How to Read a Profit and Loss Account and Balance Sheet

Key facts

Fact	Detail
P&L covers	A period, usually 12 months
Balance sheet covers	One date, the year end
Key P&L lines	Turnover, cost of sales, gross profit, profit before tax
Key balance sheet lines	Fixed assets, current assets, liabilities, reserves
Dividends come from	Retained profit (reserves)

Why directors should read their accounts

Many directors treat the annual accounts as a compliance task, but they contain valuable information. The numbers show whether the business is profitable, how much cash it holds, what it owes and whether it can afford to pay dividends. They also reveal trends, such as rising costs or slow-paying customers.

You do not need an accounting qualification to read them. Once you know the main lines and what they mean, a quick look is enough to spot problems and opportunities, and to ask your accountant useful questions.

The profit and loss account

The profit and loss account, also called the income statement, begins with turnover, which is the total sales for the period. Next come the cost of sales, which are the direct costs of delivering what you sold, such as materials and subcontractors. Turnover minus cost of sales gives the gross profit.

From gross profit, the account deducts overheads, such as wages, rent, software and marketing, to arrive at operating profit. After deducting interest and other items, it shows profit before tax. Corporation Tax is then deducted, leaving profit after tax, the figure that belongs to the shareholders.

Key ratios from the profit and loss account

A few simple ratios help interpret the numbers. Gross margin is gross profit divided by turnover, and shows how much you keep from each pound of sales after direct costs. Net margin is profit after tax divided by turnover. Overheads as a percentage of turnover show how efficiently the company is run.

Compare these figures with prior years to see whether they are improving. A falling gross margin may mean costs are rising faster than prices, while rising overheads can signal a need to control spending.

The balance sheet

The balance sheet shows the company’s financial position at the year-end date. It lists assets, which are things the company owns or is owed, and liabilities, which are what it owes. The difference is the net assets, which equals the shareholders’ funds.

Assets are split into fixed assets, such as equipment and vehicles, and current assets, such as cash, stock and money owed by customers. Liabilities are split into those due within a year, such as suppliers, tax and VAT, and those due later, such as long-term loans. Because the balance sheet must balance, assets minus liabilities always equals the shareholders’ funds.

Shareholders’ funds and retained profit

The bottom of the balance sheet shows the capital and reserves. This includes the share capital, which is the amount paid for shares, and the profit and loss reserve, also called retained profit. Retained profit is the total of all past profits after tax, less any dividends paid.

This figure is critical because a company can only pay dividends from retained profit. If it is negative, the company has accumulated losses, and dividends are not allowed. Check the reserve before declaring a dividend, and keep your management figures up to date through the year.

What the balance sheet says about cash and risk

Look at the current assets and current liabilities. If current assets are comfortably higher than current liabilities, the company can meet its short-term obligations. If they are lower, the company may face cash pressure. The ratio of the two is the current ratio, and a value above 1 is generally healthy.

Also look at the director’s loan account. A credit balance means the company owes you money, an overdrawn balance means you owe the company. An overdrawn balance can lead to section 455 tax, so it deserves attention.

Notes to the accounts

The notes explain items in the accounts. For a small company, they cover accounting policies, employee numbers, tangible assets, creditors, share capital, and related party transactions such as director’s loans. These details can reveal important issues, such as large debts falling due or unusual arrangements.

If you do not understand a note, ask your accountant. The notes are part of the public record, so they should be accurate and complete.

Using the accounts to make decisions

Once you can read the accounts, you can use them. Compare the profit with your expectations, and decide how much to pay yourself. Look at what the company owes and what it is owed, and decide whether to invest in equipment or build a cash reserve. Show the accounts to a bank or investor when you need finance.

A short annual review meeting with your accountant, going through the main figures, turns the accounts from a filing exercise into a planning tool.

A simple example

Suppose a consultancy has turnover of £120,000 and cost of sales of £10,000, giving gross profit of £110,000. Overheads of £50,000 leave an operating profit of £60,000. Corporation Tax of about £11,000 leaves profit after tax of £49,000. If the company paid £35,000 of dividends, retained profit increases by £14,000.

On the balance sheet, the company might hold £30,000 of cash, £15,000 owed by customers and £5,000 of equipment, against £12,000 of liabilities for VAT, tax and suppliers. Net assets of £38,000 equal the shareholders’ funds, made up of £100 share capital and £37,900 retained profit. Reading these figures together shows a healthy business that can afford its dividends.

Questions to ask your accountant

When you receive your accounts, a few questions help you get value. How does this year’s profit compare with last year, and why? Which costs have grown fastest? How much retained profit is available for dividends? Is the director’s loan account in credit or overdrawn? How much Corporation Tax is due and when? Are there any risks, such as large debts falling due? A short conversation around these questions turns static figures into a plan for the year ahead.

Red flags to watch for

A few warning signs are worth noticing when you read your accounts. Falling gross margins can point to rising costs or discounting. A growing figure for money owed by customers suggests slow payment. Current liabilities that exceed current assets may mean cash pressure. Negative retained profit means dividends are not allowed. A large overdrawn director’s loan balance can trigger tax charges. If you spot any of these, discuss them with your accountant early, because most problems are easier to fix when they are small.

The bottom line

A profit and loss account shows what the company earned and spent over a period, ending in profit or loss. If you would rather not do it alone, our fixed fees start at £45.83 + VAT a month.

Frequently asked questions

What is the difference between a profit and loss account and a balance sheet?

The profit and loss account shows income and costs over a period and ends with profit or loss. The balance sheet shows what the company owns and owes on a single date.

What is retained profit?

It is the accumulated profit after tax that the company has kept, less any dividends paid. Dividends can only be paid from retained profit.

What is turnover?

Turnover is the total value of the company’s sales in a period, normally excluding VAT. It is the first line of the profit and loss account.

Can a company have a profit but no cash?

Yes. Profit includes sales that customers have not yet paid for, and excludes spending on assets or loan repayments, so cash and profit can differ.

Do I need to publish my accounts?

Yes, accounts filed at Companies House are public. Small companies can file simplified accounts that do not include a profit and loss account.

What does gross profit mean?

Gross profit is turnover minus the direct cost of sales. It shows how much you keep from sales before paying overheads such as wages, rent and software.