2.1 Profit and loss statement

A profit and loss statement indicates the relationship between sales (revenue or turnover), cost of sales, gross profit, operating expenses, interest, tax and net profit for a specific period of time. It provides useful information for founders, shareholders, providers of capital and staff. A profit and loss statement is usually prepared annually.

As shown in Table 2, the profit and loss statement reveals revenues and costs and how much profit has been made over a particular period (Blundel et al., 2017).

Table 2 Profit and loss statement

PROFIT AND LOSS STATEMENT for the year ended 31 December 2016
Income £ £
Sales 6,600,000
Stock at 1 January 2016 700,000
Purchases 4,900,000
5,600,000
Stock at 31 December 2016 (980,000)
4,620,000
Gross Profit 1,980,000
Profit Margin 30.0%
Expenditure
Establishment expenses 160,000
Administration 370,000
Selling and distribution expenses 1,200,000
Finance charges 20,000
Total operating expenses 1,750,000
Operating profit 230,000
Net interest 30,000
30,000
Net profit before taxation 200,000
Net margin 3.0%
Tax 40,000
Dividends 10,000
50,000
Net profit retained 150,000
Source: Blundel et al., 2017, p. 183

A profit and loss statement includes:

  • Income (generated by business activities but not interest received)

  • Cost of sales (cost of purchased goods and manufactured goods, including manufacturing overheads and wages)

  • Gross profit (income less cost of goods)

  • Profit margin (gross profit / income x 100)

  • Operating expenses (overhead and staff, excluding wages for manufacturing)

  • Depreciation

  • Operating profit (gross profit less operating expenses)

  • Interest

  • Net profit (gross profit less operating expenses and interest)

  • Net profit before tax

  • Net margin (net profit before tax / income x 100)

  • Corporation tax

  • Net profit after taxes.

Every start-up entrepreneur needs to know how to prepare a profit and loss statement. Consider that, for a start-up, it is important to complete this statement on a monthly basis for at least the first two years. This enables you to spot trends. Activity 2 will help you to prepare a profit and loss statement for your own business.

Activity 2 Preparing a profit and loss statement

Timing: Allow approximately 15 minutes to do this activity

Use the example shown in Table 2 as a guide to produce a profit and loss statement for your own venture. It should reflect the projected results of the operation for a given period of time.

Discussion

Did you find this exercise easy or difficult to do? Are there still parts of the profit and loss statement that you don’t fully understand? For example, you might not be sure about how high your tax burden will be. Depreciation is also an issue. For tax purposes, you may deduct the cost of the tangible assets you purchase as business expenses. Thereby, you must follow the national tax laws about how and when you may take the deduction. A conversation with a tax advisor might be useful.

These examples reveal that you should consider each line of your profit and loss statement thoroughly and reflect on what the numbers mean to your business. The net profit retained will not only be used for the assessment of how profitable your business is, it will also be included in your balance sheet.

2 Cash flow management

2.2 Balance sheet