All financial statements consist of two main reports, the Profit and Loss account (P&L) and the Balance Sheet (BS). These are a summary of the trading activity over the accounting period.
Most business people focus on the P&L because it is easily understood. It basically tells you how much income came in and how much expenditure went out during the period. The difference between the income and expenditure figures is the profit or loss we made. The more profit we have made, the better we are doing.
Cash is King
So you may ask, if I have this information, why do I need to look at anything else? After all, making a profit is what business is all about! As a result, the Balance Sheet tends to be ignored, or given a quick once-over, without the business owner really knowing what the figures mean. So let me put this right. Your Balance Sheet can be your most important financial report, because while the P&L focuses on the profit you have made, your Balance Sheet shows where the cash has gone.
As the saying goes, “Turnover is vanity, profit is sanity, but cash is king.” No matter how good your business is, if you run out of cash, you will no longer have a business. Running out of cash is the major cause of business failure, and it has brought down some big organisations over the years. Therefore keeping a keen eye on the Balance Sheet is vital.
It’s all about Assets and Liabilities
Business owners are scared of the Balance Sheet because it has the names of things on it that they may not be familiar with. But in fact, the overall concept is very simple. You have Assets and Liabilities, and my simplistic way of thinking about these is:
Assets = where the money has gone
Liabilities = where the money is from
After all, your business is just a vehicle for money to come into and go out of. The Balance Sheet is therefore a snapshot at the period end of where your money has come from and where it has gone, because I will bet that you are not sitting on heaps of cash!
Assessing your Assets
Your money goes into acquiring Fixed Assets such as land and buildings, equipment, vehicles etc. These are called fixed assets because they are in your business for the longer term (i.e. more than one year, and in some cases, many years.)
Your money also goes into Current Assets, such as stock, or is lent to your customers as debtors, or lent to the bank in your bank accounts. These assets are termed current because they can change on a daily basis.
Labelling your Liabilities
Your money comes from a variety of sources. From your trade creditors, who give you credit on the stuff you purchase from them. From the bank, if you have loans or overdrafts. And even from HMRC, as you keep the VAT and PAYE you collect before you pay it to them. These items are called Current Liabilities, as you have an obligation to repay them within a year.
You may also have creditors who do not require repayment within one year, such as long term loans or Hire Purchase agreements, and these are shown separately on the Balance Sheet as Long Term Liabilities.
Then finally you have the Shareholders’ Equity. This is money the shareholders have given the business in exchange for shares, and the retained profits that you have left in the business to finance the above.
Get to Grips with your Balance Sheet
The first thing to check on your Balance Sheet is that it does indeed balance! (By that, I mean that the total figure for the assets and liabilities in the top half of the Balance Sheet, normally labelled Net Assets, equals the total for Capital and Reserves/Shareholders’ Funds shown in the bottom half of the Balance Sheet.) I know it sounds obvious, but you’d be surprised at how many Balance Sheets I have seen that don’t balance. if yours doesn’t balance, then don’t waste any more time looking at it. Throw it back to whoever prepared it and get them to produce one that does.
The second thing to check is that the cumulative profit figure shown on the P&L is the same as that shown at the bottom section of the Balance Sheet. Again, if these numbers are different and your accountant does not know why, then you need to send them away to find out.
The third thing to remember is that anything that is not cash at bank has to be working for you and making you money.
- Fixed assets should be used to give you a ROI.
- Debtors should be kept as low as possible and never allowed to become overdue, otherwise you are lending money for free to your customers.
- If you can extend the credit you get from your suppliers then you will gain more cash, but don’t take advantage and risk losing your credit facilities or the service levels you enjoy.
- Stocks are there for you to sell, so make sure you turn it over as quickly as possible.
- Every company can benefit from some level of debt, as long as they invest this money to repay it. Watch your debt to equity ratio (sometimes known as gearing) to ensure your balance is about right.
If you are not sure on any of these issues, then seek some advice on what is acceptable in your industry. Ignorance is never an excuse when it comes to the finances of your business.
Don’t Accept the Unexpected
Balance Sheets should never be looked at in isolation. You need to compare one with another, either last year, last quarter or last month. What you are looking for are unexplained changes. Bank balances that go down when you have made more profit. Stock levels that go up or down when trading has been steady. Creditors going up when you have been paying them on time.
Unfortunately, the balance sheet can be like a carpet that all the rubbish gets swept under and hidden from sight. Therefore you need to question everything that you are not sure of, and ask why figures have changed significantly from period to period if that is not what you were expecting. Any accountant or bookkeeper worth their salt will be able to give you an explanation straight away. To much scratching of their heads may indicate that your accounts are not be as accurate as you think they are.
Once you are familiar with what the Balance Sheet is telling you and have got used to the numbers, then you only need to spend a short time reviewing it, looking for things that are out of the ordinary or out of line with your expectations.
If you want to learn more about mastering your numbers then, come along to our Finance Mastery workshop which we hold once a quarter. Check out our events page for the next date!