I have, on several occasions, met many business owners some of who asked me “what is profit and loss account”?
Yet another curious person asked me “what is the importance of profit and loss account”?
A good number of business owners get terribly frightened at the mention of word “loss”.
To answer their questions, I usually tell them that the statement is one of the three important parts of annual financial statements that every business is expected to prepare yearly.
However, you can prepare profit and loss account for shorter period of time, depending on the needs of your business.
It will show whether your business made profits or losses at the end of the year.
This article is, therefore, focusing on the structure and importance of profit and loss account and how the contents can help you in decision making.
Profit and loss account: Total income
The profit and loss account typically begins with the gross profits brought down from the trading account section of the financial statements.
It can be prepared be prepared every three, six or 12 months, depending on the needs of your business.
In the statement, incomes from all sources are added to the gross profits to give you total income.
Examples of the items you can find in it include, among others:
- Interests received
- Dividends received
- Rents received
- Profits from sale of fixed assets
- and lots more
Please always bear in mind that the items you can find in many profit and loss accounts may vary from industry to industry.
Therefore, you can follow the practice in the industry you belong to.
The general expenses comprise all the actual costs of running the business during the year.
Examples of such expenses include, among others:
- Salaries and wages
- Transport and traveling expenses
- Printing and stationery
- Transport and traveling expenses
- And lots more.
At the end of the year, the total of general expenses must be deducted from the income for the year.
Profit and loss account: Special Notes On Depreciation
In all profit and loss accounts, you will find an item called ‘depreciation of fixed assets’.
It represents the estimated costs or the amount you would have paid if you were to hire the equipment during the year.
That explains why it is written off to the profit and loss account at the end of the year.
Remember that depreciation does not involve cash outflow.
The Importance of profit and loss account
Firstly, one of the most important advantages of profit and loss account is that it can show the performance of your business during the year.
Secondly, it can throw up some interesting stats that will help you in decision making.
Most importantly, it can reveal the results of your business activities during the accounting period.
Profit And Loss Account: Control expenses
The profit and loss account can help you to identify operating expenses that are sucking your profits.
In particular, you will be able to know:
- The expense items that can be eliminated:
- Those that can be closely monitored and controlled
- Retained because the business needs them to run smoothly
Thus, the profit and loss statement is the best place for you to weed out expenses that are not adding value to your business.
Enables you to make comparisons
In the first place, the Profit and loss account can provide you with info that will enable you to:
- Compare this year’s performance with that of the previous year(s).
- Compare the trading results with similar businesses in your industry
- To evaluate the effectiveness and efficiency of your business and financial management skills.
- Make better plans that can make your business more competitive fast track growth.
Secondly, an In depth analysis of the profit and loss account can even help you to verify whether you are in the right business.
In particular, the statement will provide you with stats that will enable you to calculate important ratios.
An example of such ratios include:
- gross profit to sales
- Earning per share
- Dividend yield.
Most importantly, investors and lenders can use them when it is time for them to decide whether or not to do business with you.
Helps you to make better decisions
The profit and loss account can contain useful data that can help you to make better decisions for your business.
For example, it can enable you to consider:
- Whether to diversify into other businesses or stay where you are
- How to be more competitive in your industry
Keeps employees and shareholders informed
Firstly, your employees might want to know:
- How well the business they work in has performed
- Whether or not the strategies they adopted during the period has yielded the desired results.
Similarly, shareholders will want to know:
- How well or badly you have managed their investments in your business
- Whether or not to stay with you
- Or move their investments to where they will get better returns.
Earning capacity of your business
It is an important document that investing public and lenders will certainly want to look at.
This is because investors will want to look at the earning capacity of your business before they can invest in your business
Similarly, financial institutions will like to evaluate the performance of your business before considering whether to fund your business or not.
More importantly, the statement the most important financial statement that you must prepare for your business.
It is will show you the way to go: the path to profitability and growth.
By Samuel Ijenhi
B. Sc. Accounting [University of Benin]
Benin City, Nigeria.
Founder: Ijenhi Business Solutions