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Taking the time to understand your financial documents will give you more control and a clearer picture of your business and how it’s performing. The profit and loss statement and the balance sheet are the two basic financial documents that give you this information.
As a business owner, learning about dry accounting topics may not be top of your list – unless you’re an accountant! However a basic understanding of financials makes a big difference to managing a business. It will help you make better decisions and improve your ability to communicate productively with your accountant and other advisers, such as your NAB Small Business Banker.
What’s a profit and loss statement?
A profit and loss statement, or statement of financial performance, provides a picture of your business’s trading performance over a defined period, such as a month or a whole financial year. It records sales, expenses, profits or losses, and any tax payments for the period.
The profit and loss statement typically follows this format:
Sales (or turnover) Less: cost of sales (your ‘direct’ costs, such as raw materials) Equals gross profit Less: fixed/business overheads such as rent, rates and salaries Equals operating profit or profit before tax Less: tax payable Equals net profit.
A profit and loss statement is relatively straightforward for non-financial managers to understand, but you might need to ask questions about some elements of the statement to understand all the information in it.
For instance, some items such as any principal repayments you’ve made on a business loan are not included because these don’t count as an expense, just as injecting additional capital into your business doesn’t count as sales. But the interest you pay on a business loan is an expense that should be included.
What does it tell you?
The profit and loss statement allows you to study your gross profit and net profit margins. These can reveal trends that enable you to make timely business changes.
Gross profit margin
Your gross profit margin is your gross profit as a percentage of turnover. For example, if your turnover is $2 million and your cost of sales is $600,000, you’ve made a gross profit of $1.4 million. It’s easy to turn this into a percentage: 1,400,000 ÷ 2,000,000 x 100 = a gross margin of 70%.
So every $100 of sales generates $70 that goes towards paying for expenses and towards your net profit. If this gross margin percentage starts to slip over time, it’s an indication that you need to find out why and take action. The reasons may include:
- rising inventory costs
- offering discounts
- theft by customers or staff
- selling products that have lower margins.
Net profit margin
Your net profit margin compares your net profit (gross profit less fixed or indirect costs) to turnover. For example, for a business with a turnover of $2 million and a net profit of $300,000, the net profit margin would be $300,000 ÷ $2,000,000 x 100 = 15%.
Again, if the net profit margin falls, it means you’re paying proportionately more in expenses than you should be.
Expressing net profit as a percentage is particularly useful for identifying problems you may not expect.
For example, suppose that your turnover increases from $2 million to $3 million and your net profit goes up from $300,000 to $400,000. On the surface this all looks good but let’s now work out your net profit percentage: $400,000 ÷ $3,000,000 x 100 = 13.3%. That means your net profit margin has actually deteriorated from 15% in the first example to 13.3%. Your turnover has increased by a million, and your net profit by $100,000, but you’re actually not making as much profit from that increased turnover. Talk to your accountant and identify which costs have increased out of proportion to the rise in sales, so you can stop the slippage.
Use your profit margins to benchmark your business
You can use your gross and net profit margins as benchmarks to gain a clearer picture of your performance in two ways:
Compare your profit margins to previous periods to see where your selling prices are coming under pressure or costs are increasing.
Compare profit margins on individual product lines to see which products are the most profitable.
Compare your profit margins against those of similar businesses in your industry to find out where you’re doing well and where you should set improvement goals. Your accountant or industry association might be able to give you advice on accessing industry average figures.
Profit margins tell you how much room you have to manoeuvre on pricing and the level of sales you need to break even. As long as you have a positive gross margin, each sale will make some contribution to covering your overheads.
What’s a balance sheet?
A balance sheet or ‘statement of financial position’ paints a picture of your business’s financial strength at the end of an accounting period.
The big difference between a profit and loss statement and balance sheet is that a profit and loss statement winds back to zero at the end of each financial year, recording sales and expenses for a fixed period of time only.
A balance sheet, however, is a cumulative record of what has happened in your business right from the start. The balance sheet summarises your assets (what you own) and liabilities (what you owe). The difference between the two is what you’re worth.
On the assets side of the balance sheet are:
- fixed assets – generally longer-term assets like machinery as well as intangible assets such as intellectual property rights
- current assets – short-term assets such as stock and cash.
Liabilities are similarly divided into short and longer-term items, including:
- current liabilities – amounts you owe that are due for payment within one year such as suppliers’ bills
- long-term liabilities – amounts due after more than one year, for example, long-term bank loans
- shareholder funds – share capital (amounts paid into the company for shares) and reserves, including retained profit.
The capital employed in the business will always equal fixed assets, plus current assets, less current liabilities.
Understanding your balance sheet
Balance sheets can be trickier to understand than a profit and loss statement. You’ll likely need to ask questions to get a clear understanding of what the balance sheet is telling you. For example, your accountant typically has to make judgement calls on:
- how to value intangible assets such as licences or goodwill, where values could depend on the state of the market or other factors
- how to value stock and work-in-progress
- what adjustments to make for customers who are unlikely to pay.
What can I use the balance sheet for?
The balance sheet also contains information and figures you can use to measure the health and profitability of your business. These are called key performance indicators. Some examples of these indicators or ratios include:
- Return on capital employed is net profit (before tax) as a percentage of capital employed. This shows you what return you’re making on the money financing the business (both as loans and shares). So if you have $2 million in capital, and earn $100,000 a year in profit, this is only a 5% return on capital invested. Would your money earn better returns in another investment or financing another small business?
- Return on equity is profit before tax (but after interest has been deducted) as a percentage of shareholders’ funds employed in the business.
- Financial strength looks at how large a proportion of your financing is borrowed, and how well you could cope if business conditions became difficult. Are you funding growth from debt or business reserves?
- Control of working capital is current assets less current liabilities. For example, how much money do you have tied up as stock, how efficient are you at collecting debts and how quickly can you pay suppliers? If you suddenly needed to pay everyone back, do you have enough cash to do so?
Your accountant can tell you which key performance indicators are critical for your particular business type so you can start monitoring them.
Comparing key ratios to other businesses, and against figures from previous periods, will help you identify areas where you need to take action.
- Ask your accountant which key performance indicators you should be monitoring in your business.
- Experiment with ‘what if’ scenarios to improve your business planning and working capital management.
Please note that this is a guide only and should neither replace competent advice, nor be taken, or relied upon as financial or professional advice. Seek professional advice before making any decision that could affect your business.