Understanding and managing the finances of your business must involve understanding and managing your business’s accounts.

This is an area where many people feel uncomfortable and which many business owners shy away from, seeing accounting as a technical and complex area.

The purpose of the remainder of this section is to provide an overview of what the accounts can tell you as an owner manager and to provide some tools (ratio analysis) that you can use to extract useful information with which to manage your business and its finance requirements.

If you are familiar with reading accounts you may therefore wish to skip this and the following chapter. If not, you may wish to work through each subsection of these two chapters to ensure that you are comfortable with each element, what it is showing you and why. You may also find it useful to revisit these two chapters at a later date.

WHAT ARE ACCOUNTS AND WHY ARE THEY IMPORTANT?

A set of accounts is simply a record of:

• the business’s trading performance over a period, a profit and loss account;
• a snapshot of its financial position at the end of a period of trading showing its assets and liabilities, a balance sheet.

Accounts have two principal uses.

• They are a means of providing you as the business owner with understanding and control of how the business is performing. As such they can be produced annually, quarterly, monthly or even weekly if that is how detailed the control of the business needs to be. Accounts in this sense (prepared primarily for internal consumption and known as management accounts) are part of what is known as a business’s management information systems (or MIS), where they may be tied into other reports such as key data (eg, orders in the pipeline, production efficiencies, wastage rates), compared with budgets, to see whether the business is on track, and used as the basis for cashflow forecasting to establish the finance required.
• They are also a means of communicating how the business is doing to third parties who may need to know, such as the tax man, the bank, or suppliers who you would like to give you credit. As shown in Chapter 1, part of the price of limitation of liability is a requirement to publicly file annual accounts so that people who are dealing with a limited liability company can assess its financial position.

HOW ARE ACCOUNTS PREPARED?

Accounts are prepared from the books and records kept by the business and will generally be prepared in accordance with what is known as UK Generally Accepted Accounting Practice (GAAP).

UK GAAP is the overall term for what you might think of as the rules of the game in that, in order to make accounts as easy to interpret as possible, it dictates:

• the basic assumptions which it will be expected that any set of accounts should follow;
• a standardised approach to laying out the information so that one set of accounts looks more or less like another. The accounts shown below show a simple profit and loss and balance sheet for Widget Co Ltd that might form its management accounts.

You’ll find that published sets of accounts, the formal sets that are prepared for filing at Companies House, may look different from this because, for example, the overheads will normally be consolidated into a single figure, thus showing much less detail than in the management accounts.

If you’re not familiar with accounting practice there are a small number of these key underlying assumptions that you need to be aware of to make sense of any set of accounts. There may be occasions where a set of accounts deviates from one of these key assumptions, but if so this should always be clearly indicated in the accounts so that the readers are aware of this.

In a published set of accounts the policies and specific assumptions made, such as depreciation policy, will be set out in the first of the notes to the accounts.

The four key accounting concepts are as follows.

1 Prudence

Accounts should be prepared prudently. This means first, that they should not anticipate profit before it has been earned, so sales should not be recognised in turnover until the goods or services have been supplied and normally the invoice raised.

Secondly, losses should be recognised as soon as possible, by providing for the costs or writing down any asset whose value has been impaired as soon as appropriate. So you should recognise the expense of suffering a bad debt or needing to write off obsolete stock as soon as you become aware of the problem.

2 The accruals concept (or the matching basis)

Accounts should also be prepared on the basis that costs should be matched to the relevant sales or periods. So, for example, if the company has bought three widgets during the year and has sold two of them, then the cost of the two that have been sold will appear in the profit and loss account as the costs of the goods sold, so matching the cost to the relevant sales during that period. The cost of the third will be carried forward as part of the stock in the balance sheet to be matched against the relevant sale when this occurs at some point in the future.

In the same way, overhead costs should be matched to the relevant periods. For example, if the company is billed quarterly for its electricity, but the year end to which the accounts are drawn up comes two months through a quarter, then the company should accrue a cost in its profit and loss and a matching liability in creditors (shown as an accrual) for two-thirds of a normal quarter’s electricity bill.

