How to Understand a Profit & Loss Account. What is P&L?

The main sections of a profit and loss account

Turnover

Turnover, or sales, is the total value of what you’ve sold during the period covered by the P&L account, net of VAT. It might be broken down into different types of products, helping you to see which items sell better than others.

Other income received by the business, such as bank interest or money received from the sale of assets, is not included in turnover because it does not represent income from your main trading activity.

Cost of sales

These are the costs that are directly related to the sales you have made, so it includes raw materials or stock you have purchased to resell. It may also include the cost of creating the items that you’ve sold, including the cost of staff time if you are selling services.

Gross profit

This is the sum of turnover minus cost of sales. It tells you how much profit you are making directly from your sales. It’s a very useful feature of your P&L!

Other operating costs

These are all other costs associated with running a business, such as the rent and rates on your premises, accountancy and legal fees, and depreciation. These costs cannot be directly linked to your sales and may not change very much even if your sales figures were to change significantly.

Net profit

This is the gross profit minus the operating costs. You could think of it as the true profit of your business because it’s made up of all the income and all the costs. This is not quite the profit you’ll pay tax on, because taxable profit is calculated differently, but it’s close to it.

Preparing a P&L account

There are different ways to prepare a profit and loss account and each one shows the performance of a business for a specific period of time, be this a week, a month, or a year.

Limited companies must submit a set of accounts to Companies House each year, which must be prepared in a certain format. These are referred to as statutory accounts. They are typically prepared only once a year.

Many businesses put together a separate P&L report for use by managers or directors, which are prepared a different way to those submitted to Companies House. The layout for these suit the needs of the reader and often form part of the organisation’s internal management accounts. These profit and loss documents often cover a particular month or number of months.

Things to remember

Because profit and loss accounts are easy to understand, they’re often the first port of call when assessing the health of a business. They do, however, have their limitations in what they can reveal.

For example, they cannot speak to the underlying health of the business, such as how much money it owes or is owed, and what the value of its assets are.

While they do show whether or not a business is making a profit, P&Ls do not show whether it is generating cash. This is because a business may be selling a lot of goods at a good margin, but failing to collect payment from customers for a number of reasons, rendering the profit worthless.

For this reason, companies that are profitable on paper can still be subjected to cash flow issues. Every business, from start-ups to well established firms, needs to plan where cash is going to come from for buying stock, paying wages and settling outstanding tax bills.