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Need/Purpose and Importance of Profit and Loss Account

The purpose and the importance of preparing profit and loss account is as under:

1.                           Knowledge of net profit or net loss. The purpose of preparing profit and loss account is to ascertain the amount of net profit or loss. This is the actual profit available to the proprietor and credited to his capital account. In case of net loss proprietor’s capital account will be debited. The net profit is calculated after charging all indirect expenses.

 2.                           Ascertaining ratio between net profit and net sales. We get net profit from profit and loss account. This net profit is matched with the net sales to calculate net profit ratio. This ratio is compared with the desired net profit ratio and if there is any short coming, that will be removed. This ratio can also be compared with the ratio of previous years and effective future line of action can be taken.

3.                           Calculation of expenses ratio to sales. Expenses ratio to sales is calculated. We can calculate individual expenses to sales ratio and compare it with desired expenses ratio and with the ratio of previous years. It will always be in the interest of the firm that the expenses ratio should be the minimum.

4.                           Comparison of actual performance with desired performance. The actual performance of the business is available with the profit and loss account as regards net profit, individual expenses and individual income. We compare our actual performance with our planned and desired performance, identify weaknesses and try to remove them.

5.                           Maintaining provision and reserves. We have to maintain certain reserves and provision to meet our future uncertainties. The amount of provisions, reserves and funds to be maintained depends upon net profit earned by the firm. It is necessary to prepare profit and loss account to determine the net profit, so that effective provision for uncertain future could be maintained.