This principle operates in reverse as well in that if, for example, the company has paid an insurance premium in January covering the 12 months of the calendar year, but it draws up its accounts to the end of June, then it has actually paid six months of the following year’s costs during the current year. This is dealt with by deducting half of the insurance premium paid from the cost in the profit and loss account, and showing this balance as an asset called a prepayment, as part of the business’s current assets, under the overall heading of debtors.

Where an item such as a machine is to be used over a number of periods the approach is therefore to record the item in the balance sheet as an asset, and to then spread the cost over the years when it will be used by way of a depreciation charge.

3 Historical cost convention

The assumption is that costs incurred by a business and perhaps more importantly the value of the assets on its balance sheet, are generally recognised at the original cost when they were bought. So for instance the stock used in the example at the beginning of Chapter 1 had a value of £75 because this was the cost of the goods when they were bought from the supplier.

Obviously an asset may in time have a very different value from its original purchase price (a used car may be worth significantly less, a building may be worth significantly more). For most accounting purposes, however, the cost of the asset will continue to be shown at its original purchase price. Any reduction in value is shown separately as an expense by way of a depreciation charge or a provision (as discussed above). Where assets such as a property may have increased in value it may sometimes be possible to shows this increase in value in the accounts, the increase being clearly identified as a revaluation reserve.

One of the criticisms of sets of accounts, and in particular of the balance sheet, is that because of the historical cost convention, this statement of assets and liabilities can actually have very little relation to the value of the business’s assets. This is particularly true if you are looking at say financial businesses holding a range of investments. Within the accounting profession, and the process of developing international accounting standards, there therefore appears to be a move away from this convention and towards the process of showing assets at closer to their actual market value (known as mark to market).

Within the owner managed sector, other than in respect of revaluing properties, this issue does not normally arise to any great degree.

4 Going concern

Most accounts are prepared on the assumption that the business will continue to trade into the future and is therefore a going concern.

This is important because where a company ceases to trade the following happen.

• It incurs (crystallises) a number of costs which it would not normally face, such as redundancy payments to employees or termination charges in contracts.
• The value of its assets have to be marked down to their actual realisable value in the open market, so for example, work in progress which cannot be completed may have to be treated as completely worthless.

There are also two practices which should be used in preparing most accounts, as follows.

Consistency

So as to make accounts easy to read and comparable from year to year, a business’s accounts should as far as possible be prepared on a consistent basis. This means both how they are laid out and key assumptions (such as for example the rate of depreciation) should not be changed.

For example, depreciating a piece of machinery costing £100,000 over three years gives a cost of depreciation in the P&L of £33,333 per year. Changing the period to five years reduces this cost to £20,000 per year, giving an instant apparent profit improvement of £13,333 per year, whereas in reality nothing different has actually happened.

Minimum of netting off

It is good practice when preparing accounts not to net off assets and liabilities, but to show both. So for example, you might have a piece of machinery which is an asset valued at £100,000 on which you owe money on a lease of £40,000.

You could show the value of this machinery as:

• a net asset of £60,000
• but you should really show both:
  • the asset of £100,000; and separately
  • the liability of £40,000.

WHAT IS IN EACH PART OF THE ACCOUNTS?

To explain how these assumptions and practices operate, this chapter will look at a simple profit and loss account (P&L) for Widget Co Ltd, while the next chapter will look at Widget Co Ltd’s balance sheet.

In doing so this chapter will touch briefly on profitability. While this is not the focus of this book, profitability is important for financing a business as it acts as the basis on which to attract investment and to support the ability of a business to repay loans.

A profit and loss account is a statement showing the sales and expenses for a period of trading between two balance sheet dates.

In the case of Widget Co Ltd, its P&L covers a period of the year’s trading showing the results for the year to the end of December 2005. For comparison purposes it also shows the results for the previous period which in this case is also a full year. This obviously makes comparison of this year’s performance against last year’s easier.

Widget Co Ltd’s profit and loss account is made up of the following.

