Profit and Loss Account

Introduction The Profit and loss account is one of the thee most important financial statements The Profit and loss account is one of the thee most important financial statements It records an organisations’ income and expenses (or revenues and costs) It records an organisations’ income and expenses (or revenues and costs) For companies, it is required by the Companies Act 1985 For companies, it is required by the Companies Act 1985 The P&L Account seeks to determine an organisation’s profit (income less expenses) over a period of time The P&L Account seeks to determine an organisation’s profit (income less expenses) over a period of time The account is concerned with measuring an organisation’s performance The account is concerned with measuring an organisation’s performance Profits are central to evaluating the organisation’s performance – particularly where profit is an important objective of shareholders Profits are central to evaluating the organisation’s performance – particularly where profit is an important objective of shareholders

Definitions The P&L account is a key financial statement which represents an organisation’s income less its expenses over a period of time and thus determines its profit The P&L account is a key financial statement which represents an organisation’s income less its expenses over a period of time and thus determines its profit Income - revenue earned by a business Income - revenue earned by a business Expenses - costs incurred in running a business Expenses - costs incurred in running a business

Profit and Loss Account A Profit and Loss Account (P&L) shows how much profit or loss (negative profit ) the business has made over the reporting period A Profit and Loss Account (P&L) shows how much profit or loss (negative profit ) the business has made over the reporting period It measures a company’s sales revenue and expenses over a period, providing a calculation of profits or losses during that time It measures a company’s sales revenue and expenses over a period, providing a calculation of profits or losses during that time It provides the easiest way to tell if a business has made a profit or loss during the last time period It provides the easiest way to tell if a business has made a profit or loss during the last time period The key figure is net profit after interest and tax-what is left after revenues are used to pay expenses and taxes The key figure is net profit after interest and tax-what is left after revenues are used to pay expenses and taxes

Why are profits important? Profits are a motivating force Profits are a motivating force –a reward for risk taking, an incentive for entrepreneurs to take risks –the reward for innovation Profits provide a financial reward for investors Profits provide a financial reward for investors –encourage people to lend or invest in business organisations Profits facilitate growth Profits facilitate growth –profitable businesses grow thus creating jobs –profits are a source for finance for expansion –profitable businesses have the access to funds to finance growth Profits are a measuring rod of performance Profits are a measuring rod of performance –profits are a measure of the success of a business Profits play a vital role in allocating resources Profits play a vital role in allocating resources –indicates the need for expansion or contraction –profits ensure production is carried out by the most efficient firms

The P&L consists of… Trading account Trading account –this is concerned with gross profit or the profit made on trading activities. P&L account P&L account –this is concerned with net profit or the overall level of profit made by a business Appropriation account Appropriation account –this is concerned with what is done with the profit - how much is distributed to shareholders and how much is retained

Components of the trading and profit and loss account Sales Income earned from selling goods Cost of sales The cost of directly providing the sales Gross profit Sales less cost of sales. Profit after deducting direct costs Other income Non-trading income which the firm has earned e.g. income from investment and from sale of fixed assets Expenses Indirect costs- overheads such as rent, light and heat Net profit Sales less cost of sales less expenses. Profit after deducting all costs

A profit and loss account for year ending 31/3/20XX (£m) Sales revenue 18.2 Less cost of sales 10.1 = Gross profits 8.1 Less overhead expenses 5.0 = Net profits 3.1 Less tax 1.0 = Profits after tax 2.1 Dividend paid 1.5 Retained profit 0.6

Cost of sales Expenditure incurred in producing or providing the goods Expenditure incurred in producing or providing the goods This is the direct costs that can be attributed to sales revenue generated over the trading period This is the direct costs that can be attributed to sales revenue generated over the trading period The cost of goods actually sold in any period The cost of goods actually sold in any period This excludes the cost of goods left unsold and all overheads except manufacturing This excludes the cost of goods left unsold and all overheads except manufacturing Cost of sales equals opening stock plus purchases of stock during the accounting period minus closing stock Cost of sales equals opening stock plus purchases of stock during the accounting period minus closing stock Opening stock is inherited from previous years Opening stock is inherited from previous years Closing stock is bequeathed to future years Closing stock is bequeathed to future years

Cost of sales £000 £000 Opening stock Stock “inherited” from the previous year Add purchases Additional stock purchased Less closing stock Stock “bequeathed” to the next year Cost of sales Value of stock used in generating the income

The matching principle The P&L Account matches income earned and expenses incurred during the current year The P&L Account matches income earned and expenses incurred during the current year Some of the sales during the year in question are credit sales - they are included in the P&L Account because they occurred during the year even though payment might not be received until the next accounting period Some of the sales during the year in question are credit sales - they are included in the P&L Account because they occurred during the year even though payment might not be received until the next accounting period Some of the purchases are on credit. Again because they are associated with the year’s sales they are included - even though they are not paid for until the next accounting period Some of the purchases are on credit. Again because they are associated with the year’s sales they are included - even though they are not paid for until the next accounting period

Gross Profit Equals sales revenue minus cost of sales Equals sales revenue minus cost of sales Sales revenue/sales /turnover is revenue received from selling goods or services Sales revenue/sales /turnover is revenue received from selling goods or services Cost of sales are costs arising directly from producing or selling goods Cost of sales are costs arising directly from producing or selling goods Gross profit Gross profit –tells us how well the firm is trading but is does not take into account all the costs of the firm –a measure of the gain of the organisation from buying and selling –measures how much was actually made directly from whatever the business is selling - before it starts to pay for overheads

