The profit and loss statement is considered one of the three most important financial reports. The profit and loss, or income statement, is regularly used in conjunction with the balance sheet and statement of cash flows to accurately gauge the financial health of the underlying institution. The following paper will discuss the importance of the profit and loss statement to retailers.
The profit and loss statement follows a general mathematic equation to provide key financial health metrics for any organization. The formula begins with total sales or revenue. This is the total amount of payment that has been received from selling retail goods. Retailers typically have discounts and returns that will reduce total sales to net sales. In the example provided (Donna’s Gift Shop) the net sales are provided first and any discounts or markdowns are not provided. The net sales figure includes both cash transactions and payment received on account, or credit. The cost of goods sold, in retail, is generally the amount paid for the items that have generated total sales. The calculation for cost of goods sold involves taking beginning inventory, adding any purchases during the accounting cycle, and then subtracting ending inventory. For retailers, this is generally the largest expense that has to be managed.
Table 1 illustrates a standard cost of goods sold as a percentage of net sales at 50%. This is particularly important for retailers as it also provides the markup price required to cover expenses. For example, a dress that costs the company $10 will have to be “marked up” 100% to cover the cost of doing business as well as provide an adequate profit. Therefore, a markup of 100% on that dress will provide the cost of goods sold to net sales ratio of only 50%. The result of net sales less cost of goods sold is the gross profit. This is the amount left over to cover indirect expenses, pay taxes, and provide a profit to business ownership. For a retail business, operating expenses are the indirect costs associated with providing the service. Operating expenses generally include salaries (in retail), freight out, utilities, rent, advertising, insurance, and any miscellaneous costs. After operating expenses are reduced from gross profit, the outcome is the profit before taxes. The retail budget should be familiar with the tax rate in the jurisdiction of operations as well as FASB's rule for reporting discontinued operations. For the analysis, Table 1 has implied a corporate tax rate of 30%. The last value, after taxes are paid, is the net income or overall profitability for the company. Depending upon the organizational entity, the profits can be reinvested in the business, returned to ownership, or in the event of a corporation, applied to retained earnings or distributed to shareholders in the form of dividends.
The statement of profit and loss ties to the balance sheet to further illustrate financial health. The balance sheet is comprised of assets, liabilities, and owners’ equity. The accounting equation for the balance sheet is assets equal liabilities plus owners’ equity. Table 2 illustrates a retail organization’s balance sheet that “balances” assets and liabilities plus owners’ equity. As such, the values for these calculations should be equal. There are several mechanisms that bind the profit and loss with the balance sheet. First, the net income from the profit and loss flows to the equity section of the balance sheet in the form of retained earnings. Second, as inventory fluctuates from month to month, this fluctuation is directly displayed in the cost of goods sold on the profit and loss statement (IRS, 2014). Third, the receivables on the balance sheet and the sales on the profit and loss are tied together. Any payment on account for merchandise is reflected in the month of sale on the profit and loss and then also appears on the balance sheet as an accounts receivable. As payments on account are made by credit customers, an entry reducing the account receivable while increasing cash is made on the balance sheet. It’s important to keep in mind that the sale is recorded, regardless of payment method, in the accounting period when the initial transaction takes place. Fourth, operating expenses directly relate to the cash held on the balance sheet. For example, as payments are made throughout the accounting cycle to cover operational items such as insurance, wages, or marketing, the cash on hand is reduced by that value. Fifth, equipment in the retail environment is subject to depreciation. While the equipment is held on the balance sheet at cost, the cost is distributed over time according to Generally Accepted Accounting Principles. The cost generally reflects the useful life of the equipment and is spread out while the equipment is being used. As a result, the cost of the equipment on the balance sheet flows through the profit and loss on a monthly basis as an expense labeled as “depreciation” (FASB1, 2014). Lastly, retailers can also pay for items such as insurance in advance. When this occurs, the advanced payment is reflected on the balance sheet as an asset labeled “prepaid insurance.” This is because the payment has been made in advance for the insurance coverage effective at a future date – It is something owed to the business by the insurance company. Therefore, it is an asset. As the insurance coverage is used, the insurance cost flows from the balance sheet to the profit and loss as an insurance expense (FASB2, 2014). If the retailer pays for insurance monthly, there will not be a prepaid expense account on the balance sheet. In the event the insurance is paid quarterly or yearly, a prepaid account would be necessary.
In closing, the profit and loss statement provides many key indicators of financial health. The document is extremely important in regards to budgeting and strategic management for any retailer. The balance sheet adds to that capacity by including additional metrics that can further the analysis and the success of the retailer. Therefore, the most strategic retail executives will combine the knowledge held in the profit and loss with the balance sheet to further their understanding of the organization’s health and what adjustments might be necessary.
(Tables 1 & 2 omitted for preview. Available via download)
FASB1. (2014). Summary of Statement No. 93. Retrieved from http://www.fasb.org/summary/stsum93.shtml
FASB2. (2014). Summary of Statement No. 113. Retrieved from http://www.fasb.org/summary/stsum113.shtml
IRS. (2014). Chapter 34 – Retail industry. Retrieved from http://www.irs.gov/irm/part4/irm_04-043-001-cont03.html