Profit and Loss AccountProfit and Loss Account

Introduction Introduction

• The Profit and loss account is one of the thee most The Profit and loss account is one of the thee most important financial statementsimportant financial statements

• It records an organisations’ income and expenses (or It records an organisations’ income and expenses (or revenues and costs)revenues and costs)

• For companies, it is required by the Companies Act For companies, it is required by the Companies Act 19851985

• The P&L Account seeks to determine an organisation’s The P&L Account seeks to determine an organisation’s profit (income less expenses) over a period of timeprofit (income less expenses) over a period of time

• The account is concerned with measuring an The account is concerned with measuring an organisation’s performanceorganisation’s performance

• Profits are central to evaluating the organisation’s Profits are central to evaluating the organisation’s performance – particularly where profit is an important performance – particularly where profit is an important objective of shareholdersobjective of shareholders

Definitions Definitions

• The P&L account is a key financial The P&L account is a key financial statement which represents an statement which represents an organisation’s income less its expenses organisation’s income less its expenses over a period of time and thus over a period of time and thus determines its profitdetermines its profit

• IncomeIncome - revenue earned by a business - revenue earned by a business

• ExpensesExpenses - costs incurred in running a - costs incurred in running a businessbusiness

Profit and Loss AccountProfit and Loss Account

• A Profit and Loss Account (P&L) shows how much A Profit and Loss Account (P&L) shows how much profit or loss (negative profit ) the business has profit or loss (negative profit ) the business has made over the reporting periodmade over the reporting period

• It measures a company’s sales revenue and It measures a company’s sales revenue and expenses over a period, providing a calculation of expenses over a period, providing a calculation of profits or losses during that timeprofits or losses during that time

• It provides the easiest way to tell if a business has It provides the easiest way to tell if a business has made a profit or loss during the last time periodmade a profit or loss during the last time period

• The key figure is net profit after interest and tax-The key figure is net profit after interest and tax-what is left after revenues are used to pay what is left after revenues are used to pay expenses and taxesexpenses and taxes

Why are profits important?Why are profits important?

• Profits are a motivating forceProfits are a motivating force– a reward for risk taking, an incentive for entrepreneurs to take a reward for risk taking, an incentive for entrepreneurs to take

risksrisks– the reward for innovationthe reward for innovation

• Profits provide a financial reward for investorsProfits provide a financial reward for investors– encourage people to lend or invest in business organisationsencourage people to lend or invest in business organisations

• Profits facilitate growthProfits facilitate growth– profitable businesses grow thus creating jobsprofitable businesses grow thus creating jobs– profits are a source for finance for expansionprofits are a source for finance for expansion– profitable businesses have the access to funds to finance growthprofitable businesses have the access to funds to finance growth

• Profits are a measuring rod of performanceProfits are a measuring rod of performance– profits are a measure of the success of a businessprofits are a measure of the success of a business

• Profits play a vital role in allocating resourcesProfits play a vital role in allocating resources– indicates the need for expansion or contractionindicates the need for expansion or contraction– profits ensure production is carried out by the most efficient firmsprofits ensure production is carried out by the most efficient firms

The P&L consists of…The P&L consists of…

• Trading accountTrading account– this is concerned with gross profit or the this is concerned with gross profit or the

profit made on trading activities.profit made on trading activities.

• P&L accountP&L account– this is concerned with net profit or the this is concerned with net profit or the

overall level of profit made by a businessoverall level of profit made by a business

• Appropriation accountAppropriation account– this is concerned with what is done with the this is concerned with what is done with the

profit - how much is distributed to profit - how much is distributed to shareholders and how much is retainedshareholders and how much is retained

Components of the trading and Components of the trading and profit and loss accountprofit and loss accountSalesSales Income earned from selling goodsIncome earned from selling goods

Cost of salesCost of sales The cost of directly providing the salesThe cost of directly providing the sales

Gross profitGross profit Sales less cost of sales. Profit after Sales less cost of sales. Profit after deducting direct costs deducting direct costs

Other incomeOther income Non-trading income which the firm has Non-trading income which the firm has earned e.g. income from investment and earned e.g. income from investment and from sale of fixed assetsfrom sale of fixed assets

Expenses Expenses Indirect costs- overheads such as rent, light Indirect costs- overheads such as rent, light and heatand heat

Net profitNet profit Sales less cost of sales less expenses. Profit Sales less cost of sales less expenses. Profit after deducting all costsafter deducting all costs

A profit and loss account for year A profit and loss account for year endingending 31/3/20XX (£m)31/3/20XX (£m)

Sales revenueSales revenue 18.218.2Less cost of salesLess cost of sales 10.110.1= Gross profits= Gross profits 8.18.1Less overhead expenses Less overhead expenses 5.05.0= Net profits= Net profits 3.13.1Less taxLess tax 1.01.0= Profits after tax= Profits after tax 2.12.1Dividend paidDividend paid 1.51.5Retained profit Retained profit 0.60.6

Cost of salesCost of sales

• Expenditure incurred in producing or providing Expenditure incurred in producing or providing the goodsthe goods

