Analysing financial statements allows small business owners to know the health of their company and make sure it stays on track.

A Profit and Loss (P&L) account and a balance sheet are financial statements that record the actual results of your business activities. In this article, our small business accountants look to discuss them in detail and highlight why these financial statements are the health indicators of your small business.

Profit & Loss (P&L)

A P&L account has a few other names: an income statement, a statement of earnings, or a statement of operations. Usually produced monthly, it contains what your business has earned versus what you have spent for the particular time period.

A P&L usually has these five components:

• Revenue from sales and other forms of income
• Cost of goods sold (COGS), the accumulated costs to acquire or create the products (or services) you sell
• Gross profit (revenue minus GOGS)
• Expenses, these can be payroll, rent, insurance and office stationery
• Net profit or net loss (gross profit minus expenses)

Lessons from your P&L

Use gross profit to enhance your efficiency

Gross profit refers to the difference between your sales revenue and cost of goods sold and a useful indicator of efficiency. If you are a retailer, the cost of goods sold would be your cost of merchandise or cost of services.

When your gross profit is high, it means your business is keeping more money from each sale. In other words, it is efficiently managed.

If your gross profit is low, then you need to find the reasons and take actions. For example:

• Can you ask your raw material suppliers for a discount?
• Can you lower the production cost through streamlining your production process?
• Can you lower your delivery cost by switching to a different courier company?

If you are in retail, you may not pay much attention to gross profit but focus on net profit margin which we will cover next.

Use net profit margin to determine profitability

While gross profit offers an insight to the efficiency of the business pertaining to its use of labour, raw material and other supplies, net profit is used to determine your company’s profitability, meaning how much money your business is actually making after expenses.

The formula to calculate net profit margin is to have net income divided by revenue x 100. Here is a quick example:

• Your revenue is £10,000 and your cost of goods sold is £3,000. This means your gross profit is £7,000.
• Your rent, utilities, insurance, marketing, office supplies add up to £5,000.
• Gross profit £7,000 – expenses £5,000 = net profit £2,000.
• Your net profit margin is £2,000 / £10,000 = 0.2; you multiple this number by 100 to get a percentage, which is 20%.

You want the net profit margin figure to be high because it means:

• Your business is selling products or services that are popular
• Your marketing effort is reaching to the right audience
• Your price structure is right
• Your expenses are controlled
• Your business is profitability

If an unfavourable event occurs, like customers no longer find your products or services relevant or your advertisements do not reach the right target audience, then chances are your net profit margin will decrease accordingly.

To have a healthy and profitable business, talk to a qualified and experienced small business accountant like us and let us work with you to review the numbers. Use data to guide your decision making. For example, the numbers will tell you which items are low-performing and you may want to terminate them, or controlling costs by moving to a smaller office will immediately show an impact. Other factors to consider may include raising prices on the best-selling items, trying a new marketing campaign, building better relationships with your customers, to name but a few.

Balance sheet

Giving you a snapshot of what a business owns versus what it owes at a specific point in time, a balance sheet is also an indicator of the financial health of your company.

A balance sheet consists of three things, namely assets, liabilities and owner’s equity. Let’s take a look at each one.

Assets

Assets are all items of value that a business owns. Assets are further divided into current and non-current.

Current assets are cash and other items which can be converted into cash within the next 12 months. For example, you sell to client A and you expect them to pay you next month and this receivable is considered as part of your current assets.

Non-current assets, as the name suggest, refer to items of value that cannot be converted into cash quickly. They include equipment, vehicles and goodwill, to name but a few.

Liabilities

Obligations which a business must fulfil are considered liabilities. Liabilities are also further divided into current and non-current liabilities.

Current liabilities are obligations which the business is expected to pay within the next 12 months. Generally they include short-term loans, stock purchases, credit card debts, payable tax to HMRC, among others.

Non-current liabilities are obligations which the business cannot settle within the next 12 months. An example is a long-term loan.

Owner’s equity

Also known as net assets or book value, owner’s equity indicates what you the business owner can claim to the company’s assets after all liabilities are paid off. This amount does not necessarily represent the fair value of a business, hence the name book value. Retained earnings are often included in this section and they refer to left over profits made in previous years.

