| You are
in business to make money. To do so, you need to understand
where the money is coming from and where it is going. This
is why you keep accounts and produce regular reports from
these, including the profit and loss account and the balance
sheet.
These two financial statements provide a picture of what
is happening in your business, which is why any bank manager
or other financiers will want to see them when you ask for
a loan or other credit facilities. However, you don’t
have to be a fully-fledged accountant to understand what they
mean. Yet unless you understand these two core documents,
you are not in a position to make safe decisions – instead
of managing your business, you are leaving some things to
chance. This guide will give you the basics of what you need
to know.
Overview
Your profit and loss account (often described as ‘P&L’)
shows business performance. It measures how
much money you have made, and how you made it, over a given
period. Typically, this period is a month or consolidated
over a year.
Your balance sheet shows the value of your business,
at a specific point in time (for example, the last day of
the month or your financial year). It reveals how the profits
shown in the P&L have been used.
Most simple computer accounting packages seek to describe
and lay things out in lay terms and so are quite easily understood
by non-accountants. There are several manual book-keeping
systems available, which explain clearly how and where entries
should be made. However, it will be necessary with these to
transfer the totals to the P&L.
The profit and loss account
Whether you use accountancy software to create your P&L
account automatically, or you keep your accounts manually
on paper or on a spreadsheet, the figures are usually set
out as follows.
Your P&L account starts with the gross income
(the total of all money that comes in from your sales to customers),
and takes away any discounts or allowances (for example, for
early payment or bulk purchases) to give net income.
From this, it takes away cost of sales (for
example, the cost of the goods you sell, the packaging and
delivery) and that gives gross profit.
Then it takes away overheads (sometimes
called fixed costs). These include the rent for your premises,
marketing costs, wages, telephone, postage, and stationery.
That gives you the operating profit.
Then you add any other income (for example,
the rent that you get for the flat above your shop or the
sale of an old desk) and subtract any other expenses
(for example, the cost of paying the letting agents who handle
that rental) and you have your profit before tax.
Take the tax away from profit before tax and you have your
net profit or loss.
A P&L account is usually laid out like this:
£
Gross income
Less discounts and allowances
100,000
(1000)
Net income
Less cost of sales
= 99,000
(30,000)
Gross profit
Less overheads
= 69,000
(16,000)
Operating profit
Plus other income
Less other expenses
= 53,000
7,500
(1,500)
Profit before tax
Less tax
= 59,000
(23,000)
Net profit (or net loss)
= 36,000
Some computerised accounting systems may lay the figures out
differently to this but when accounts are printed, they are
generally shown in this format. While accounts for internal
use will show far more detail than above, published accounts
for limited companies or limited liability partnerships rarely
do since it is not a requirement.
There are a few accounting conventions to be aware of:
- It is usual to show the same set of figures for the previous
period alongside the figures for this period, so you can
compare the two.
- Putting figures in brackets means a minus figure.
- Instead of drawing a line under a sequence of figures
to indicate that the following figure is a total, sometimes
the total is shown in the column immediately to the right,
like this:
100,000
10,000
25,000
135,000
Each of the figures in the P&L account will be the total
of many others and may come from several places in your accounts,
depending on the type of business you are in. For instance,
cost of sales for a retail business will include many purchases
of stock and packaging, but for a one-person consultancy,
they may consist of no more than special stationery on which
reports are printed for clients.
For that consultancy, the day-to-day accounts can be kept
in a very simple form because there will not be very many
individual sums of money coming in or going out. However,
for a retail business there will be many transactions every
day, and these have to be recorded in a form that makes it
easy to transfer them to the P&L account. This is done
by entering them into separate sections in your accounting
program (or columns in your accounts book). You may want to
consult your accountant on which items should be recorded
in which section of your accounts – for instance, does
the new shelving for the shop displays form part of ‘cost
of sales’ or is it part of the ‘furniture and
fittings’?
Balance sheet
The balance sheet is presented in two sections:
- Assets such as buildings, furniture and
fittings, equipment, stock for sale and other items like
stationery, plus cash at the bank and money owed to you.
- Liabilities such as your bank overdraft,
loans and other money you owe.
Balance sheets are usually laid out in this standard format:
Fixed assets, listed by type of item
50,000
(Depreciation, listed by item)
(8000)
Total fixed assets
42,000
Current assets (cash, money in bank, debtors)
12,000
Total assets
54,000
Current liabilities, for example, bank loan, tax
(49,000)
Proprietor’s interest, represented by capital invested
67,000
Profit/loss for the year (from the P&L)
36,000
Capital at end of year
54,000
- Note that the two figures ‘total assets’ and
‘capital at end of year’ are the same –
they must be, as the whole point of a balance sheet is to
balance the two sides of your accounts.
- Proprietor’s interest (also known as equity) simply
means the amount of money you have tied up in the business.
- Depreciation is a figure given each year for the loss
of value in such items as equipment and vehicles. Say you
buy a new piece of machinery for £10,000, and expect
it to last 10 years before you replace it. At the end of
those 10 years it will be worth nothing, so it will have
reduced in value each year by £1000 – which
is called depreciation. There are some conventions on the
lifetime of certain types of item; these are used because
the Inland Revenue accepts them as reasonable.
Note that sometimes these ‘rules’ on depreciation
change, even temporarily. For example, in the 2001 Budget,
the Chancellor introduced a new scheme for 100% first year
capital allowances for investments in designated energy-saving
equipment. This means you can immediately write off against
taxable profits all of your capital spending on designated
energy-saving plant and machinery.
