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Managing Finance and Budgets Lecture 5 Profit & Loss Accounts

Session 5 – Learning Outcomes Learning outcomes:  Understand the terms within the Profit & Loss Account, and be able to interpret a Profit & Loss account relating to a particular organisation.  Be able to discuss certain key issues: » Cash versus Profit »Capital/Revenue expenditure »Depreciation »Cost of Sales & Valuation of Stocks » Provision for Bad Debt.

Presentation 5 – Menu Section AProfit & Loss: Some TermsProfit & Loss: Some Terms BThe Profit & Loss Account FormatThe Profit & Loss Account Format CProfit & Loss: Some IssuesProfit & Loss: Some Issues DPreparation for Seminar 5Preparation for Seminar 5

Section A The Profit & Loss Account

The Profit and Loss Account  In Week 2 we saw an example of a Profit and Loss account for a day’s trading in a lemonade stall.  Before we see an example of a ‘real’ Profit and Loss account, we need to understand:  the idea of revenue  the idea of expenses

Further Financial Terms  Income – An amount of money which comes in to, or is earned by, the business during an accounting period - sometimes called Revenue  Turnover - total value of sales over a given period – this is sometimes called Income or Revenue So what is actually meant by the term Revenue?  Revenue – technically this simply refers to the inflow of assets, or the reduction in claims that arise as a result of trading operations.

Financial Terms Expenditure – An amount of money which has been spent by, or goes out from, the business during an accounting period. Cost - the amount of actual or notional expenditure incurred on or attributable to a specified thing or activity (fixed, variable, direct, indirect )

Profit & Loss Equation for a period Profit (loss) Total expenses incurred in generating the revenue less equals Total revenue

The Format of the P & L Account Normally a Profit & Loss Account will consist of: Sales (Turnover) Less Cost of Sales = Gross Profit Less Overheads = Net profit Less Interest on Loans = Profit Before Tax Less Tax = Profit after Tax Less Dividends = Retained profit for the year P & L Terms: For a quick explanation Click Here Activity 5.1 example

Terms on the Profit and Loss AccountProfit and Loss TurnoverTurnover: Total value of sales over a given period - sometimes called Income or Revenue Cost of SalesCost of Sales: The costs incurred in making the sales in a given period OverheadsOverheads:Other costs incurred in running the business, but not directly related to making sales Interest on LoansInterest on Loans: Money paid to lenders for the privilege of borrowing money. TaxTax: Money paid to the government as a contribution to the National Exchequer. DividendsDividends: Money paid to shareholders as a ‘reward’ for investing in the company. For a more in-depth explanation, please click on the item

Turnover  Sale of goods or Fees for services  Subscriptions  Interest earned  To all intents and purposes, Income = Revenue = Sales = Turnover  VAT is excluded from Sales figures (and all other figures)

Cost of Sales (Direct Costs)  Costs which are directly related to the cost of providing the goods or service (Cost of Sales)  For example:Goods purchased for resale Direct Labour costs Raw materials, Packaging, Energy  Direct Costs often vary with sales (though some Direct Costs can be FIXED)

Overheads (Indirect Costs)  Operating Expenses  Costs which are not directly related to sales.  Costs which are incurred even when an organisation produces no output. Often Fixed Costs  For example:Administrative salaries Advertising, Stationery, Rent & Rates Insurance, Bank charges Depreciation  Indirect Costs do not (necessarily) vary with sales  Interest usually shown later

Interest on Loans Includes  Interest on Bank loans and other formal loan arrangements (e.g. debentures). These are normally charged at some fixed rate e.g. 12% of the loan  Interest on Overdrafts (rates may be variable), and more expensive (e.g. up to 15%) Does not include  Money paid to shareholders in dividends  Interest charged by creditors for late payment

Tax Corporation Tax is charged on profits made after all costs and interest charges (but not dividends) have been accounted for. The current rate of tax is 19% for SMEs and 30% for large companies, but there are allowances which mean that this will be reduced. In the examples in the slides, a ‘flat rate’ of 20% is used, to simplify calculations For more on tax, consult:

Dividends  Limited companies are financed primarily through shareholding.  Shareholders buy shares in the company. These may have a face value ranging anywhere from 1 penny to thousands of pounds.  At the end of each financial period, the directors of the company may decide to issue dividends. This is money paid to the shareholders out of net profit after tax, as a reward for their continued investment.  The dividend paid does not affect the face value of the share.

