Business Studies

08 May 2000

The profit and loss account is a financial statement which shows the profit made by a business during a defined period of time (this is usually one year). The account also shows the uses to which the profit has been put. Unlike the balance sheet, this statement covers a period of time rather than a snapshot at a particular time. It is a legal requirement for all firms to produce these accounts. As such, the profit and loss account is very much a statement that reflects performance of the organisation over the financial year.

The profit and loss account is made up of three main sections, the first section is called the Trading account. The trading account reveals the gross profit of the business. This is defined as the difference between sales revenue and the direct cost of the goods sold. The latter is the cost of purchasing the goods from suppliers or producing the goods that are sold. The production cost of goods sold is equal to the cost of raw materials in the finished good plus the cost of labour to make the product and an amount for production overhead costs. Because of an important feature of the trading account called the matching principle, (where the costs of production and sales are matched together) only the cost of producing the goods sold in the period concerned is charged against that period’s sales revenue.

The second important section of the profit and loss account, is the ‘profit and loss section’. This section shows the net profit of the business, defined as the difference between gross profit (plus income from other sources) and various sources. The other income might be the profits from selling an item of machinery. It can, therefore, be regarded as other operating income. However, we must deduct some of the following: selling costs, distribution costs, admin. expenses, interest paid etc. Depreciation within the profit and loss account refers to that year’s depreciation, which is charged against last year’s sales revenue under the matching principle. The same choice of method either straight line or reducing balance method is available to calculate depreciation.

The third section of the profit and loss account is called the appropriation account. Within this section, it reveals what to net profit. It is likely that the government will claim a proportion of these profits as corporation tax and, if the company operates abroad, it is possible it will have to pay equivalent taxes to foreign governments. However, the appropriation account does not include payments of value added tax since sales revenue is net of VAT. Profits after tax are available for distribution or for retention. The size of a dividend is determined by the board of directors, who are of course answerable to shareholders. Retained profit is transferred to the balance sheet.

There are two types of profit margin which affect different industries. Firstly there is the Gross profit margin. This briefly shows the gross profit made on sales. It is calculated using the following equation:

Gross Profit Margin = Gross profit x 100

Turnover (sales)

For example, if a company has gross profit at £24.5m and their total turnover was £70m, then they would be operating with a gross profit margin at:

G.P.M. = 24.5 x 100

70

= 35%

For obvious reasons, the higher a businesses profit margins, the more profitably the company is operating. As a rule, the quicker the turnover of money, the lower the gross profit margin. For example, a car retailer with a low rate of turnover would enjoy a higher margin than a clothes retailer with a higher rate of turnover. Therefore the rise in speed of turnover is inversely proportional to the gross profit margin. However if all companies within a certain sector enjoy similar profit margins then it is to be expected that their profit margins will be similar (cerates parabus)

The second type of profit margin is called the Net profit margin. This ratio is the net profit expressed as a percentage of turnover. It is an indicator of management’s ability to control indirect costs, such as overheads, as net profit equals gross profit minus overheads. For example, if gross profit remains the same percentage and the net profit falls then this must mean that overheads have risen. The net profit margin is calculated using the following equation:

Net Profit Margin = Net profit x 100

Turnover

As an example, if a business has a turnover of £50m and a net profit of £3.5m then the calculation would be as follows:

NPM = 3.5 x100 = 7%

50

Once again, the higher the net profit margin, the better. Whether the calculated 7% per cent figure calculated is good or not would depend on the figure from previous years. If it was low in comparison with other years, then it would suggest that indirect costs are higher than the business may want. The NPM may only be useful if it is used for comparison of different figures for previous years. Interfirm comparisons could be misleading because different businesses have different patterns of spending, which will affect the outcome of the NPM but not necessarily relate to the profitability or how the business is faring in the current market.

Margins will vary from industry to industry because the costs of production will fluctuate as one investigates different industries. For example, durable consumer goods (often called white goods) may enjoy a healthy level of both the gross profit and net profit margins. This is because the costs of production may not necessarily account for a significant proportion of the products cost. For example, a television may cost on the high street £100 but the actual costs either to the retailer buying the television from the manufacturer or to the manufacturer in constructing it, the actual cost of the television will be a very low percentage perhaps £60 or 60%. This would therefore mean that if this company sold 500,000 units in one year, then their revenue would be:

500,000 x £100 = £50m

and their costs of either purchasing or production depending upon your choice would only be:

500,000 x £60 = £30m

Therefore their gross profit margin would be:

£20m x 100 = 40%

£50m

However in distinct contrast, a supermarket selling consumer products may have a significantly larger revenue but be chasing significantly smaller profit margins. For example, a supermarket may sell an Apple for 40p, but the cost of purchasing or growing this apple equates to 37p which as a percentage of the retail price represents 92.5%. Therefore if the supermarket sells 1,000,000 apples per year, then their revenue would be:

1,000,000 x 40p = £400,000

and their costs or purchasing or growing depending upon your choice would be:

1,000,000 x 30p = £370,000

Therefore their gross profit margin would be:

£30,000 x 100 = 7.5%

£400,000

So, through the use of examples of two different industries, I have been able to show that due to the fluctuating costs associated with purchasing and production, the gross profit margins will fluctuate between different industries. One of the most influential factors affecting the gross profit margins will be in what type of market the business operates in, for example if the business operates in an oligopoly market with great emphasis placed on competitive prices and costs as low as possible, then the gross profit margin will be low because the business cannot afford to price it’s products significantly above the cost of purchasing or production.

However, if the business operates in a monopolistic market, then it will be able to expect a higher gross profit margin because it can price it’s products will less emphasis placed on the costs of either production or purchasing.

The profit and loss shows as previous explained, how the retained profit of a company has changed during a particular accounting period. This is useful for a business because it allows it to present these accounts to the bank manager if he wants to evaluate how the business is paying off it’s debts, using it’s resources, paying wages etc. but also it will be useful for potential investors because it will allow them to look at the accurate P+L account and see exactly how a business may have been performing.

Alternatively, a business may wish to use the Balance sheet. This accounting sheet contains two main sections – a list of a company’s assets and a summary of its liabilities and capital. One of the most significant differences between the balance sheet and the P+L account is that a balance sheet is a snapshot of a businesses accounts at any point in time. Whereas the P+L account is taken at a pre-determined interval in the businesses financial year. The benefit of the balance sheet is that it shows exactly the funds a business has and how they are being used.

In conclusion, a business would be running most effectively if it successfully managed to balance out the production of annual P+L accounts identifying the underlying expenditure trends with either monthly or quarterly analysis of short-term company expenditure and capital allocation through the balance sheet.

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