A profit and loss statement is a document that shows how the revenue of a business is turned into the net income of a business.
A profit and loss account statement is the main indicator of a company's financial well-being. It is an important and crucial document needed by any company to acquire financing and pitch for investments. The statement gives the potential investor or bank a sneak peek into how your company has been performing and its future potential.
There are other basic accounting concepts crucial to understanding a profit and loss account.
What is a Profit and Loss Balance Sheet?
A profit and loss statement or a profit and loss account in the balance sheet summarises the revenues, costs, and expenses that were incurred by a company in a specific fiscal period, usually a year or a quarter. This account is very important in analyzing the business's earning potential and feasibility for sustenance in the future.
There are other common terms assigned to a profit and loss account like an income statement, or statement of operations, or statement of financial results, or an income and expense statement. All of them refer to the one and the same thing.
Learn more about other key terms of accounting.
The profit and loss statement, along with the balance sheet and cash-flow statement are the three pillars of financial accounting for an organization. While the P&L statement and cash-flow statements are quite similar in their characteristics, the balance sheet is slightly different.
Difference Between Profit and Loss Account and Balance Sheet
The primary difference between a balance sheet and a P&L account is that the former gives a detailed account of a company's assets, liabilities, and equity, while the latter is dedicated exclusively to earnings and expenses. Other key differences between the two include:
- The balance sheet reflects data at a particular date as against the P&L account's representation over a period of time.
- While balance sheets are usually prepared on the last day of the financial year, the profit and loss account is maintained throughout the year.
- Accounts, once transferred to a profit and loss account, lose their identity and cease to exist. In a balance sheet, accounts are rolling and show as opening balance at the beginning of each succeeding fiscal year.
- The balance sheet is the final stage of financial accounting in a fiscal year. By virtue of this, they are prepared after the profit and loss accounts are done.
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Profit and Loss Account and Balance Sheet Examples
A P&L account can include the following types of expenses and earnings:
- Revenue or gross profits.
- Sales of goods and services.
- Administrative costs.
- Marketing and business development expenses.
- Depreciation costs.
- Investment in technology.
- Interests earned and paid.
- Tax liabilities.
- Net income.
- Salaries and resource fees.
Accounting software makes it easy to prepare these account statements.
A profit and loss statement is derived from the basic accounting principles of revenue recognition, matching, and accruals. Comparing P&L statements over different time periods is a useful exercise that most businesses engage in to draw insights and analyses for future business decisions.
The components included in a balance sheet constitute:
- Assets or anything that the company owns like property or equipment.
- Liabilities or everything that the company owes in the form of loans, taxes, etc.
- Shareholders' equity.
Find out more useful examples of profit and loss accounts and balance sheets.
Understanding a Profit and Loss Statement Correctly
In order to fully understand the meaning and significance of a profit and loss statement, it is important to familiarize yourself with the different sections in the account. The following are the various sections of a P&L statement:
- Revenue: This is the first thing you will notice in a P&L statement. All the money that flows into the company account, whether a corporation or a non-profit organization is captured under this head.
- Direct Costs: These are the costs incurred by the company in manufacturing the final product or offering a specific service to the market. Some examples would be the cost of equipment to manufacture a bicycle wheel.
- Gross Margin: The difference between revenue and direct costs will give you the gross margin. This is the money left over for business after covering the costs of production.
- Operating Expenses: These are mainly rolling expenses that you would incur on a regular basis like rent on property or telephone and internet bills.
- Operating Income: This is the total income earned before paying for taxes, interests, and depreciation.
- Depreciation: All assets are subject to wear and tear, which results in them losing their value. This is captured in the depreciation costs.
- Taxes: Any legal entity like a business or a company or an organization or even an individual is mandated by law to pay taxes
- Net profit: The money that you are left with after deducting your costs and operating expenses, including taxes, will give you the net profit. This is the bottom line of a P&L statement.
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Drafting a Profit and Loss Statement
A P&L statement is a business requirement, whether you own a big corporation or work as an accountant at an NGO. Hence, learning how to prepare this document is only going to add to your advantage in terms of productivity and efficiency. You can take some inspiration from the double-entry bookkeeping system.
The first order of business requires you to gather certain documents and put together different pieces of information from all corners of the business. These include the following:
- The entire list of financial transactions or money flowing in and out of the company's current account.
- All purchases booked under the company credit card.
- Detailed bills and receipts of cash transactions, including petty cash.
- All sources of income such as checks, credit cards, and payments that can easily be found on the company's bank statement.
Once you have got the challenging task of gathering documents out of the way, you can simply follow these steps to arrive at the P&L statement:
- Enlist business revenue for each quarter of the year.
- Calculate business expenses for each corresponding quarter.
- Determine the difference between sales and costs to arrive at the net earnings.
- The next item to be noted down is the interest paid for debts.
- Calculate tax liabilities.
- Calculate total depreciation for the year.
- Subtract business expenses, interest, tax, and depreciation to finally arrive at your net income, which can be positive implying a profit or negative, signifying a loss.
How Does a Profit and Loss Statement Help?
Profit and loss account represents a company's ability to generate income through their business operations.
A P&L statement is like a lifeline that signifies whether a company will thrive or will go into oblivion. It is thus important to review its benefits and drawbacks to understand its importance further.
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Benefits of P&L Account
The P&L account presents the following merits to a business:
- Represents financial well-being: The net income that the P&L statement helps generate is the main indicator of the financial health of a company.
- Important for documentation: Without an effectively-prepared and managed P&L account, it will be next to impossible for businesses to attract investment and stay in business altogether.
- Helps in forecasting: The whole purpose of assessing the financial health of a firm is to be able to predict future performance. Using past profit and loss statements from different quarters can help the business' financial advisors detect what the future holds.
- Tracks different expenses and income sources: The P&L account is critical to identify sources of unnecessary expenses or high income. This helps in budget control and even performance management by assisting in managerial decision-making.
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Demerits of P&L Account
- Data might be subjective: This is true mainly of depreciation and asset values. The data might be volatile and difficult to associate with accurate values.
- Over-dependence might be a problem: Due to their convenience, many accountants and finance professionals have purely relied on profit and loss statements as the only picture of the health of the business. This can be dangerous considering the importance of other financial documents like cash-flow statements and balance sheets.
- It is heavy on documentation: To prepare and maintain a P&L account, an accountant needs to gather a lot of paperwork and information, which might be time-consuming.
Despite its disadvantages, a profit and loss account remains a crucial element of financial accounting. Without it, businesses may crumble, and the economy may not flourish in the absence of insight-driven business development.
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