Profit and Loss Statement - Essential analysis for determining business success

Published on 25 July 2023

Practical ways of establishing the viability of the business include producing and analysing a profit and loss account, a form of the financial balance sheet that provides a detailed and timely picture of a company's performance. It is superior to a simple balance sheet because it can accurately capture a company's performance over a period of time, which makes it possible to determine its financial health.

In the lines below you will discover the importance of carrying out a financial analysis on the profit and loss account, what this accounting term means, and what it contains. In addition, you will learn the recommended procedure for ensuring that a profit and loss account is prepared, which gives an accurate picture of a business's performance.

Contents:

1. What is the profit and loss account

1.1. Definition of profit and loss account

1.2. The importance of carrying out a profit and loss account analysis

2. Structure of the profit and loss account

2.1. Income and operating costs of the profit and loss account

2.2. Income and non-operating expenses of the profit and loss account

2.3. About the profit and loss account and the results of its analysis

3. The procedure for making and presenting the profit and loss account 

1. What is the profit and loss account

Decision-makers in a company need to have detailed financial analyzes available in real time that capture the evolution of a company. In this way, problematic situations can be quickly identified, which can endanger economic success. It is also easy to determine what needs to be done to return to the profit zone. Based on the detailed analysis of financial data, reports and other indicators, a clear picture of the level of profit or loss is provided by creating a dedicated account that captures these aspects.

1.1. Definition of profit and loss account

The profit and loss account is a component of financial analysis through which a company's performance can be established over a limited period of time. This analysis usually reflects a short period of time, being able to be performed for monthly, semi-annual or annual intervals. Basically, the document is drawn up by capturing the company's income and expenses, based on which a final result can be calculated that indicates whether the company generates profit or losses.

The profit and loss account comprises three main elements:

• Revenues that can be operating (from the sale of products and services), financial (interest, short-term investments) and extraordinary (state subsidies, European funds, donations, etc.);
• Expenses are also operating, financial and extraordinary, the difference being given by the fact that the amounts come off the balance sheet and are not added, like those from income;
• The final result is obtained by realizing the difference between income and expenses for the period that will be captured in the account. If the result is positive, the company operates profitably, and if the result is negative, then the company is operating at a loss.

1.2. The importance of carrying out a profit and loss account analysis

The financial analysis of a company must be a properly prepared approach because through it useful information can be obtained to make correct business decisions. Companies can call on their own financial services or firms that offer accounting and outsourcing services to perform an analysis of the profit and loss account. Its usefulness arises from the following reasons:

• Through it, the company's financial performance can be established in a certain period according to the manager's wishes. Thus, the revenues and costs resulting from the activity can be highlighted, based on which the net profit or loss recorded can be calculated;
• Account analysis provides essential data for managerial decision-making. If the analysis is carried out correctly and professionally, then it results in data on risk or performance areas, which helps to establish short, medium and long term financial objectives;
• Performance monitoring over time, by comparing the results of successive analyses, allows the identification of trends and significant changes in the company's activity;

• The analysis can also be used as a reporting element to stakeholders. Shareholders, investors, creditors and regulators can use the data to assess the company's performance, which makes it easier to make investment, financing or regulatory decisions;
• This type of financial analysis is part of the mandatory documents to be completed in order to achieve accounting standards and to comply with specific regulations, according to the legal norms of the Romanian state;
• The document is also useful in assessing risks and solvency. With its help, dependence on certain sources of income and exposure to high costs can be identified. In addition, through the document, information can be obtained regarding the capacity to cover debts and liability in front of financial obligations.

2. Structure of the profit and loss account

For the proper realization of the profit and loss account, it is necessary to take into account two categories of data with the help of which a correct interpretation of the real situation of a certain period can be reached. Thus, accountants will take into account the operational side of the business in terms of income and costs and the non-operational side.

From a practical point of view, such a financial analysis can be carried out using two models. First of all, there is the version that is presented in the form of a table consisting of three parts (the first of operating income and expenses, the second of financial ones and the third of extraordinary ones). At the top of the table are the operations that generate income, and at the bottom are the expenses. Secondly, there is the version of the list that includes the same data, but in a different practical format.

2.1. Income and operating costs of the profit and loss account

Operating income and costs result from the company's core business. The first category, that of income, results from the receipts made following the sale of production or services provided by the company.

The second, that of costs, consists of all expenses associated with the production and delivery of goods or services that are part of the company's portfolio. The category of these costs are included the raw material used, labor payment, logistics, and distribution expenses, and those for marketing and advertising.

