Essential Business Finance 1
This document has been produced to provide a non finance trained manager / business owner with
a basic understanding of the accounts that are produced by the book keeper / accountant,
an explanation of why the figures are produced in the way that they are,
an examination of the relationship between a profit and loss account and the company’s balance sheet, and
to introduce a few of the common tools to monitor a business’s financial performance.
The document is not trying to teach accounting or finance but merely to remove some of the mystique that accountants and finance managers like to
build around their subject.
If it helps you when you next look at the figures for your own business then it has achieved its objective. The next step is for owner managers to tailor
the information that is provided for them by their own book keeper / accountant so that it is produced in a specific format that can assist in the
decision making processes of the business.
Document content
Balance sheet and P& L Relationship
How a business finances its activities
Standard format for UK limited company accounts
Ratio analysis – a summary
An example – ‘Essential Angels’
For further details or comments please contact info@lynheath.co.uk
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Essential Finance / Accounts - Balance sheet and P&L relationship
Annual Statement of Accounts - Balance Sheet and Profit and Loss – what are they?
The ‘statement of accounts’ is a representation in financial terms of the
business.
Balance
The balance sheet is a record of the assets and liabilities of a business at
Sheet &
the moment in time that the record is taken. The trading profit and loss
Profit and
is the record of the trading of the business between two points in time.
loss summary
For some businesses there is also a cash-flow statement, which shows
the movement of cash within the business between the same points of
time as the trading profit and loss account.
There are certain rules and conventions which set out the way that the
Profit & Loss / Balance Sheet accounts have to be presented – to protect shareholders and other
trading a/c & Profit and stakeholders of the business from fraudulent representation as to the state
loss summary of the business and allow comparison with other similar businesses.
Time
Profit & Loss /
trading a/c
Balance Sheet
& Profit and
loss summary
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How a business finances its activities
A business finances its activities and resources with a mix of debt and equity. These can be distinguished by definitions such as;
Debt = ‘a promise to pay’ i.e. if you have debt you are obliged to give it back (with interest).
Equity = ownership of part of something, or an option to ownership of something.
How a business finances its operations / activities is dependant upon a number of factors, such as industry sector, historical trading performance,
general economic situation and availability of debt or equity funding.
A typical way of financing a trading business might be as follows:-
Assets How financed / liabilities
Bank Loan
Freehold / Property
Money owed by business Debt
(Creditors)
Money owed to business
(Debtors)
Bank overdraft
A few Questions for you
Stock
How is your business financed ?
Historical retained profits
Vehicles / equipment Equity Why is it financed in the way it currently is ?
Could it be done differently to give you more Profit / Cash?
Share capital Could it be done differently to help you sleep at night?
Cash in hand
Note that the assets and liabilities of a business always balance.
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Standard format for a set of UK company accounts.
Annual statement of accounts for trading businesses should be prepared on an accruals basis and consist of a set structure. These formats are set out in
Companies Acts and within UK accounting conventions. Currently there are different rules between different countries but it is targeted to use
International Accounting Standards (IAS) by 2005, making cross border company comparisons clearer. These currently and in future require;
A report and statement of Directors responsibilities including review of operations and finances
A statement by the Accountant / Auditor
An income and expenditure account / Profit and loss account
A cash flow statement
A Balance sheet statement.
Notes to the accounts – setting out accounting conventions and providing more details on profit and loss, balance sheet and cash flow
statements.
There are certain modifications to this set format available for presentation of annual accounts at Companies House, subject to the size of the business
being below certain thresholds.
The UK FRS 3 ‘Reporting Financial Performance’ defines the way that the basic components of the financial statements should be presented.
In the profit and loss statement the minimum level of disclosure is turnover and operating profitability in the three areas of continuing operations,
discontinued operations and acquisitions.
With standard formats for profit and loss and balance sheets (see next page for examples) it is possible for stakeholders in a business to look at the
accounts and gain an impression of the trading performance of the business. It is also possible to compare businesses within different industry sectors
and also within the same industries.
The main way to achieve this review of a business’s trading performance is through analysis of certain key financial indices, using ratio analysis.
Ratios being the mathematical relationship between different parts of the financial accounts or measures of operational performance; these being
preferable to absolute figures as, for example a net profit of £50,000 may be a good profit result for an SME company might be small change and a
disastrous result for a multinational one.
Ratio analysis should not just be used by those outside the organisation to look at its performance but also by owners and managers to monitor their
own company’s performance. To identify any adverse trends, take steps to identify the causes and then rectify them before they become a problem.
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Typical layout of Annual Accounting statements for UK companies.
Balance Sheet statement
Profit and loss statement
Fixed Assets
Turnover x Showing all operations & acquisitions Property x Leasehold / freehold assets usually shown separately
Direct costs of sales x Plant & machinery x
Gross profit x Vehicles x
Office equipment x
Total Fixed Assets x
Operating expenses x Administration, operations, incl. depreciation.
Operating profit x for all operations & acquisitions Intangibles x Goodwill upon purchase, R&D, often ignored by banks.