• Sales (or turnover) which represents the business’s total sales that relate to the period. Where a businesses is registered for Value Added Tax (VAT), both the sales and all of the costs shown in the profit and loss account are always stated exclusive of the VAT.
• Costs of sales (CoS or sometimes COGS, Cost of Goods Sold) are the costs to the company in buying in materials or producing things, of the goods or services that have been sold which make up the turnover. This is an area where the matching concept comes into play since during any particular period the goods sold may not be the goods actually purchased during that period. So for example the cost of goods sold in this case represents:

  Opening stock at the beginning of the period (brought forward)	60
  Purchases in the period *	530
  Total	590
  Less closing stock at the end of the period (carried forward)	–90
  Cost of the goods sold in the period	500

• Gross profit (GP or gross margin) is the profit that the company has made by selling the goods or services, before having to pay its overheads. Thinking back to the cash pump diagram in Chapter 1, this represents the £25 generated by having sold the £75 purchase for £100, and the business illustrated in the diagram in Chapter 1 would be said to have a gross profit percentage of 25% (being £25/£100). In the case of Widget Co Ltd, its gross profit is £500,000 on a turnover of £1,000,000 which gives it a gross profit percentage of 50%. As a measure of how much profit is generated from trading to contribute towards paying the business’s overheads, this gross profit percentage figure is the first important ratio for analysing a set of accounts.
• The overheads are the general costs that the company incurs by being in business. Many of these, from its audit fees through to its wages and salaries, are obvious items that it is having to pay for. Some overheads are, however, not items that you buy, but are provisions for costs that you may incur. An example of this is a bad debt provision. You obviously don’t go out and buy a bad debt, but the cost of suffering one is an expense that the business has to cover if it occurs. Widget Co Ltd has decided to split its overheads into two sections, and can therefore calculate an operating profit designed to see how much the trading activities of the business are generating, before thinking about depreciation which is a non-cash item, and the costs of financing. The basis on which Widget Co Ltd has calculated this operating profit is also known as EBITDA (earnings before interest, tax, depreciation and amortisation). EBITDA is important, as it is often used by financial institutions as a way of measuring the underlying profitability of a business on a quasi cash basis when thinking about how much debt it may be able to service.
• Net profit is the profit that the company has left after covering the overheads out of the gross profit. This can be stated before and after tax.

Elsewhere within a published set of accounts there should be a note showing how the profit and loss account ties up with the item on the balance sheet which is labelled as the profit and loss.

This is because the net profit made each year after tax can either be:

• distributed to the owners as a sole trader’s or partner’s drawings or shareholder’s dividends; or
• retained in the business, appearing as part of the owner’s capital or shareholder’s funds as a profit and loss reserve.

The working below shows how Widget Co Ltd’s shareholders have divided the net profit made during the year of £50,000 into a £20,000 distribution of a dividend to the shareholders and have left £30,000 in the business.

WHAT INFORMATION CAN YOU FIND IN THE PROFIT AND LOSS ACCOUNT?

The key information provided by the profit and loss account is obviously profitability, or at its simplest: does the business make money?

This is important for financing because in the long term it is profits that turn into business cash through the operation of the working capital cycle.

It is therefore profits that generate the ability to:

• repay loans;
• provide a return for investors for having put their money into the business.

So, the greater the profitability of the business the easier it is likely to be to:

• generate finance internally from the business;
• raise money externally when required.

So it is important to be able to ‘read’ a profit and loss account and understand what it is saying about profitability. To help with this the rest of this chapter will cover:

• horizontal and vertical analysis;
• types of cost;
• gross profit, contribution and break-even;
• interest cover;
• cost drivers;
• profit improvement;
• breaking the business down.

Horizontal and vertical analysis

As a starting point in understanding any set of P&L accounts, horizontal and vertical analysis can be used to spot the trends in turnover and costs over time.

Horizontal analysis (as above) compares the levels of income and expenditure across years to see the relative degrees of change that have taken place in each item, which can be expressed as a percentage.

To compare more than two years, treat the first one as your base point (so all items equate to 100%) and express the numbers in other years as percentages compared with this, so that the level of change can be seen.

This type of approach is useful for showing how revenues and costs are changing over time (but you must be careful to adjust for inflation effects over longer periods).

Vertical analysis (as above) shows how the figures for each element of the P&L is changing as a percentage of that year’s sales. This is useful for understanding how much of the business’s sales each category of expenditure is consuming in each year.

