Bookkeeping and financial statements are an integral part of any business operation. Tracking and reporting a company’s finances helps to improve its financial performance and attracts investors or potential buyers. However, to track a business’s economic performance, one of the most critical documents one needs is the profit and loss statement.
What is a Profit and Loss Statement?
The profit and loss account is a type of financial statement that provides a gist of expenses, revenues, and profits/losses of a company over a period. This period can range from monthly to quarterly or annually. The profit and loss account indicates a business’s financial health and its ability to generate profit with the help of increasing revenue and cost reduction.
Financial Analysis and Businesses
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How Do the Profit and Loss Statements Work?
Every publicly traded company should issue a profit and loss statement regularly, quarterly or annually. It is one of the most important financial statements of a business, as it shows whether a business has made a profit or loss.
Here is how to prepare a profit and loss account:
- One needs to prepare an account statement for each ledger in the journal book to determine the closing balance of this account.
- Create a trial balance to summarise the ledger account. It lists every individual ledger account statement with its closing balance.
- Lastly, accountants need to include all these ledger accounts in the profit and loss statement.
Why Comparing Profit and Loss Statements are Important?
It is essential to conduct a comparative analysis of P&L statements as it helps a business to identify changes in meaningful numbers. These include revenues, operating costs, spending, and earnings over a period. A company can compare their own statements from different periods or statements from different companies.
Comparing the profit and loss statement with a statement from another company will help in evaluating the market competition and growth potential of the company.
What are the Different Methods of Preparing Profit and Loss Statements?
- Cash Method
The cash method of preparing profit and loss accounts considers all cash transactions present in the journal. The cash basis profit and loss statement are mostly used by small businesses as they usually make transactions using cash. This statement is recorded only when cash is incoming and as liabilities cash is outgoing.
- Accrual method
The accrual method records all types of transactions and money that is earned. While calculating the profit and loss account by the accrual method it is essential to include the accounts receivables too. It has to be included in these accounts even if a business has not received the payment. A similar rule applies to liabilities as well.
Example of a Profit and Loss Statement
Let us imagine, ABC Ltd. is a bakery shop that sells bakery food items. During the year ending in December-2022, the total sales of this shop were ₹1 lakh and its cost of goods sold was ₹45000.
Other expenses of the company were ₹10000 on rent, ₹5000 on utility bills and the salary of its staff was ₹8000.
Profit and loss account of ABC Ltd. will look like this:
|Particulars||Amount (₹)||Amount (₹)|
|Cost of Goods Sold||₹45000|
Why are Profit and Loss Statements Important?
The profit and loss statement is one of the three most important financial statements. The other two important statements are the balance sheet and cash flow statement. It shows a business’s total earned revenues and expenditures over a particular period. Usually, these statements are made for one fiscal year.
The statement is mostly used to determine the profitability of a business. Business owners and investors check the profit and loss account to assess and make well-informed decisions accordingly.
Profit and Loss Statement vs Balance Sheet
- The profit and loss account summarises the results of financial operations for a particular period. It can be monthly, quarterly or annually. Whereas the balance sheet shows the financial position of a business up to a particular date. E.g. Balance Sheet of ABC Ltd. up to 31 December 2022.
- The profit and loss statement provides an overview of the income and expenses of the company. Whereas the balance sheet provides an overview of the current assets, current liabilities and working capital.
- The balance sheet does not change from period to period. In contrast, the profit and loss account changes with each time and over some time.
- With comparative analysis, the profit and loss account allows business owners to identify issues and track the performances and profitability of a business over a period. Contradictorily, if you compare the balance sheet with other statements, it will show the relative stability, liquidity and solvency of the business.
Do All Companies Need to Prepare P&L Statements?
Yes, all publicly traded companies must prepare a profit and loss statement. It helps investors to identify the profitability, growth potential and finances of a business. The statement is important as it provides an overview of the financial operations of a business and makes it transparent. With the help of this statement, business owners can also make informed decisions to improve their business.
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Frequently Asked Questions
What are the components that should not be included in the profit and loss statement?
The profit and loss statement does not include selling or administrative expenses. If you have a service-based business, the P&L account should not include any account of the cost of goods sold.
What are the two most important components of a profit and loss statement?
The two main components of a profit and loss account are revenue and expenses. This statement is prepared by comparing its total revenue against its total expenses. It reflects the company's ability to generate profits and growth potential.
Is it mandatory for companies to prepare a profit and loss account?
Yes, according to the Schedule III of the Companies Act, 2013, it is mandatory for publicly traded companies to prepare a profit and loss account for their stakeholders and investors.
What is the most critical disadvantage of the profit and loss statement?
The most critical disadvantage of this profit and loss account is that it cannot guarantee future success. It shows only the past performance of a business over a period.
Who prepares the profit and loss statement?
Typically, a business owner prepares its profit and loss statement. They can take the help of an accountant to prepare the statement.