Profit or (Loss) There are many different sorts of profit:  Gross Profit = Sales less Direct Costs  Operating Profit = Sales less Direct Costs less Indirect Costs  Profit before tax = Operating Profit less Interest  Profit after tax = Profit before tax less tax  Retained profit = Profit after tax less dividends

Activity 5.1 Which type of Profit specifically might you be interested in if you were:  A Shareholder  The Inland Revenue  The Sales Manager  The Managing Director Answer

Activity 5.1 solution Which type of Profit might you be interested in if you were: A Shareholder  All types of profit, but specifically profit after tax, and the amount that the company has offered in dividends and the retained profit. The Inland Revenue  Profit before Tax The Sales Manager  Normally Turnover and Gross Profit The Managing Director  All types of profit, but specifically the Retained Profit, which will be reinvested into the company.

Section B The Profit & Loss Account Format

Sample Profit & Loss Account The next slide shows a profit and loss account for a company over a one-year period. The format varies according to the type of business, but there is a fairly uniform convention to structure the accounts in the following way: Total Income: Less expenditure item #1 Less expenditure item #2 Less expenditure item #3etc. = Earned Surplus (Profit)

Turnover (Sales) (Income)£ 100,000 Cost of Sales (Direct Costs) Materials£10,000 Transport£ 5,000 Labour£15,000 Total Cost of Sales £ 30,00030% Gross Profit (Gross Margin)£ 70,00070% Overheads (Indirect Costs) Administrative salaries£18,000 Depreciation£ 5,000 Rent & Rates£ 4,000 Total Overheads £ 27,00027% Operating Profit (Net Margin)£ 43,00043% Interest on loans£ 3,000 Profit before tax£ 40,00040% Corporation tax due £8,000 Profit after tax & interest£ 32,00032% Dividends payable£22,000 Retained Profit (Earned Surplus) £ 10,00010%

Turnover (Sales) (Income)£ 100,000 Cost of Sales (Direct Costs) Materials£10,000 Transport£ 5,000 Labour£15,000 Total Cost of Sales £ 30,00030% Gross Profit (Gross Margin)£ 70,00070% Overheads (Indirect Costs) Administrative salaries£18,000 Depreciation£ 5,000 Rent & Rates£ 4,000 Total Overheads £ 27,00027% Operating Profit (Net Margin)£ 43,00043% Interest on loans£ 3,000 Profit before tax£ 40,00040% Corporation tax due £8,000 Profit after tax & interest£ 32,00032% Dividends payable£22,000 Retained Profit (Earned Surplus) £ 10,00010% The first part of the account is usually concerned with the total amount of income and working out the Gross Profit. This is called the Trading Account

Turnover (Sales) (Income)£ 100,000 Cost of Sales (Direct Costs) Materials£10,000 Transport£ 5,000 Labour£15,000 Total Cost of Sales £ 30,00030% Gross Profit (Gross Margin)£ 70,00070% Overheads (Indirect Costs) Administrative salaries£18,000 Depreciation£ 5,000 Rent & Rates£ 4,000 Total Overheads £ 27,00027% Operating Profit (Net Margin)£ 43,00043% Interest on loans£ 3,000 Profit before tax£ 40,00040% Corporation tax due £8,000 Profit after tax & interest£ 32,00032% Dividends payable£22,000 Retained Profit (Earned Surplus) £ 10,00010% The next part of the account is usually concerned with the indirect costs and working out the Net Profit.

