As a founder, it’s essential to have a clear understanding of your company’s financial performance. One of the key financial reports you need to be familiar with is the Profit and Loss (P&L) account, also known as the Income Statement.
This report shows your company’s revenue, expenses, and net profit or loss over a specific period. Understanding your P&L statement is critical in evaluating your company’s financial health, identifying areas of strength and weakness, and making informed business decisions.
In this article, we’ll provide you with a comprehensive guide to profit and loss accounts, including their importance, how to read and interpret them, and key financial ratios you need to know.
Table of Contents
What is a Profit and Loss Account?
A profit and loss account also referred to as a profit and loss statement reflects the business’ expenses and revenue over an accounting period. It is a financial statement that highlights the final picture of business activities carried over the year.
The reported earnings and expenditures reflected in the profit and loss account help to gauge the overall business performance in a financial year. In addition, it helps business owners to comprehend business operations and annual profits.
What Is the Importance of a Profit and Loss Account?
The main purpose of the profit and loss account is to evaluate whether a business entity is generating profit or making a loss.
➡️It is possible by summarising business costs, revenues and expenses over a specific period. As a result, businesses can compare current business performance with past performance in terms of revenue generation.
➡️This financial statement helps to comprehend operational efficiency and the varied costs that are incurred by a business body in order to stay afloat.
➡️Profit and loss statement enables businesses to fulfil statutory requirements like curating financial statements and getting the same audited and approved.
➡️In addition, it helps shareholders comprehend their net income per share, while investors can easily estimate their investment liability.
What is a Profit and Loss Account used for?
- Assessing financial performance: The P&L statement helps businesses assess their financial performance over a specific period, such as a quarter or a year. By comparing revenue, expenses, and profits or losses, businesses can evaluate their profitability and financial health.
- Identifying areas of strength and weakness: The P&L statement provides insight into the areas of a business that are performing well and those that need improvement. For example, a high gross profit margin may indicate that a business is pricing its products or services effectively, while high operating expenses may highlight the need for cost-cutting measures.
- Making informed decisions: The P&L statement helps businesses make informed decisions about their operations and strategies. For example, if a business has a high net profit, it may decide to invest in new products or expand its operations. Conversely, if it has a low net profit, it may consider cost-cutting measures or exploring new revenue streams.
- Meeting legal requirements: In some jurisdictions, businesses are required by law to prepare and submit P&L statements as part of their financial reporting obligations.
- Attracting investors and lenders: Investors and lenders use the P&L statement to assess a business’s financial health and potential for growth. They examine revenue and profit trends, operating expenses, and other factors to evaluate a business’s profitability, liquidity, and solvency.
Components of Profit and Loss Account
The business revenue or income is a key component of a profit and loss account which is related to the primary business operations. It even includes the earnings generated from different business investments. Business income or gross sales are considered to be the top line.
Operating expenses are not the direct expenditure that results from manufacturing or production but refers to the indirect expenses incurred while running a business operation. These expenses include depreciation costs, employee costs, marketing and distribution costs, etc. Such expenses have a direct influence on the business’s net profits.
The net income of a business body is considered to be the bottom line of the company’s income statement. It refers to the net profit that a business entity generates after subtracting operating and non-operating expenditures. Net income is evaluated by deducting all interest and taxes.
The operating profit of a business, also known as EBIT (Earnings Before Interest and Taxes) refers to the positive balance obtained after excluding operating expenditure. A positive figure of operating profit ensures stakeholders as well as investors of the solvency and profitability of a business.
Profit and Loss Account Terms Explained
- Revenue: This represents the income earned by a business from its normal operations, such as sales of goods or services. It is usually the first item listed on a P&L account.
- Cost of Goods Sold (COGS): This refers to the direct costs associated with producing or delivering the goods or services sold by a business. It includes expenses such as raw materials, labour, and shipping costs.
- Gross profit: This is the difference between revenue and COGS. It indicates how much profit a business is generating from its core operations.
- Operating expenses: These are the costs associated with running a business, such as rent, salaries, marketing expenses, and utilities.
- Operating profit: This is the difference between gross profit and operating expenses. It represents the profit a business earns from its core operations.
- Other income and expenses: These are non-operating items that can affect a business’s profit or loss. They include items such as interest income or expenses, gains or losses from the sale of assets, and one-time expenses or income.
