Profit and Loss Account (P&L) – Meaning, Types & Importance

The sole purpose of every business is to earn profits. Every business decision is taken considering its impact on the profits of the business. To know its profits, a business must have a detailed record of all its income and expenses. This is possible with a Profit and Loss Account. It is a type of financial statement that reflects the financial outcome (profits or losses) from business activities within an accounting period. 

The profit and loss statement is also a crucial part of any company’s financial statements. Let’s take a look at profit and loss account in detail, format of profit and loss account, and why it is important.

What is profit and loss account?

A profit and loss account, in simplest terms, is a record of all the income and expenses of the business during a particular period of time. Such a period can be the entire financial year, an interim period like half financial period, or a quarter. Every business whether it is a sole proprietorship to a company needs to maintain a profit and loss account to get their correct financial position at the end of the required period. All the cash and non-cash income and expenses of the business are recorded in the profit and loss account.

A profit and loss statement is prepared based on certain basic principles of accounting. These principles include the principle of accrual accounting, matching principle, and revenue recognition. It shows various stages of profits earned by the business organization like gross profit or loss, the operating margin, or the net profit or loss incurred by the business.  

Types of Profit and Loss (P&L) statements

There are two kinds of P&L statements: cash accounting method and accrual method.

1. Cash accounting method – In cash accounting, revenue and expenses are recognized when the actual cash transactions occur, providing a simplified way for small businesses to manage their finances and track their cash flow. The cash accounting method considers only the received or paid cash. This method is widely used by small businesses.
2. Accrual Method – On the other hand, the accrual method takes into account the earnings, even if the money is not yet received. It also tracks the liabilities that are not yet expenses. The accrual method provides a more comprehensive financial picture by recording revenues and expenses when they are earned or incurred, regardless of when the actual cash transactions take place, making it suitable for larger businesses with complex financial operations.

How Profit and Loss (P&L) statements work?

A Profit and Loss (P&L) statement is a financial report that summarizes a company’s revenues, costs, and expenses over a specific period. It shows the company’s net income or loss during that time. The report helps companies track their financial performance and make informed decisions about their operations.

What are the components of the profit and loss account?

The profit and loss account consists of various components that record the income and expenses of the business under various categories. The details of the same are mentioned below. 

a. Revenue/ Income 

The revenue of a business is also referred to as the top line. The income of the business is classified into two main categories. The revenue from the primary business operations are recorded first. It includes the revenue generated in the normal course of business. The next category refers to the other income or the miscellaneous income of the business. It will include the income generated from the various investments of the company (for example, interest or dividend income). 

b. COGS

The next broad category of the profit and loss statement is the cost of goods sold (COGS). It includes the direct cost of operating the business like the raw material cost, labour cost, or the direct overheads of the business entity related to the manufacturing or purchasing the goods. These expenses are the first line of expenses deducted from the revenue to generate the gross margin of the business. 

It is important that the business has a higher gross margin as the operating and non-operating expenses to be deducted from the gross margin further reduce the profits of the business. It is, therefore, important to keep the COGS in check to ensure net higher gains for the owners or the shareholders of the company. 

c. Operating expenses

Operating expenses are not the direct expenses involved in the production or manufacturing process but the indirect cost of running a business. These expenses include administrative expenses like employee costs, depreciation costs, selling, marketing and distribution costs, research and development costs, etc. These costs have a direct impact on the net profits of the business. If the operating costs of the business are too high, it can turn the positive gross margin into a net loss too. 

d. Operating profit

The operating profit is the positive balance from the gross margin after deducting the operating expenses. It is also referred to as EBIT (Earnings before Interest and Taxes). A positive operating margin assures the investors and the stakeholders of the profitability and the solvency of the business.  

e. Net income

The net income of a business is the bottom line or the net profit generated by the business after deducting all the operating and non-operating expenses as well as interest and taxes. This is the profit that is available for distribution to the shareholders. The earning per share are also calculated based on the net profit or the net income of the business. 

How to prepare Profit & Loss Statement?

The profit and loss account of a business organization can be prepared in either horizontal or vertical format. The Companies Act, 2013 does not lay down a set format for any business organizations except for companies. In the case of companies, the profit and loss account is to be prepared and presented in the vertical format to be included in the financial statements of the company. 

The horizontal and vertical format of the profit and loss account is shown below. 

a. Horizontal format (T format)

The horizontal format of the profit and loss account (also known as income and expenditure account, statement of operations, etc.) is highlighted here.

Profit and loss account for the period ——–

b. Vertical format

The vertical format of the profit and loss account that is mandatory for companies is mentioned below.

Statement of Profit and Loss for the period ended ——-

Why is a profit and loss account important?

The profit and loss account of any business is the reflection of its financial viability. It is a mandatory statement that is important for every business and has to be prepared with due diligence without which the survival of a business whether small or big can come in serious jeopardy. The importance and benefits of the profit and loss account are mentioned hereunder.

1. It helps the business understand its operational efficiency and the various expenses incurred by the business to keep it afloat. 
2. The profit and loss account helps the shareholders understand their net earnings per share while the investors can evaluate the viability of their investment. 
3. It also helps the business meet the statutory requirements of drafting the financial statements and getting them audited and approved in the AGM.
4. A profit and loss account is the direct evaluation of the profitability of the business and comparison with its past performance. 
5. A negative net profit despite a positive gross margin can indicate a high operating cost and help the management take executive decisions to optimize it. 
6. It can also form the basis to make future profit and loss statements to estimate projected profits of the business and make better business decisions.  

What is the difference between the balance sheet and the profit and loss account?

Balance sheets and profit and loss accounts are part of the financial statements of a business entity and are used in the fundamental analysis of the business. They are to be prepared and presented in a specific format to meet the compliance requirements laid down under various laws. Both the statements are important in their own right and have to be read in totality to get the true picture of the financial position of the business and its future growth prospects. However, the basic differences between the balance sheet and profit and loss accounts are highlighted below. 

Red flags to look out for in the profit and loss accounts

A company’s profit and loss account is used to understand the feasibility of the business operations and its ultimate profitability. Investors and other stakeholders can also review the profit and loss account to look for any warning signs that can indicate if the business is in trouble. Some of such warning signs are mentioned below.

1. Falling profit margins of a business without valid reasons can be an immediate red flag for the investors and owners. There can be several reasons for reducing profit margins like the increase in operating or non-operating costs, increase in competition, reduction in sales or revenue from the core business operations, etc. 
2. Irregular and inconsistent remunerations for the owners can indicate the lack of interest in the business or simply window dressing to increase the bottom line. Hence, it has to be reviewed by the relevant stakeholders with caution. 
3. A decline in the sales and revenue of the business can indicate new entrants in the market or the product of the business being stale and no longer attractive. This can impact the long-term survival of the business and warn the potential investors of declining market share. 
4. If the other income of the business is consistently higher than the income generated from the core business resulting in a positive profit margin, it is also a red flag for the management as well as the shareholders and investors. It reflects that the business is dependent on other sources of income for its financial viability which can endanger the profitability of the business in the long run.

Conclusion

A profit and loss account is also known as an income and expenditure statement. It has to be prepared on a continuous basis and reviewed with caution to know the true profitability of the business. The profit and loss account can also help the business organization chalk out the money-draining areas that affect the bottom line of the business and thereby help in streamlining the production and operation process. 

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