Gain and/or loss on x Acquisitions, disposals of assets, difference Current Assets
property transactions between book price of assets and actual Stock x Broken down, Raw mats, work in progress, finished.
transaction price Debtors x
Profit on ordinary x PBIT – profit before interest and tax Prepayments x Payments made in advance, or VAT due back.
activities before interest Cash x
Interest x Total Current Assets x
Profit before tax x PBT
Current liabilities (due within next 12 months)
Tax on profits x
Creditors x
Profit after tax x Bank x Overdraft and/or current portion of long term loan.
Minority interests x Payments due to minority shareholders. Other finance x e.g. Hire Purchase
Profit for financial year x Accruals x Payments due but not yet invoiced,
Dividends x Tax Corporation and other tax, such as NI, PAYE, VAT
Total Current Liabilities x
Retained profits x Net profit
Net current liabilities x
Long term liabilities x Likely to be mainly finance debts due over one year
Net Assets y
Equity Capital
Shares x May be broken into different categories of shares
Share premium a/c x Value of shares above their ‘par’ value
Revaluation reserve x Usually property revaluations
Retained Profits x Historical profits / or losses
Total Equity y
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Ratio Analysis - Summary
Pyramid of Core ratios
Shows financial strength / vitality of an organisation. At the top of the pyramid ROCE
is return for shareholders! Return on Capital Employed. Other ratios (NPAT / Equity)
contribute an understanding of the way a business operates.
NB Different stakeholders, who look at a company’s ratios will
do so for different reasons, be they creditor, financier, or Asset turnover x Asset leverage x Net Margin
Shareholder / Investor; they also have different (Sales / Total assets) (Total assets / equity) (NPAT / Sales)
perspectives and focus on different issues.
Who ever is undertaking analysis will need to look at the ratios in systematic manner; creditors will begin with the categories that impact in the short term upon a
businesses ability to make its payments to meet liabilities as they fall due (its liquidity), as they are concerned about being paid for their goods and services before
moving to financial structure and profitability. A banker will take a different perspective as will a shareholder / investor. One way is to split the analysis into four
key areas with typical ratios for each being named below (for how to calculate the ratios or for a greater explanation see your adviser / accountant / text book).
Liquidity – ability to meet liabilities as they fall due (Readies) Company’s financial structure – equity / debt – solvency (Risk)
Current ratio / Quick ratio / Working capital / Dividend cover Gross gearing / net gearing / leverage (incl. All liabilities) / Seasonal debt /
Cash flow ratios - Operating cash flow / Residual free cash flow (after Interest cover
dividends) – look again at interest and dividend cover from actual cash –
depreciation and amortisation adjusted. Company’s operating efficiency – the cycle of production. (Rigor)
o Supply – Raw Material Days / Trade Creditor days
Company’s profitability (Return) o Production – WiP days / Net property, plant and equipment turnover /
Gross Margin achieved / Net operating margin / Interest cover / PBT plant life / Productivity, profit & sales per employee
margin / net margin / core or non-core income. o Demand – Finished goods days
Investor ratios – Dividend yield / dividend cover o Collection – debtors days
Each to be considered and questioned.
a. Have ratios changed over time – i.e. Horizontal / time series / trend analysis
b. How do ratios compare with similar companies’ - i.e. cross sectional / peer / benchmarking analysis.
c. Do ratios make sense.
In undertaking ratio analysis usually looking at historic data, this can only be a guide; to make business decisions you need current or future data (forecasts).
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Essential Business Finance - An Example
Balance sheet and Profit and Loss account are a historical record – at one point in time – produced for a specific purpose. To provide a ‘true and fair’ picture of
the financial status of the company, for its shareholders and other stakeholders.
Balance sheet The Profit and loss shows the trading record of the business.
Period 0 The Balance Sheet shows a company’s assets and liabilities,
and the owners’ level of investment in the business.
P&L
Period 1 Balance Sheet
End period 1
Time
P&L Balance Sheet
Period 2 End period 2
Example a start up business – a village shop / newsagent
– The Essential Angels store has an initial balance sheet as follows:-
Assets ‘Things’ of value Liabilities How things paid for
Value £’s Value £’s
Building 100,000 Bank o/d 10,000
Vehicles x 2 30,000 Creditors 40,000 Money owed to suppliers
Stock 50,000 Goods in the shop Bank loan 70,000
Own money 60,000
180,000 180,000
This record of assets and liabilities is then set out in a more structured fashion so that all accounts are in a similar format so that people who deal with the
business can compare it with others and seek to understand what the figures represent.
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Essential Angels Store – start up position (year 0)
Essential balance sheet ratio
£’s £’s £’s
Financial Gearing
Long Term Assets Buildings 100,000
Vehicles 30,000
Prior charge capital or Prior charge capital
130,000
Equity Capital Total capital employed
Current Assets Stock 50,000 80,000 or 80,000
50,000 60,000 140,000
Current liabilities Creditors (40,000)
Bank (10,000) 1.33 : 1 / 133% or 57%
(50,000)
Net current Assets 0 This shows the extent to which the business is financed by own capital as
against borrowed funds.
