The profit & loss account
The cash flow statement
‘Definitive’ vs ‘descriptive’ statements
Now we know what a balance sheet is and how to construct one, we can
move on to the P&L and cash flow statement. In this session, all I am
going to do is explain what the P&L and cash flow statement are. We’ll
see how to construct them in our next session.
The profit & loss account
Let’s start by looking at a hypothetical situation relating to an individual’s
P&L. Assume you’re a fortune-hunter, Tom, after Sarah for her money.
What would you want to know before asking her to marry you?
How rich she is or, as you would say, what her net worth is.
So if I told you that her net worth today is £25,000, and added that it was
only £20,000 this time last year, what would you think of her as a target
for your ‘affections’?
Not a great deal.
The profit & loss account and cash
flow statement
a c c o u n t s d e m y s t i f i e d
Which could just be one of your bigger mistakes, Tom. We know Sarah’s
net worth has gone up by £5,000 over the last year. There are many ways
that could have happened. Here are two very different ones:
It could be that Sarah earned a total of £15,000 during the year
and spent £10,000 of this on food, drink, holidays, tax, etc. The
remaining £5,000 she saved, either by spending it on real assets or
by putting it in her bank deposit account. Add these savings to the
£20,000 net worth she had at the start of the year and you get her
net worth today of £25,000.
An alternative scenario is that, a year ago, Sarah landed an
extremely well-paid job, earning £500,000 a year. She’s quite
extravagant, but in a normal year could only have spent (includ-
ing a lot of tax) £245,000 of this income on herself. She should,
therefore, have saved £255,000. Unfortunately, during the year
she had to pay an American hospital for a series of operations for
her brother. He’s better now, but the operations cost her a total of
£250,000. As a result, she only saved £5,000 during the year.
What would you feel about Sarah in each of those situations, Tom?
I’d obviously write her off in the first case. In the second, I’d be more than a little
interested, provided she didn’t have any more sick relatives.
Exactly. My point is that, as well as knowing what Sarah’s net worth is
and by how much it has changed since last year, an explanation of why
she only got £5,000 richer during the year can be very important. If we’re
going to make a sensible judgement about a company’s future perform-
ance, we need a similar explanation. This is what a P&L gives you.
If you look at the bottom of Wingate’s balance sheet on page 246, you will
see that the company’s retained profit (its ‘savings’) rose by £268k during
the year from £2,178k to £2,446k. If you look on page 245, you will see
Wingate’s P&L, the penultimate line of which shows retained profit in
year five of £268k. This is not a coincidence. The P&L is just giving you
more detail about how and why the retained profit item on the balance
sheet changed over the last year. That’s all there is to it.

Get Accounts Demystified, 6th Edition now with the O’Reilly learning platform.

O’Reilly members experience books, live events, courses curated by job role, and more from O’Reilly and nearly 200 top publishers.