Finance / Cash Flow
Understanding Finance (the Profit and Loss Statement)
How well is your organization performing? How can its performance be improved? Why is turnover up and yet profits are down? How effectively are you using resources? What can be done to improve the cash flow of the organization? How is your organization viewed by ‘outsiders’ and indeed do you assess other organizations?
Questions such as these are constantly being asked and a mass of accounting information is often given in an attempt to provide the answers. Many managers, however, fail to make effective use of the available information, often because there is so much data available and information overload so easily occurs. So what can we do to simplify the task of thinking about profit and loss and to better understands the accounting data that the Profit and loss account offers (on your enterprise or others)?
The Income Statement or Profit and Loss Account
The measurement of profit is central to the “art” of accounting. The calculation of profit simply aims to list the income of a given business, which is then matched against the expenditure incurred in generating that income. It should be noted however that profit it not a precise figure. Some of the cost figures used to determine profit are subjective and will, therefore, vary according to the view taken by the person preparing the operating statement.
The profit and loss account (or income statement as it is also sometimes called) is really three statements in one. Firstly, the trading account (calculates gross profit), secondly the profit and loss account (calculates net profit) and thirdly an appropriation account (shows how profit was paid out or retained). For simplicity the whole statement is usually referred to as the profit and loss account.
What does a Profit and Loss Statement cover in detail?
At the top line, a Profit and loss statement will show income or revenues flowing into an enterprise. This may be a single line or broken into several different kinds of revenue before being totaled.
Underneath the revenue line is then the Cost of Sales or Cost of Goods Sold (often referred to as COGS for short) which are the variable costs incurred in selling whatever the enterprise is providing. This is likely to include the cost of raw material and supplies, distribution expenses, commissions, fees and other payments related directly to selling but may also include costs like direct labor associated with manufacture or selling (as opposed to overhead salaries which are listed in the general and administrative expense section).
The next section of the profit and loss statement is often called general and administrative expenses and usually contains fixed and discretionary expenses.
Fixed Expenses: Fixed expenses are constant. They do not vary with sales or production. They are the basic overhead costs of the company, such as utilities, rent, insurance, etc., which are charged against revenues on a periodic basis (weekly, monthly or annually).
Discretionary Expenses: Discretionary expenses are those which the business owner may control in order to decrease the reported profits. Specific expense categories here may include things like: Travel and entertainment costs, Training Expenses or Advertising or Marketing costs etc.
Finally, at the bottom of the Profit and Loss statement are the profits (gross and net). Simply stated, profits are equal to the difference between revenues and expenses:
Profits = Revenues – Expenses
Gross profits are initially shown, from which is then deducted interest, tax and depreciation creating a net profit figure, which can then be reinvested into the enterprise or paid out as dividends (where shareholders exist of course).
Organizational managers, whether they are in a public, private or voluntary sector organization, should be commercially aware of what a profit and loss account is telling them and for monitoring and controlling financial resources to one degree or another (usually through the use of carefully constructed budgets which help manage the ever important cost side of the enterprise).