Monday, 27 May 2013

Accounting Statements: Profit and Loss

As I said in the introduction to accounting statements, the profit and loss (P&L) statement provides an historical picture of how our business has performed over a given time period. It is calculated annually, at the end of a financial year, but may also be calculated on a monthly basis if we wish to have more detailed knowledge of how we are doing.

The financial year is not necessarily the same as the calendar year (January to December), although in some countries, it is exactly that. In UK, a limited company may use any year end date they wish, although 31st March is the most common one since it co-incides with the tax year. Whichever year end we pick, we still have to fit in with the HMRC timetable for PAYE, National Insurance and tax returns, all of which operate on the year April to March. If we are self-employed, our year end will be 5th April, in line with the individual tax year which starts on 6th April each year.

If we do want monthly statements, then we are probably at the point where a computerised system is appropriate. It is not a necessary part of running a business to know how to construct financial statements, but it is essential that we know how to interpret these statements and understand what they are telling us. That’s the aspect from which I’m approaching these articles.
In previous articles, we’ve already looked at the P&L equation: I (total income) - E (total expenditure) = profit (if I is bigger than E) or loss (if E is bigger than I). This time, we’re going to look at this in a little more detail and cover five lines on the statement instead of the three quoted above.
Total Income

As the term suggests, this is the total amount of money that has been invoiced in the year. Note the use of the word ‘invoiced’. It’s more than likely that not all the money has been received yet, especially for any invoices raised in the last month, but everything earned in a financial year should be accounted for. Total income is also sometimes called Turnover, Revenue or Sales. It is a measure of the total amount of business we have done in the year.
Direct Expenses

This is the expenditure incurred directly in doing the business measured above. It is the cost of printing our book (but we can only include the cost of copies that have actually been sold); the postage for distribution of specific copies of our book; the travel costs incurred in presenting a training course or a paid-for appearance. We should ask ourselves the question: would those costs have been incurred if that piece of work had not been carried out. If the answer is ‘no’, then those are direct expenses. They are also sometimes called Variable Costs since they vary with the level of business or the Cost of Goods Sold.
Gross Profit

When direct expenses are deducted from total income, the resulting figure is called gross profit. In traditional businesses like manufacturing, it is a measure of how efficiently labour and materials are utilised. In our writing business, we don’t include labour costs unless we sub-contract out a specific piece of work, so it’s a measure of how efficiently we use the materials and other resources that go into generation of our income. There is no right answer to the question: what is a good percentage gross profit; it varies with circumstances and the type of business. However, I would suggest it should always be a positive number. In other words, we should always generate a gross profit, no matter how small, in our business. Otherwise, we might as well set fire to our money or (preferably) give it away. There may be times when we choose to sell our goods or services at cost (for example if we speak at an event for expenses only ) or even make a loss (for example by donating copies of our books for a raffle) but that’s not a sustainable business model in the long-term.
Indirect Expenses

There are all sorts of other expenses we incur running our business but which cannot be associated directly with any one income stream. For example, the cost of running our office, whether it is part of a serviced building or our back bedroom; marketing costs (business cards, book marks, adverts); Internet and phone charges; and most important of all, what we pay ourselves. We should ask ourselves the question: would those costs have been incurred even if no work had been carried out. If the answer to this question is ‘yes’, then we are looking at an indirect cost. They are sometimes called Fixed Costs or Overheads since they are independent of the level of business.
Net Profit

When the indirect expenses are subtracted from the gross profit, the resulting figure is called net profit.  Mathematically, the same figure is obtained by subtracting total costs (direct and indirect) from total income. So net profit, which is sometimes referred to as bottom line, is a measure of the overall success of the business in financial terms (I fully accept there are other ways of measuring success).  In formal company accounts, net profit is further sub-divided into net profit before tax and net profit after tax. I’m not going to go into tax, as it’s a highly complex area, apart from making the point that while not all income will be taxable, not all expenses will be tax-deductible. This is an area where I believe it pays to take expert advice.
Unlike gross profit, it is very likely that in the early years of a business, net profit will actually be a negative figure (more correctly called net loss) and so long as we have funding available to cover the short-fall, that’s perfectly acceptable. And that’s where cash-flow comes in. We’ll talk about that next time.

As always, note that I am not an accountant or a lawyer, just a long-term business owner, talking about my own experience. If you are unsure about anything, always take advice from an appropriate professional.

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