There’s a menu on the far right-hand side of your FreeAgent account that you might either avoid like the plague or look at and think “what on earth?”
It’s called Accounting.
If you know what a profit and loss account is, know how it can help you in your business, and understand all its contents, then you don’t need to read this. But if you’d like to find out more about what it’s showing you, read on.
Why would I want to know that?
The P&L contains information that’ll help you make important decisions about your business. For instance, it’ll help you decide if and when it’s time to put your prices up, or start selling a new range of services or goods.
OK, sounds good. Tell me more.
The profit and loss account (or P&L for short) shows your business’s income and expenses, over a given period of time. That’s usually a year, but it can be a month, or the year so far.
A business’s income is usually made up of the following:
Sales invoices and when they show up
First and foremost, it’s all the invoices that the business has issued to its customers during the period covered by the profit and loss account.
The invoices will appear on the P&L whether or not you’ve been paid for them.
In accountantese that’s called “accruals accounting” because in the UK you have to show the invoice in the P&L for the period when the income accrued, i.e. when you did the work and issued the invoice.
Strictly speaking, that also means that if you’ve done some work right at the end of your accounting year and not invoiced your customer till the start of the next accounting year, you should do journal entries to show the income in the earlier accounting year. Sticky stuff.
In the US and Canada, businesses are allowed to track their income and expenses on a cash basis, that is they’d only show invoices in the P&L (which they call an income statement) when the invoices were paid for. Much easier in some ways, but sadly not allowed in the UK, no matter how small your business is.
There are some other items that’ll appear in income, such as bank interest you receive, but by and large it’ll be your sales invoices.
Now we come to the business’s expenditure.
Depending on your business, this might be broken down into the immediate cost of making your sales (or “cost of sales” in accountantese) and the business’s day-to-day running costs (or “admin expenses” in accountantese), such as staff wages, telephone bills and so on.
Tell me more about cost of sales please.
I have a client who’s a jeweller, making jewellery from wire and beads. Her “cost of sales” would include the cost of the wire and beads, plus the cost of having those materials delivered to her.
Do all businesses show cost of sales?
No, they don't.
Many service-based businesses don’t have a “cost of sales” area, because their only immediate cost of making a sale is the business owner’s own labour.
For example, if you’re selling your services as a computer consultant, all it costs you to actually make those sales is your own time. You don’t have to buy anything in to make the sales - you’re selling your own expertise.
If you do have a “cost of sales” section in your P&L, that’ll come just below your income, and then you’ll see the word “profit” for the first time - because income less cost of sales is called “gross profit” in accountantese.
How is this figure useful?
“Gross profit” helps you work out how much you’re earning from your sales. If your direct costs are eating up too much of your business’s income, then you need to put your prices up to make sure you have enough to cover the rest of the running costs.
Accountants often take the gross profit and divide it by the sales figure to work out what’s called the “margin” or “gross profit margin”.
For example, a business with sales of £10,000 and cost of sales of £4,000 would have a gross profit of £6,000 and a gross profit margin of 60%.
Why’s that important?
Because it means you and your accountant, if you have one, can check how profitable your business is compared to other businesses in the same industry, or compared to how your business did last year.
If your margin has dropped year-on-year, it might be because one of your suppliers has put up their prices, but you haven’t passed that cost on to your customers.
Should I consider doing that?
That’s up to you, but if you hadn’t compared this year’s margin to last year’s, you might not have picked it up.
It might also be because your customers are going elsewhere because everyone who’s going to buy a bespoke IT system, has one. You might need to start selling a service to repair and maintain systems as well as install them.
OK, I get the picture. What are the rest of the expenses on the P&L?
Under the gross profit come all your business’s running costs that aren’t directly related to actual sales.
Often these will be “fixed” costs, which are costs that you’d have to pay exactly the same amount for no matter how many sales your business made. That might include wages for salaried staff, or office rent.
“Variable” costs are those that go up or down with your business’s sales income, for example the wages for a team member who’s paid on commission, or the cost of buying materials to sell.
What costs aren't here?
What the P&L won’t include is the cost of any large items you’ve bought for your business’s own use which are going to be useful for more than about a year, for instance a new iMac to design your customers’ websites.
These are called “capital assets” and they go on your business’s balance sheet rather than its P&L, for two reasons.
Firstly, they’re treated differently for tax, and secondly, because they’re going to be useful to your business for more than a year.
More about capital assets in a later post.
When do costs show up on the P&L?
Costs that go in both cost of sales and expenses will be entered as the cost is incurred, not when it’s paid.
So if your P&L runs to 31st March 2010 and you enter a bill into FreeAgent dated 25th March 2010, then pay that bill on 1st April 2010, the bill will show in the P&L to March 2010 - not to March 2011.
This is to make sure the costs match the income that they were helping to earn.
Profit or loss figure
Then at the bottom of your P&L comes the profit, or “net profit” to distinguish it from the gross profit.
The profit figure is simply all the income less all the expenses, both cost of sales and admin expenses.
If your business’s expenses are greater than its income, it’s made a loss. If the business’s income is greater than its expenses, it’s made a profit.
Why’s that important?
Because you pay tax on profit, after some adjustments. FreeAgent helps you by working out a ball-park projection of your tax, which is income tax if your business is a sole trade or a partnership, corporation tax for a limited company.
If you want to raise cash for your business, a bank will look to see whether your business is making a profit.
And, while losses at the start of your business are almost inevitable, if your expenses outweigh your income you won’t be in business very long!
Also, particularly if none of your expenses count as “cost of sales”, you can use the final profit figure to work out a margin and consider, using that figure, whether your business is making “enough” profit.
So the profit is what I pay tax on, right?
The profit on your profit and loss account isn’t necessarily the profit figure you pay tax on. Some expenses aren’t tax deductible.
What does it mean to say an expense is “tax deductible” or you “get tax relief on it”?
If an expense is not tax deductible, e.g. business entertaining, you can include it when you’re working out the profit and loss account profit figure, but you’ll have to add it back when you’re working out the profit figure to pay your tax on.
If an expense is tax deductible, you don’t have to add it back!
If you're confused about any of this, please post a comment below or talk to your own accountant!
Disclaimer: This article is written on a general basis and is no substitute for specific advice provided by an accountant.