Posted: Wed 23rd Oct 2019
Understanding profit and loss reports is essential for creating a sustainable business. We look at how to produce your first report and understand how much money your business has made.
Businesses normally aim to generate profits. You may be able to improve your cashflow by borrowing money or getting investment, but net profit - the amount left over after all the expenses of running a business - provides the clearest picture of how well the business is doing.
"Profit and loss compares your revenue against your expenses," Ahmed Cliffords, owner of Ahmed-Clifford's Chartered Accountants, explained. "If you made £10,000 from selling widgets and incurred £5,000 buying them and £2,000 of expenses such as rent, your net profit is £3,000."
Profit and loss accounts cover a specific period. The minimum requirement for limited companies is to create one at your year-end. However, you could look at the report every six months or monthly.
The frequency depends on how it will impact your decision making and how complicated it is to create. If you're using accounting software like Xero or QuickBooks the report can be produced in a matter of minutes.
"The regularity depends on how big the business is," said Yarka Krajickova, Enterprise Nation member and Red Money Accounting founder. "Under £40,000 turnover, you could get away with quarterly, above that it should be monthly. It gives you a picture of the business as it is and will help you understand how to grow."
Whatever period you choose to cover, it's really helpful to get into a regular routine. The better you know the performance of your business the better informed decisions you can make.
The requirements for creating a profit and loss report depend on how you've registered your business.
"If you're running a limited company, there's a compulsory requirement to produce financial statements for the tax office and Companies House. If you're a sole trader or partnership the requirement is not that stringent, although you have to create a profit and loss to complete your self-assessment," Cliffords said.
If you want to get a finance facility like a loan or overdraft the provider may require you to produce a profit and loss statement.
The report starts by showing income. If your business does more than one thing you can break this down into income lines for the different types of thing you sell. This helps you understand the profitability of different aspects of the business and where you should spend your energy. For example, if you run an IT company you might divide income into hardware sales and repairs.
The section records the money you spend creating the product or service. This is called cost of sales or cost of goods sold (COGs). Common items include manufacturing and packaging, transportation etc. Because the cost relates directly to producing the product, the costs normally change based on the amount sold.
If you're VAT registered, the profit and loss report doesn't include VAT. It's something you're collecting on behalf of the government.
"Nowadays, there are so many software packages that allow you to measure COGs and create the report at any point in time," said Cliffords. "Most are not very user friendly. The problem is if you put garbage in, you get garbage out."
Clifford stressed the last point - you need to keep on top of your bookkeeping to make sure you get the right insights.
A company's gross profit is their sales minus the cost of goods sold. Krajickova suggests comparing the gross profit between different months.
"It's really good to see how the COGs has performed. Have you spent more or less and why?" she said. "When you start your business you don't know the charges. After a while you get a feel for it, is it too much? Should you be looking for another supplier?
This records the day-to-day expenses a business incurs that are not directly related to the production of a good or service. Common operating expenses include rent, marketing and payroll.
The final part of the profit and loss report is the net profit. This shows how much money the business has made after all the expenses it has incurred.
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Krajickova said that if you're a small, straightforward company with no loans, you can create a profit and loss in Excel or another piece of accounting software. However, all businesses will have to file their accounts to HMRC digitally by April 2021. At that point, everyone will have to use some kind of software.
Accounting software is relatively user-friendly and can allow you to create these kinds of reports automatically. It's worth watching tutorial videos and reading the help articles of the provider you choose, particularly if you don't have an accountant to help set everything up.
"There are lots of people who are switched on enough to do it themselves. If they're not, they mustn't be afraid to ask for help," Krajickova said.
Whatever method you choose for creating a profit and loss report, it's important to think about it when you start a business.
"Don't wait 18 months to do your accounts or contact an accountant. Things will be more expensive and the data won't be there," Krajickova said. "When people start a business they should look at it. Accountants have a good idea of the expenses a business should have and getting advice can help."
Cliffords echoed the statement and pointed out that most accountants will offer a small amount of free advice.
"Most accountants offer free advice, such as ICAEW's Business Advice Service members, we're more than happy to help free of charge to understand how to do it."
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