Profit and loss accounts and balance sheets are two of the most useful tools to see how well a company is performing.
The profit and loss (P&L) account is a basic record of an organisation’s annual accounts. It will show how much the company has earned, how much it has spent to earn that amount and the difference between the two, which is the profit or loss made.
The P&L is calculated as follows: total sales minus the cost of those sales (also known as direct or variable costs) will give you the gross profit. Subtract from that the fixed costs (for example insurance, marketing, administration costs etc) to find the net profit. Tax payments and shareholder dividends must then be subtracted and an allowance can made for retained profit to reinvest in the business. This will give you a picture of performance over a particular period in time, either historical or forecast for the future.
In contrast a balance sheet gives a snapshot at a specific moment in time, as it is constantly changing with day-to-day activities, sales and expenditure.
The balance sheet shows the relationship between a firm’s assets and liabilities.
Assets are things that the company owns or money it is owed and are used to generate sales. There will be fixed assets which are kept in the business long-term and include buildings, computers and machines. There will also be current assets which can be turned into cash in the short-term. An example of a current asset would be customer invoices that are due for payment. The two are added together to give a total asset worth.
Liabilities are concerned with money the firm owes to other people, both internally and externally, such as bank loan repayments and shareholder funds. They are split into creditors due in less than one year (short-term) such as invoices to be paid and creditors due in more than one year (long-term) such as bank loans and mortgage repayments. The sum of the two gives an amount for total liabilities.
Total assets will always be equal to total liabilities as assets are financed by liabilities. Hence the name ‘balance sheet’.
Only limited companies and partnerships where the partners are limited companies are legally obliged to complete these financial statements. It’s produced mainly for corporate purposes to be used by the owners and shareholders and for Revenue and Customs (HMRC) for tax purposes. However they are beneficial to all companies seeking finance to grow or expand their business as potential investors will want to see current and projected performance.
Whilst they make take time to put together there are clear benefits to be gained. If the company knows its financial position, it can manage it. Compiling a profit and loss account will ensure that the business knows how much tax it is liable for and can therefore plan and budget for that in its cash flow.
Source: ChinaStones - http://china-stones.info/free-essays/accounting/accounts-profit-loss.php