Profit and Loss Account (P&L Account), or an income statement, contains financial data which business stakeholder groups find extremely useful. It shows the Sales Revenue, all business costs and profit or loss of a business over a given period of time.
Earning Profit is the main objective of all businesses in the private sector of the economy. However, even for non-profit organizations and those in the public sector, it is important to make a surplus in order to survive and keep operating.
Profit creates an incentive for most businesses to do well. After all, if a business does not earn Profit, or surplus, it would struggle to survive.
How Profit is made?
A business earns Profit by selling its products to customers at a price which is higher than Total Costs (TC) of making and supplying those products.
The total amount of money a business receives from selling its products to customers is called Sales Revenue. Revenue is the inflow of money from ordinary trading activities. The formula for calculating Sales Revenue is:
Sales Revenue = Price x Quantity
Costs are the outflow of money from a business due to its operations. The Total Cost (TC) to a business of supplying its goods and services can be divided into the cost of production (Variable Costs (VC)) and the overall expenses of the whole firm (Fixed Costs (FC)). The formula for calculating Total Costs (TC) is:
Total Cost (TC) = Variable Costs (VC) + Fixed Costs (FC)
The formula for calculating Profit is then:
Profit = Sales Revenue – Total Costs (TC)
Profit is simply the difference between Sales Revenue and Total Costs (TC) of the business.
The importance of Profit and Loss Account (P&L Account) to different business stakeholders
Both Internal Stakeholders and External Stakeholders use the information from Profit and Loss Account (P&L Account) when analyzing business performance against their own objectives. The most important figure on Profit and Loss Account (P&L Account) for any stakeholder group is obviously Profit.
The purpose of Profit and Loss Account (P&L Account) and usefulness of profit data to stakeholders is summarized below:
Shareholders (owners)
The owners of the business are interested in Profit because it is a reward for them for the risk that they take investing their money into the business. They want to know how much return from their investment they will receive based on financial performance of the firm.
As Net Profit After Interest and TAX that the company generated belongs to the owners, they want to know how much the business earned for them. The higher the Net Profit After Interest and TAX, the higher the dividend payment. Based on seeing how much the owners have earned from their investment in the business, they will decide whether to hold shares of this company, or sell the shares, or maybe buy more.
The market value of the business, hence the share price, will depend on Sales Revenue and Profit.
Profit and Loss Account (P&L Account) will also show to the owners how their money was spent to generate Sales Revenue.
Shareholders (owners) will ask the following questions about Profit and Loss Account (P&L Account):
How much Net Profit After Interest and TAX did the business earn last year?
How much Dividends will be paid out from Net Profit After Interest and TAX?
Managers
The managers of the business are interested in the overall success of the firm. The business success is usually determined by Sales Revenue, Profit and market share.
Managers will use Profit and Loss Account (P&L Account) to measure performance of different parts of the business and judge the operational efficiency of their organizations. This will be done based on comparing last year’s Profit with the amount of Profit that the firm had earned in previous years, as well as benchmarking against competitors.
Based on costs data and profit data, managers will make informative decisions whether to continue producing and selling the product, or stop making it.
Finally, Profit and Loss Account (P&L Account) will be used for strategic planning for the future. Based on the amount of Retained Profit managers will decide whether to expand the business, or not.
Also, they will set targets for different divisions and departments about how much sales and Profit should the firm achieve next year.
Managers will ask the following questions about Profit and Loss Account (P&L Account):
How much Sales Revenue did the business generate last year?
What is the cost of production (Variable Costs (VC))? How much Gross Profit did the business make last year?
What are the expenses of running the business (Fixed Costs (FC))? How much Net Profit Before Interest and TAX did the business make last year?
Is the business able to pay Interest on the loan to the bank?
What is the percentage of Net Profit After Interest and TAX that we pay out as Dividends and the percentage that we keep in the business as Retained Profit?
Employees
Workforce is interested in Profit and Loss Account (P&L Account) of the firm mainly because of their compensation.
Firstly, to assess the degree of job security. Businesses that generate stable and robust Profit can provide high job security. Businesses that make a loss provide low job security as they may start laying off people soon in order to break-even.
