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.
