Creating a P&L Account and Cash Flow Statement

Creating a P&L Account and Cash Flow Statement

In this lesson, you’re expected to learn:
– how to prepare and use a profit & loss statement
– how to prepare and use a cash flow statement
– how to interpret a cash flow statement

Profit & Loss as a List

As we know, a P&L merely shows how the retained profit changes over a period of time.

Using the example of Sarah’s company that we referred to earlier, we can see in the table below which entries affected Company X’s retained profit.

The net effect on retained profit of all nine entries is £5,000. However, this P&L list does not provide detailed information of the transactions.

A More Useful P&L

We therefore rewrite the above P&L in the following way:

Here are some of the differences:
• We show the total value of sales (£42,000) and the total cost of the products sold (£18,000). The difference between these two (£24,000) is the gross profit – the amount by which sales affect retained profit.
• We then take all the operating expenses and group them into categories. In this case, the operating expense categories are ‘Selling & Distribution’ and ‘Administration’.
• Operating profit is the profit after these operating expenses, which is equal to £13,000.
• Profit Before Tax (‘PBT’) of £12,000 is effectively all the profit that is left over for the shareholders after paying interest to the lenders (£1,000 paid to Sarah’s parents, in this case).
• After deducting a corporation tax of £4,000, this leaves a Profit After Tax (‘PAT’) of £8,000, which is due to the shareholders.
• Some of this is paid out as dividends (£3,000) to shareholders. So what is then left (£5,000) is the retained profit.
[Optional] How to Complete a Profit and Loss Statement
Cash Flow Statement as a List

From the table below, you can see that 11 entries affected the amount of cash. The net effect was to increase cash by £4,000.

Just as we did with the income (P&L) statement, similarly we can improve our understanding of this statement by grouping the entries into different headings:
A More Useful Cash Flow Statement
• Operating activities consist of all activities that relate to the company’s operations. This could include buying and selling stock, paying expenses, collecting cash from debtors and paying cash to creditors.
• Capital expenditure includes all buying and selling of fixed assets that enable the operating activities to take place.
• Returns on investments and servicing of finance: means the interest paid on loans and any dividends or interest received on investments or cash that the company has on deposit.
A More Useful Cash Flow Statement
• Taxation refers to the tax on the profits of the company.   
 Equity dividends paid: the dividends paid out to shareholders   
 Financing consists of all the transactions relating to the raising of funds to operate the business.

Presenting a cash flow statement in this way makes it easy to understand where the cash in the business has come from and gone to.

Profit and Cash Flow

Two points to keep in mind:
• With most businesses, profit and cash flow are not the same at any particular time (day, month or year).
• Total profit and total cash flow will be the same in the long run.

These two observations form the basis of a different cash flow statement, as shown below:
All of the sections of this cash flow statement are identical to the previous one except ‘operating activities’. As you can see, the first line of this section is operating profit. The rest of the section consists of the adjustments we have to make to operating profit to get the cash flow due to the operating activities.

We’ll now look at each of these adjustments.

1) Depreciation 
Depreciation affects operating profit but it does not affect cash.

2) Trade Debtors 
When sales are made on credit, not all of this money is collected from customers.

3) Stock 
At the end of the year, a company typically has some stock that it has not sold – this is treated as an asset and not included in the calculation of operating profit for the year. The effect of this stock is to make cash flow lower than operating profit. Thus an adjustment on the cash flow statement is necessary.

4) Prepayments 
Similar to stock, cash has been paid out which is not included as an expense in the calculation of the operating profit. This will tend to make cash flow lower than operating profit and an adjustment needs to be made.

5) Trade Creditors & Accruals 
Some of the expenses considered in calculating operating profit and some of the stock at the end of the year have not actually been paid for. However, the cash flow statement assumes that they have. We must therefore adjust the cash flow upwards to take account of this.

[Optional] How to Prepare a Statement of Cash Flows
Read this article to learn more:
Having made these adjustments, the operating activities section of the cash flow statement is now much more useful.
By looking at the table, we can clearly see that the operating cash flow (- £3,000) was substantially worse than operating profit (£13,000).
In the cash flow statement, you can clearly see that increase in trade debtors, increase in stock, and increase in payments are all negative values.
Effect of a previous year’s transactions

At the start of the year, most companies will have some debtors left over from the previous year – these debtors will be collected during the current year. Thus, you have to allow for the cash you collect from these debtors in your cash flow calculation.

Let’s use an example to understand how this works.

Assume that you’ve been running a company for the last few years. Your sales for this year are £100,000 and your expenses are £80,000, giving you an operating profit of £20,000. If all your sales and expenses are paid in cash at the time, your cash flow must also be £20,000.

Now, let’s say that last year some of your customers did not pay in cash so that at the end of the year (i.e. the beginning of this year) you were owed £15,000. Those customers paid during the current year so you end up receiving that extra amount apart from the cash received from this year’s sales.

Thus, your cash flow for this year would be:
£20,000 (operating profit) + £15,000 (last year’s debtors)

If we now assume that some of this year’s sales were made on credit and at the end of this year, you are still owed £30,000 by customers, your cash flow would only be £5,000 (£35,000 – £30,000), as shown below:
As you can see, what we are actually doing is adjusting operating profit downwards by the increase in debtors between the start and the end of the year.
[Optional] Fundamental Analysis: The Cash Flow Statement
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