Understanding financial statements

As a small business owner, it probably wouldn't have been top of your list to learn about debits, credits and other potentially off-putting accounting topics - unless you're an accountant! However, regardless of your area of expertise, a basic understanding of financial management will give you an informed view of your company's performance, aid communication with anyone giving you business advice (including your bank manager), and allow you to make better decisions.

On this page:

• The profit and loss statement
• The balance sheet
• Next steps

Top

The profit and loss statement

The profit and loss statement (or statement of financial performance) provides a picture of your business trading performance over the last accounting period - usually a year, and generally from April 1^st of one year to March 31^st of the year after.

It records sales, costs and expenses, profits (or losses), and any tax payments for the period. This is the document that  Inland Revenue uses to determine what tax you owe, so it is important that you understand how it works.

The profit and loss statement usually follows this relatively easy format:

Turnover (or sales).

Less: cost of sales (your 'direct' costs, such as raw materials).

Equals gross profit (turnover less cost of sales).

Less: fixed or 'indirect' costs (also called business overheads) such as rent, rates and salaries. This will include depreciation on fixed assets.

Equals operating profit or profit before tax.

Less: tax payable.

Equals net profit.

The profit and loss statement is usually straightforward and relatively easy for non-financial managers to understand, but you might need to ask questions about some elements of the statement to understand all the information in it.

Some things aren't included. For example, the principal repayment of a loan is not included in the profit and loss statement, because it does not count as an expense, in the same way that injecting additional capital doesn't count as sales. But the interest you pay on a loan is an expense that you would include.

As a business owner, you'll want to claim as many legitimate expenses as possible to keep the tax bill down; however, it is important not to rush out and buy things you don't really need just to reduce your tax bill. You'd be better off making a higher profit and paying a little extra tax, than a lower profit and spending your hard earned cash on things you don't need.

What can you do with the profit and loss statement?

The best use of your profit and loss statement is to look at your profit margins, and to see if any expenses have increased dramatically since last year.

Gross profit: Your gross profit margin is your gross profit as a percentage of turnover. For example, if your turnover is $2mn with a cost of sales of $600,000, you have a gross profit of $1,400,000 and a gross profit margin of 70% (1,400,000 ÷ 2,000,000 x 100). So every $100 of sales generates $70 that goes towards paying for expenses (and towards your profit). If this percentage starts to slip over time, it is an indication that you need to take action. Find out why. Some reasons include:

• Rising inventory costs
• Offering discounts
• Theft by customers or staff
• Selling products that have lower margins.

Net profit: Your net profit margin compares your net profit (gross profit less fixed or indirect costs) to turnover. For example, for a business with a turnover of $2mn and an operating profit of $300,000, the operating profit margin would be 15% ($300,000 ÷ $2,000,000 x 100). Again, if this falls, it means you are paying proportionately more in expenses (rent, power, salaries, etc.) than you should be.

This is particularly useful in pointing to problems when you don’t expect them, for example when your net profit is going up. Using the above example, if your sales increased to $3mn and net profit was up at $400,000, this looks good. But while your profit is up, your net profit percentage has fallen ($400,000 ÷ $3,000,000 x 100) to 13.3% from 15%.

Benchmarking your business

You can compare your profit margins with the margins of similar businesses to get a clearer picture of your performance.

External benchmarking:

• Compare your profit margins against those of other companies to find out where you are doing well and where you should set improvement goals. Your bank manager, accountant, industry association or local Chamber of Commerce might be able to give advice on accessing these figures.

Internal benchmarking:

• Compare your profit margins to previous periods to see where your selling prices are coming under pressure or costs are increasing.
• Compare profit margins on individual product lines to see which products are the most profitable.

Profit margins tell you how much room you have to manoeuvre on pricing and the level of sales you need to break even. As long as you have a positive gross margin, each sale will make some contribution to covering your overheads.

Top

The balance sheet

The balance sheet or the 'statement of financial position' gives you a picture of your company's financial strength at the end of an accounting period (for example, a quarterly period or your full 12 month financial year). The big difference between the profit and loss statement and balance sheet is that the profit and loss only has the last 12 months' information. Every year on April 1^st (or whenever you start your financial year), the profit and loss statement winds back to zero. However, the balance sheet is a record of what has happened in your business right from the start, and is a cumulative record. The balance sheet summarises your assets (what you own) and liabilities (what you owe).

On the assets side of the balance sheet are:

• Fixed assets (such as plant and machinery). These can include intangible assets such as goodwill, licences and intellectual property rights, and are generally longer-term assets.
• Current assets (short-term assets) include stock and work-in-progress inventory, debtors (customers who owe you money), and cash.

Liabilities (what your company owes) are similarly divided into short and longer-term items:

• Current liabilities are amounts you owe that are due for payment within one year, such as suppliers you owe money to, your bank overdraft and hire purchase payments.
• Long-term liabilities fall due after more than one year, and include bank loans, leases and directors’ loans.
• Shareholder funds include share capital (amounts paid into the company for shares) and reserves (including retained profit).

The capital employed in the business will always equal fixed assets, plus current assets, less current liabilities.

Understanding balance sheets

Balance sheets can be trickier to understand than a profit and loss statement. You'll likely need to ask questions to get a clear understanding of what the balance sheet is telling you. For example, your accountant or financial manager has to make judgement calls on:

• What method to use in depreciating fixed assets.
• How to value intangible assets such as licences, or goodwill, where values could depend on the state of the market or other factors.
• How to value stock and work in progress.
• What adjustments to make for customers who are unlikely to pay.

What can you do with the balance sheet?

Comparing profits to assets provides a measure of profitability.

• Return on capital employed is net profit (before tax) as a percentage of capital employed. This shows you what return you're making on the money financing the business (both as loans and shares). So if you have $2mn in capital, and earn $100,000 a year in profit, this is only a 5% return on capital invested. Maybe your money will earn better returns sitting in a bank, or financing another type of business?
• Return on equity is profit before tax (but after interest has been deducted) as a percentage of shareholders' funds.
• Financial strength looks at how large a proportion of your financing is borrowed, and how well you could cope if business conditions became difficult. Are you funding growth from debt or company reserves?
• Control of working capital (that is, current assets less current liabilities). For example, how much money do you have tied up as stock, how efficient are you at collecting debts, and how quickly can you pay suppliers? If you suddenly needed to pay everyone back, do you have enough cash to do so?

As with the measures of profitability, comparing key ratios to other businesses, and against the same figures for previous periods, helps to highlight areas where you need to take action.

Top

Next steps

• Make the effort to become more familiar with the key financial documents in your business. The reward will be better money management. Get guidance from your accountant on the key performance indicators for your business that you need to benchmark and monitor, or get help from your accountant with understanding a balance sheet - the trickiest of the documents.
• Look for basic accounting workshops that will help you improve your financial skills.
• Experiment with 'what if' scenarios to improve your business planning and working capital management.
• Access this online training lesson on financial forecasts for further help.