If you have just launched a small business or have been in business but don’t have a financial background, understanding your company accounts may seem somewhat daunting.
Even accounting isn’t your forte, you still need to know the accounting basics to manage the business better.
What are a company’s annual accounts?
Company accounts are a summary of an organisation’s financial performance over a 12-month period.
They are prepared every year for filling income tax returns and consist of the Profit and loss statement and the Balance sheet.
The Profit and Loss Statement
A P&L statement, also referred to as the “Income statement” summarises the revenue and overall cost of the company during a specific period, usually a quarter or fiscal year.
How is profit or loss calculated?
Gross profit – Calculating your gross profit is relatively straight forward.
The first line you will see on the P&L is your turnover, the value of your sales. When you deduct the selling costs (cost of sales) from this you will arrive at your gross profit.
Gross profit = Turnover – Cost of sales
Operating profit – This is your profit before deducting interest or taxes.
You simply need to deduct you administration expenses from the gross profit to get your operating profit. Administration expenses include expenses such as salaries, telephone charges and rent.
Operating profit = Gross profit – Administrative expenses
To understand better, you can compare P&Ls from different accounting periods, and you will see which way your company is heading. Any changes over time can be more meaningful than the numbers themselves.
Depreciation is the falling value of your company fixed assets, such as mobile phones, laptops, and computers. It represents how much of an assets value has been used within the period.
Assume you purchase a laptop which you plan to use for 3 years, the vale needs to be allocated over its useful life (3 years).
The Balance Sheet
A balance sheet, also known as a “Statement of financial position” is a financial statement that reports the company’s assets, liabilities, and the shareholders equity at specific point in time.
It provides a snapshot of what a company owns and owes, and it indicates the financial health of your company as of a particular date.
All the things that your company owns in order to run your business such as cash, computer equipment, buildings and furniture.
An asset can be either a:
- Fixed Asset – Fixed assets are long term assets that have been purchased and being used in its operations to generate income. This includes things such as Computer equipment, Furniture and fixtures, Buildings, and vehicles.
- Current Assets – Current assets are all the assets that are expected to be sold or used for business operations over the next year. This includes cash, cash equivalents, Inventory, accounts receivable and other liquid assets.
A liability is a financial obligation, something a company owes to someone else.
A liability can be either a:
Long-term liability – Money which need not be repaid within the next year. Long term loans and mortgages fall under this category.
Short-term liability – Money which needs to be repaid within the year. These mainly occur as regular part of business operations.
For example, accounts payable, interest payable and short-term loans.
3 Simple financial ratios you can track
Knowledge of accounting is not a prerequisite to become a business owner. However, you need to understand the basic accounting fundamentals and ratios if you want to grow the business.
Your business gross margin will speak to the health of your business and comparing this with different periods you will notice trends before they become problems.
For example, if you sell a product for £5,000 and the cost of the product is £3,000 the calculation would look like this:
Revenue – £5,000
COS – £3,000
Gross profit margin = Gross profit / Revenue= 40%
Higher the gross margin, it is better.
Operating margin measures how much profit a company makes on a pound of sales after covering all operating expense.
Continuing from the example above:
Operating expenses – £1,000
Operating profit – £1,000
Operating profit margin = Operating profit / Revenue = 20%
Similar to gross margin, the higher the number the better.
Does your company have enough cash to meet its short-term liabilities?
The Current ratio, also known as the working capital ratio, will give you the answer. When you divide your current assets (cash, inventory, receivables) from your current liabilities (payables, short term debts) you get the current ratio.
Current ratio= Current Assets / Current Liabilities
Let’s assume, you have £20,000 in current assets and £12,000 in current liabilities.
£20,000 / £12000 = 1.66
Higher the number, the better. If your current ration is below 1, that indicates that your liabilities in a year are greater than the assets in a year. If it is above 1, your company is on the safe side.
Other common accounting terms
An accounting period is the span of time covered by a set of financial statements. Some businesses choose to do financial reports monthly, so each accounting period is one month.
If you look at your results on a quarterly, the accounting periods are 3 months and if annually, the accounting periods are 12 months.
This is the amount of money due from your customers for the goods or services provided but not yet paid for. This will be shown as a current asset on the balance sheet.
This the amount due to your suppliers for the goods or services received but not yet paid for. This will be shown as a current liability on the balance sheet.
Accrual basis accounting
This is a method of accounting where revenues and expenses are recorded when they occur rather than when payment is made or received.