold

Cost of goods or cost of sales is the price of the goods minus operational expenses.Service oriented companies do not incur cost of goods as there is no inventory. Their revenue is from fees, commissions and royalties. Their cost of services is included in operating expenses.

Wholesalers and retailers in the merchandizing industry who are involved in buying and selling and do not produce goods calculate their costs

  • Directly via actual price of goods sold based on inventory

The cost of goods sold is calculated from:

  • Original inventory – inventory at the beginning of the accounting period
  • New inventory – value of goods bought during this period
  • Ending inventory – remaining inventory at the end of the accounting period.

Original Inventory + New inventory – Remaining inventory = Inventory used to produce goods

  • Indirectly via estimation of sales

For manufacturers, the process is different as their costs are derived from the purchase of raw material to produce the goods along with the manufacturing costs. This can be direct and indirect costs.
 

Direct costs which include:

  • beginning, new and closing inventory costs,
  • raw material costs
  • work in progress inventory and
  • direct labor costs to convert raw materials into finished goods

 

Indirect costs include:

  • Indirect labor involved in logistics and maintenance
  • Factory overhead expenses including plant and machinery depreciation, electricity, insurance, property taxes, wages and other indirect staff expenses
  • Materials bought but not used directly in production

If the manufactured product has packaging as part of the product, it is part of cost of goods sold. If not, it becomes a selling expense.

The cost of sales goes into the profit and loss statement after which the net income is computed.
 

Gross Profit

This is derived by deducting cost of goods sold from the net sales.
 

Selling expenses

Selling expenses relate to the cost of taking orders and fulfilling them. They include direct and indirect expenses related to sales and these are salaries to sales staff, costs related to the sales office, commissions paid, promotion costs, warehousing and shipping.
 

General and administrative expenses

These are indirect operating expenses including salaries to non-sales people, office supplies and other administrative expenses classified under “overheads” such as rent, electricity, phone bills, travel, repair and maintenance costs.

After selling, general and administrative expenses are entered in the profit and loss statement, the net operating profit can be calculated by deducting these expenses from the gross profit.

Finally, other income, other expenses and income taxes are recorded in the income statement.

Other income and other expense relate to expenses other than operational costs. This can be interest income, dividend income, rents, royalties and proceeds from the sale of capital assets. Other expenses include unforeseen losses.

To compute net profit before income tax, other expenses is added to net operating profit. From this other expenses is deducted to arrive at net profit before tax.

After assessing taxes to be paid, this is deducted from net profit before income tax to calculate net profit or loss as the case may be.

To summarize, expenses are categorized logically to determine the gross profit, operating income and net income.

If the net revenue and gains minus expenses and losses is positive, there is net income. If it is negative, it is loss.

Regardless of the size and nature of a business,the profit and loss statement is the basis on which it can analyse the feasibility of its business operations as it offers, at a glimpse, its most important activities. When it is prepared regularly at periodical intervals it places a powerful tool in the hands of the business owners enabling them run their operations efficiently.
 

Important Finance Topics

Introduction to Finance
Balance Sheets
Cash Flow
Ratio Analysis

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