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.
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:
On the liabilities side of your balance sheet are:
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:
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.
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:
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.
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:
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.
Commit to learning more about the key financial documents in your business. The reward will be better money management.
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.