3 Profit and loss (P&L)

Need to know

The P&L records the financial activities of a business over a period of time, which could be a day, a week, a month, a quarter or a year. It can be useful to think of the P&L as a video recording of the business’s journey from one balance sheet (see Chapter 4 Balance sheet) date to another. In each period the recording starts from scratch (or zero).

A funnel analogy can be used to represent the P&L. Revenue (sales) enters a business at the top of the funnel and is then reduced by various costs and expenses. The remaining output of the funnel, if any, represents the profit retained in the business.

The following diagram explains the inflows and outflows as in more detail.

The diagram represents the key headings seen within a P&L, each of which is explained below:

Why is this important?

Profit is the primary measure of business performance, success and long-term survival. Simplified P&Ls can also be prepared for individual divisions, departments, products, customers, etc. P&Ls should be commonplace throughout an organisation.

For managers, it may be the most important source of their financial information and a key financial performance measure.

When is this important?

Although company accounts containing P&Ls are produced at least annually for statutory purposes (see Chapter 19 Accounting and financial reporting standards), many businesses will prepare more frequent and regular P&Ls internally. Typically, P&Ls are prepared monthly as part of a business’s management accounts (see Chapter 31 Management accounts).

Nice to know

Some additional terms related to the P&L are explained below:

Alternative performance measures (APM) have become more prevalent in company reports. APMs are non-GAAP (see Chapter 19 Accounting and finance reporting standards) measures. They are not defined in accounting standards and therefore open to interpretation. APMs must be given no more prominence than GAAP required figures and there must be a reconciliation of GAAP profit to the underlying amount showing each adjustment clearly. Two common APMs are explained below:

Optional detail

Alternative titles

The P&L is known under a number of different titles. Here is a selection of the most common:

• ■The profit and loss account
• ■The profit and loss statement
• ■The statement of profit or loss and other comprehensive income
• ■Income statement
• ■Statement of comprehensive income
• ■Earnings statement
• ■Statement of financial performance.
• ■Income and expenditure statement
• ■Statement of financial activities.

Some of these titles are defined in company law and some by accounting regulations, depending on the jurisdiction. Some are historical, some are used internally only and many are used interchangeably.

Other income not shown in the P&L

The P&L records the revenue-producing activities of a company. For some companies there are non-primary or non-revenue producing activities which cause a change in net assets. Some examples are:

• ■Revaluation surpluses related to property, plant and equipment (see Chapter 17 Revaluation)
• ■Actuarial gains and losses
• ■Gains and losses arising from translating the financial statements of a foreign operation
• ■Specific gains and losses from financial instruments.

There is very specific accounting regulation around these areas.

Other income not shown in the P&L is recorded in the ‘Statement of Other Comprehensive Income’, a separate financial statement, which typically appears after the P&L.

Reflect and embed your understanding

• 1In your view, which profit figure is the ‘right’ profit figure? Consider this question from the perspective of different users of financial statements.
• 2Consider your expectations of the relative size of direct and indirect costs within an example organisation. Is this reflected in the relative size of both ‘cost of sales’ and operating overheads?
• 3How widely is the P&L shared and understood across your organisation?
• 4Should an organisation place primary importance on its P&L or should there be equivalence to other financial statements? If so, why?
• 5Look for comparable companies which use alternative performance measures, such as ‘underlying profit’ and EBITDA. Are the measures clearly defined and comparable?
• 6‘Turnover is vanity, profit is sanity’. Is chasing turnover at the expense of profit always a bad idea?
• 7Consider the profits of two companies: Company A and Company B. If Company A has generated a higher profit than Company B, would it be right to conclude that it has performed better? What additional information would you require to compare performance?

For the authors’ reflections on these questions please go to financebook.co.uk

Where to spot in company accounts

There will usually be a single-page P&L account which shows values against each of the major P&L headings for the current and previous financial period.

The majority of P&L headings will have a note reference where more detail can be found within the notes to the accounts.

Extract from Greggs plc 2020 annual report and accounts

(Appendix p. 445)

There are detailed notes for:

• ■Revenue (Appendix p. 459)
• ■Exceptional items (Appendix p. 462)
• ■Finance income and expense (Appendix p. 463)
• ■Profit before tax (Appendix p. 461)
• ■Income tax (Appendix p. 463)
• ■Earnings per share (Appendix p. 464 and see Chapter 27 Investor ratios).

Consolidate and apply

To see how the concepts covered in this chapter have been applied within Greggs plc, review Chapter 36, p. 377.

Watch out for in practice

• →The P&L should be benchmarked. Useful internal benchmarks are prior period, budget and forecast. Useful external benchmarks are competitors and industry averages.
• →The P&L is a short-term record of a business’s performance. It is useful to analyse P&Ls over a number of years to establish a trend.
• →Be aware that profit can be distorted by timing differences. Transactions around the period-end can make a particular period appear more or less profitable than usual. Hence the importance of analysing the trend.
• →Be aware that profit can be distorted by accounting adjustments, such as:
  • →accruals and prepayments (see Chapter 13 Prepayments and accruals)
  • →provisions (see Chapter 14 Provisions and contingencies)
  • →impairments (see Chapter 18 Impairment).
• →Be aware that profit can be affected by accounting policies and decisions (see Chapter 19 Accounting and financial reporting standards) such as:
  • →opex and capex (see Chapter 7 Opex and capex)
  • →depreciation (see Chapter 9 Tangible fixed assets and depreciation).
• →Analysts commonly calculate percentage performance measures from the P&L. For example, gross profit margin and net profit margin (see Chapter 23 Profitability performance measures).
• →Retained profits are a potential sign of future confidence or a safety net for future years. The business could be ‘saving’ for a future investment opportunity (see Chapter 15 Capital and reserves).