A beginner’s guide to Profit and Loss

There are several documents that are important for understanding your business’ financial position and outlook. Among them is your profit and loss account, also known as your profit and loss statement or sheet.

Whatever you prefer to call it, knowing how to create, maintain and read one is great for understanding where your business is excelling or struggling. And that’s where our handy guide comes in! But for more in-depth analysis on your SMEs profit and loss, sign up to Pulse here:

Below, you can read about:

• What a profit and loss account is
• Why it’s important for understanding your business’ performance
• How a profit and loss statement is different to a balance sheet
• How to calculate your business’ profit and loss account
• How to create your document
• How to read a profit and loss account
• Filing your profit and loss statement

What is a profit and loss account?

As we’ve mentioned, a profit and loss account can have many names. You might even see one referred to as an income and expense statement. But, in essence, it’s a financial statement that details your business’ revenue and expenses over a particular period.

You could produce them weekly, monthly, quarterly, or annually. Quarterly and annual statements are standard practice, however, as they allow you to track trends easier.

Whatever reporting period suits your business, a profit and loss account is a key document for understanding your company’s financial performance. You – or your accountant – will often review it along with your balance sheet and cash flow statement.

Why is your profit and loss statement important?

In short, an accurate profit and loss statement will show you whether your company has made a profit or a loss over the period you’re looking at. That means balancing your income against expenses.

Over time, mostly making a profit – or at least breaking even – is essential for running your business sustainably. Reaching the break-even point is particularly significant for start-ups. But your profit and loss account can tell you other things about your company’s financial health too, allowing you to make important decisions and actions with confidence.

Potential takeaways include:

• Spotting what’s driving your profit or loss and identifying what you can do to improve them, like increasing marketing of a popular product, or switching to cheaper suppliers.
• Seeing how your business is performing compared to previous periods and identifying positive and/or negative trends.
• Working out important margins like gross profit and net profit (read more on those terms below) and understanding what areas need work.
• Calculating rates of return for any investments or assets like equipment.
• Creating or updating your business plan based on real-world data, which could include reinvesting any profit left over.
• Building confidence and trust with investors and other key stakeholders, including customers and suppliers.
• Complying with tax and accounting regulations with HM Revenue and Customs (HMRC) and Companies House, if appropriate.

How is a profit and loss account different to a balance sheet?

A profit and loss account and a balance sheet both tell you important stories about your business’ financial situation. But they come at it from different angles, so it helps to understand the distinction.

Instead of looking at customer demand, your balance sheet tells you what your business owns (assets) and what it owes (liabilities). Assets include cash as well as outstanding invoices, property, equipment, and stock, while liabilities include debt, wages, and supplier payments.

Crucially, your balance sheet provides a snapshot of a particular point in time, whereas a profit and loss account measures performance over a set period. In this sense, think of a balance sheet as a photograph of your business’ financial health, and your profit and loss account as a video.

How to calculate your profit and loss account

Knowing how to work out profit and loss accurately is important for making sure it’s reliable. Your profit and loss sheet should be built from several components, including:

• Revenue: The total income you earned from sales of your products and/or services over the period you’re looking at.
• Cost of goods sold (COGS): The costs involved with creating and selling your products and/or services, such as materials, storage, and labour.
• Gross profit: The number left over after taking away your total COGS from your revenue.
• Operating expenses: The general costs of running your business, including things like rent, wages, transport and marketing, as well as taxes and interest.
• Net profit: What’s left after deducting operating expenses from your gross profit. Calculating net profit before tax is the same, only without taking away taxes.
• Other income and expenses: Any income or unexpected costs not related to your main business operations. The former could include royalties or gains from selling assets, for example, while the latter might include equipment repairs.

Learning whether you’ve made a profit or a loss means taking away all your outgoings from all your income to see whether you’re left with a positive or negative number. That could be as simple as subtracting your COGS, operating costs and other expenses from your revenue and other income.

(Revenue + other income) – (COGS + operating costs + other expenses) = Net profit or loss 

Breaking down the individual components, however, like gross profit and net profit, will help you spot where you need to fine-tune things. You could decide to reduce your COGS or operating expenses as a result.

How to create a profit and loss account

Producing a watertight profit and loss statement can be a complex process, so it may be something you’d prefer to leave to a qualified accountant. This could give you extra peace of mind when presenting reports to shareholders or HMRC.

If you’re feeling confident, you could find free templates to download online, while popular accounting software tools such as Pulse can pull the information you need in just a few clicks. Whatever your preference, keeping accurate accounts throughout the year will make the process easier and more reliable.

In terms of regularity, we’ve mentioned how it’s common to create profit and loss accounts quarterly and annually. But you could benefit from producing them more often if your business is new or if you’re going through a period of change, like launching a new product or expanding into a new market.

How to read a profit and loss account

Much like with creating your profit and loss statement, you might find it useful to have a professional accountant interpret the numbers and tell you the key stories. If you’re struggling to read between the lines, they could point out where your revenue is really coming from and help you find areas that need optimising.

But, again, online accounting software could be useful to you here. Many tools will automatically generate charts, graphs, and reports to help you visualise each aspect and share key information easily.

Filing your profit and loss statement

If you’re a private limited company, you’re usually obliged to send copies of your ‘statutory accounts’ to shareholders, HMRC and Companies House. Otherwise known as your annual accounts, this includes:

• A balance sheet on the last day of the financial year
• A profit and loss account showing profit for the financial year
• A director’s report

Sending this information to HMRC helps make sure you’re paying the right amount of tax, while shareholders use the information to judge your financial health. There are cases where you might not need to send your profit and loss account to Companies House, though:

• If your business is classed as ‘small’ (equal or less than £10.2 million in turnover, equal or less than £5.1 million on your balance sheet, fewer than 50 staff)
• If your business is classed as a ‘micro-entity’ (equal or less than £632,000 in turnover, equal or less than £316,000 on your balance sheet, fewer than 10 employees)

Get to grips with your business’ finances

Feeling confident with creating and harnessing your profit and loss account? Good work! If you’re still a little unsure, don’t sweat it! Simply sign up to Pulse to receive insights on your profit and loss, turnover, liquidity and gross margin – and better yet, it’s totally free! If you want to keep learning, head to our blog hub to read more on business finance or get in touch with the Pulse team for more guidance.