Understanding Accounts

To steer your company in the financial direction you want it to take, you need to understand where you’re making money and where you’re spending it. This is why you should keep accounts and produce regular reports, including a profit and loss account and balance sheet.

What is a profit and loss account?

A profit and loss account tells you how a business is performing over a period of time. It includes the following:

  • Turnover – The sales or business income for the period.
  • Cost of sales – e.g. items purchased to resell,
  • Gross profit – Turnover minus the cost of sales,
  • Overheads – These include the rent for your premises, marketing costs, wages, telephone, postage, and stationery etc…
  • Operating profit/loss – The gross profit less the overheads..
  • Other income – Such as interest received.
  • Net Profit – Profit before tax is paid.

A profit and loss account (P&L) is useful to show owners, investors and shareholders how your business is doing at a glance. However its true value is achieved by analysing the figures to identify trends and discrepancies which will help with decision making. A P&L may, for example:

  • Identify regular sales patterns.
  • Ensure gross profit margins are maintained.
  • Compare profitability against previous years.
  • Identify unexpected increases in overheads.
  • Ensure budgets are being kept to.

Balance sheet

A standard balance sheet has three main items on it, Assets, Liabilities, and Equity. These can be defined as follows:

  • Fixed Assets – Long-term possessions
  • Current Assets – Short-term possessions
  • Current Liabilities – What the business owes and must repay in the short term.
  • Long-term Liabilities – Debts to be repaid over a longer period e.g. mortgages.
  • Equity – The difference between the assets and liabilities and, for sole traders or partnerships, also money that has been introduced into or drawn from the business by the proprietors.

Analysis of a balance sheet can show:

  • How solvent the business is.
  • How liquid its assets are – how much is in the form of cash or can be easily converted into cash, ie stocks and shares.
  • How the business is financed.
  • How much capital is being used.

Ratios are often used for analysis purposes and these can be compared against previous period or against competitors balance sheets.