Profit, the statement of profit or loss and the statement of financial position

Last time

Before we start: last time, in Cash and cash flow forecasts, you learned these points. Here they are again on one card. Keep them in mind, because today builds on them.

Keeping score

How do owners, banks and investors know how well a business is doing? They read its accounts. This lesson covers profit, and the two main statements: the statement of profit or loss, and the statement of financial position.

What profit is

Profit is the surplus of revenue over costs over a period of time. It rewards the owners for the risk they took, and it is a source of finance for growth, as retained profit. It also shows success, which attracts investors and lenders.

The statement of profit or loss

This statement shows the revenue, costs and profit of a business over a period, usually a year. Revenue minus cost of sales gives gross profit. Cost of sales is the cost of the goods sold. Gross profit minus expenses, such as rent, wages and advertising, gives profit.

A statement, worked

Revenue is 400 thousand dollars and cost of sales 200 thousand, so gross profit is 200 thousand. Expenses are 60 thousand, so profit is 140 thousand.

Why gross profit may fall

Gross profit falls if revenue falls: lower sales, or lower prices because of competition. Or if cost of sales rises: suppliers raise prices, or the business wastes more materials. Always say which part of the calculation changed.

The statement of financial position

This statement shows what a business owns and owes on one particular date. Assets are what it owns. Non-current assets last more than a year: buildings, machines. Current assets are used within a year: inventory, cash, trade receivables. Liabilities are what it owes. Current liabilities are due within a year: overdrafts, trade payables. Non-current liabilities are due later: long-term loans.

A financial position, worked

Non-current assets 800 and current assets 300 give total assets of 1,100. Take away current liabilities of 240 and non-current liabilities of 300, and net assets are 560. This equals the owners' equity.

Equity and working capital

Net assets equal total equity: the owners' share capital plus retained profit. Working capital is current assets minus current liabilities: here 300 minus 240, which is 60 thousand dollars. A positive working capital means the business can pay its short-term debts.

Profit or loss vs financial position

The statement of profit or loss covers a period, and shows how much profit was made. The statement of financial position shows one moment, and what the business is worth. Together they show whether the business is profitable, and whether it can pay its debts.

Should you invest?

An investor looks at profit: is it rising, and is it large compared with the money invested? And at the financial position: are net assets growing, and is working capital healthy? Then other factors from the case, such as competition and the owner's plans. That is the judgement.

Mistakes that lose marks

Mistake one: taking expenses away from revenue to get gross profit. Gross profit is revenue minus cost of sales. Mistake two: putting inventory as a non-current asset. It is a current asset. Mistake three: saying the statement of financial position shows profit for the year. The fix: learn the order of each statement, and what each shows.

The full-marks tip

The full-marks tip: set out the statement in order: revenue, cost of sales, gross profit, expenses, profit. In a financial position, sort each item into current or non-current.

On one card

So, on one card: the accounts. Keep it for revision.