The two main factors that affect the profit of an organisation are its income and expenses. The Oxford Dictionary of Finance and Banking defines income as being ‘a return that is measured over a given period of time’; and Gerald Klein (1995) defines expenses as being ‘money spent in the day-to-day operations of a business entity’. Geoffrey Holmes Et al (2005) mentions that until today, four formats of profit and loss accounts have been used, of which formats 1 and 2 are single-paged as well as vertical, and are considered to be the most modern of the four; and formats 3 and 4, which are two-sided and are considered to be traditional.
Although these traditional formats are nowadays very rarely practiced by UK listed companies, they were, however, quite common only 50 years ago. Geoffrey Holmes Et al goes on to explain that format of the profit and loss account is structured in a particular way so that it can be conveniently divided into three parts to how much profit (or loss) was earned, how much was taken by taxation and what happened to the profit (or loss) that was left after taxation.
The format of the profit loss account is set up so that it flows from top to bottom, taking into consideration all income and expenses.
Like the balance sheet, the profit and loss account also groups together its figures for presentation purposes. A profit and loss account is usually prepared for monthly, quarterly and annual records.
And would start at the top with the amount of turnover an organisation has achieved for the given period of time. The figure would be written as its net sales revenue, which James O. Gill defines as ‘the total value of all cash or credit sales less returns, allowances, discounts and rebates’.
Just as liabilities were separated for the balance sheet, the costs would also be grouped separately for the purpose of the profit and loss account. Costs would be separated into two categories, the first being the initial cost of sales and the second being any other expenses. Thomas Ittelson defines cost of sales as being the cost an organisation records as the total cost of manufacturing a product and are normally found in businesses, which buy and sell goods rather than those, which provide services.
This would include expenses incurred for purchasing the raw materials and any direct labour i.e. factory staff. All other expenses occurred during that period such as rent, wages and salaries, advertising, legal fees etc. would be categorised separately, as these are expenses that are incurred for developing and then selling the product, which would also include all administrative costs. The profit and loss account would conclude its income and expenses in to figures, the gross profit and the net profit.
The gross profit is a profit that is calculated by only taking into consideration the cost of sales.It is the difference left once the cost of sales has been deducted from net sales. It can also be called the gross profit margin as it measure how much an organisation makes for every $1 of its sales revenue. Net profit on the other hand is basically what is left over after the remaining expenses have been deducted from the gross profit. If the calculated sum is of a positive nature then the organisation would have made a profit, however, had it have been of a negative nature, then the organisation would have made a loss.
Both the gross and net profit is used as method of measuring an organisation’s performance. A point to mention is that although Thomas Ittelson agrees with Michael Jones’ perception that the profit and loss account measures the performance of an organisation, he also believes that it does not tell the complete picture about an organisation’s financial health. Now that I have established what the main factors of the profit and loss account are, I can look into how these factors are used to create a financial picture of an organisation at a given period of time.
Just as like the balance sheet, the profit and loss account is also analysed and interpreted using ratios. Without using these ratios it would be extremely difficult to interpret what the profit and loss account is portraying. The profit and loss account uses the information of income and expenses to determine how profitable the assets of an organisation are. Although there are a variety of ratios that could be used to interpret the information, in this case it would be best to use either the ratio for gross profit margin or net profit margin.
Once again I will not go into too much detail of what these ratios mean, as I have gone into greater detail in the section of my exercises. As the overall purpose of a product and loss account is to illustrate the amount of profit an organisation is generating, I will conclude my analysis by leaving you with a thought of what is meant by the term of profitability. According to The Oxford Dictionary of Finance and Banking, the term profitability is defined as being ‘the capacity or potential of a project or an organisation to make a profit’.
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