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How to understand key financial documents

Your balance sheet and profit and loss statement are the two basic financial documents you’ll need to understand. Find out how to read and use this vital financial information.

Understand and use your financial documents

Understanding your financial documents will give you more control and a clearer picture of your business and how it's performing. Your profit and loss statement shows how much money you're making - and what tax you will owe - and your balance sheet shows how sound and financially viable your business is.

Understanding your balance sheet

Your balance sheet provides a snapshot of your business's financial strength at the end of an accounting period, either at the end of a quarter or a full financial year.

It is a cumulative record of what has happened in your business right from the start and summarises your assets (what you own) and liabilities (what you owe). The difference between your assets and liabilities tells you what your business is worth.

On the assets side of your balance sheet are:

  • Fixed assets - generally longer-term assets such as machinery and intangible assets such as goodwill and intellectual property rights
  • Current assets - short-term assets including stock, debtors (customers who owe you money) and cash

On the liabilities side of your balance sheet are:

  • Current liabilities - amounts you owe that are due for payment within one year such as suppliers' bills and bank overdrafts
  • Long-term liabilities - amounts that fall due after more than one year; for example, long-term bank loans and leases
  • Shareholder funds - share capital (amounts paid into the company for shares) and reserves (including retained profit)

The capital figure in your balance sheet will always equal fixed assets, plus current assets, less current liabilities.

Using your balance sheet

Your balance sheet gives you a quick summary of your business performance and enables you to compare performance to past years and track overall trends. It also contains information and figures you can use to measure the health and profitability of your business. These are called key performance indicators. Some examples of these indicators or ratios include:

  • Return on capital employed is net profit (before tax) as a percentage of capital employed – the return you're making on the money financing the business (both as loans and shares). So if you have £2 million in capital, and earn £100,000 a year in profit, this is only a 5% return on capital invested. You could possibly earn better returns in another investment.
  • Return on equity is profit before tax (but after interest has been deducted) as a percentage of shareholders' funds employed in the business.
  • 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 business reserves?
  • Control of working capital 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?

Your accountant or business adviser can tell you which key performance indicators are critical for your particular business. Comparing key ratios with other businesses, and against the same figures for previous periods, will help you identify areas where you need to take action.

Understanding your profit and loss statement

Your profit and loss statement provides a picture of your business's trading performance over a defined period, such as a month, quarter or financial year. It records sales, expenses, profits or losses, and any tax payments for the period – it winds back to zero at the end of each financial year, recording sales and expenses for a fixed period of time only.

A profit and loss statement typically follows this format:

  • Sales (turnover)
  • Less cost of sales (your 'direct' costs, such as raw materials)
  • Equals: Gross profit
  • Less fixed or 'indirect' costs (overheads, such as rent, rates and salaries)
  • Equals: Operating profit (profit before tax)
  • Less tax payable
  • Equals: Net profit.

Using your profit and loss statement

Your profit and loss statement lets you study your gross profit and net profit margins. These can reveal trends that enable you to make timely changes.

Gross profit margin

Your gross profit margin is your gross profit as a percentage of turnover. For example, if your turnover is £2 million and your cost of sales is £600,000, you've made a gross profit of £1.4 million. It's easy to turn this into a percentage: 1,400,000 ÷ 2,000,000 x 100 = a gross margin of 70%.

So every £100 of sales generates £70 that goes towards paying for expenses and towards your net profit. If your gross margin percentage starts to slip you need to find out why and take action. The reasons may include:

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

Net profit margin

Your net profit margin compares your net profit (gross profit less fixed or indirect costs) to turnover. For a business with a turnover of £2 million and a net profit of £300,000, the net profit margin would be £300,000 ÷ £2,000,000 x 100 = 15%.

If your net profit margin falls, it means you're paying proportionately more in expenses than you should be. It is also useful for identifying other problems. Let's say your turnover increases from £2 million to £3 million and your net profit goes up from £300,000 to £400,000. This looks good until you look at your net profit percentage: £400,000 ÷ £3,000,000 x 100 = 13.3%. That means your net profit margin has actually dropped from 15% to 13.3%. Your turnover has increased by a million, and your net profit by £100,000, but you're actually not making as much profit from that increased turnover. Time to identify which costs have increased out of proportion to the rise in sales, so you can stop the slippage.

Benchmark your business

You can use your gross and net profit margins as benchmarks to gain a clearer picture of your performance in two ways.

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

External benchmarking

  • Compare your profit margins with those of similar businesses in your industry to find out where you're doing well and where you should set improvement goals

Financial documents tip

Commit to learning more about the key financial documents in your business. The reward will be better money management.

Financial documents support

  • Ask your accountant or business adviser to help you understand how to get the information you need from your balance sheet and profit and loss statement
  • Find out which key performance indicators are important to your business and how to use the information in your financial documents to monitor them, and the performance of your business
  • Use the Financial health check online tool to get a better idea of your business's performance

This guide is intended as general advice only, and not intended to cover specific circumstances and needs. The information in this article is also not linked to any of the products offered by Clydesdale Bank PLC.

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