There are some other common terms that you need to understand:
- Current assets . This means things which represent money
you can get your hands on fairly quickly, and includes the
cash in your till and in credit in your bank account, money
owed to you by customers, your stock and any pre-paid expenses
which you could, theoretically, get back, such as the rent
on your premises.
- Fixed assets . These are the items you own and will keep
for a long period for use in the business, rather than sell
for a profit. This heading covers buildings, fixtures and
fittings, vehicles, equipment and plant. You could think
of these as the items that depreciate (although this might
not apply to buildings in a rising property market).
- Other assets . These are sometimes called ‘intangible’
assets, and include such things as goodwill, and the value
of any licences, copyrights, trademarks or patents you might
own.
- Current liabilities . These are amounts you owe and will
have to repay within one year, such as your suppliers’
invoices, a short-term loan, your overdraft (which is in
this section because it is usually repayable on demand)
and VAT, or other taxes due.
- Long-term liabilities . These include long-term loans
such as mortgages or lease payments on vehicles.
Money owed by your customers in this context means the money
you are confident of collecting. If you are uncertain about
payment, you need to have another section in your balance sheet
called ‘provision for bad debts’. So if customers
owe you a total of £10,000, and you think you may not
be able to collect £2000 of it, you show £8000 under
‘accounts receivable’ and £2000 under ‘bad
debt provision’.
Using your profit and loss account and balance sheet
If you are making a profit and a decent living, why should
you bother going to all the trouble of setting out the figures
this way? The answer is, it will help you begin to see patterns.
For example, you might be able to shave a bit off the cost
of sales to improve your gross profit. Or if your profits
decline, you may be able to see that you are not selling less,
but running up more overheads in proportion to your sales,
at which point you can ask yourself, why? Working only with
a net figure at the end of the day is like looking at an old
master painting, and only seeing it in terms of wall space.
Similarly, why should you care about your balance sheet if
you are showing a healthy profit? Producing these two reports
regularly and looking at them together gives you a wealth
of information about how to drive your business forward.
First, the P&L measures your profitability while your
balance sheet measures your financial health – your
ability to pay what you owe out of your current resources.
So they indicate your long-term prospects and reveal how you
could manage your business better.
In its simplest form, seeing two sets of figures can show
that things are going reasonably well. For example, you are
showing a steady profit and your balance sheet is improving
every month.
One of the big advantages of computer accounting software
is that it makes it easy for you to create different views
of your figures. You can compare this month with last month,
this year-to-date with last-year-to-date, several months in
sequence, or you can convert the figures into percentages
and compare them that way. This makes it easier to spot the
trends over time. Your aim is for your sales and profits to
increase, and your expenses to decrease. Are there any sudden
changes or anomalies that ring warning bells? For example,
if you spend roughly £100 a month on stationery, and
one month you spend £500, you would want to look into
this. Of if your staff costs on average 30% of your income
and this figure suddenly leaps to 40%, again you would want
to investigate what was happening. If it dropped to 20%, alarm
bells might equally ring. What have you missed out?
You can also draw some deeper conclusions than just seeing
that more money is coming in than previously. Is the increase
equivalent to, or better than, the rate of inflation? Is it
the result of more sales, or is it hiding the fact that although
you have charged more per sale, you actually made fewer sales?
Assuming that the percentage increase continues in each of
the next few years, is this going to be satisfactory, or should
you be looking for a bigger percentage increase?
Interpreting the numbers with ratios
There are a number of ratios that are commonly used to work
out how a business is doing. They are simple to grasp.
The acid test
This is sometimes called the quick ratio. This shows the
business’s ability to meet its current liabilities with
the money it has readily available. The calculation excludes
stock because this is notoriously hard to sell quickly and
to do so, you may have to drop the price considerably.
- Acid test = (current assets – stock) ÷ current
liabilities
So if your current assets on your books are £13,000, your
stock is worth £3000 and your current liabilities are
£5000, you have a ratio of 2:1. If the ratio were the
other way round, at 1:2, you could be in trouble if all your
creditors demanded payment instantly because you don’t
have the money available to pay them.
Gross margin
The gross margin shows the average profitability of your
sales. This indicates how well you are generating the means
to pay for all your expenses and still make a profit. The
average figure will vary from industry to industry.
- Gross margin = gross profit* ÷ sales x 100
(*Gross profit = sales – cost of sales)
For example, for a company with a gross profit of £92,000
and sales of £138,000, the gross margin would be 67%.
Net margin
The net margin shows how well you are doing as a business
overall, taking into account the level of overheads against
sales.
- Net margin = net profit (before tax)* ÷ Sales x
100
(*Net profit = sales – total expenses)
For example, for a company with a net profit of £52,000
and sales of £138,000, the net margin would be 38%.
Again, the average figure will vary from industry to industry.
Many people would like a very high figure for this, but most
businesses earn a net margin of under 10% and are quite successful.
Break-even
Your gross margin is used to calculate your break-even point,
or level of sales you need to achieve to actually start to
make a profit.
- Break-even = fixed expenses ÷ gross margin
For example, for a business with fixed expenses of £50,0000
and a gross margin of 40%, break-even would be at £125,000
of sales.
Why produce ratios
The point of producing these ratio figures is to give you
a specific figure, which you can compare between different
periods, whether these periods are years, quarters or months.
Financial reports allow you to look at your business objectively,
and as an integrated whole. Without precise comparisons, you
can only operate on ‘gut feeling’ – a notoriously
vague and inaccurate way to monitor the progress of your business,
and one which often leads to trouble.
In most cases, some extra calculations will be required by
your accountant to prepare final accounts. These include depreciation,
accrual tax and so on. That said, the raw report you produce
will be more than adequate to help you manage your business
day to day.
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