Interpreting your Profit and Loss Account

The Profit and Loss account should be starting to make sense by now. If you need a reminder, check out our other two blogs – What is a Profit and Loss Account? and What’s in a Profit and Loss Account?

Now we’re looking at what it all means but before we get there, we need to make sure the information is somewhat meaningful.

Xero is clever, but not enough to know the type of your expense. You need to tell it whether the expense is a direct cost that impacts gross profit, or an operating/overhead expense (operating expenses). Instructions can be found here – just scroll down to the heading “Type” to find what you’re looking for.

Xero’s chart of accounts has default settings which may already be suitable for you but feel free to change them.

As with most financial reports, looking at the current year’s information is only part of the picture. You also need to look at previous periods for trends. Are your sales and expenses in line with the previous year? If you have a budget, how well did you do?

Sales (revenue)
Cost of sales
Gross profit
Non-cash expenses
Operating expenses
Net profit
Where has my profit gone?

Sales 

“Nothing happens until someone sells something” (Henry Ford)

How true. Without sales, your business cannot pay its employees (including you). The whole point of being in business is to make money (net profit), so sales should be the centre of your attention. Sales should cover all business expenses and provide the owner with a reasonable return.

However (and it’s a big ‘however’), more sales don’t necessarily mean more profit. Ask yourself these questions:

  • Have your sales increased or decreased over the years?
  • If you hire an extra contractor or employee for $45,000 a year, are you getting at least that back in additional sales?*
  • Are you pricing your product correctly?
  • Are some products selling better than others, and if so, why?
  • Do you receive a higher margin on certain products?

* Or does the extra person mean you can reduce your own hours, let you have more free time, or allow you to focus on other business areas? Remember – your time is also valuable and mustn’t be discounted.

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Cost of sales*

If you’re paying for an extra contractor or employee, you should see either an increase in sales by at least the same amount, or your own workload should lessen, or a combination of the two.

With your purchases – if these increase but revenue doesn’t, what’s happened with the items you bought?

Xero is able to track categories for income and expenses if you’d like to determine the profit on individual projects or jobs. Xero can provide a Profit and Loss Account for each job. From here, you can see if you’re pricing each job correctly – you may have an idea of the profit in your mind or jotted it down somewhere, but have your workings taken into consideration all costs?

* Some businesses may not have any cost of sales, such as those providing services

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Gross profit*

Gross profit is important. Very important.

It’s calculated by taking your sales from operations (don’t include any interest or one-off items), then deducting your cost of sales.

Gross profit should be able to cover your operating expenses.

* Some businesses won’t have gross profit, such as those providing services; in these circumstances, gross profit is just sales/revenue.

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Non-cash expenses

We’re not saying ignore these when analysing your profit and loss account, but the business often has no control over non-cash expenses. They include:

  • Depreciation – this may not be a true reflection of your assets’ loss in value because we use the maximum deduction allowed by Inland Revenue.
  • Home office expenses – this is an expense calculated only because Inland Revenue allows a deduction for business owners using part of their home for business purposes
  • Motor vehicle reimbursement – similar to home office expenses, we only adjust your financial statements for tax purposes
  • Depreciation recovered – this pops up in your profit and loss account when the business sells a fixed asset for more than its book value; it’s purely arbitrary as it directly related to depreciation
  • Loss on disposal of assets – this is the opposite to depreciation recovered and happens when the business sells a fixed asset for less than its book value
  • Shareholder salary – this is an adjustment made by your accountant as a means of allocating company profit
  • Bad debts – considered to be a non-cash expense because you’ve recorded the sale as income but won’t receive payment; we don’t want you paying tax on income you’ll never receive

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Operating expenses

Your focus on operating expenses should be looking at trends (comparing against past years) and unusual items. If you have Xero’s profit and loss account on your screen, click into the expense and you’ll see the listed included there.

We’ve written a blog – How to identify and measure the key indicators for your business – which will give you more ideas. Also check out our budgeting and forecasting articles. Comparing your actual figures against your expectations (and understanding any variances) will provide great insight into your business.

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Net profit

Your net profit is the gross profit less non-cash and operating expenses. From reading other sections in this article, you’ll be understanding that the bottom line itself doesn’t provide any insights – you need to compare against previous years, and see how accurate (or realistic) your budget/forecast has been.

Sole traders and partnerships

Your net profit would be the equivalent of receiving wages – is it enough for you to live on? What changes would you need to make?

Companies

Take into consideration any PAYE-paid wages you receive from the company, your shareholder salary if one has been allocated, dividends you receive, and your net profit. As with the sole trader, are you happy with that as income?

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Where has my profit gone?

You’ve made a net profit, but don’t see it reflected in your bank account – business or personal. You ask yourself – I’ve made a profit, but where’s the money?

It’s such a common question that we’ve created a blog specifically on the topic. You’ll find explanations of various reasons, including:

  • Non-cash transactions
  • Fixed assets purchased
  • Drawings taken by business owners
  • Loans received or repaid during the year

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We love helping business owners improve their bottom line and lifestyle – whether it’s more money or more free time. We work with a large number of clients on forecasting, growing the business, regular management reporting, and virtual meetings. Email us at [email protected] or call us on 0800 755 333 for more information.

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