Turnover (Sales) (Income)£ 100,000 Cost of Sales (Direct Costs) Materials£10,000 Transport£ 5,000 Labour£15,000 Total Cost of Sales £ 30,00030% Gross Profit (Gross Margin)£ 70,00070% Overheads (Indirect Costs) Administrative salaries£18,000 Depreciation£ 5,000 Rent & Rates£ 4,000 Total Overheads £ 27,00027% Operating Profit (Net Margin)£ 43,00043% Interest on loans£ 3,000 Profit before tax£ 40,00040% Corporation tax due £8,000 Profit after tax & interest£ 32,00032% Dividends payable£22,000 Retained Profit (Earned Surplus) £ 10,00010% The final part of the account is usually concerned with the interest which needs to paid, tax, and dividends to shareholders.

Turnover (Sales) (Income)£ 100,000 Cost of Sales (Direct Costs) Materials£10,000 Transport£ 5,000 Labour£15,000 Total Cost of Sales £ 30,00030% Gross Profit (Gross Margin)£ 70,00070% Overheads (Indirect Costs) Administrative salaries£18,000 Depreciation£ 5,000 Rent & Rates£ 4,000 Total Overheads £ 27,00027% Operating Profit (Net Margin)£ 43,00043% Interest on loans£ 3,000 Profit before tax£ 40,00040% Corporation tax due £8,000 Profit after tax & interest£ 32,00032% Dividends payable£22,000 Retained Profit (Earned Surplus) £ 10,00010% The bottom line here is what the company has actually made as a profit over the year. This is the Surplus.

Activity 5.2  Suppose the company in the example just explored needed money for business expansion.  Which items of expenditure would you consider reducing, so as to increase the amount of retained surplus? Re-examine P & L Account Answer

Turnover (Sales) (Income)£ 100,000 Cost of Sales (Direct Costs) Materials£10,000 Transport£ 5,000 Labour£15,000 Total Cost of Sales £ 30,00030% Gross Profit (Gross Margin)£ 70,00070% Overheads (Indirect Costs) Administrative salaries£18,000 Depreciation£ 5,000 Rent & Rates£ 4,000 Total Overheads £ 27,00027% Operating Profit (Net Margin)£ 43,00043% Interest on loans£ 3,000 Profit before tax£ 40,00040% Corporation tax due £8,000 Profit after tax & interest£ 32,00032% Dividends payable£22,000 Retained Profit (Earned Surplus) £ 10,00010%

Turnover (Sales) (Income)£ 100,000 Cost of Sales (Direct Costs) Materials£10,000 Transport£ 5,000 Labour£15,000 Total Cost of Sales £ 30,00030% Gross Profit (Gross Margin)£ 70,00070% Overheads (Indirect Costs) Administrative salaries£18,000 Depreciation£ 5,000 Rent & Rates£ 4,000 Total Overheads £ 27,00027% Operating Profit (Net Margin)£ 43,00043% Interest on loans£ 3,000 Profit before tax£ 40,00040% Corporation tax due £8,000 Profit after tax & interest£ 32,00032% Dividends payable£22,000 Retained Profit (Earned Surplus) £ 10,00010% Reduce Dividends: 22% is far too high if we are looking to expand the business. Reduce Dividends: 22% is far too high if we are looking to expand the business. Reduce Labour Costs: 15% is a large proportion of turnover. May be difficult. Reduce Labour Costs: 15% is a large proportion of turnover. May be difficult. Reduce Admin: 18% is a very large proportion of turnover. Reduce Admin: 18% is a very large proportion of turnover.

Section C The Profit & Loss Account Some Issues

Some Issues  Cash versus Profit Cash versus Profit  Capital & Revenue Costs Capital & Revenue Costs  Cost of Sales Cost of Sales  Valuation of Stocks Valuation of Stocks  Depreciation Depreciation  Bad Debt Provision Bad Debt Provision  Prepaid Expenses Prepaid Expenses  Accrued Expenses Accrued Expenses Activity 5.3

Cash Versus Profit  In accounting terms, to calculate Profit (or Loss) Sales Income must be matched against relevant expenditure for a given period  Some goods may be purchased on credit, some sales may be sold on credit  Some purchases may have a useful life which lasts longer than the given period  Therefore Profit in accounting terms is NOT equivalent to Cash in less cash out during that period

