Understanding Balance Sheets and Profit and Loss Accounts Part 3
This third article which features the Profit and Loss Account follows on directly from the first two articles in the series which covered the balance sheet. If possible do read part 1 and part 2 first as there is a natural progression to this point.
The Profit and Loss Account
This is the second and an equally important part of a set of accounts. As the name suggests, the purpose of the document is to show whether the business has made a profit or a loss over a specific period of time (e.g. a month or a year). It shows the total of the sales less the direct cost of those sales (i.e. if the business sold furniture then the cost of buying or making the furniture) which gives the Gross Profit. The next part shows the deduction of the overheads such as rent, fuel, insurance, advertising etc. and also depreciation (see below), giving a Net Profit (Before Tax).
At this stage it is worth asking what normally constitutes an overhead for the purpose of inclusion within a profit and loss account. The answer is that these ‘expenses’ are distinguishable because once these payments are paid away they are ‘gone’ (or will shortly be gone) and nothing individually is left: e.g. electricity or rent. However, payments for assets such as vehicles, fixtures and fittings and equipment are not set against profits when they are purchased because they remain within the business to help you continue trading. They have therefore not ‘disappeared’ as you still have them.
This is a good time to mention Depreciation. We all know that at the end of the year a vehicle will be worth less than the amount of money paid for it at the start of the year. This is accounted for by charging a percentage of its value (say 20% – but this varies depending on the expected usable life of the asset) to the P&L account and reducing the value in the balance sheet by the same amount. The year-end balance sheet then gives the true value of the asset, which of course it is supposed to do.
Wages will be shown in the P&L in a number of different places depending on the nature of the business. For example if the business referred to above made the furniture, the wages paid to the manufacturing staff would be shown with the cost of sales and therefore be included in the Gross Profit calculation. Wages relating to say admin or sales staff would be included with the other overheads and therefore within the ‘net profit’ calculation.
In a sole trader or partnership business the owner’s wages are often referred to as drawings and are normally shown after the Net Profit figure. The remaining amount, which is called the ‘Retained Profit’, is then transferred to the owners ‘Capital’ part of the Balance Sheet. In a Limited Company, the ‘drawings’ are called Dividends and the owners are called Shareholders. The shareholders decide how much of the Net Profit after tax they want to pay themselves and make a Dividend payment (which is normally in proportion to the number of shares they hold) and if there is any money left over (Retained Profit) this is transferred to the Capital part of the balance sheet as part of the Profit Reserves. A more detailed example Profit and Loss Account is shown below.
VAT is a highly technical subject but for the purposes of this article and assuming your franchise is (or will be) registered for VAT, then you need to know that you exclude VAT in the Profit and Loss Account. The reason for this is that you are simply acting as a VAT collector for the Tax Authorities. The VAT you charge does not belong to you so it does not form part of your profits. However, in most cases, you are able to offset the VAT you pay against the VAT you charge and only pay over the difference. Do please always refer to your accountant though, to ensure you are dealing correctly and efficiently with VAT in your particular set of circumstances.
If you have been brave enough to read through the three articles I have written so far in an attempt to dispel some of the fears or concerns that people sometimes have about reading or understanding a set of accounts then I thank you. Do please drop me a line by email at email@example.com and let me know if this is the case. I am planning next to write about how you can use this knowledge to monitor and improve the performance of your business. Watch this space!
The author, Chris Roberts, runs a series of one to one and group courses and Franchise Finance also prepare full business plans and financial projections for their clients.