Secondly, staff are interested the income statement to figure out the likelihood of pay increases. Employees will expect a decent pay rise, if a business has earned high Profit as there will be enough money to share.
Employees will ask the following questions about Profit and Loss Account (P&L Account):
How much wages do the business pay to the production workers? Let’s look at the cost of production!
How much salaries do the business pay to the managers? Let’s look at expenses!
Did the business earn large profits last year to increase our pay this year?
Competitors
Rivals of the business are interested in Profit and Loss Account (P&L Account) to make judgement whether their firms are better or worse.
Based on sales levels, they will try to find out who the market leader is in a given sector of the economy (e.g. financial services), and then within a very specific industry (e.g. asset management, banks, capital markets, insurance, etc.).
Competitors will also make comparisons of their financial performance with rival firms to see which company is more profitable.
Competitors will ask the following questions about Profit and Loss Account (P&L Account):
How much Sales Revenue did the business generate last year?
How much Net Profit After Interest and TAX did the business earn?
Government
Mainly the TAX authorities will be interested in the business’s Profit and Loss Account (P&L Account) to examine whether the correct amount of Corporate TAX was paid.
The TAX bureaus will examine Net Profit Before TAX to ensure that the business pays its TAXes properly, and on time. The higher the profit, the more TAX the government will receive. The lower the profit, the less TAX the government will receive.
Government will ask the following questions about Profit and Loss Account (P&L Account):
How much Net Profit Before TAX did the business make?
How much TAX was the business supposed to pay last year?
Was the correct amount of TAX paid by the business?
Banks
Financial lenders such as banks, microfinance institutions and Business Angels scrutinize Profit and Loss Accounts (P&L Account) before they agree to provide any funds to businesses.
They want to know how well-managed the business is. They will do it by checking profitability, liquidity and efficiency of the firm using Ratio Analysis.
They want to be sure that the business makes enough Profit to pay Interest on the loan and whether the business is able to repay in the future the borrowed capital in full.
Banks and other lenders will ask the following questions about Profit and Loss Account (P&L Account):
How much Net Profit Before Interest and TAX did the business make last year?
Is the business able to pay Interest on the loan regularly?
How much Net Profit After Interest and TAX does the business make?
Will the business manage to repay the borrowed capital when due?
Suppliers
Suppliers will investigate how much the business sells every year to estimate the demand for supplies.
The higher the sales of the firm, the more raw materials are needed and the business is going pretty well. The lower the sales of the firm, the less raw materials are needed and the business is not going well.
Suppliers will also examine a firm’s profitability to find out whether it will continue purchasing supplies in order to decide if Trade Credit should be given. It is because without being profitable, a business may not be able to pay its creditors on time and in full in the long-term.
Suppliers will ask the following questions about Profit and Loss Account (P&L Account):
How much does the business produce?
Is Sales Revenue increasing or decreasing, or maybe remains at the stable levels?
Is the business making a profit to be able to pay for those supplies?
Have all of our supplies been paid for yet?
Potential investors
Private individual investors and institutional investors such as investment banks and asset management firms use Profit and Loss Account (P&L Account) to decide whether to invest in the business or not.
They will conduct the fundamental analysis of the firm using Ratio Analysis to assess whether an investment would be financially worthwhile for them.
If potential investors are attracted by the amount of profit that the business generates, they will provide additional funds. If potential investors are not attracted by the amount of profit that the business generates, they will not provide additional funds. Instead, they will invest in other firms.
Potential investors will ask the following questions about Profit and Loss Account (P&L Account):
What are Earnings Per Share of this the company?
How much Dividends can this company pay out every quarter?
What is Dividend Yield of this company?
In summary, the purpose Profit and Loss Account (P&L Account) is to judge business performance. And, to make future decisions.
Internal Stakeholders will use the income statement to manage the business and to aid strategic decisions.
External Stakeholders will use Profit and Loss Account (P&L Account) to make evaluative judgments about the firm’s ability to generate Sales Revenue higher than Total Costs (TC).
