Understanding Profit and Loss Statements

The ultimate objective of any business is to earn maximum profits. Every decision taken on behalf of the company will affect the overall profits of the business. To understand the respective profits, a business is expected to ensure a detailed record of the income and expenses. It is possible with the help of a dedicated profit and loss or P&L account. It is regarded as a type of financial statement reflecting the financial outcome (both profits and losses) of the particular organization out of business activities during a specific accounting period. 

The profit and loss or P&L statements form a crucial aspect of the financial statements of any organization. Let us understand the same in depth.

What is a Profit & Loss (P&L) Account?

A profit and loss account is regarded as a detailed record of all the expenses and incomes of the organization during a specific duration of time. This period can refer to the complete financial year, a quarter, or an interim period like a half financial period. All businesses -whether a sole proprietorship or an enterprise, are expected to maintain a proper profit & loss account. This helps them in obtaining the right financial position during the end of the stipulated period. All non-cash as well as cash-based income & expenses of the organization are effectively recorded in the profit & loss account.

A detailed profit & loss statement is generated depending on particular accounting principles. These accounting principles encompass the principle of accrual accounting, revenue recognition, and matching principle. It reveals multiple stages of profits garnered by the organization like gross profit & loss, the net profit & loss, and the operating margin incurred by the particular business.

How Do Profit & Loss Statements Work?

The profit & loss statement can be regarded as one of the primary financial statements that every public organization is expected to issue on an annual or quarterly basis. Additionally, the organization is also expected to present cash flow statement and balance sheet. P&L statement is one of the most popular financial statements in any financial plan. It is because it reveals the total amount of profit or loss a company generates in a given period of time.

Profit & loss statements can also be recognized in the following ways:

• Expense statement
• Statement of operations
• Statement of profit & loss
• Earnings statement
• Statement of financial income or results
• Income statement

The profit & loss statement -quite similar to the cash flow statement, helps in revealing changes in the respective accounts over a particular period of time. On the other hand, balance sheet refers to the snapshot -revealing what the organization currently owes and owns at the given moment. It is crucial to compare profit & loss statement with the cash flow statement. It is because within the scope of the accrual accounting method, a business can consider logging in expenses and revenues before cash will change hands.

The profit & loss statement or document has a particular format. The format commences with the revenue’s entry -referred to as the top line. The statement goes ahead with subtracting the costs of executing business -along with the costs of items sold, tax expenses, operating costs, and interest-based expenses. The difference is referred to as the bottom line or net income. It is also referred to as the overall earnings or profits. 

Types of Profit & Loss Statements

A profit & loss statement can be prepared in the following ways:

• Accrual Accounting Method: This method helps in recording revenue in the form it is earned. This implies that an organization utilizing the accrual method will account for the amount it expects to receive in the coming future. 

For example, an organization delivering a service or product to the customers will be recording its revenues on the profit & loss statement -even though it might not have received the payment yet. At the same time, liabilities are accounted for even when the company might not have yet paid for its expenses. 

• Cash Accounting Method: This method is utilized only when the cash will go in & out of the particular business. It turns out to be a simple method accounting for only the cash paid or received. An organization can consider recording transactions in the form of revenue whenever cash has been received and in the form of liabilities when cash is being used for paying liabilities or bills. This method is popularly used by small-scale organizations and people looking forward to managing their overall personal finances. 

What are the Essential Components of Profit & Loss Statements?

The P&L account encompasses different components that are helpful in recording income & expenses of the particular business under diverse categories. Some of the core components are:

• Revenue or Income: The revenue of an organization is also known as the top line. The revenue earned out of core business operations are recorded initially. It will feature revenues generated during the day-to-day course of the organization. The following category will refer to additional income and other miscellaneous income of the company. It will feature income that is obtained out of multiple investments of the organization.
• COGS: COGS or Cost of Goods Sold is the next category of the profit & loss statement. It features the direct operating cost for any business -including labor cost, cost of raw materials, or the overheads of the respective entity linked with purchasing or manufacturing goods. These expenses refer to the first line of expenses that are deducted out of the revenues for generating gross margin of the particular business.

It is crucial that a company should feature a higher gross margin as the non-operating and operating expenses will be deducted from the gross margin. It will ultimately minimize the business’ profits. Therefore, it is crucial to check the COGS to make sure that your business has higher net gains for the shareholders or owners of the organization.

• Operating Expenses: These are not the direct expenses in the manufacturing or production process but the indirect form of cost of running any business. These expenses will feature administrative expenses including depreciation costs, employee costs, research & development costs, distribution and marketing costs, selling costs, and so more. 

These indirect costs tend to deliver a direct impact on the net profits of any business. When the operating costs of the organization are significantly higher, it might make the positive gross profit margin be converted into net losses as well.

• Operating profit: It is regarded as the positive balance from the company’s gross margin after minimizing the overall operating expenses. It is also known as the EBIT or Earnings Before Interest & Taxes. A positive outcome of operating margin offers the assurance to stakeholders and investors that a higher profitability will be earned. It also indicates the solvency of the particular organization.
• Net Income: The organization’s net income is regarded as the net profit or bottom line generated by the particular business after subtracting all non-operating as well as operating expenses along with the respective taxes and interests. It is the amount of profit that is made available for getting distributed to the stakeholders. 

What is the Importance of Profit & Loss Statements?

The profit & loss account of any organization is the ultimate reflection of the financial viability. It is an essential statement that is crucial for all businesses out there. The statement should be prepared carefully to ensure the overall correctness. Some of the important aspects of the benefits of these statements are:

• It assists businesses understand the operational efficiency and different expenses incurred by the organization.
• The P&L account assists the shareholders in understanding the net earnings per share. At the same time, the investors can think of evaluating the overall viability of the respective investment. 
• It also assists businesses in meeting the statutory specifications of coming up with financial statements and ensuring proper auditing as well as approval.
• A P&L account refers to the direct evaluation of the business’ profitability along with in-depth comparison of the past performance.
• It also helps in forming the basis of ensuring future P&L statements towards estimating projected profits of the organization and making improved business decisions.

Conclusion

A P&L account is the income & expenditure statement. It is expected to be prepared on a constant basis while being reviewed carefully to understand the ultimate profitability of any business.