Understanding your Profit and Loss Account and Balance Sheet

Your profit and loss statement ensures you know where you’re making and spending money, key information for running a business effectively. Here's how...

Understanding your Profit and Loss Account and Balance Sheet

To steer your company in the financial direction you want it to take, you need to understand where you’re making money and where you’re spending it. This is why you should keep accounts and produce regular reports, including a profit and loss account and balance sheet. Your bank manager or other financier will also want to see these when you ask for a loan or other credit.

You may also like to read 10 ways to improve your cashflow

The benefits of producing accurate profit & loss accounts and balance sheets

Your profit and loss account (P&L) shows business performance. It measures how much money you have made, and how you made it, over a given period. Typically, this period is a month or consolidated months over a year.

Your balance sheet shows the value of your business, at a specific point in time (for example, the last day of the month or the end of your financial year). It shows how the profits shown in the P&L have been used.

These records are valuable for many reasons.

  1. Your bank manager, financiers and prospective partners will want to see clear records of the business’ profitability.
  2. You get a clear view of patterns emerging in the way you do business. By examining accurate monthly figures, for instance, you may be able to identify months when you are busier than others, enabling you to plan staffing and resource levels more efficiently.
  3. Producing both these reports regularly and looking at them together gives you a wealth of information about how to drive your business forward.

The P&L measures your profitability while your balance sheet measures your financial health – your ability to pay what you owe out of your current resources. Taken together, they indicate your long-term prospects and reveal how you could manage your business better.

It could be that a growing business overstretches itself. A look at the P&L will reveal healthy profit, but will not show you, for example, if you are running out of cash, as you build stock. For this you will need to look at your balance sheet. Working with them together allows you to plot growth and avoid financial perils.

Using ratios to interpret the figures

There are a number of ratios that are commonly used to work out how a business is doing, from the acid test ratio, which looks at a business’ ability to meet its current liabilities, to the gross margin percentage, which shows the average profitability of your sales. These reports will enable you to make these very useful calculations easily. See our guide to Key Accounting Ratios

How to keep a profit & loss account

Most simple computer accounting packages set out P&L and balance sheets in a straightforward way that’s easy to understand even for non-accountants. There are several manual book-keeping systems available, which explain clearly how and where entries in each should be made.

Whether you use accounting software to create your P&L account, or you keep your accounts manually on paper or in a spreadsheet, the figures are usually set out in a similar way.

Your P&L account starts with the gross income (the total of all money that comes in from your sales to customers, assuming you are not VAT-registered), and takes away any discounts or allowances (for example, for early payment or bulk purchases), giving you your net income. From this, the P&L takes away cost of sales (for example, total unit costs, packaging and delivery), giving you your gross profit.

Then it takes away overheads (sometimes called fixed costs). These include the rent for your premises, marketing costs, wages, telephone, postage, and stationery etc. This leaves your operating profit.

You then add in any other income (for example, from machinery sales, rent from tenants in your office space etc) to give you your profit before tax.

Take the tax away from profit before tax and you have your net profit or loss.

So, your P&L account should look like this:

Gross income (excluding VAT)
Less discounts and allowances
Net income
= 99000
Less cost of sales
Gross profit
= 69000
Less overheads
Operating profit
= 53000
Plus other income
Less other expenses
Profit before tax
= 59000
Less tax
Net profit (or net loss)
= 36000

NB: figures in brackets are minus figures (a loss).

Some computerised accounting systems may lay the figures out differently, but when accounts are printed, they are generally shown in this format. Internal accounts show far more detail, while published accounts for limited companies or limited liability partnerships rarely show more than the information above.

Remember, it is usual to show the same set of figures for the previous period alongside the figures for this period. Also, instead of drawing a line under a sequence of figures to indicate that the following figure is a total, sometimes the total is shown in the column immediately to the right.

Each of the figures in the P&L account will be the total of many others and may come from several places in your accounts, depending on the type of business you run.

How to keep a balance sheet

The balance sheet is presented in two sections:

  • Assets such as properties, furniture and fittings, equipment, stock for sale, cash and money owed to you.
  • Liabilities such as your bank overdraft, loans and other money you owe.