• This is the direct costs that can be attributed to This is the direct costs that can be attributed to sales revenue generated over the trading periodsales revenue generated over the trading period

• The cost of goods actually sold in any periodThe cost of goods actually sold in any period• This excludes the cost of goods left unsold and This excludes the cost of goods left unsold and

all overheads except manufacturingall overheads except manufacturing• Cost of sales equals opening stock plus Cost of sales equals opening stock plus

purchases of stock during the accounting period purchases of stock during the accounting period minus closing stockminus closing stock

• Opening stock is inherited from previous yearsOpening stock is inherited from previous years• Closing stock is bequeathed to future yearsClosing stock is bequeathed to future years

Cost of salesCost of sales

£000£000

Opening stockOpening stock 650650

Stock “inherited” from Stock “inherited” from the previous yearthe previous year

Add purchasesAdd purchases 12201220

Additional stock Additional stock purchasedpurchased

Less closing Less closing stock stock

500500

Stock “bequeathed” to Stock “bequeathed” to the next yearthe next year

Cost of salesCost of sales 13701370

Value of stock used in Value of stock used in generating the incomegenerating the income

The matching principle The matching principle

• The P&L Account matches income earned and The P&L Account matches income earned and expenses incurred during the current yearexpenses incurred during the current year

• Some of the sales during the year in question Some of the sales during the year in question are credit sales - they are included in the P&L are credit sales - they are included in the P&L Account because they occurred during the Account because they occurred during the year even though payment might not be year even though payment might not be received until the next accounting periodreceived until the next accounting period

• Some of the purchases are on credit. Again Some of the purchases are on credit. Again because they are associated with the year’s because they are associated with the year’s sales they are included - even though they are sales they are included - even though they are not paid for until the next accounting periodnot paid for until the next accounting period

Gross ProfitGross Profit

• Equals sales revenue minus cost of salesEquals sales revenue minus cost of sales• Sales revenue/sales /turnover is revenue Sales revenue/sales /turnover is revenue

received from selling goods or servicesreceived from selling goods or services• Cost of sales are costs arising directly from Cost of sales are costs arising directly from

producing or selling goodsproducing or selling goods• Gross profit Gross profit

– tells us how well the firm is trading but is does not tells us how well the firm is trading but is does not take into account all the costs of the firmtake into account all the costs of the firm

– a measure of the gain of the organisation from a measure of the gain of the organisation from buying and sellingbuying and selling

– measures how much was actually made directly measures how much was actually made directly from whatever the business is selling - before it from whatever the business is selling - before it starts to pay for overheadsstarts to pay for overheads

Gross profit and mark upGross profit and mark up

• By looking at sales revenue, cost of sales and gross By looking at sales revenue, cost of sales and gross profit we can calculate the mark up on direct costsprofit we can calculate the mark up on direct costs

• Consider this example from retailing: Consider this example from retailing:

• Sales revenue £600k ,cost of sales £400k giving a Sales revenue £600k ,cost of sales £400k giving a gross profit of £200k.gross profit of £200k.

• The shop added a 50% mark up to the cost of sales. The shop added a 50% mark up to the cost of sales. This made the sales revenue 50% greater than the This made the sales revenue 50% greater than the cost of sales. Gross profit were £200k but cost of sales. Gross profit were £200k but remember we have not yet deducted indirect costsremember we have not yet deducted indirect costs

Expenses Expenses

• These are indirect of overhead costsThese are indirect of overhead costs• They are directly linked to productionThey are directly linked to production• Expenses are divided into:Expenses are divided into:

– selling and distribution costs (including marketing selling and distribution costs (including marketing costs, delivery and distribution)costs, delivery and distribution)

– administration costs (general running of the administration costs (general running of the business including rent, rates, telephone bill)business including rent, rates, telephone bill)

• Most expenses are a result of a cash payment Most expenses are a result of a cash payment or will lead to a cash paymentor will lead to a cash payment

• But depreciation is a non-cash expense. It But depreciation is a non-cash expense. It represents the expense of using a fixed assetrepresents the expense of using a fixed asset

Net profitNet profit

• Net profit is equal to gross profit minus Net profit is equal to gross profit minus all indirect expensesall indirect expenses

• But we are now presented with a variety But we are now presented with a variety of different definitions of net profit:of different definitions of net profit:– Operating profitOperating profit– Profit before interest and taxProfit before interest and tax– Profits before taxProfits before tax– Profits after taxProfits after tax

Operating profits Operating profits

• This is profit from day to day operationsThis is profit from day to day operations• All direct costs and indirect expenses All direct costs and indirect expenses

have been deducted buthave been deducted but– it only concerns profit from normal trading it only concerns profit from normal trading

activitiesactivities– income from other activities such as the sale income from other activities such as the sale

of one off exceptional items and income of one off exceptional items and income from investments are not includedfrom investments are not included

– interest payments/receipts have not been interest payments/receipts have not been taken into accounttaken into account

