Friday 15 November 2013

What does a 'profit and loss' account tell us?

10/10 Key terms test on financial statements - profit and loss accounts
  1. Financial statements - a summary of financial records of the business.  These include profit an loss accounts and balance sheets.
  2. Profit and loss account - this financial statement summarises if a business made a loss or a profit over the financial period (usually a year) 
  3. Sales Revenue - the value of goods sold.  Number of goods sold x selling price
  4. Cost of Sales - The cost to the business of the goods sold
  5. Gross Profit - the difference between the sales revenue and the cost of the goods sold.  Sales revenue - cost of sales 
  6. Gross Profit Margin - the percentage of sales revenue that is gross profit.  The gorss profit % margin = gross profit /  sales revenue x 100
  7. Overheads - expenses of the business that are not normally directly part of the production process (e.g. rent and management salaries) 
  8. Net Profit - the difference between sales revenue and total costs of the business.  Net profit = gross profit - overheads
  9. Net Profit Margin - the percentage of sales revenue that is net profit.  Net profit margin % = (net profit / sales revenue) x 100 
  10. Shareholders - the owners of the company who invest in share capital in order to share a proportion of the profit in the form of a dividend.
Exam board expectations
Candidates should be able to identify the various components of a profit and loss account.
Candidates should be able to make judgements of the performance of the business through interpretation of the information contained in simple versions of the profit and loss accounts and the application of gross and net profit margins.
Candidates will be given the relevant formulae for ratios as part of the examination paper

Purpose of financial statements
Profit and loss accounts are just one of the two financial statements that a business uses to show the stakeholders what is happening in the business:
  • Managers need to know if a profit is being made
  • Shareholders or the owners would not know whether to invest more into the business
  • Banks would be uncertain whether to lend more or to demand repayment of earlier loans
  • Government would not know how much tax the business should pay
  • Workers will be uncertain about jobs and whether the business can afford to pay higher wages
The main financial records that every business needs to calculate include:
  1. The number of products sold, the value and what still need to be paid for
  2. The goods and services bought
  3. Equipment and other assets purchased
  4. Wages and other labour costs
The profit and loss account contains five important pieces of information:
  • Sales revenue - this increases when the number of units sold or the unit price increases
  • Cost of sales - this is the bought in value of the goods plus direct labour costs needed to make the goods
  • Gross Profit - this can be increased by increasing sales revenue or by reducing the costs of sales
  • Expenses or overheads - these include the fixed costs of the business
  • Net Profit - this is a very important profit calculation as it shows how successful the managers were at turning a profit out of the sales once all the costs were deducted from the revenue.

In the news Unlike most top football clubs, Arsenal FC is a Public Limited Company.  This means that its accounts are published and anyone can see how well its doing.  Arsenal is owned by Arsenal Holdings plc, with the main shareholder being Danny Fiszman, a Swiss-resident diamond dealer with 24.1%.  The club has two major trading arms football and property and is one of the few Premiership clubs that makes a profit. Posting £36.7m profit in the financial year ending 2008. ( Chelsea lost £76m in the same period and Man U £58m and Liverpool £22m in the same period.  The Profit and Loss account lets all shareholders major and minor and all stakeholders know how well a company is doing. Arsenal revenue was up £23m on the previous period to £223m due to selling more TV and broadcasting rights.  Match day tickets from supporters and season ticket holders was also up £94.6m 

Group activity Punch 'arsenal holdings plc' into a search engine and you will see a list of sites that describe the company, what its worth and how it trades, who its directors are etc. Choose a few sites and see what info they provide and say which you thought was best.  

Teach yourself P&L accounts Click on the powepoint here to tell you more. 

The trading account sales revenue ;less the cost of sales (opening stock + purchases - closing stock) this gives the GROSS PROFIT

The profit and loss account gross profit less other expenses such as rent, wages, transport, power, fuel, equipment to give the NET PROFIT

The appropriation account net profit - tax - dividend = retained profit 

Discussion The law requires companies to produce profit and loss accounts to certain standards and at regular intervals.  Why do you think that such accounts have to be made public? Do you think that it is fair that company income should be revealed to everyone in this way?

Web-based activity Look at the other clubs in the football Premiership and find out which are publicly quoted.  Look at the profit and loss accounts for each (go to the 'corporate' or 'investors' part of the website) and decide which is the most profitable.  Make sure that you follow the rules for making comparisons.  If you are not interested in football, you could compare businesses in another sector, fashion for example, or technology.

Typical exam questions on understanding profit & loss accounts
  1. What is a public limited company?
  2. What is meant by 'sales revenue'?
  3. Name three other sources of income, besides sales revenue?
  4. Define Gross Profit
  5. Name the three parts of the profit and loss account.
  6. Explain what happens to retained profit.
  7. Outline the unusual items included in the cost of sales.
  8. Explain what is meant by 'dividends'
  9. Give one major limitation to the usefulness of profit and loss accounts
Calculating total costs click here
Calculating profit click here

Nine mark question
By practicing these nine mark questions you are developing skills and confidence and will access the other 50% of the marks in the Paper 1 & Paper 2 exams

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