Balance sheets are usually laid out in this format:

Fixed assets (listed by type of item)
Depreciation (listed by type of item)
Total fixed assets
Current assets (cash, money in bank, money owed to you)
Total assets
Current liabilities e.g. bank loan, tax
Proprietor’s interest, represented by capital invested
Profit/(loss) for the year (from the P&L)
Capital at end of year

The two figures “total assets” and “capital at end of year” are the same – they must be, as the whole point of a balance sheet is to balance the two sides of your accounts.

Proprietor’s interest (also known as equity) simply means the amount of money you have tied up in the business.

Understanding depreciation

Depreciation is a figure given each year to the loss in value of items such as equipment and vehicles. Say you buy a new piece of machinery for £10,000, and expect it to last ten years before you replace it. At the end of those ten years it will be worth nothing, so it will have reduced in value each year by £1000 – which is called its depreciation.

The depreciation of value of these items is written into your accounts as a loss, reducing your taxable profit.

There are some conventions that govern the lifetime of certain types of item. These are used because the HM Revenue & Customs accepts them as reasonable.

Note that sometimes rules on depreciation change, even temporarily. For example, in the recent Finance Act, the Chancellor updated the scheme for 100 per cent first year capital allowances for investments in designated energy-saving equipment. This means you can immediately write off against taxable profits your capital spending on designated energy-saving plant and machinery, reducing your tax bill.

Accounting terms explained

There are some other common terms you may find it useful to understand:

Current assets includes money you can use quickly, including cash in your till and credit at your bank, money owed to you by customers, your stock and any pre-paid expenses which you could, theoretically, get back, such as the rent on your premises.

(Money owed by your customers here means money you are confident of collecting. If you are uncertain about payment, you need to have another section in your balance sheet called “provision for bad debts”. So if customers owe you a total of £10,000, and you think you may not be able to collect £2000 of it, you show £8000 under “accounts receivable” and £2000 under “bad debt provision”.)

Fixed assets includes items you own and will keep for a long period for use in the business, rather than sell for a profit. This covers buildings, fixtures and fittings, vehicles, equipment and plant. You could think of these as the items that depreciate (although this might not apply to buildings in a rising property market).

Other assets, sometimes called intangible assets, covers things such as goodwill, and the value of any licences, copyrights, trademarks or patents you might own.

Current liabilities includes amounts you owe and will have to repay within one year, such as your suppliers’ invoices, a short-term loan, your overdraft (which is in this section because it is usually repayable on demand), VAT, or other taxes due.

Long-term liabilities includes long-term loans such as mortgages or lease payments on vehicles.

Computerised accounting

Accounting software makes it easy for you to create different views of your figures. For instance, you can compare this month with last month, this year-to-date with last-year-to-date, several months in sequence, or you can convert the figures into percentages and compare them that way. All this makes it easier for you to spot trends over time.

Your aim is for your sales and profits to increase, and your expenses to decrease. Are there any sudden changes or anomalies that ring warning bells? For example, if your stationery spending suddenly rose from roughly £100 a month to £500 for one month, you would want to look into this. Or if your staff cost on average 30 per cent of your income and this figure suddenly leaps to 40 per cent, again you would want to investigate.

You can also draw some deeper conclusions than just seeing that more money is coming in than previously. Is the increase equivalent to, or better than, the rate of inflation? Is it the result of more sales, or is it hiding the fact that although you have charged more per sale, you actually made fewer sales? And, looking ahead, is the rate of increase satisfactory or do you need to set a new target? These are just some of the many questions accurate accounts can help you address.

This business advice article published in association with Lloyds TSB.

Whether you are looking to start-up a business account or want to move your existing business account Lloyds TSB can offer you all the Business Banking support you need

While all reasonable care has been taken to ensure that the information in this website is accurate, no liability is accepted by Lloyds TSB for any loss or damage caused to any person relying on any statement or omission in the content of this website. The content of this website is provided for information only and should not be relied on as offering advice for any set of circumstances and specific advice should always be sought in each instance

Understanding your Profit and Loss Account and Balance Sheet

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