A Profit and Loss Account is designed to show the financial performance of a business over a given period (usually Monthly or Annually) and to indicate whether it is (or, in the case of a P & L Forecast, if it will) make or lose money.
Without Profit there eventually will be no business
Profit and Loss is also essential in providing information for Inland Revenue for Taxation purposes
Understanding how a Profit and Loss Account works will help you to choose the right time to buy items that you need for the business, reduce your tax liability (Tax Bill) and work out how much Tax you will have to pay.
Even if you have an Accountant you will have to sign to say you have "Read, Understood and Agreed" with their figures and the eventual responsibility for getting your Tax return correct is yours.
Example Profit & Loss Forecast for AB Plumbers
Cost of Salespacespacespace£2.095
Net Profit spacespacespacespacespacesp£10,850
Retained Profit spacespacespacespacesp.£850
This looks really simple, doesn't it? However some people get very nervous when they are faced with producing a Profit & Loss Forecast (or Account) so let's look at where all the items in the above example come from.
For the Plumber, in the example we have followed, the Sales for his Forecast come from the Sales Forecast final total. For an established, or trading, business the Sales figure comes from sales made in the period you are producing the P & L Account for (this may be monthly or annually).
This sales figure should not included VAT (if you are VAT registered) otherwise you are paying Tax on a Tax.
In addition, if you issuing invoices, you have to decide whether you will include sales in this total when you issue the invoice, or when the customer pays the invoice. It doesn't really matter which way you decide to calculate it - but whichever way you decide to go you should always keep the same method and apply the same to your incoming bills
This figure is taken from the estimated materials, that the Plumber has calculated he will need, to carry out the forecast work - not including VAT if he is VAT Registered. For an established, or trading, business the Cost of Sale comes from the invoices and bills you have for all the materials (or stock) you have sold during the period you are preparing the account for.
Some businesses carry stock and, if this is the case, you will need to do a "stock movement calculation" to work out exactly how much of the stock you bought in you have sold, and how much you are left with - this sounds complicated, but it isn't. Stock can include materials, goods bought in for resale, work in progress, finished items waiting to be sold and , if you employ subcontracted labour to produce finished goods, the cost of labour.
To calculate stock movement you start with how much you had in stock at the beginning of the period you are working out (for new start businesses this will be the amount of stock bought to set up)
Next, you work out, from invoices and bills, how much stock you have bought during the period you are calculating and add the two together - this gives a figure for the total amount of stock you could have sold.
Now you do a stock check and see how much stock you have left that is unsold - at the price you paid for it, not the selling price.
Now you take away the amount of stock you have left, from the amount you could have sold and - the result is what you did sell (of course it may also have been stolen, or lost and you can check this by working out the actual Gross profit Margin and comparing it to your estimated Gross profit Margin)
An Example of a Stock Movement Calculation is as follows:
Opening Stock £500
Stock Purchased £2,000
Total available for Sale £2,500
Stock Check £405
Amount of Stock Sold £2,095
The Gross Profit is simply calculated by taking the Cost of Sales from the Sales figure. As discussed in Sales forecasting, there are recognised guidelines for many business as to there gross profit and we have provided a table, at the end of this section for a number of types of business.
Calculate the Overheads (or Indirect Costs) from the Cashflow Forecast (for the Example of the Plumber and for new start businesses) and from actual bills, invoices you have received and receipts you have - not including VAT if you are VAT registered. Remember to decide whether you are adding these when you get the bill, or when you pay the bill - whichever one you choose stick with it.
A list of allowable running expenses is included in the Answers section, under Inland Revenue.
If you are a Sole Trade, or Partnership, drawing (or your wages) are not included in this section and are not allowable against Tax, but all staff wages are allowable as Overheads.
If you have a Limited Company then you should be paying yourself on PAYE and your wages are deductable as Overheads.
The Net Profit can now be calculated by taking the Overheads from the Gross profit. This is what Inland Revenue will work out your Tax Liability (or Bill) on.
Please check in the Answers section of this web site for the current dates you will receive self Assessment Tax forms and the dates by which they must be returned.
This is the amount of money you draw out of the business for your personal expenses, and to live on. It is not taxable because Inland Revenue have worked out your Tax on the Net Profit - so, realistically, you can draw however much, or little, you want from your business without worrying about tax.
However it may be advisable to keep putting some away for when the tax bill arrives. There is a 'Ready Reckoner' in the Answers section under Inland Revenue which will show you how much you need to save to pay your bill, based on profit.
This is what is left, after you pay all running expenses of the business and take your income from it. This will go on into the following year and form a 'safety cushion' for future expansion.
Please note: If you leave money in your business as a retained profit, you will not be taxed on it again, since it is not included in your Sales figure for the following year - Tax is only calculated on your Trading Profit and Loss, not on money left in, or invested, in the business.
The Inland Revenue Tax Year runs from April 6th to April 5th the following year and they calculate tax on this period. however very few people start their business on April 6th and therefore it can become difficult to estimate your tax bill because of what is known as 'Rollover Taxation'.
In other words, let's say you start a business on October 1st - your 'Trading Year' runs from October 1st to September 30th the following year. The profit you make between Oct 1st and April 5th is taxed in one year and the profit you make from April 6th to Sept 30th is taxed in another year. It can become complicated working out what your Tax Liability is going to be from one year to the next.
Solution: Start your trading year on Oct 1st and end your first trading year on April 5th. Ten start your second trading year on April 6th (simply send a letter to Inland revenue telling them this what you are going to do).
Now your Trading Year and the Tax Year are in line and you know that whatever profit you make in any trading year is what you will be liable to pay Tax on.
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Because if you can calculate your Profit and Loss (and therefore your Tax Bill) before the end of the Trading Year you can 'Buy Overhead' in other words stock up with Stationery, Computer Supplies, Pension, etc. and reduce your tax bill.
It's far better to do that, than to go to your Accountant and he, or she, says "Well, you should have spent £...s and you should have renewed this and that and, because you didn't know the basics of Profit and Loss you're now paying more tax than you needed to."