Learning to assess and manage your financial situation is perhaps the most important part of running a successful business.
Whatever your background, you will need to know how to collect numbers and use them to establish your performance, your problems and your opportunities for growth.
This guide will help you manage your profit and loss as well as your cash flow and profitability by carefully preparing realistic balance sheets and budgets.
How do I manage my profits and losses?
You have to write an income statement.
This records all sales, expenses, costs, profits and losses for the previous “accounting period” (usually one year), as well as all tax provisions.
It gives you a picture of your trading performance and allows you to identify areas of growth or problems.
Follow the next steps and save as follows:
- Turnover, excluding VAT.
- Direct costs. These are costs that increase with the volume of sales (for example, raw materials, etc.).
- Gross profit. That is, turnover less direct costs / cost of sales.
- Indirect costs. That is, overhead costs – rent, salaries, depreciation of fixed assets, etc.
- Operating profit. Or PBIT – your profit before taxes and interest, including any income or cost not related to your operations (e.g. money earned from the sale of an asset, etc.). If you have a long-term contract, decide how much to include in that contract.
- Net interest payable. For example, interest payable on bank loans, etc.
- Profit before tax. Remove interest charges from PBIT to reach this figure.
- Tax payable.
- Net profit.
Remember, whether it’s invoices or not, record sales and purchases. Likewise, record prepayments and accruals during the relevant period. For example, any prepaid rent, or interest payable, should be added later. Finally, distribute the costs of fixed assets. Instead of charging the full cost up front, add a “depreciation” charge to each period of the asset’s life. You will need to determine the likely depreciation rate yourself.
What is a balance sheet?
A balance sheet is a summary of your assets and liabilities – the value of what you own and the price of what you owe.
Creating one gives you an idea of where your business is at the end of an accounting period.
You must register:
Fixed assets – These are all the assets you own for the long term – machinery, equipment, as well as intangibles such as licenses and intellectual property (you will need to calculate their value yourself). Record them at their depreciation values, after calculating their depreciation rate.
Current assets – These are all the assets you hold for the short term – stock, inventory, capital, and any debtors (customers who owe you money). Again, you will have to assess them yourself.
Long-term liabilities – These are all debts you owe that are due after more than a year – bank loans, principal’s loans, etc.
Current liabilities. – This is any payment due in the year – trade creditors, hire purchase and your overdraft.
Shareholder funds – This is a record of the value of your shareholders’ interest in the business – retained earnings and any money paid to the business for shares.
Use them to get your “capital employed” figure, which is the total amount of funding available to the business. Capital employed = assets – liabilities.
How should I measure my cash flow?
Prepare a statement of cash flows.
It is a record of how your cash position has changed during the accounting period.
Adjust your income statement for non-cash items and be sure to record all new financing, amortization, and movement of accounts receivable and creditors.
For example, your cash flow position will be reduced if creditors owe you an increased amount.
Show schedules for payments and receipts, although they usually aren’t recorded on the income statement, they should be on your cash flow statement.
The statement will show you if you are generating money or swallowing it.
If you are a newly formed business, chances are you will use more money than you earn, even if you are profitable – consider ways to raise additional funds if you want to maintain your current growth.
How to measure my profitability?
First, use your income statement to calculate your profit margins.
Generally, you will have two types of profit –
Operating margin / net profit
Gross profit margin is your growth profit as a percentage of your sales. Subtract your direct costs from your turnover to get the figure – for example a turnover of £ 100,000 and direct costs of £ 30,000 would give you a gross profit of £ 70,000 and a margin of 70% .
Operating margin / net profit is your operating profit (your growth profit minus your overhead costs) as a percentage of your sales. Subtract your direct and indirect costs from your turnover to get the figure – for example a turnover of £ 1,000 and direct / indirect costs of £ 65,000 would give you an operating profit of £ 35,000 and a margin of 35%.
How can I use profit margins to facilitate my operations?
By comparing your margins to other relevant numbers, you can get a feel for your performance. Compare them to:
1.Previous periods to determine where your costs are increasing or where selling prices are under pressure.
2.Individual product lines to establish which of your products are profitable and which are not. Use your internal management accounts to get the relevant numbers.
3.The other companies to establish your performance against your competitors. To measure your profitability, you can compare your profits to your assets.
4. Calculate your earnings before interest / taxes as a percentage of your invested capital. This will give you your return on capital employed – the return you make on your funding.
5. Calculate your profit before tax (but after interest) as a percentage of shareholders’ funds. This will give you your return on equity. They can also tell you how to manage your pricing.
6. Divide your overhead costs by your gross margin to get your breakeven point. For example, with an overhead of £ 30,000 and a 40% margin, you need to reach a turnover of £ 750,000 to break even (30,000/40 x 100).
7. Your financial strength. Determine how much of your financing is borrowed and needs to be repaid. How would you manage if the conditions worsened?
8.Your growth. Find out how your sales are changing from period to period.
9.Your control of working capital. Establish that much of your money is tied up in inventory, the rate at which suppliers are paid, and how quickly you collect debts owed to you.
What else should I do?
While annual returns can give you a picture of your performance, they cannot give you financial control over your business. To do this, you need to prepare budgets based on these statements to forecast your future performance. To prepare:
Base it on your income statement.
- A provisional balance sheet.
Base it on your balance sheet.
Base it on your cash flow statement. Use it to anticipate any funding you will need for the coming year.
Break down the sales and costs of each product and figure out where your profits and cash flow are coming from.
Your budgets should be realistic – avoid the temptation to allocate more money than you have / can afford.
- Monthly forecast figures. These must take into account the seasonal variation.
- Take into account the relevant changes. For example, if a new competition appears.
- Take into account the effects of time. For example, if there is a large discrepancy between the customer’s purchase and payment.
- Use budgeting software. A good program can help you see how you will be affected by various scenarios, such as if your actual sales are 20% lower than forecast.
Compare these budgets to your actual performance.
- Compare the budgeted figures to the actual counterparts. Express the differences as percentages.
- Establish the causes of the discrepancies. Ex. Differences in volume or price.
- Update budgets regularly. They should reflect your actual performance as closely as possible.
Avoid over-ambitious budgets that don’t accurately reflect your performance, or over-ambitious budgets that hamper your potential growth and motivation.