Rural entrepreneurship in Wales
Rural entrepreneurship in Wales

Start this free course now. Just create an account and sign in. Enrol and complete the course for a free statement of participation or digital badge if available.

Free course

Rural entrepreneurship in Wales

5.2.2 Profit-and-loss account

To determine whether a profit has been made, we need to produce a profit-and-loss account. In a cash flow account, monies in and out are entered in the month when the money leaves or arrives.

A profit-and-loss account has a crucial difference. Monies in and out are entered when they are invoiced, not when the cash comes in (in other words, when a credit or a debt is incurred). If you have a sale that will be delivered in April with payment in May, the profit-and-loss account shows the sale in April, whereas the cash flow shows the money arriving in May. Similarly, a purchase for February delivery with payment due in March will be shown in the profit-and-loss account as February, and in the cash-flow as March.

Case study: Catterline profit-and-loss account

A profit-and-loss account is a method of showing what is happening over a period of time. Hannah will not have to produce a balance until after she has been trading for 12 months at the end of Year 1. A balance sheet shows the situation at one point in time and is used to report to shareholders, investors, partners and so on. A balance sheet is best drawn up by an accountant.

Cash flow and profit-and-loss accounts should be prepared monthly by management to help them control the business. The bank charges Hannah an annual 10 per cent on her credit limit (the negative balance each month in the cash flow) so her profit and loss looks like: Cash flow spreadsheet filled in [Tip: hold Ctrl and click a link to open it in a new tab. (Hide tip)]   and Profit and loss spreadsheet.

Looking at the end of the cumulative profit-and-loss row, we can see that Hannah has made a loss of £3,749. If you total up the bank interest payments you can see that she would have made a profit if she had not been carrying a large credit limit. Hannah will go beyond her credit limit.

The bank is unlikely to agree to this at the company start up, especially when borrowing is going so far beyond agreed limits. In addition, the bank interest has pushed Catterline into a loss by June of Year 2 – eight months from start up.

Task 34: Profit-and-loss scenarios

Using the spreadsheet you have just completed for Catterline, try out the following scenarios.

  1. What happens if we split Catterline’s supplies into two deliveries, a month apart for each batch, rather than the existing one delivery?
  2. What happens if we supplied in two batches rather than one batch at the end of the three months of manufacturing?
  3. What happens if we changed banks to one offering a 7.5 per cent rate on credit limits?
  4. How could Hannah keep within her credit limit and be in profit within eighteen months of start up?

Use the spreadsheet to test your proposals.

Case study: Catterline loss problem

It was very helpful for Hannah that she did an 18 month cash flow and profit-and-loss estimate. She can now see two problems. In February, March and April of Year 2, she is over her borrowing limits. Of course, one possibility is to get the bank to agree to the new limits needed of £228,000. However, this will not solve the loss problem.

One partial solution would be to negotiate with the suppliers of the boards and case. At present she has to pay in advance – perhaps she could pay on delivery? If she could get agreement to this, then the cash flow would look like Profit and loss estimate.

This has helped a little, for example, in May there is now only a £9,500 credit limit as opposed to the original £104,500, this will help the interest payments, but is not really addressing the problem. She could make further minor adjustments – for example, Austin might agree to his bonus for the first two years being paid three months in arrears. All this will help a little and may get her into a small profit at 18 months. However, the maximum credit limit required will still be over £220,000.

Hannah really has to take firm action: she could negotiate a larger credit limit from the bank, sell more products, reduce her costs or increase her selling price to get over this problem.

By carrying out this estimate of cash flow and profit-and-loss Hannah has been able to conclude that her business is not profitable after 18 months and needs extra loan facilities to provide a total of £228,000 for two months.

The use of spreadsheets to calculate a forward cash flow and profit-and-loss situation is crucial to any start up. In addition, the spreadsheets allow you to make ‘what if’ calculations quickly. In the example above, we did a calculation to find out ‘what if we didn’t have to pay for supplies in advance?’ Even for someone not expert in spreadsheets, this calculation should take less than five minutes.

GB093_2

Take your learning further

Making the decision to study can be a big step, which is why you'll want a trusted University. The Open University has 50 years’ experience delivering flexible learning and 170,000 students are studying with us right now. Take a look at all Open University courses.

If you are new to University-level study, we offer two introductory routes to our qualifications. You could either choose to start with an Access module, or a module which allows you to count your previous learning towards an Open University qualification. Read our guide on Where to take your learning next for more information.

Not ready for formal University study? Then browse over 1000 free courses on OpenLearn and sign up to our newsletter to hear about new free courses as they are released.

Every year, thousands of students decide to study with The Open University. With over 120 qualifications, we’ve got the right course for you.

Request an Open University prospectus371