The following are the importance of preparing profit and loss account for your small business:
- Contents of Profit and Loss Account
- General Expenses
- Special Note on Depreciation of fixed assets
- Importance of Profit and Loss Account
- Enables you to control expenses
- Provides info to enable you make comparisons
- Generate Data to enable you calculate ratios
- Helps you to make better decisions
- Keep employees and shareholders informed
- Shows the earning capacity of your business
I have, on several occasions, met many small business owners many of who asked me “what is profit and loss account”?
Many of them say they do not understand:
- its features,
- how to analyze it
- and its importance.
I have also observed that even the mere mention of “loss” drives fear into the spines of some business people.
Their concern is understandable because no business owner wants to incur losses in his business.
To answer their question I usually tell them that profit and loss account is a very important and an integral part of annual financial statements that every company is required by company’s law to prepare.
Furthermore, profit and loss account should disclose:
- Total Income
- Total expenses
- Net profit
- Net loss, if any
The profit and loss account of your business can be prepared for any given period of time: quarterly, semi annually and annually depending on the needs of your business.
This article, therefore, seeks to highlight the basic features of Profit and Loss account. It is hoped that you will find some useful insights below.
Content of Profit and Loss account
The profit and loss account typically begins with the gross profits brought down from the trading accounts.
Incomes from all sources are usually added to the gross profit to give you Total income.
Examples include, among others:
- Interests received or receivable.
- Dividends received
- Rents received or receivable
- Profits received from extra ordinary activities such as sale of fixed assets, shares etc.
- Profit from foreign exchange transactions
Please take note that the above are just a few of the many items that can be added to the gross profit.
What you can add depends on the practice in the industry you find yourself.
All the expenses incurred by your business during the year should be totalled and debited to your Profit and Loss Account a
Note also that items you can find in any Profit and Loss account will usually depend on the standard practices in the industry you are in.
For example, if you are into mining, oil and gas words and terms you will see in their profit and loss account will be different from those you can find in profit and loss account of a bank.
However, there are many items of expenses that you can find in all profit and loss accounts.
- Salaries and wages
- Printing and stationery
- Transport and traveling expenses
- Loss on sale of fixed assets
- Loss on sale of investments
- Depreciation of fixed assets
- And lots more.
What you get after deducting all business expenses is known as Total Income.
Special Notes On Depreciation
In all profit and loss accounts you will find an item called depreciation of fixed assets.
Depreciation is usually included in the profit and loss account because of the wears and tears that occurred while your business used them in generating revenue.
Thus Depreciation reduces the value of the assets concerned.
However, depreciation does not involve cash outflow. In other words, you do not pay out cash for depreciation.
Going forward, the total expenses of running your business, including depreciation, should be deducted from Total Income.
The balance represents your net profits for the year. Thus, Total Income minus Total Expenses = Net profit.
The net profit is subsequently added to the capital of your business.
Thus, if your small business continues to make profits yearly, your business will continue to grow.
It can happen that in a particular year, your business will operate at a loss.
Loss report can be due to management inefficiency or due to circumstances beyond your control.
Operating losses occur when your business Total Expenses exceed your Total Income.
In other words, Expenses > Revenue = loss
When your business operates at a loss, the loss should be deducted from the capital of your business. Thus, it reduces the capital of your business.
The effect of trading losses is that if it continues for a long period of time, your small business can shutdown.
The Importance of Profit and Loss Account
Firstly, one of the most important benefits of the Profit and Loss Account is that the statement can disclose whether your business made a profit or loss during the year.
If you made a profit, you should try to identify the products that resulted in high sales.
You can tap more into those products with a view to getting higher profits in future.
On the other hand, those products that performed below average, you can work on them so they can perform better in the future.
Helps to control expenses
Going forward, you can identify the expense items that are eating deep into your profit margins.
Furthermore, you can track those costs items that can be:
- Strictly controlled
- Avoided outright
- Retained because the business needs them to run smoothly
Thus, the profit and loss account is the best place for you to track down the costs of running your business.
Enables you to make comparisons
The Profit and loss account can provide you with a basis to compare the performance of your business during the current year with that of the previous year.
Moreover, this will help you to investigate any differences that may exist between the two financial statements.
Furthermore, you can also compare the performance of your business with similar businesses in your industry.
The outcome of your comparison will enable you know whether you actually belong to the industry or you are just sitting on the fence.
Generates data to enable you calculate ratios
In particular, the statement will provide you with the best possible data to calculate useful ratios.
Ratios are useful because when it is time for you to seek funding from banks and investors, it those ratios that will guide them in decision making.
Enables you to make better better decisions
More importantly, the data generated by the P & L account will enable you to make far reaching decisions that can move your business to the next level.
Keeps employees and shareholders informed
Your employees might want to know how well the business they work in has performed.
Similarly, shareholders will want to know how you have managed their resources.
This will enable investors to decide whether to divest or to stick with your business.
Shows the earning capacity of your business
In the same vein, the investing public and lenders will certainly want to look at the earning capacity and profitability of your business before they can grant you access to funding.
By Samuel Ijenhi
B. Sc. Accounting [University of Benin]
Benin City, Nigeria