Capital & Revenue Costs  Capital Costs are incurred in purchasing assets  Revenue Costs are incurred in delivering the goods or services and operating the company  Capital Costs are not charged directly to the Profit & Loss Account. They are reflected in a depreciation charge over their useful life.  Accounting profit = Revenue Income less Revenue Expenditure - Capital expenditure is only deducted from Accounting profit through depreciation  To “capitalise” an item means to treat it as capital expenditure

Cost of Sales (1) This is the cost of goods sold over a period. For retail and manufacturing companies this will mainly be the amount of stock throughput, and can be calculated by: Opening stock level for the Period + Amount of stock purchased during the period - Closing stock level for the Period = Cost of materials during the Period

Cost of Sales Example At the start of January, a small furniture retailer held £35,000 worth of stock. During the month, a further £12, 000 was bought in, and at the end of the month, the stock level was £27,000. Calculate the cost of Sales for January. Opening stock:£35,000 Purchases:£12,000 Total£47,000 less Closing stock:£27,000 Cost of materials:£20,000

Cost of Sales (2) In service and some manufacturing industries, The cost of sales may also include other Direct Costs. These are costs directly incurred as a result of making the sale, manufacturing the item, or in carrying out the service. Direct Costs: Cost of Materials Labour costs incurred Transportation costs Fuel & other costs

Stock Valuation  Opening and Closing Stocks must be taken into account when calculating Direct Costs to in order to keep to the matching convention  Where sales volume is high (or prices are standard) an average price may be used  Manufacturing Companies may incorporate cost of manufacture into stock value (e.g. materials, power, labour)

Stock Valuation Conventions  Where stock is bought in at different times, from different suppliers and at different prices, the valuation of stock may be an issue.  There are basically three conventions:  FIFO (First In First Out)  LIFO (Last In First Out)  AVCO (Weighted Average Cost)

Stock Valuation Methods Three methods First in, first out (FIFO) Last in, first out (LIFO) Weighted average cost (AVCO)

Stock Purchases and Sales Opening Stock Level200 £10 each Purchase # 1100 £12 each Purchase # £15 each Sales400 £20 each

FIFO Stock Valuation Example Opening Stock Level200 £10 each Purchase # 1100 £12 each Purchase # 2200 £15 each Sales400 £20 each FIFO = First in, First Out Items will be sold in the order in which they were bought. The 400 items sold will be made up of:  200 £10 each£2000 (prev. stock)  100 £12 each£1200 (purch. #1)  100 £15 each£1500 (purch. #2)  Total Cost of Sales:£4700

LIFO Stock Valuation Example Opening Stock Level200 £10 each Purchase # 1100 £12 each Purchase # 2200 £15 each Sales400 £20 each LIFO = Last in, First Out Items will be sold in the reverse order of purchase. The 400 items sold will be made up of:  200 £15 each£3000 (purch. # 2)  100 £12 each£1200 (purch. # 1)  100 £10 each£1000 (prev. stock)  Total Cost of Sales:£5200

AVCO Stock Valuation Example Opening Stock Level200 £10 each£2000 Purchase # 1100 £12 each£1200 Purchase # 2200 £15 each£3000 Sales400 £20 each AVCO = Weighted Average Cost An average cost will be calculated. All items sold will be charged at that cost. Total value of stock = £2000+ £ £3000 = £6200 Total no. of items = = 500 Average value of stock = £6200/500= £12.40 per item Total Cost of Sales = £12.40 = £4960

Depreciation  Depreciation is the method used to spread the cost of a purchase (normally of a fixed asset) over a number of time periods (usually years) This is a way of charging to the business the cost of the asset, in a way which accounts for the ‘wear and tear’ of the asset, and the fact that over time it is reducing in value. Depreciation is shown in the Profit & Loss Account as an Overhead