Long Term Liabilities Bank (70,000) Either method is acceptable the first common in banks the second used by
investors / analysts; you just need to be consistent in the method you use
Net Assets 60,000 when comparing different businesses and the same company over time.
So why might this matter?
Financed by A business that is very highly geared (has a lot of debt in relation to own
equity) and making profits is likely to give a better return to its
Share capital 60,000 shareholders for the amount that they invest than one that has low gearing.
Profit & Loss 0 However, it is also more likely to go out of business if those profits
Equity 60,000 disappear. Higher return for more risk for owners. For a lender, in basic
terms, the higher the gearing the higher the risk for them.
Note that although the business has total assets of £180,000 it has net assets, after liabilities due to third parties (bank and creditors) are deducted, of £60,000.
On paper the business is worth £60,000, which is what the owner invested.
In the first year’s trading Essential Angels produces the following profit and loss statement:
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Essential Angels Store
£’s Essential profit and loss ratios
Sales 300,000
Gross Profit Margin = Gross profit / sales x 100
Cost of goods (150,000)
This shows how much profit (on average) is made on each item sold in shop.
Gross Profit 150,000
GPM = 150,000 / 300,000 x 100
GPM = 50%
Admin Costs (120,000)
Depreciation Vehicle (10,000)
s
Operating Margin = PBIT / sales x 100
Profit Before Interest & Tax 20,000
Shows, regardless of the effects of how a business is financed or taxed, its net
profits and therefore its efficiency in turning sales into profits.
Interest Charge (5,000)
Operating Margin = 20,000 / 300,00 x 100
Profit Before Tax 15,000
Operating Margin = 6.7%
Tax (2,000)
Dividend 0
Employee Productivity
Net Profit 13,000
These measures might be used to see how productive the workforce is when
compared to competitors or over a number of years. Can be influenced by
innovation and technology changes in work place not just working harder.
The shop employs 3 members of staff with a total salary bill of £70,000. Income per employee
3 staff being the minimum number to run the shop – a fixed cost. Sales / employee number
£300,000 / 3 = £100,000
Split in this example of fixed to variable costs is
Fixed = £130,000 (basic costs of business regardless of sales) Profit per employee
Variable = £150,000 (costs that are dependant upon volumes of sales) Net profit (pre dividends) / 3
£13,000 / 3 = £4,333
NB Breakeven sales
This is an accounting ‘profit’ it is not the same as cash generated Breakeven sales being the level of sales to be achieved where losses are no
or an ‘economic profit’ longer being made. A fundamental target sales level for all businesses.
Fixed costs / contribution ratio = Breakeven sales or
Once a profit and loss account is prepared the balance sheet of the business Overheads & finance costs / GPM = Breakeven (Quick & Dirty method)
then needs to be changed to reflect the changes that have taken place in the
period of the P&L statement i.e. twelve month period in this example. In this case the breakeven sales level is £135,000 / 50% = £270,000
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Essential Angels Store
Year 0 Year 1 Essential Ratios
£’s £’s £’s £’s £’s £’s
RoCE (Return on Capital Employed)
Long Term Assets Buildings 100,000 100,000 Net income / Owners capital x 100
Vehicles 30,000 20,000 13,000 / 60,000 = 21.67%
130,000 120,000
Current Assets Stock 50,000 50,000 The owners made a return of 21.67% on
Cash 3,000 their investment in business of £60,000, a
50,000 53,000 satisfactory return for the risk of running the
Current liabilities Creditors (40,000) (40,000) business. If they had deposited the money in
Bank (10,000) a bank (for little risk) they may have got a
(50,000) (40,000) return of about 5%.
Net current Assets 0 13,000
To make the same RoCE next year however
Long Term Liabilities Bank (70,000) (60,000) they will need a profit of £15,817, as they
now have more money in the business; their
Net Assets 60,000 73,000 initial £60,000 plus accrued profits of
£13,000. (£73,000 x 21.67% = £15,817)
Financed by
This can be achieved by either
Share capital 60,000 60,000 a. increasing sales
Profit & Loss 0 13,000 b. increasing net margin
c. reducing equity to debt ratio
Equity 60,000 73,000
Assuming no change in level of stock or creditors and that all sales are for cash.
Also assumes tax paid immediately / in advance of year end – unusually!
Note that the Long term asset values change, down £10,000, to reflect the depreciation in the assets, yet as it is a non cash item – a book-keeping entry in
the P&L, it is available in cash in the bank.
The cash balances available are therefore P & L balance £13,000 plus £10,000 depreciation = total £23,000. In this case these funds are applied - £10,000
to clear O/D, £10,000 to clear part of loan and £3,000 cash balances.
The net asset value of the business has risen from £60,000 to £73,000.
It is usual to show the two most recent years figures side by side for comparison when producing statutory accounts.
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