The following are the importance of preparing profit and loss account for your small business:
- 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 stats 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 some 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 minds 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 financial statement every company is expected to prepare.
This article is, therefore, focusing on the main features of Profit and Loss account. Its importance can be seen in the later part of this article. Please read on.
Profit and Loss account
The profit and loss account typically begins with the gross profits as contained in the trading account.
Moreover, it can be prepared for any period of time.
In other words, it can be prepared every three, six or 12 months, depending on the needs of your business.
All incomes from various sources must be added to the gross profits.
Examples of items you can see it it include, among others:
- Interests received
- Dividends received
- Rents received
- and lots more
However, there are many other items you can find in it, depending on the industry you belong to.
The general expenses represent all the costs of running your business during the year.
Examples of such expenses items include, among others:
- Salaries and wages
- Printing and stationery
- Transport and traveling expenses
- Depreciation of fixed assets
- And lots more.
At the end of the year, all your business expenses must be deducted from the total income of your business.
Special Notes On Depreciation
In all profit and loss accounts, you will find an item called ‘depreciation of fixed assets’.
Depreciation is usually calculated based on the rates approved by the board of inland revenue.
However, depreciation does not involve cash outflow.
In other words, you do not pay out cash for depreciation.
Sometimes your business can operate at a loss.
However, business losses can be due to poor management or to situations outside your control.
Consequently, if your business sustains a loss, the amount must be deducted from your business capital.
In other words, it reduces the capital of your business.
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 is making profits or not.
Secondly, it can throw up some interesting stats that will help you to make important decisions that can move your business to the next level.
Thirdly, It is like a report card that shows the performance of a pupil in his school work.
Most importantly, it can reveal the results of your business activities.
Profit And Loss Account: Control expenses
Going forward, the profit and loss can help you identify those expenses that eating deep into your margins.
Furthermore, the profit and loss account can help you to know the expense items that can be:
- monitored and controlled
- avoided altogether
- retained because the business needs them to run smoothly
Thus, the profit and loss account is the best place for you to identify unnecessary expenses that are not adding value to your business.
Enables you to make comparisons
The Profit and loss account can provide you with info that will enable you to:
- know whether your business is making profits or not.
- compare this year’s performance with that of the previous year.
- make better plans that can make your business grow
- compare the trading results with similar businesses in your industry.
Most importantly, the result of such comparison will enable you to decide whether are:
- in the right industry
- to the stay
- or move to another industry
Profit And Loss Account: calculate ratios
In particular, the statement will provide you with stats that will enable to calculate important ratios.
An example of such ratios is gross profit to sales.
Beyond that, ratios are helpful for your internal management of your business.
Most importantly, investors and lenders can use them when it is time for them to decide whether or not to do business with you.
Enables you to make better better decisions
The profit and loss account can contain useful data that you can use to make better decisions for your business.
For example, it can enable you to think of how you can improve your profits in the future.
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 well or badly you have managed their investments in your business.
Furthermore, it will enable investors to decide whether to stay with you or move their investment away to where they will get better returns on their investments.
Shows the earning capacity of your business
The profit and loss account is an important documents the investing public and lenders will certainly want to look at.
Moreover, they will want to look at the earnings pattern of your business before they can consider whether or not to fund your business.
Therefore, the profit and loss account is an important statement that you must prepare for your business.
By Samuel Ijenhi
B. Sc. Accounting [University of Benin]
Benin City, Nigeria.
Founder: Ijenhi Business Solutions