2.2. Income and non-operating expenses of the profit and loss account

The category of non-operating income and expenses consists of those elements that are not a direct part of the company's main activity. Basically, in this area are passed the earnings and expenses that do not come from the usual supply of goods and services. For example, in the category of non-operating income, amounts from investments, the sale of assets to third parties, dividends, subsidies from the state, or European funds obtained as a result of applying to various programs can be entered.

The category of expenses of this type are included the sums needed to pay the interest related to the loans, for the resolution of some commercial disputes, or for those occasioned by the restructuring or depreciation of the assets. Another example is represented by the fines or penalties that can be received from the state authorities if they identify a problematic situation, which entails such penalties.

The financial analysis based on the profit and loss account can be carried out according to various schemes, the essential being the use of accurate data to obtain results that can be used in reality.

2.3. About the profit and loss account and the results of its analysis

The final part of the profit and loss account is where the results of the analysis are entered. With the help of this information, the financial health of the company can be made aware by taking into account some key aspects:

• Revenues and margins are financial information that can result from a proper analysis. These elements highlight operational efficiency and the firm's ability to make a profit and keep costs under control. Comparative analysis of documents from successive periods may indicate solid performance, while declines signal the existence of problems;
• Operational costs can be pinpointed to identify bottlenecks and areas where savings can be made through increased efficiency. In this way, profitability can be improved to near-maximum levels;
• Profitability and profitability show not only whether the firm obtains revenues over expenses, but also the profit margins obtained in relation to the investments and resources involved;
• The identification of trends can indicate the directions to be followed or those to be abandoned;
• Competitive comparisons can provide insights into the company's positioning in the industry.

3. The procedure for making and presenting the profit and loss account

The correct realization of the financial analysis regarding the profit and loss account is a relatively complex undertaking, especially in the case of medium and large companies, which carry out varied activities. The complexity comes from the need to perform a correct analysis of this account, with the aim of providing useful information that can be used in daily management activities.

In order to obtain this data, it is recommended that the activity be carried out by professionals with extensive experience in this field, such as those who work for consulting firms that provide accounting services and financial and tax reporting, as well as other types of administrative services with the help of which it can be established when the profit and loss account is drawn up, how it is calculated or what format will be chosen to achieve maximum results. Also, the expertise of professionals will allow them to observe accurately the variation of stocks in the profit and loss account and what are the correlations between the account and the balance sheet.

The actual procedure for carrying out a financial analysis of this type involves the following steps:

• The collection of financial data is carried out by recording the relevant information from the period to be analyzed. Data on sales, production costs, operating and non-operating expenses and income, taxes and other relevant costs and taxes will be used;
• The information obtained is organized into relevant categories to obtain a coherent structure, on the basis of which the subsequent interpretation will be made. Thus, relevant categories include operating income and costs, non-operating income and expenses, operating profit and loss, operating and non-operating income and net profit and loss;

• Based on the information, total revenues and costs are calculated. For relevant results, it is necessary to include some adjustments and depreciations that capture the reality at a given moment;
• Certain categories of income and expenses will be excluded as irrelevant elements of the profit and loss account. For example, revenues and expenses that occur exceptionally are not relevant for a longer period, their presence not being one to modify the management's business decisions;
• Based on the total revenues and costs, the net profit or loss will be determined. To reach these results, total revenues are subtracted from total costs, the result reflecting the company's financial performance;
• Checking and reconciling data is an important step because there must be a match between the financial information recorded in the ledger accounts and that entered in the profit and loss account. If errors or discrepancies are identified, they must be corrected before the report is presented so that the data provided reflects reality. Also at this stage, it will be determined whether the accounting standards were respected in the financial analysis. The application of relevant principles, recommended at a national level, will be taken into account;

• The presentation of the profit and loss account must be made in a clear, precise, concise and understandable manner. Mandatory, an explanatory note must be inserted at the end to clarify the significant aspects and to provide additional details that can be easily understood, even by those who do not have economic studies. In this way, the document will be useful for the widest possible category of interested persons, not only for those qualified in the financial-accounting field.

In conclusion, the profit and loss account can be a document of financial analysis of maximum utility for decision-makers in a company, provided it is prepared in a fair and transparent way, using recognized accounting principles.

*This material has been prepared for informational purposes only and is not intended to provide tax, legal or accounting advice. We recommend that you consult with our team of tax, legal and accounting advisors before making any decisions regarding the topics mentioned in this article.