To run a business efficiently, management must thoroughly understand its financial position. To this end, accountants produce financial statements like balance sheets, cash flow statements, and profit and loss statements. This article focuses on the profit and loss statement.
What is a profit and loss statement?
This crucial financial tool records the revenues of a company during a particular operating period against the costs of operations and other expenses. Otherwise called an income statement, this accounting tool is prepared every three months or annually, depending on the preference of the company. The profit and loss statement helps management compute profits from operations over a specific operating period. Companies use the formula Profit = Revenue – Expenses to measure their activity through a given period.
The profit and loss statement makes it easier to understand the health of the business. You can know how much inventory was sold for a given time and how much buying customers did at that same time. Once you’ve made sense of sales and earnings, a simple subtraction of costs and other expenses will tell you how much profit was generated over the period.
Another significance of monitoring the profit and loss statement is that you get to understand the expansion potential of the business. Having a good idea of the company’s cash flow enables management to determine how much debt they can commit to the business. This knowledge also helps management to make decisions like reinvesting earnings.
Creating a profit and loss statement
A profit and loss statement comprises revenue and expenses during an operating period. We take you through this process below.
The first step in profit and loss statement creation entails establishing the company’s top line. This involves creating a revenue profile of the company. Here, you list all the revenues generated over the specific operating period, then subtract discounts to obtain net revenue.
Second, do away with the cost of sales from net revenue. This includes the money spent on the process of developing goods or services. The result of this is gross profit, as in earnings before interest and taxes (EBIT), otherwise called operating profit. Next is the deduction of interest expenses and any other expenses such as income tax. Ultimately you will be left with net income, which represents net profit from the specific operating period.
What is the significance of profit and loss statements to stakeholders?
Income statements provide a snapshot of the activity of a company over the particular operating period. As such, the item is a source of crucial insights into the company for the benefit of stakeholders like management and shareholders. Usually, companies prepare income statements frequently, either quarterly or annually. Stakeholders are thus able to monitor the progress of the company and to determine the impact of specific projects on the financial performance of the business.
In addition, the income statements are important to management when it comes to developing and implementing strategies. Notably, information from the income statement helps management answer questions like, should we expand our operations and introduce new products? Would shutting down the production of certain products boost net profits?
Other stakeholders that might find information from the income statements are creditors. The information helps them to determine if a company has the capacity to honour its financial obligations.