Gross profit and mark up By looking at sales revenue, cost of sales and gross profit we can calculate the mark up on direct costs By looking at sales revenue, cost of sales and gross profit 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 gross profit of £200k. Sales revenue £600k,cost of sales £400k giving a gross profit of £200k. The shop added a 50% mark up to the cost of sales. This made the sales revenue 50% greater than the cost of sales. Gross profit were £200k but remember we have not yet deducted indirect costs The shop added a 50% mark up to the cost of sales. This made the sales revenue 50% greater than the cost of sales. Gross profit were £200k but remember we have not yet deducted indirect costs

Expenses These are indirect of overhead costs These are indirect of overhead costs They are directly linked to production They are directly linked to production Expenses are divided into: Expenses are divided into: –selling and distribution costs (including marketing costs, delivery and distribution) –administration costs (general running of the business including rent, rates, telephone bill) Most expenses are a result of a cash payment or will lead to a cash payment Most expenses are a result of a cash payment or will lead to a cash payment But depreciation is a non-cash expense. It represents the expense of using a fixed asset But depreciation is a non-cash expense. It represents the expense of using a fixed asset

Net profit Net profit is equal to gross profit minus all indirect expenses Net profit is equal to gross profit minus all indirect expenses But we are now presented with a variety of different definitions of net profit: But we are now presented with a variety of different definitions of net profit: –Operating profit –Profit before interest and tax –Profits before tax –Profits after tax

Operating profits This is profit from day to day operations This is profit from day to day operations All direct costs and indirect expenses have been deducted but All direct costs and indirect expenses have been deducted but –it only concerns profit from normal trading activities –income from other activities such as the sale of one off exceptional items and income from investments are not included –interest payments/receipts have not been taken into account

Financial Reporting Standard 3 To provide stakeholders with a clear understanding of the future prospects for the business, FRS 3 requires that operating profits be broken down into profits from continuing operations, profits from acquisitions and profits from discontinued operations To provide stakeholders with a clear understanding of the future prospects for the business, FRS 3 requires that operating profits be broken down into profits from continuing operations, profits from acquisitions and profits from discontinued operations In the year to 2/4/05 Marks and Spencer enjoyed operating profits of In the year to 2/4/05 Marks and Spencer enjoyed operating profits of – £667m from continuing operations –£10m from acquired operations –£32m from discontinued operations

Net profit Profit before interest and tax (PBIT) is equal to operating profits plus net income from other activities. It is profit after all costs have been met apart from interest charges and before tax has been paid Profit before interest and tax (PBIT) is equal to operating profits plus net income from other activities. It is profit after all costs have been met apart from interest charges and before tax has been paid If we deduct net interest (interest paid less interest received) we profits before tax (PBT) If we deduct net interest (interest paid less 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 dividend the key measure is PAT but in terms of assessing overall profitability it is PBT Which measure to use? In terms of shareholder dividend the key measure is PAT but in terms of assessing overall profitability it is PBT

Appropriation account This tells us what happens to the profits This 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 tax –payment of dividends to shareholders –retained within the business The payment of corporation tax is compulsory and will be deducted before any payment of dividends The payment of corporation tax is compulsory and will be deducted before any payment of dividends Post tax profit is labelled as “profit attributable to shareholders”. It is the amount available to pay out as a a dividend Post tax profit is labelled as “profit attributable to shareholders”. It is the amount available to pay out as a a dividend But not all will be paid out - some will be retained within the business But not all will be paid out - some will be retained within the business

Retained profit After all costs are covered and tax paid we have profits attributable to shareholder i.e. profits available for distribution in the form of a dividend to shareholder After all costs are covered and tax paid we have profits attributable to shareholder i.e. profits available for distribution in the form of a dividend to shareholder Directors will decide how much of this will be distributed and how much will be retained in the business to finance future activities Directors will decide how much of this will be distributed and how much will be retained in the business to finance future activities For many firms retention of profit is the main source of funds for expansion but directors need to balance the need to retain funds with the need to satisfy shareholders For many firms retention of profit is the main source of funds for expansion but directors need to balance the need to retain funds with the need to satisfy shareholders

Profit is not the same as cash The P&L records all sale in the period whether or not the firm has received payment The P&L records all sale in the period whether or not the firm has received payment It also record all expenditure on inputs associated with sales whether or not payment has been made It also record all expenditure on inputs associated with sales whether or not payment has been made There are also some non-cash items - notably depreciation which is a negative item on the P&L account but there is no cash flow involved. There are also some non-cash items - notably depreciation which is a negative item on the P&L account but there is no cash flow involved. Therefore it is possible for a firm to show profit but still have cash flow problems Therefore it is possible for a firm to show profit but still have cash flow problems

Profitability Profitability is not the same as profits Profitability is not the same as profits Profit is an absolute measure - sales revenue minus costs. It is expressed in monetary terms Profit is an absolute measure - sales revenue minus costs. It is expressed in monetary terms Profitability is a relative measure - profit relative to what created profit. It is profits relative to sales revenue or profits relative to the amount of capital invested in the business. It is expressed as a percentage Profitability is a relative measure - profit relative to what created profit. It is profits relative to sales revenue or profits relative to the amount of capital invested in the business. It is expressed as a percentage

The essence of a P&L account Sales revenue minus cost of sales = gross profit Sales revenue minus cost of sales = gross profit Gross profit minus expenses = operating profit Gross profit minus expenses = operating profit Operating profit plus revenue from other sources = net profit (profit before interest and tax) Operating profit plus revenue from other sources = net profit (profit before interest and tax) Net profit minus interest payments = profit before tax Net profit minus interest payments = profit before tax Profit before tax minus tax = profit after tax Profit before tax minus tax = profit after tax Profits after tax minus dividends paid = retained profit Profits after tax minus dividends paid = retained profit

Example: Marks and Spencer Year to 2/4/05 £m £m Turnover (sales) Operating profits Interest charges Profit before taxation Taxation Profit attributable to shareholder Dividends Retained profits