In the case of Widget Co Ltd, from horizontal analysis you would want to know why the bad debt provision has grown by 400% over the year.

However from the vertical analysis you can see that the bad debt cost is still only 2.5% of sales; the more immediate issue is the increase of cost of sales to 50.0% of sales from 43.3%.

This process can help you to understand how your business is performing and start to indicate some areas to investigate. In Widget Co Ltd’s case you can see that:

• sales have increased by a third (33.3%);
• but costs of sales have gone up by 53.8% to 50% of the sales price (from 43.3%), so the gross margin being achieved has been squeezed from 56.7% to 50%.

So have extra sales been achieved simply by reducing prices, or by aggressive discounting?

Whatever the reason, this is bad news as instead of a gross profit of £570,000, which might have been expected from the increased turnover based on last year’s gross profit, the business is only generating £500,000, a £70,000 shortfall.

There has also been a significant rise in bad debts. Why is this? Is it that in chasing for more sales the business is being less careful about who it is selling to and how much risk there is that they will not pay?

The operating overheads have otherwise risen reasonably in line with sales (at 38% against 36.3%) and if it weren’t for that increase in bad debt they would have been bang on target.

The result is that despite an increase in turnover, the company’s profit has gone down (from £153,000 to £120,000 at operating profit level), largely as a result of a fall in contribution.

The company needs to take a look at what is happening to its sales and margins.

This approach can be particularly helpful if you have information from other companies in the same sector against which to compare your performance (benchmarking) to see what this might tell you about your relative levels of efficiency.

Types of costs

To really understand your business’s profitability, you must first understand its cost structure.

If you imagine for example a shop, you can see that in the same way as its funding requirements can be split into working capital and investment, its trading costs fall into two broad categories.

• The costs of buying goods in for sale, where the level of purchases will broadly move (vary) up and down in line with the level of sales.
• The day-to-day costs of being in business that have to be met each day irrespective of the level of sales on that day, such as the rent and rates, heating and lighting bills and so on.

These types of cost should be familiar by now from looking at both the working capital cycle and the profit and loss account as the cost of sales and overheads respectively.

This is, however, a slight oversimplification as for most businesses there are essentially three types of costs for any business.

	Variable level of cost varies closely with changes in the level of sales	Fixed do not vary in the short term as sales fluctuate
Direct costs relate directly to the cost of producing or acquiring goods for sale	raw materials/purchases piecework wages overtime pay factory energy costs	normal factory wages machinery costs and depreciation factory rent
Indirect costs general costs of being in business, not directly related to particular costs of trading		auditors’ fees admin staff’s wages directors’ fees interest on loans*

Fixed costs are of course not fixed in the long term (you can move factory, or hire and fire factory staff), and will eventually reflect levels of production and activity.

As already shown however, the profit and loss account divides costs only into two broad areas:

• costs of sales (CoS) which will include all variable direct costs;
• overheads which will include all fixed indirect costs.

This can lead to a problem in interpreting accounts, as businesses differ as to how they deal with analysing direct fixed costs between costs of sales and overheads.

At present Widget Co Ltd’s accounts CoS figure simply shows the costs of materials. But the company makes, installs and repairs widgets, all of which require labour and in fact £100,000 of its wages overhead actually relates to its production workers.

So it could restate its P&L to show this cost as part of its cost of sale as follows:

This obviously also illustrates why consistency in how accounts are prepared is important. Changing how the item is shown could give a very misleading picture when compared with last year’s results if you were not aware of what had been done.

It is also something to be careful of when attempting to benchmark your performance against a competitor’s accounts.

This approach can be extended to include all relevant direct overheads such as factory rent, power costs and even depreciation of the production machinery, depending on how sophisticated an analysis your business requires.

The reason this is important is that if you do not include all your direct costs in calculating your cost of sales, you risk underestimating your costs when it comes to setting prices or tendering for contracts. The result for businesses of continuously selling at less than their true cost of manufacture (ie at a loss) is inevitably failure. It is generally best practice therefore to include direct costs as fully as possible in establishing your costs of sales.

