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What is the Use of a Profit and Loss Account and a Balance Sheet?

It is unlikely that in many exams you will have to construct a balance sheet or profit and loss account - they are normally given to you - but you will be expected to comment on what these accounts tell you.

Many different groups of people will use these accounts to make a judgement on the success or otherwise of the business and how it is performing. It will tell potential investors whether it is worth buying shares in the business. It tells suppliers whether the business might be worth doing business with (you would not want to enter into a contract with a firm that was likely to close down in the coming months!) and a host of other stakeholders including banks, employees, customers and other firms who might be interested in taking over or merging with the business.

From the balance sheet, we might get a picture of the way the company is financed - one that has a very high proportion of loan capital might be more risky than one financed more by shareholders. We can look at how the value of assets changes over a period of time.

Think about a football club; it might class its players and its stadium as part of its assets. A player like Michael Owen was bought for £18 million! For much of the time since he was bought he has been injured and not able to play - does that reduce the value of him as an asset to the club? What happens to the value of the stadium if a large supermarket comes along and expresses an interest in buying the land on which the stadium is built?

The profit and loss account tells us very much more about a businesses performance. We can see how sales revenue is changing, what is happening to the cost of production, how well the business is controlling its fixed costs and what is happening to its profit.

Remember earlier on we were talking about 'mark up'? The mark up was the 'profit' divided by the cost of production. We mentioned that it was different to the profit margin.

The profit margin relates the profit to the sales revenue. If we sell an apple to our customers for 30p, how much of that 30p represents profit?

Profit margin is usually expressed in two ways - 'gross profit margin' and 'net profit margin'.

This is where the difference between 'cost of sales' and 'sales revenue' becomes very important.

Return on Capital Employed

There is one other commonly used accounting ratio that is used at this level - the Return on Capital Employed, or ROCE.

ROCE is useful is helping us see how efficient the business is in using its assets to generate profit. We have covered this term in a previous Biz/ed resource on business success, where you will find more details. (http://www.bized.co.uk/cgi-bin/level2/typein.pl?module=success15)

To calculate the ROCE, remember that we need to divide the profit by the total capital employed by the business. The ratio tells us something about the way the business spends its money and how effective it is in using that spending to generate profit - which, after all, is a major aim of many private sector businesses! (Which profit measure do we use, however? Gross or net?)

At this level, we can assume that our capital employed is the total of our assets, which we can get from the balance sheet.

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