Lessons from your balance sheet

Determine how is the business being funded

If you take total liabilities divided by total assets, you will get what is called a debt to total assets ratio. You want this number to be low as it means the company is less dependent on debtors to operate. Accordingly, a high debt to total assets ratio means the company depends on borrowed money and money owed to others to survive.

Compare periods and see if you’re doing better or worse

Compare the numbers between two selected periods will unveil if the company’s performance has improved or not. For example, as your business progresses, ideally it should accumulate more assets (like cash) to fuel its growth.

Check if your business can pay its bills

If you take the total of current assets divided by the total of current liabilities, you have a liquidity ratio. Assuming your total current assets are £20,000 and your total current liabilities are £10,000, you get a ratio of 2. This means you have £2 to cover every £1 owed, enough cash or items of value to cover your debt obligations. If the ratio is low, you need to act immediately before the business sinks further into debts.

The ability to meet an unexpected event

The formula for debt to equity ratio is total liabilities divided by equity. This figure tells you how much debt the business has versus the amount invested by you the business owner. If the number is high, it means your company has a great financial risk and may not be ready should an unexpected event happens.

Work with an accountant to review the numbers

If you are a small business owner, chances are you already have an accountant working with you to review the numbers of your financial statements and support your company to grow.

Your accountant should not be someone whom you only see once a year. They should be working you regularly and helping you to understand how you can use numbers to make shrewd business decisions that will increase the value of your company and help it grow. This is how our team of chartered accountants for small businesses at Berley operates. We talk to you, understand your circumstances, look at data, and use numbers from your financial statements to analyse key questions such as:

• How much sales do you need to cover your expenses?
• How do you know your business is operating profitability?
• If your business is recording net losses, what counter-measures can you take immediately?
• How much working capital should you retain in your company?
• Is your investment yielding a good return?
• If you are selling products, do you know how quickly they turn over?
• How long does it take for your clients to pay you?
• Are your expenses under control?
• How do you compare to your industry peers?

Our objective is to help your business become profitable and grow, because we believe in mutual benefits – when you grow, we will grow too. So call us on 020 7636 9094 or use our Online Form to arrange a no-obligation meeting and find out what Berley can help to analyse your financial statements.

Berley is here to assist small businesses in London

For over 30 years, Berley has helped entrepreneurs and small business owners across London grow and flourish by strengthening their financial health.

We offer a complete range of tax and accounting services:

• Tax advice, planning and efficiency – Our tax experts keep you up-to-date with your tax obligations. We also look at how your business can lower its tax responsibilities legally, giving your business more cash to operate and thrive.

• Value Added Tax (VAT) and Pay As You Earn (PAYE) – VAT is a consumption tax on the sale of most goods and services, and PAYE refers to an income tax deducted from a salary before an employee receives it. With the assistance of our VAT and PAYE services team, we provide thorough and professional services that meet your business needs.

• Payroll services – Berley’s outsourced payroll services are here to streamline your payroll process while adhering to the latest rules and regulations. By outsourcing your payroll function to us, you are likely to see a reduction in cost as you do not need to pay for a full-time payroll administrator.

• Management accounts – Often featuring executive summary, cash summary, profit and loss report, balance sheet, aged receivable and aged payable, well-prepared management accounts give you well-rounded insights to your business’s performance.

• Bookkeeping – Accounting and bookkeeping functions should not be a burden or slow down your progress, so let Berley step in to provide a bookkeeping service that matches your needs.

• Company audit – Essentially a health check process, a company audit can identify potential areas of weakness and new opportunities, thereby improving profitability and business efficiency.

• Completing tax returns – We help you submit your tax returns in a timely and efficient manner, ensuring that you only pay what is required for a business of your type and size.

In addition, we can also help you with more detailed aspects of your business such as:

• Sourcing and applying for business funding
• Dealing with any international operations you may have
• Restructuring your business when necessary
• Working with you to create investment strategies
• Offering advice on retirement planning

You might also be interested in:

• How to become a financially secure business?
• Why working with competitors can benefit small business owners
• How business mentors can help small business owners

This post is intended to provide information of general interest about current business/ accounting issues. It should not replace professional advice tailored to your specific circumstances.