How Does Profit and Loss Account Work and Why Is It Important
A profit and loss account are one of the most important documents that showcases the financial health of a business, no wonder why from investors to lenders and from managers to business heads are after this piece of document. This document reveals the financial position, enabling informed decisions by investors and business owners.
Besides the bad news, it highlights the good, showing areas where the business is thriving and boosting confidence for the business and stakeholders. The profit and loss account helps a business person analyze trends and prepare for the best or worst.
Such an important financial statement deserves to be understood much better, so let us dive into it.
What is a Profit and Loss Account?
There are many names for this important financial statement profit and loss account, profit and loss statement, and income and expense statement, but in this blog, we will stick to profit and loss account. A profit and loss account shows revenues, expenses, and costs incurred during the financial year.
The profit and loss accounts are mostly prepared on a quarterly basis and then on a yearly basis. It is important to mention that the cash flow statement, the profit and loss account, and the balance sheet are the most sought-after pieces of financial document by your client and its stakeholders. The goal is to showcase financial performance, help clients make informed decisions, and guide stakeholder investments.
How Does Profit and Loss Account Work?
The profit and loss accounts are made of multiple sections. These sections are as follows:
- Revenue (income generated from selling your products or services)
- Cost of goods/services sold
- Selling, general and administrative (also referred to as SG&A) expenses, which can cover everything from advertising and marketing costs to rent and travel costs
- Interest expenses
- Taxes
- Net income
We can explain in a simpler way how the profit and loss account work by subtracting the value of debts during the set period. If the numbers are positive, then your client is making profits; if they are negative, then your client’s business is in loss.
In the past, profit and loss accounts were made manually by accounting practices; however, it was a time-consuming process and were prone to errors. That’s why these days majority of the profit and loss accounts are made using various accounting software. However, installing and operating accounting software is not an easy task and requires training and experience. Such commitments are unnecessary because they divert your attention from other important work and strain your financial resources. Instead, it can be handled by the service provider to whom you can outsource the work by availing their year-end outsourcing services.
Why Is Profit and Loss Account Important?
Without profit your clients will be unable to make out how their business is performing. The profit enables your clients and their stakeholders to determine profits, identify causes of losses, and take corrective actions.
Through the profit, your client will be able to analyse certain important things, which are:
- Identifying the areas that are bringing in profits
- Analysing the reasons for losses and costs overhead
- Studying the performance of the business on a year-on-year basis and identifying good and bad trends
- Work out important margins, including gross and net profit margins, operating margin and EBITDA (earnings before interest, tax, depreciation and amortisation) margin, and take action to improve them.
- Calculate rates of return, including return on equity (which you’ll also need the balance sheet for) and return on assets.
What Makes Profit and Loss Account Different from Balance Sheet
Clients and stakeholders seek both the profit and the balance sheet as important financial documents. Both these documents do distinct but important jobs. The profit will show the profitability of your client’s business, thus helping them in seeing their financial performance over a fixed period. Based on the profit, your clients will be able to make decisions to reduce costs, increase profits or both.
On the other hand, the balance sheet will show the ratio of assets and liabilities of your client’s business. By adding the liabilities and shareholder equities, your clients will be able find the value of their assets. If the balance sheet shows lesser assets than liabilities then it means that the business is going towards insolvency.
Profit reflects business health, while the balance sheet shows the financial position at a specific time. Both are useful and important and but both are distinct from each other.
Do You Require an Accountant to Handle Profit and Loss Account?
A business person can prepare a profit all by himself; however, it is a time-consuming and complex process. Certainly, a business person cannot afford to leave their business to do this job. That’s why they need to appoint a team of accountants who can do the job.
When preparing profit and loss accounts, your business clients must ensure all records and accounts are accurate. This will help in creating an accurate profit and also a compliant one as per the HMRC and shareholder’s requirement.
Recruiting and training accountants burdens both your HR team and your clients’ finances. Your accountants can handle this, but they may become overburdened, especially with multiple clients. In this case, use accountant outsourcing services from providers like Corient.
Conclusion
We hope that we have been able to explain the profit in the simplest way possible. We acknowledge that this is a complex financial document, and it becomes more challenging with a complicated business. In that case, you can approach and outsource the task of preparing a profit to an accountant working for an accounting outsourcing service provider such as Corient.
Our well-trained accountants will prepare your profit and loss accounts transparently and professionally as part of our year-end outsourcing services. For more details about our services and to explain your requirements more freely, please do contact us via our website.