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The purpose of a profit and loss account is, as the name suggests, to enable the user to tell whether the business is making a profit of whether it is making a loss in terms of revenue.
The account is structured in a way that allows subtotals to be kept whilst reading down the account.
Therefore it is clear to see in what areas the business is losing money or making it.
Profit and Loss accounts are also a useful tool in demonstrating to potential investors, be they individuals or companies such as banks, how profitable the company is and the quality of the profit in question. Profit quality is determined by the source of the majority of the revenue. Is the profit was made up entirely from revenue from sales then it is said to be high quality profit. However, if the profit is mostly the result of selling on assets then it is said to be low quality because it is an extraordinary circumstance and cannot be relied on in the future.
A profit and loss account, as is said above, works down a sheet. The top is revenue or turnover. This is made up of the money brought in from the selling of goods to customers. In large businesses this can be broken down into the different products that the business sells. The next section is the cost of sales. This comprises wages for shop floor assistants and other costs directly related to the sales of goods (such as the cost of purchasing stock). The subtraction of cost of sales from turnover gives Gross Profit. This is a useful measure only if it is low because then it highlights that something needs to be done to reduce the cost of selling goods or to increase the quantity of goods being sold.
Expenses and overheads are the next section in the account. These are costs that do not directly relate to the sale of gods such as salaries for office staff, bills for the factory/shop, advertising costs etc. The subtraction of this from gross profit gives Net Profit. This measure is very useful as it highlights whether expenses are running too high and cutting into the profitability of the company.
From here interest paid on any loans must be deducted to give Net profit before tax. After this tax must be deducted to give Net Profit, the measure of whether or not the business is making money for its owners.
Also See
Read these other AQA A2 Business Studies Unit 4 revision notes:
Comments
These notes are aimed at people studying for AQA A2 Business Studies Unit 4, but will also be suitable for other courses and exam boards.
Originally submitted by eksman on TSR Forums.
