Most small businessmen do not prepare, read, understand or analyze their profit & loss account. They think this document is required mainly by big companies and it is not necessary for small businesses.
As a business grows year-on-year, the issue for most businessmen is, how can one determine their income-tax obligations? How can one avail loans from bankers? And finally the most important concern is how to forecast their revenue and expenses while setting yearly targets?
The profit & loss account provides information about an enterprise’s income and expenses which result in net profit or net loss. It helps a businessman to evaluate the performance of an enterprise and provides a basis for forecasting future performance. It also provides valuable information required by a banker while sanctioning a loan.
The Profit & Loss account describes different business activities such as revenues and expenses, particularly useful in assessing the risk of not achieving certain level of income in the future. It also provides information required to determine tax obligations.
“A profit & loss account is not only the statement of income and expense, but it also enables you to increase your earnings by reducing unnecessary expenses and increasing incomes,” states Garg Sharma Tandon & Associates, partner Sanjeev Tandon, a practising chartered accountant since 1995.
Setting and achieving targets is the bedrock for the growth of SMEs and setting a target requires projection of revenues and expenses. An established SME can make projections for its future revenue based on its past sales and expected income using their Profit & Loss account. As a small business starts and grows, it may find that its expenses increase at a higher rate.
The SMEs may make accurate expense projections to avoid unnecessary expenses. The Profit & Loss account also allows enterprises to see where it can improve its revenue streams and cut costs.
Analysing a profit and loss account
The profit & loss account of an enterprise can be analysed by understanding its basic components.
Gross turnover/sales: The gross turnover describes the total sales or gross receipts made during the year. Basically, it provides information about the size and value of the business. A comparison can be made between the previous year’s turnover and the current year’s turnover to analyze the growth of the business.
Direct expenses: Expenses connected with purchases and manufacturing of goods are known as direct expenses. For example, purchase of raw materials, factory labour, factory wages, electricity expenses, etc. It describes the operating costs of a business.
Gross profit: This is the profit from the sale of goods that will be utilized to pay operating expenses of the enterprises. Higher gross profits mean that the enterprise will have more money to pay operating expenses like salaries, rent and administrative expenses.
Indirect expenses: All expenses other than direct expenses are assumed as indirect expenses. For example, rent and taxes, salaries and wages, interest, depreciation, agent commission, advertisement, etc. These expenses describe selling and administration cost of a business.
Net profit/loss: A profit & loss account has two sides, that is, income part (credit side) or expenditure part (debit side). The difference in the two sides of this account will represent either net profit or net loss. A higher net profits indicates that the enterprise is more effective in converting their revenues into actual profit.
Accrual basis of accounting in a profit & loss account gives a correct picture of the profit or loss for a given period. This is because accrual basis of accounting recognizes all revenues and expenses in a given period regardless of actually when the cash transactions occur.
For example, a local lender issues a loan to a business, and sends the borrower an invoice detailing the amount of interest owed for each month, Hence, the borrower can record the interest expense every month as it pertains to that month without being paid the interest in cash under the accrual basis of accounting. This translates into the fact that while preparing the profit & loss account for that period, it will be considered as expenses. 
However, in the cash basis of accounting, such interest expenses will be considered when it is paid out. Even accounting standards also require preparation of books of account on accrual basis.
This account describes profitability or operating results of an organization that help shareholders make decisions on their investments, that is, hold, sell or buy. In the same way, owners need profitability to determine business is profitable and whether to continue, improve or drop the business or part thereof. It also informs about how a business generates its income and manages its costs to the investors.
Did we meet our targets? How much did we make last year? How many supplies will we purchase? All these, and many other questions and business decisions of management, require managers to analyze the profit & loss account. Lenders of funds such as banks and other financial institutions are interested to give credit to a company if their profit & loss account shows ability to pay interest and liabilities on maturities.
“Business means looking for profit and if you are not looking at your profit & loss account it simply means you are not a businessman,” concludes Ashutosh Agarwal & Associates, Partner, Hitesh Agarwal, a practicing chartered accountant.
( By: Rahul Kumawat)
Source: The Economic Times
