Understanding the profit and loss statement
The profit and loss account is a primary statement that is found in a company’s set of
financial accounts. The profit and loss account provides details of the company’s
performance during a specific period, which is usually a year, although it can be for any
duration, which is very different to a company’s balance sheet, which is merely a snap
shot of the company’s financial position at a given time.
The top heading in a profit and loss account is turnover, which is obviously the level of
sales achieved during the period. A profit and loss account is prepared on the accruals
basis, therefore sales will include total sales made during the year, regardless of whether
the cash has been received or not. Similarly, sales will not include cash received during
the reporting period in respect of sales made in the previous reporting period.
The next figure on the profit and loss account is the cost of sales (in the case of service
providers) or the cost of goods sold (in the case of manufacturing companies). The cost of
sales and cost of goods sold are made up of all direct costs attributable to generating the
sales, therefore are effectively the same thing.
The next figure on the profit and loss account is the gross profit, which comprises of
turnover less cost of sales or cost of goods sold. In the profit and loss account the gross
profit will be represented by a figure, however it is common practice to express the gross
profit as a percentage of sales, i.e. as a gross margin. For example, a business made sales
of £100,000 and incurred direct costs of £60,000. The gross profit is £40,000 and the
gross margin is 40% (i.e. £40,000/£100,000). The gross margin is a common ratio that is
used to compare the performance of the businesses to prior periods, or to compare to
other businesses in the same industry.
The next figure after the gross profit will be the overheads and indirect costs. Only the
total figure will be included on the statutory profit and loss account, although it may be
split in to a few broad category costs, such as distribution costs and administrative costs
etc. When dealing with small and medium sized companies a detailed analysis of the
overheads is not included on the face of the profit and loss account, although it is
common practice to provide this information on a separate schedule at the back of the
accounts. It should be noted that this detailed schedule is for the use of the directors only
and it is not attached to the set of financial statements that becomes publicly available
once filed at Companies House.
Gross profit less overheads equals the operating profit, i.e. the profit generated from
trading activities and it is this figure that is next on the profit and loss account. Some
people will express the operating profit as a percentage of sales for ratio analysis,
although the value of this ratio is questionable as large one off expenses, non-recurring
expenses, extraordinary expenses etc in a particular year is likely to affect the results.
Below the operating profit is interest receivable and other similar income. If a business
receives interest from a large ban deposit or interest for a loan to a director or an
employee it is not trading income, therefore it is excluded from the trading results and
stated the profit and loss account here.
The next figure is interest payable, which is obviously deducted from profit. Interest
payable on a loan is not a trading expense, therefore it is treated like interest receivable
and excluded from the trading section of the profit and loss account.
The operating profit add interest receivable less interest payable results in profit before
taxation and this figure is separately stated on the face of the profit and loss account. The
corporation tax charge is then deducted from the profit and the resultant figure is called
the profit for the year after taxation.
UK accounting standards and GAAP specifies the format and the headings of the
statutory profit and loss account to be included in the financial statements, however if the
profit and loss account is being prepared for internal purposes the directors of the
company can prepare it however they see fit.