- Net profit: This is the final profit or loss figure calculated by subtracting all expenses from revenue, including operating expenses and other income and expenses. It represents the profit or loss a business has earned after all costs have been accounted for.
Calculating Net Profit
Net Profit = Revenue – Cost of Goods Sold (COGS) – Operating Expenses – Other Income + Other Expenses
Types of Profit and Loss Statements
- Single-step P&L statement: This is the simplest type of P&L statement, where all revenues are listed together, followed by all expenses. The net profit or loss is then calculated by subtracting the total expenses from the total revenues. This type of P&L statement is commonly used by small businesses and startups.
- Multi-step P&L statement: This type of P&L statement provides more detailed information than a single-step P&L statement. It breaks down the revenues and expenses into several categories, such as operating revenues, cost of goods sold, gross profit, operating expenses, and net profit. The gross profit is calculated by subtracting the cost of goods sold from the operating revenues, and the operating profit is calculated by subtracting the operating expenses from the gross profit. Finally, the net profit or loss is calculated by adding or subtracting any other income or expenses not included in the operating revenues or expenses. This type of P&L statement is commonly used by larger businesses and corporations.
How Is the Profit and Loss Account Prepared?
Step 1: Create Ledger Accounts
Ledger is a collection of accounts that shows the transaction details of a business recorded over the year. It contains elaborate financial information on different business accounts. Even details related to the opening balance of an account, all debits and credits made on the account and the ending balance. There is a separate ledger for each account.
Step 2: Prepare Trial Balance
Trial balance refers to the financial report that encompasses a list of all general ledger accounts. The list reflects the names of nominal ledger accounts. In this financial statement, the cumulative sum of debits should match the sum of credits. In addition, this financial report highlights the closing balances of all ledger accounts.
Step 3: Curate the Profit and Loss Statement
The profit and loss statement is drafted after recording every balance in the trial balance sheet and making adjustments. A profit and loss statement records debit items i.e., expenses or losses on the expense column and credit items including incomes and gains on the income side.
Example of a Profit and Loss (P&L) Statement
Here is a sample Profit and Loss (P&L) statement for the years 2020 and 2021 for the fictitious company, Cupcake Industries, with all values expressed in INR, except for per-share data.
|Cost of Goods Sold
|Salaries and Wages
|Total Operating Expenses
|Operating Income (EBIT)
|Earnings Before Taxes (EBT)
|Income Tax Expense
|Earnings Per Share (EPS)
|Dividends Per Share (DPS)
|Weighted Average Shares Outstanding
The company generated a revenue of INR 4,50,000 and INR 5,00,000 in 2020 and 2021 respectively. The cost of goods sold was INR 2,00,000 and INR 2,25,000 for 2020 and 2021 respectively. This resulted in a gross profit of INR 2,50,000 in 2020 and INR 2,75,000 in 2021.
The company incurred operating expenses of INR 1,75,000 and INR 1,97,000 in 2020 and 2021 respectively. These expenses include salaries and wages, rent, utilities, advertising, insurance, depreciation, and other expenses. After subtracting these expenses from gross profit, the company had an operating income of INR 75,000 and INR 78,000 in 2020 and 2021 respectively.
How RazorpayX Helps Business Maintain a Profit and Loss Statement?
RazorpayX helps entrepreneurs sustain themselves and gather the necessary capital for carrying out smooth business operations. It enables business bodies to keep control over expenses and generate more revenue, thereby helping them generate a positive profit and loss statement. This, in turn, ensures financial stability throughout a financial year. A positive financial statement not only helps businesses sustain themselves but also attracts investors.
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Frequently Asked Questions
What are the differences between a balance sheet and a profit and loss account?
A balance sheet refers to the business's financial position on a given date. On the other hand, a profit and loss account holds the record of expenses and income of a business body over a given span of time. Business bodies refer to the balance sheet at half-year or end of a financial year, on the contrary, the profit and loss account is reviewed by business professionals from time to time.
What are the warnings to look out for in a profit and loss account?
Here are some warning signs that stakeholders and investors can come across while reviewing business profit and loss account:
Declining business profit margins without a concrete reason.
Falling business sales and revenue.
What are the different types of profit and loss statements?
There are two types of profit and loss statements: accrual method and cash accounting method. The cash accounting method revolves around paid or received cash and is mostly opted for by small businesses. On the other hand, in an accrual accounting method, a record of the revenues and expenses is kept before payments have been received or initiated.