Financial Reporting Financial Reporting Standard 3Standard 3• To provide stakeholders with a clear To provide stakeholders with a clear

understanding of the future prospects for the understanding of the future prospects for the business, FRS 3 requires that operating profits business, FRS 3 requires that operating profits be broken down into profits from continuing be broken down into profits from continuing operations, profits from acquisitions and operations, profits from acquisitions and profits from discontinued operationsprofits from discontinued operations

• In the year to 2/4/05 Marks and Spencer In the year to 2/4/05 Marks and Spencer enjoyed operating profits ofenjoyed operating profits of– £667m from continuing operations£667m from continuing operations– £10m from acquired operations£10m from acquired operations– £32m from discontinued operations£32m from discontinued operations

Net profitNet profit

• Profit before interest and tax (PBIT) is equal to Profit before interest and tax (PBIT) is equal to operating profits plus net income from other operating profits plus net income from other activities. It is profit after all costs have been activities. It is profit after all costs have been met apart from interest charges and before tax met apart from interest charges and before tax has been paidhas been paid

• If we deduct net interest (interest paid less If we deduct net interest (interest paid less interest received) we profits before tax (PBT)interest received) we profits before tax (PBT)

• After deducting tax we get profits after tax (PAT)After deducting tax we get profits after tax (PAT)• Which measure to use? In terms of shareholder Which measure to use? In terms of shareholder

dividend the key measure is PAT but in terms of dividend the key measure is PAT but in terms of assessing overall profitability it is PBTassessing overall profitability it is PBT

Appropriation accountAppropriation account

• This tells us what happens to the profitsThis tells us what happens to the profits• With all costs covered, profits will used as follows:With all costs covered, profits will used as follows:

– payment of taxation - corporation taxpayment of taxation - corporation tax– payment of dividends to shareholderspayment of dividends to shareholders– retained within the businessretained within the business

• The payment of corporation tax is compulsory and The payment of corporation tax is compulsory and will be deducted before any payment of dividendswill be deducted before any payment of dividends

• Post tax profit is labelled as “profit attributable to Post tax profit is labelled as “profit attributable to shareholders”. It is the amount available to pay shareholders”. It is the amount available to pay out as a a dividendout as a a dividend

• But not all will be paid out - some will be retained But not all will be paid out - some will be retained within the businesswithin the business

Retained profitRetained profit

• After all costs are covered and tax paid we After all costs are covered and tax paid we have profits attributable to shareholder i.e. have profits attributable to shareholder i.e. profits available for distribution in the form of a profits available for distribution in the form of a dividend to shareholderdividend to shareholder

• Directors will decide how much of this will be Directors will decide how much of this will be distributed and how much will be retained in distributed and how much will be retained in the business to finance future activitiesthe business to finance future activities

• For many firms retention of profit is the main For many firms retention of profit is the main source of funds for expansion but directors source of funds for expansion but directors need to balance the need to retain funds with need to balance the need to retain funds with the need to satisfy shareholdersthe need to satisfy shareholders

Profit is not the same as Profit is not the same as cashcash• The P&L records all sale in the period whether or The P&L records all sale in the period whether or

not the firm has received paymentnot the firm has received payment

• It also record all expenditure on inputs It also record all expenditure on inputs associated with sales whether or not payment associated with sales whether or not payment has been madehas been made

• There are also some non-cash items - notably There are also some non-cash items - notably depreciation which is a negative item on the depreciation which is a negative item on the P&L account but there is no cash flow involved.P&L account but there is no cash flow involved.

• Therefore it is possible for a firm to show profit Therefore it is possible for a firm to show profit but still have cash flow problemsbut still have cash flow problems

Profitability Profitability

• Profitability is not the same as profitsProfitability is not the same as profits

• Profit Profit is an is an absolute measureabsolute measure - sales - sales revenue minus costs. It is expressed in revenue minus costs. It is expressed in monetary termsmonetary terms

• ProfitabilityProfitability is a is a relative measurerelative measure - profit - profit relative to what created profit. It is profits relative to what created profit. It is profits relative to sales revenue or profits relative relative to sales revenue or profits relative to the amount of capital invested in the to the amount of capital invested in the business. It is expressed as a percentagebusiness. It is expressed as a percentage

The essence of a P&L accountThe essence of a P&L account

• Sales revenue minus cost of sales = gross profitSales revenue minus cost of sales = gross profit

• Gross profit minus expenses = operating profitGross profit minus expenses = operating profit

• Operating profit plus revenue from other Operating profit plus revenue from other sources = net profit (profit before interest and sources = net profit (profit before interest and tax)tax)

• Net profit minus interest payments = profit Net profit minus interest payments = profit before taxbefore tax

• Profit before tax minus tax = profit after taxProfit before tax minus tax = profit after tax

• Profits after tax minus dividends paid = retained Profits after tax minus dividends paid = retained profitprofit

Example: Marks and Spencer Example: Marks and Spencer

Year to 2/4/05Year to 2/4/05 £m£m

Turnover (sales) Turnover (sales) 77107710

Operating profitsOperating profits 709709

Interest chargesInterest charges 102102

Profit before taxationProfit before taxation 618618

TaxationTaxation 176176

Profit attributable to Profit attributable to shareholdershareholder

442442

Dividends Dividends 203203

Retained profitsRetained profits 239239