Calculating a depreciation charge Factors to be considered Cost of the asset Useful life of the asset Residual value of the asset Depreciation method The depreciation charge is calculated as a result of these four factors:  Initial Cost  How long it will be used for  What it will be worth at the end  Calculation method

less Residual value equals Cost Depreciable amount Annual depreciation charge Year 1Year 3Year 2 Year 4 and so on Calculating an annual depreciation charge Whatever method is used, the procedure is the same:

Depreciation Methods There are two main methods used:  Straight-line depreciation = Cost of item divided by number of years over which it is to be written off  Reducing balance = Current value x Depreciation%

Written- down value (£000) Asset life (years) Graph of written-down value against time using the straight-line method The same amount is used to reduce the asset value each year.

Written- down value (£000) Asset life (years) Graph of written-down value against time using the reducing balance method The amount used to reduce the asset value decreases year on year.

Depreciation calculation Purchase of a piece of equipment costing £10,000 Straight-line over 5 years Reducing balance at 30% Written down Written down Depreciation Value Depreciation Value Year 1 £ 2,000 £ 8,000 £ 3,000 £ 7,000 Year 2 £ 2,000 £ 6,000 £ 2,100 £ 4,900 Year 3 £ 2,000 £ 4,000 £ 1,470 £ 3,430 Year 4 £ 2,000 £ 2,000 £ 1,029 £ 2,401 Year 5 £ 2,000 £ 0 £ 720 £ 1,681 Year 6 £ 0 £ 0 £ 504 £ 1,176

The Problem of Bad & Doubtful Debts  Many businesses sell goods on credit. The revenue generated is recognised in accounts as soon as the goods are passed to the customer.  As soon as this happens, the sale is recorded, and the amounts appear as Turnover on the P & L account, and as Trade Debtors on the Balance Sheet.  There is a risk that the customer will not, or cannot pay. If this occurs then this is called a bad debt and must be written off.  This involves reducing debtors on the Balance Sheet, and creating an expense in the ‘Overheads’ section for Bad Debt.

Provision for Doubtful Debt  In some enterprises the problem of bad debt is endemic, and it may not be possible to identify with certainty the amount of debt which is “bad”, or which will not be retrieved.  In this case, the business will use past experience to estimate the amount of debt which might be lost in the accounting period.  The Provision for Doubtful Debt is calculated as an estimate and this will be used to reduce debtors on the Balance Sheet, and create an expense in the ‘Overheads’ section called Provision for Doubtful Debt.

Prepaid Expenses  Pre-paid expenses - goods or services which have been paid for in advance. When you eat in MacDonald's, they require you to pay ‘up front’ before you get the food. At the point at which you have paid, before you get your meal. This is a prepaid expense. Prepaid expenses are things like rent & rates paid in advance, as well as some consultancy fees.

Accrued Expenses Accrued expenses - any amount which the organisation owes for expenses already consumed but for which a bill has not been yet received or paid When you eat in a ‘posh’ restaurant they normally provide you with the food, then present you with the bill at the end. At the point at which you have eaten the meal, but not paid, this is an accrued expense. Accrued expenses are things like tax, dividends, wages and fuel bills.

Activity 5.3 Discuss the following:  Why does an increase in cash in the bank during a particular accounting period not necessarily mean that the organisation has made a profit?  Why is it important to distinguish between capital and revenue expenditure?  Why is it important to differentiate between indirect and direct costs? Answer

Activity 5.3 – Possible Solution  Increase in cash in the bank could be the result of: a loan, payment of a previous debt, selling off an asset, even selling goods at a loss! None of these incurs profit.  Capital expenditure buys things still owned by the company. Revenue expenditure ‘disappears’.  Indirect costs need to be paid even if you don’t sell anything; in difficult times overheads need to be cut.

Seminar 5 - Activities  Preparation: read M & A Chapter 3  Carry out Self-Assessment Question 3.1; the answer is at the back of the book.  Also M & A ex. 3.4; answer also at the back of the book  Activities to prepare for the seminar: M & A ex. 2.6 (from last week) P & L Activity Spreadsheet M & A ex. 3.8