Understanding your business financial position
- The Profit & Loss Statement
- The Balance Sheet
- Analysing Your Business
Knowing the financial position of your business is essential for good management and sustainable business performance. As a business owner, when you are able to understand the key numbers that apply to your business you will be better able to:
- Set and manage to profit and revenue targets
- Decide what your pricing needs to be
- Know how many customers at what price you need to attract
- Know which products are profitable and which are not
- Attract finance from a lender or investor
- Keep track of your expenses and budget accordingly
- Make decisions early to avoid future financial difficulty
The Profit & Loss Statement
There are two fundamental financial reports that measure organisational financial performance. These are the profit and loss or income statement, and the balance sheet.
The profit and loss statement (P/L): Measures the operating performance of a business over a period.
The basic form of a P/L statement is based on two equations:
Sales – Cost of Goods Sold = Gross Profit
Gross Profit – Expenses = Net Profit
Sales (or revenue / income): For an upholsterer this would be the sale of repair and recover services. For a vet it would be fees charged. For a store, the value of stock sold.
Cost of Goods Sold (COGS): This is the difference between stock on hand at the start of a trading period less stock on hand at the end of a trading period. The calculation also needs to include stock purchased or made during the period.
Note that this calculation only applies where there is a sale of stock (or inventory). For instance, a tax agent only sells services so there would be no COGS calculation on a P/L Statement for a tax agent, in that case, Sales = Gross Profit.
To calculate COGS:
COGS = Opening Stock + Stock Purchased or Made – Closing Stock
Opening Stock or inventory: The value of stock on hand at the close of the last operating period. The stock is counted and valued based on the cost of buying the product (or the cost of manufacture if the seller has made the product).
Stock Purchased or Made: The value of additional stock purchased or made for sale.
Closing Stock: The value of stock on hand at the end of the current period. The closing stock for the current period becomes the opening stock for the next period.
Gross Profit: The difference between sales and the COGS figure. This calculation only applies to where products are sold. There is generally no gross profit figure where services are sold.
Expenses: These are all those other expenses of a business apart from the stock costs. They could include items such as wages, rent, electricity and interest paid on loans.
Net Profit: The net profit is the difference between the gross profit and the total of the non-stock expenses. For a service business, this will be the difference between the income of the business and its expenses, given there is no gross profit calculation.
The Balance Sheet
The Balance Sheet is a statement of what is owned and owed at a point in time by an organisation. It has several key components:
Assets: These fall into several categories:
- Current Assets:Includes cash or items that are expected to become cash in the normal course of business within one year. Examples include stock on hand that is turning over regularly and debtors (accounts receivable, people who owe money) that are paid on a regular basis.
- Non-Current Assets:Assets that the business would generally keep for more than one year. This would include items such as plant and equipment, cars and buildings.
- Liabilities:Money owed by the business. Liabilities can include:
- Current Liabilities: Debts that normally have to be paid within one year. Examples include creditors, (accounts payable, people to whom you owe money) for stock purchases, short-term loans and credit card debts.
- Non-Current Liabilities: Debts which are generally repaid over a period exceeding a year. Examples include mortgages on buildings and equipment and long term loans.
Owner’s Equity: The owner’s share of the business. Includes money put in by the owner – capital. Shareholders put in money by buying shares plus any profits earned or less any losses incurred. Owner’s equity will always be equal to the difference between assets and liabilities.
Analysing Your Business
Gauging the liquidity of the business, that is can it pay its debts on time, and what percentage of sales revenue is net profit can be determined quite easily using some simple analytical tools called financial or accounting ratios.
There are a number of financial ratios that can be used to analyse a balance sheet and determine the underlying health of the business. Two of the more important are:
- Current Ratio
- Quick Ratio
Current Assets / Current Liabilities
Looks at the short-term ability of the business to pay debts. Also known as the cash asset ratio, cash ratio, and liquidity ratio. A higher current ratio indicates the higher capability of a company to pay back its debts.
(Current Assets – Inventories)/ Current Liabilities
Also referred as the “acid test ratio” or the “quick assets ratio”, this ratio is a gauge of the short term liquidity of a firm. The quick ratio is helpful in measuring a company’s short term debts with its most liquid assets.
Generally the higher the ratio the better
A good ratio to use for analysing profitability is the:
Net Profit Margin
Net Profit / Net Sales
The net profit margin indicates efficiency in cost control. A higher net profit margin shows more efficiency in converting revenue into actual profit.
This ratio is a good way of determine whether the business is on track, particularly in comparison with other similar businesses.
For a more detailed explanation of financial ratios and their application click here.