What lenders want - part 2: Profit & Loss Account

In part 2 of our mini-series, we look at your profit and loss account.

 

If you've been in business for any time, you will know that consistently selling your product or service for more than it costs to deliver is easier said than done. Yet, this is the basic principle of business!

 

Your profit and loss account is a statement of how profitable your business has been across any defined period of time. Normally, this is for a full 12-month period, but it can equally be for the year-to-date, the last quarter, or anything else.

 

Like a bank statement, it has credit items (income) and debit items (costs).

 

Turnover is the total value of your income (net of VAT if your business is VAT registered).

 

You might see your turnover broken down into two parts: sales and other income. Sales is your trading income. Other income might include non-trading receipts like grants or interest received on deposit accounts.

 

Turnover growing steadily over time is lovely to see, although, as we shall see, there are many more important components to your Profit & Loss account than this. A steady, or even declining turnover, can be better if the profit on it is increasing.

 

Cost of sales are the costs that are directly linked to the value of your trading income. They will fluctuate according to the volume of sales you are making.

 

Most simply explained, if your business is importing goods for resale in the UK, the amount that you pay for the goods will be your cost of sales, and the value that you sell them for will be your turnover. The more you sell, the more goods you will need to buy in, and the higher your cost of sales will be.

 

Gross profit is the value of your turnover, less your cost of sales.

 

Your gross profit margin is your gross profit, divided by your turnover and expressed as a percentage.

 

The definition of a 'good' gross profit margin will vary from industry to industry. A lender might look for data on industry averages, but is more likely to simply look at the trends in your business over time. A consistent or improving gross profit margin is reassuring. You might face questions if your margin is falling.

 

There are many reasons why your gross profit could fall. Most commonly, it is because your your costs of sale have increased and you have not passed these on to your customers in the form of a price increase. Another reason could be because you have changed the structure of your business. Perhaps you outsource more and have less employees on the payroll.

 

Expenses are the fixed costs in your business that react more slowly to changes in your turnover.

 

You will see a long list of items here for expenses such as lighting and heating, rent, computer costs, wages and salaries, and interest payments. You will also see 'non-cash' items like depreciation on vehicles and equipment.

 

Every cost your business incurs that is not included in your cost of sales line will be be accounted for here.

 

Your gross profit, less your expenses, leaves your operating profit. A positive figure is a profit and a negative figure, which is sometimes shown in brackets, is a loss. If you have made a profit, this is the amount that you will pay tax on.

 

Your retained profit for the period is the amount that is left after any tax has been paid. This gets transferred across to your balance sheet and is added to the reserves. Dividends can be paid to shareholders out of retained profit reserves. Read our earlier post for a more detailed explanation of how your balance sheet is constructed.

 

A lender will be most comfortable when it can see consistent operating profits and a nicely accumulating retained profit in the balance sheet. This shows that the business is healthy and living within its means.

 

Of course, there are many reasons why a business might not make a profit consistently. An early stage business will often spend more than it earns as it works to get itself established; a seasonal business can know it will incur losses for part of the year while it builds capacity for peak season; an established business may enter a short period of decline in sales or gross profit, but make a conscious decision not to cut overheads if it is confident of weathering the storm; equally an established business might gear up for growth by taking on larger premises or more staff in anticipation of making more profit in the future.

 

In all these cases, the ability to absorb the losses within accumulated retained profits is going to look better than a creeping increase in debt.

 

Few profit and loss accounts are text book perfect. The important thing is that you understand yours and can explain the performance that it shows.

 

We hope this post helps you to do that.

 

In the next article in our series, we will look at some of the more common accounting ratios.