According to soon-to-be-released rules outlined by Companies House, small businesses are set to have the option to file abridged accounts removed. This will mean that, alongside other information, they will be required to file their profit and loss (P&L) accounts [1].
While more small businesses than ever are producing P&L statements for members, this change will make the practice universal among businesses. But compiling P&L statements is more than just an administrative task, it is an important step in setting or adjusting your business strategy.
In this article, we’ll look at how businesses are using their P&L accounts to help drive smarter business strategy that increases profits and helps drive growth.
Why SMEs need a profit and loss statement
In the UK, all registered companies with a turnover of more than £10.2 million and a balance sheet of more than £5.1 million are legally required to file annual accounts with Companies House that include a balance sheet, directors’ report, and P&L account. Companies House recently announced that it will change the rules to include businesses that fall under the threshold in the legal requirement [2].
A profit and loss account is a financial statement that outlines a company’s revenues, expenses and profits over a specific period of time, usually a quarter or financial year. It is important because it provides an overview of your company’s financial health and profitability.
According to Neil Hutchings, director of corporate finance with Albert Goodman, they can also be vital in other ways. “They allow you to see changing trends around margins, demand, pricing, and revenue,” he says.
Understanding your P&L account
The main items captured in your company’s P&L account are listed below.
Sales and revenues
This captures any income generated by your company through selling products or services, but might also include revenue from investments, interest, or affiliated companies. “If your P&L shows an increase in sales of a particular product or service, this could help you to change strategy to increase prices without necessarily becoming uncompetitive,” says Hutchings.
Operating costs
This will generally list costs in your accounts by broad category. Tracking this part of the P&L account helps business owners to understand where costs are rising or falling, and how those changes affect operating profits.
“P&L accounts can be whatever you want them to be," says Hutchings. "Although you’ll submit an abbreviated version to Companies House, your own P&L account can drill down into whatever categories and details are useful to you in making strategy.”
Common cost categories listed under operating costs on a P&L account will include:
- Cost of goods sold: raw materials, shipping, and other costs involved in selling your product or service.
- Office and administrative costs: stationery, postage, office equipment, technology.
- Overheads: this can include utilities and rent.
- Payroll: your P&L account might break down expenses for contractors and freelance staff.
- Loans and interest: if your business makes payments to loan accounts these will usually be listed in the P&L account.
Operating profit
The P&L account will deduct expenses from revenues to show the business’ operating profit before taxes (these will be listed separately). Understanding operating profit is vital to gauging the health of your business and to spot potential dips in profit that could affect the company’s ability to function.
What you can learn from a P&L account
By tracking your P&L account over a period of multiple months or quarters, business owners can track trends over time. For example, is a dip in profits just a normal seasonal variation, or a sign that your marketing strategy isn’t delivering?
P&L accounts can also be a useful way to benchmark your company’s performance against industry averages. By comparing P&L forecasts against the actual results of other companies, businesses can identify areas they might need to improve or focus on. For example, is the business spending too much on overheads compared to other businesses in the sector? Does this suggest a need to reduce energy consumption, or move to cheaper premises?
Ben Austin, CEO of digital marketing agency Absolute Digital Media, finds this benchmarking exercise hugely valuable. "If one of our costs starts to spiral outside of industry norms, it’s a sign to look at whether we need to renegotiate terms or look at whether we need that particular product,” he says.
Your P&L account is also an important document when approaching potential partners, investors or buyers of your business. “If you’re talking to potential investors or looking to raise cash to help your business grow, then you need to be able to show that you have good profit margins, that your growth is increasing on a particular curve, and you’re investing enough to keep your business competitive,” says Hutchings.
How to use your P&L account to make smart decisions
To really make the most of your P&L accounts, it’s important to check them regularly.
“Our P&L account is generated quarterly, but we’re pulling reports and looking at P&L at least monthly, if not daily," says Austin.
Absolute Digital Media holds a monthly finance meeting attended by the CEO, finance manager and finance director. “We look at the P&L accounts and see whether our budget forecasts are realistic, in light of those numbers,” says Austin. “We work in an industry where things can change very rapidly, and a client might pull a budget, or we might pick up new clients. Our P&L tracks that, and those monthly meetings are an opportunity to see if we need to adjust our annual forecast for spending on things like marketing, recruitment or software platforms.”
When the P&L accounts show that revenues are falling, this is the sign for Austin and his departmental heads to review strategies.
“As a small company we’re always looking to identify ways that we might improve profitability, and where our costs might be increasing in ways we can mitigate,” he adds. "The bank account can be really misleading if we’ve just taken a big payment on an account. The P&L account is a much more useful way to set strategy.”
P&L accounts can also identify when it’s a good time to invest. Several years ago, Austin’s team was approached by a potential new customer looking for a number of services, including some that Absolute Digital Media didn’t offer. “Because we were constantly tracking P&L, we could see that we had a bump in revenue over the usual," says Austin.
"We felt more confident investing in building those new services, and that allowed us to then sign a substantial contract with the customer.”
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