Karen Szotek BSc ACCA
Joanna Grant BSc ACA
If you are in business, and intend to stay in business, then you must make a profit. In simple terms profit is the difference between your income and your expenditure. Your income is what you generate from selling goods and services to your customers. This must be sufficient to pay for all your expenditure and leave a bit extra for you - the profit. The expenditure includes everything you spend to buy or make the goods and services you sell and all the costs you incur to keep the business running such as rent, rates and insurance.
HMRC and possibly Companies House will require you to prepare a statement showing your profit, a profit and loss account, once a year. This will not be frequent enough for you. You need to know on a much more regular basis whether your business is trading profitably or not so that you can take early corrective action if things are going wrong and take advantage of those things that are going right. You don’t necessarily need a full profit and loss account to do this, a look at a few key numbers may be sufficient.
Your annual profit and loss account shows all the income received and expenditure incurred by your business during the financial year and whether your efforts have been rewarded by a profit or loss. Trading income, or sales, will be shown separately from other types of income. From the sales we deduct the cost of sales. If you are a retailer this will simply be the cost of buying the merchandise which you have sold. If you are a manufacturer then this will be the cost of materials, labour, and other expenses incurred directly in making the products you sell.
Whatever the business, cost of sales is made up of those costs incurred directly to make the product or provide the service which you sell. Sales minus cost of sales equals your gross profit. The gross profit expressed as a percentage of sales tells you how much, on average, your business is making on each sale and can usefully be compared with the percentage for last year or with that achieved by your competitors. Comparative figures for last year are provided alongside each entry in your accounts.
The gross profit has to be enough to cover all your expenses and leave enough profit for you to live on. Not only do you have to make a profit on each item you sell, but you also have to sell enough of them to cover your expenses and make a decent profit. Expenses are analysed into as many categories as is necessary to enable you to control them and to make it possible to complete the Inland Revenue returns. The net profit is your reward and is the basis for computing your tax bill.