The exception to this is if your production volumes swing significantly between periods. In this case you will need to be careful in using cost of sales to establish a meaningful contribution figure for sales, and you may find it best to treat all fixed costs as overheads for the purpose of calculating break-even levels (see below).

Gross profit and break-even

One of the principal reasons that an understanding of the cost structure is important in calculating your gross profit and gross profit percentage is that these are then used to calculate break-even.

In the diagram of the working capital cycle in Chapter 1 (Figure 1), the business bought its supplies at £75 and sold these on at £100, thereby generating a £25 contribution towards its overheads for every transaction completed. While this tells us that that business has a gross profit percentage of 25% (£25/£100) we do not know the level of overheads that it needs to cover.

We do, however, know Widget Co Ltd’s overheads and its cost of sales. So if Widget Co Ltd sells each of its widgets for £100, then from the above its average cost of sales per widget are:

On the same basis, Widget Co Ltd has operating overheads of £280,000 per year, plus a further £45,000 in depreciation and interest, giving a total of £325,000.

As its gross profit per widget (or contribution towards covering overheads) is £40 per widget, it has to sell 8,125 widgets a year (£325,000/£40) before the total contribution is sufficient to cover all the overheads, or break-even.

Its break-even turnover is therefore £812,500 per year (£100 selling price per widget x 8,125). If it sells less than this it will make a loss, if it sells more it will make a profit.

The above break-even has used accounting figures based on costs taken from the profit and loss accounts. It is often useful to redo this exercise to calculate a cash break-even by stripping out the key costs that do not represent cash (eg depreciation) and replacing this with real cash items (eg total loan payments).

Widget Co Ltd’s overheads include charges of £25,000 for depreciation and £20,000 for bank interest. Looking at the balance sheet, the amount due to the bank in respect of the mortgage has reduced (from £150,000 at the end of last year to £100,000 at the end of this) so this must mean that the company has repaid £50,000 of capital during the year.

So the company’s overheads restated on a cash basis are:

As a result its break-even turnover on a cash basis is 8,750 (£350,000/£40) widgets a year or £8,750,000.

Interest cover

Another key ratio for lenders is the ratio of:

This shows the sensitivity of available profit in covering interest payments (eg to the bank), in Widget Co Ltd’s case:

So a lender to this business knows that the business’s profits have to fall to almost a fifth of its present levels before the interest cannot be paid.

Cost drivers

The relative level of a business’s costs compared with its competitors will be due to a number of factors, of which some of the most common are listed below. If your analysis is suggesting that the business’s costs are out of line with those of its competitors these are the areas you might look at for opportunities to cut expenditure. Be alert, however, for the common pitfalls of poorly applied cost reductions, where disruption and other problems brought about outweigh the planned saving:

• economies of scale (sometimes bigger is better);
• capacity utilisation (the business is paying for that plant and those people, whether they are earning for it or not);
• learning curves (the more it does of something, the better at it the business should become);
• location (relative local costs and transportation costs);
• purchasing (how good at buying is the business?);
• operating efficiency;
• investment (eg in automation or training);
• waste management.

Profit improvement

As you start to think about break-even calculations, something becomes very clear. To improve profits, you can do any or all of three things:

• increase turnover;
• increase margin (gross profit percentage);
• reduce overheads.

If you can do all three, the effects multiply. So if Widget Co Ltd could achieve a 10% improvement in each of these areas, the overall effect would be an incredible 93.3% increase in profit.

Breaking the business down

To see what is happening to a business it is often helpful to break performance down by individual area (known as a profit centre), at least at gross profit and contribution level, even if it is impractical to separately allocate overheads.

Looking more closely at Widget Co Ltd, a more detailed set of management accounts might therefore show:

However, by breaking this down into different areas of activity (profit centres), a clearer picture emerges of where the company really makes (or loses) its money:

This analysis stops at gross profit level. However, you could go further, identifying and allocating overheads to each area and apportioning any overheads which cannot be directly linked to a particular part of the business on an appropriate basis so as to find an operating or a net profit for each area.

By capturing enough information in your accounting system you can apply this approach to establishing the profitability of different areas of your business, as well as to individual customers or groups of customers, or individual orders, contracts or products.