Profit and loss forecasts: How to understand them

If you're to run a successful business that works in an efficient manner, it's likely that very soon into your venture you will need to work out how to use profit and loss accounts. And if you're to understand them, first you will need to know exactly what they are.

What is a profit and loss account?

Profit and loss accounts and forecasts are documents that record exactly how much money a business receives and pays out over a fixed period, usually a year. It will show your total income from sales as well as any other cash generators you may have had, while every cost from wages to materials and rent will be displayed.

The documents are not particularly complex, so there is no reason why you shouldn't be able to get your head around it fairly quickly. A good way to start might be by familiarising yourself with all of the columns that appear on a profit and loss account and what they stand for.

After an initial income figure, you will probably see a net income statistic. This is the amount of revenue after various allowances have been taken into consideration. It's followed by gross profit, depicting the amount of money you have to your name once direct operating costs have been calculated, and is followed by an operating profit figure.

Finally, you will need to pay tax on any profit you make, so a figure before this is usually given and then a final total, also known as net profit, is recorded.

The bottom line shows you exactly whether you have made any money or not and the extent of your profit or loss. It's an essential record and one that will help you to make profit or loss forecasts for the months and years to come. This information is invaluable, particularly if you need to convince a bank or investor to back your project.

It will also come in particularly handy when you file your tax returns, as HM Revenue & Customs does not take kindly to businesses that cannot work out their own financial results. Similarly, shareholders will be interested in the data and can be appeased by fair and accurate records.

Do all businesses have to produce formal profit and loss accounts?

If your business is a limited company or a partnership whose members are limited companies, then by law you must produce a profit and loss account for each financial year.

Self-employed sole traders and most partnerships don't need to create a formal profit and loss account, but they do need to keep adequate records to complete their self-assessment tax return fully and accurately.

However, there are key benefits to producing formal accounts. If you're looking to grow your business, or need a loan or mortgage, for example, most institutions will ask to see three years' accounts.

The benefits of understanding your accounts

The benefits of tackling this subject head on and gaining an excellent working understanding of it are clear. It seems fair to suggest that some businesses even go to the wall because their bosses don't run the financial side effectively, so don't become one of the statistics and do all you can to keep your finger on the pulse.

If you would like to get to grip with the financial side of your business - and you should, as a greater understanding of your status will help you to operate more effectively and identify potential cash leaks - it could be worth reading up on the subject.

We offer an excellent book entitled Understanding Accounts Made Easy that will offer you all the information you need to learn and run your profit and loss records adequately.

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Published on: October 2, 2012

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