Anatomy of the profit and loss account and balance sheet
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- FUA Team
Together the profit and loss account and balance sheet describe the financial position of a business. The profit and loss account reports sales, expenditure and profit during a given period. The balance sheet shows what the business has and what the business owes on a particular date. It is a snapshot at one given time as opposed to the profit and loss account which includes transactions from a period.
So as an example a company might have a financial year ending in March 2012. The profit and loss account will cover the previous 366 days. The balance sheet will show the position at midnight on the 31 March 2012.
As well as providing a picture of the trading of the business, the profit and loss account and balance sheet are part of the underpinning of the accounting system. Under double entry accounting any transaction is represented by two entries each of which must be correctly categorised to the profit and loss account or balance sheet. Fortunately a good accounting system such as Clear Books will take care of that for you.
Profit and loss account
Example: Profit and loss account for XYZ Limited year ended 31 March 2012
|Cost of sales
|Gross margin 60%
|Profit before tax
|Net margin 15%
|Profit after tax
Notes on the profit and loss account
Also referred to as revenue or turnover. Stated net of VAT.
|Cost of sales
These are all the costs that vary directly with sales. So a cost included in cost of sales would be expected to double if sales doubled and be cut in half if sales were reduced by a half. A good example would be the purchase cost of goods sold for a retail business. Other examples are:
Frequently businesses have no cost of sales as there are no costs which directly vary with the level of sales. For instance in a software development business the software can be sold either once or a million times without affecting the development cost.
This is sales minus cost of sales. The gross profit is sometimes referred to as a contribution to paying the fixed costs.
This is the gross profit divided by the sales. The higher this is the better. The gross margin does not change when sales increase or decrease. If the gross margin increases then it is due either to an increase in sales price or a decrease in direct costs. In the above example the gross margin is 60% being £60,000 gross profit divided by £100,000 sales.
Sometime gross margin is confused with the markup. Markup is the percentage in a trading business that is added to the purchased goods cost to reach a sales price. The markup in the above example would be 150%. It is calculated as £40,000 direct costs x 150% = £100,000 sales value.
The admin expenses are all the expenses which do not vary directly with the sales. The expenses could be fixed or semi-fixed. So if sales double and the related expense is not expected to double then it will be categorised as an admin expense.
Depreciation is the profit and loss account cost of fixed assets.
Fixed assets are the things bought by a business to use in its trade rather than to be sold as a part of the trade. So for a traditional manufacturing business its fixed assets would certainly include plant and equipment and also potentially land and premises. For a software business in rental offices the fixed assets would more likely include office furniture and software licences.
In accounting buying a fixed asset does not automatically lead to a profit and loss account cost. However over time the fixed asset will wear out or become outdated so over the period of its life then the original cost needs to be charged to the profit and loss account. This is achieved via a depreciation charge which is made to reduce the value of the fixed asset in the balance sheet and include the depreciation cost in the profit and loss account on a regular basis.
Depreciation is often looked at separately because it is a non cash expense. So for example most other costs such as wages or rent or utilities bear some relation to the cash spent during the year. However the depreciation charge may relate to an asset that was purchased several years previously. Therefore although it has reduced profit the cash being generated by the business will not be affected. So a business with low looking profits but a high depreciation charge may actually be trading strongly.
A good example of this is the cable business Virgin Media. They showed very modest profits or losses in some recent years. However they have a huge depreciation charge for the investment made in their cable network which was built several years ago. Therefore they are making £100’s millions of cash profit in each year.
This represents interest paid on loans. It is often listed separately because the interest expense does not reflect on the trading of the business rather the way it is being financed. So in analysing a business sometimes the interest paid will be added back to the profit before tax to show a profit before interest and tax.
In early 2012 Peacocks a large high street retailer went into administration after incurring significant losses. Looking more closely at the financial results it was possible to see that the company was generating profits before interest (although these profits were perhaps not as large as they should have been due to moderate margins). Subsequently the majority of the business was sold to another company.
In summary the profit generated before interest and tax showed that it was a viable business - hence we should not be surprised the majority of the business was sold. The fact that after interest the business was making a significant loss was evidence that the company had borrowed too much money. This is often referred to as “overgearing”.
|Profit before tax
Profit after taking off all the other expenses except tax.
Calculated as profit before tax/sales. This is often seen as a key indicator of the overall performance of a company against expected industry standards. Different industries expect very different net margins. For instance a good retail margin is 5%. In investment banking it might be closer to 30%.
Note that there are a large number of factors affecting net margin - all those affecting gross margin plus the fact that an increase in volume of sales will increase the net margin because some costs are fixed.
Note this is corporation tax. (So not sales tax such as VAT or payroll tax such as employers NI).
|Profit after tax
Final profit after all deductions. Note that sometimes a net profit margin can be stated based on profit after tax.
Dividends are paid out of profit after tax. The dividend account acts as part profit and loss account and part balance sheet account. It does not affect any element of the trading profit or the profit chargeable to corporation tax. Once the dividend is paid the remaining amount is the retained earnings. This is the amount transferred to the balance sheet.
Distributions from partnerships known as drawings have similar characteristics to dividends.
The balance sheet is a statement of assets and liabilities at a given point in time.
- Assets are things you have or are owed to you. Assets are good things.
- Liabilities generally are the things that you owe. Liabilities are bad things.
The balance sheet has a top part and a bottom part - and they must be equal. The top half is the statement of assets and liabilities. This must be equal to the bottom half which sets out the total capital and reserves.
Example: Balance sheet for XYZ Limited at 31 March 2012
|Assets & Liabilities
|Fixed assets - tangible
|Plant & equipment
|Prepayments and accrued income
|Cash at bank
|Accruals and deferred income
|Long term liabilities
|Capital and Reserves
|Total capital and reserves
Notes about the balance sheet:
These are assets used in the trade of the business not resold as part of the business. Fixed assets can be described as tangible (they physically exist) or intangible (intellectual or legal rights having ongoing value but no physical existence).
Tangible fixed assets include:
Intangible fixed assets include:
Fixed assets are initially stated at their purchase price. As they continue in use they are stated at “written down value” being cost less accumulated depreciation.
Depreciation is calculated each year to spread the purchase value of the fixed asset over its useful life. There are a number of ways of calculating the charge each year. The most straightforward is the straight line method where an equal amount is charged each year.
So for an asset purchased for £100 with an estimated 5 years of useful life each year there will be a depreciation charge of £100/5 = £20. That means that every year for 5 years there will be a depreciation charge of £20 to the profit and loss account.
In the balance sheet the accumulated depreciation is deducted from the purchase cost to show the asset value. So at the end of the first year the asset will have a balance sheet value of £100 - 1 x £20 = £80 at the end of the second year £100 - 2 x £20 = £60 until at the end of the fifth year the written down value will be zero.
The charge used to write down intangible assets is known as amortisation rather than depreciation. It is comparable to depreciation in all other respects.
These are assets which are either cash or can be readily converted to cash.
These are liabilities payable within one year.
|Long term liabilities
These are liabilities due after one year. A bank loan is the most common example. For annual statutory accounts a bank loan will be split into the amount that is repayable within the next year as a current liability and the amount repayable after that time as a long term liability.
|Capital and reserves
This is the bottom half of the balance sheet. Generally it is less intensively used and scrutinised than the top half. It represents the shareholder financing of the business. As such it contains the share capital and the retained profits.
The share capital represents the amounts originally paid for shares issued by the business.
The retained profit is the cumulative profits of the business as calculated from the sum of the retained profits of the business over the period of its operation.