What does your Profit and Loss say about your business?
This article (Part 2 of 2) sums up some of the unusual key terms you will see on your Profit and Loss Statement. Explanations have been kept simple but for the full glossary download our Handy Help sheet: FAQ – What does your Profit and Loss Account say about your business
Also, you can read the Part 1 article: Do you have a healthy Balance Sheet?
Profit & Loss Account for calculating tax liability
Your Profit & Loss Account is a summary of your business income and business expenses within a given time-frame, typically a month, quarter or year.
It is designed as a statement to calculate your tax liability, based on the profits you have left after deducting “allowable” expenses from taxable income.
Profit and Loss Account for reporting and business planning
It is also a useful report to review on a monthly or quarterly basis as part of a management review. It shows all sorts of valuable information regarding the health of your business and when comparing month on month you can see trends in income and key expenses as well as track your overall performance against targets set for the year, to make sure you are going to meet your business goals. If you keep a close on this report you can start to really understand your business.
What classifies as an “allowable expense”?
Allowable expenses can broadly be defined as costs that are necessary to run the business. These can be broken down into:
- Cost of Sales – expenses that are directly linked to making the sales
- Overheads – the rest of the costs incurred to run the business
Expenses that appear on the Profit & Loss Account are also considered “consumable items” so things that are broadly used within the financial year, as opposed to items that have a longer life span, like equipment.
So, if you have been wondering why your new laptop doesn’t show on your Profit and Loss, don’t worry, it has been accounted for, just on your Balance Sheet as an Asset.
Similarly to this, payments to Loans, for example, also don’t appear in their entirety on the Profit and Loss Account as the Loan itself features on the Balance Sheet as a Liability. Payments to the loan are then offset against this Liability and it is only the Interest that is then transferred onto the Profit and Loss Account as an “allowable expense”.
There are a few of these anomalies to watch out for.
What is a Cost of Sale?
A Cost of Sale (or sometimes called a Direct Cost) is an expense incurred which is necessary for making the sale.
Examples of this are:
- Stock – if you didn’t buy the stock then you wouldn’t be able to sell it and generate income from it
- Associate Wages – if you don’t pay the associate then the practice won’t generate income from their work
- Materials – if you don’t have certain consumable items used when treating patients then you wouldn’t be able to do your job.
What is Gross Profit (GP)?
When the total value of the Cost of Sales is deducted from Income you will get what is called Gross Profit (GP). It represents the profit you “directly” make on sales.
A useful metric called the GP% can be calculated by dividing the GP by the Income. For example Income of £250k and GP of £200k, leaves a GP % of 80%.
GP is a good measure of business operations and the higher the GP ultimately the less it is costing you to generate your income.
Doctors and dentists as service providers will find their GP % should be healthy as it is their time and skills that earn them the money. Where it is useful though is to track the performance of Associates, seeing how much GP they are generating compared to their Income contribution.
For more on how to track business performance read our article:
7 simple KPI’s to track financial performance
What is an Overhead?
An Overhead is an expense incurred that is not directly related to generating Income but is necessary to run the business regardless. Examples of Overheads that are allowable for tax relief are:
- Bank Charges & Interest
- Business Rates
- Entertainment (staff only)
- Hire Purchase Interest
- Light and Heat (electric, gas etc)
- Loan Interest
- Mortgage Interest
- Motor Expenses
- Rent (business premises)
- Seminars & Conferences
- Telephone & Internet
- Travel expenses
- Use of home office
- Wages & Salaries
- Water rates
Keep an eye on our blog for October’s article for more information on tax-deductible expenses: A-Z of expenses allowable for tax relief
What is Net Profit (NP)?
Net Profit (NP) is calculated as Gross Profit less all Overheads. It is this figure that is taken into the tax return to calculate tax liability.
Because Profit and Loss Statements can be presented in many different ways, sometimes NP is simply calculated as Income less all Expenses, as they are not always broken down between Cost of Sales and Overheads.
Similar to the GP %, the NP% can be calculated by dividing the NP by the Income, for example Income of £250k and GP of £80k, leaves a GP % of 32%.
A good NP% is typically between 30% and 35%
This article really just touches on the basics of understanding your Profit and Loss Account. However, if you review this Statement on a monthly basis then you will start to be more strategic in your approach to your business.
Work out the GP% and NP% each month and track them to see if they are consistent. Try to spot why some months are better than others and work to perfect your business approach based on the results.
For the best advice around your Profit and Loss Account, your accountant has the knowledge to guide you.
Figurit can help shed light on those little questions to help you understand better what your business summary means and how you can also use this to your advantage, particularly if you are buying or selling a business.
Call today and speak to the director Michael: 020 7376 9333