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How to understand key financial documents

Your balance sheet and profit and loss statement are the two basic financial documents you’ll need to understand. Find out how to read and use this vital financial information.

Understanding your financial documents will give you more control and a clearer picture of your business and how it’s performing.

Understanding your balance sheet

Your balance sheet shows how sound and financially viable your business is. It provides a snapshot of your business’s financial strength at the end of a quarter or a full financial year. It summarises the:

  • Assets that you own, and
  • Liabilities that you owe.

The difference between your assets and liabilities tells you what your business is worth.

Looking at your assets

On the assets side of your balance sheet are your:

  • Fixed assets. These are generally longer-term assets such as machinery, and include intangible assets such as goodwill and intellectual property rights.
  • Current assets. These are short-term assets and include stock, debtors and cash.

Examining your liabilities

On the liabilities side of your balance sheet are your:

  • Current liabilities. These are amounts you owe that are due for payment within one year, such as suppliers’ bills and bank overdrafts.
  • Long-term liabilities. These fall due after more than one year, like long-term bank loans and leases.
  • Shareholder funds. These include share capital (amounts paid into the company for shares) and reserves (including retained profit).

The capital figure in your balance sheet will always equal fixed assets plus current assets less current liabilities.

Using your balance sheet

Your balance sheet gives you a quick summary of your business performance and contains information and figures you can use to measure the health and profitability of your business. These are called key performance indicators (KPIs).

Some examples of these KPIs include your:

  • Return on capital employed. For example, if you have £2 million in capital, and earn £100,000 a year in profit, this is only a 5% return on capital employed. You could probably earn better returns in another investment.
  • Return on equity. This is profit before tax (but after interest has been deducted) as a percentage of shareholders’ funds employed in your business.
  • Financial strength. This 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. This is current assets less current liabilities. For example, how much money do you have tied up as stock and how quickly can you pay suppliers? If you suddenly needed to pay everyone back, do you have enough cash to do so?

Understanding your profit and loss statement

Your profit and loss statement shows you how much money you’re making – and the amount of tax you owe. It provides a picture of your business’s trading performance over a defined period, such as a month, quarter or financial year.

A profit and loss statement typically follows this format:

Sales (turnover)

Less cost of sales (your direct costs like raw materials)

Equals: Gross profit

Less fixed or indirect costs (your overheads like rent and salaries)

Equals: Operating profit (your profit before tax)

Less tax payable

Equals: Net profit

Using your profit and loss statement

Your 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 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 – a gross margin of 70%.

So every £100 of sales generates £70 that goes towards paying for expenses and towards your net profit. If your gross margin percentage starts to slip you’ll have 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 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%.

If your net profit margin falls, it means you’re paying proportionately more in expenses than you should be.

If your turnover increases from £2 million to £3 million and your net profit goes up from £300,000 to £400,000, this can look good until you see your net profit percentage:

  • £400,000 ÷ £3,000,000 x 100 = 13.3%.

That means your net profit margin has actually dropped from 15% 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.

In this scenario, identify which costs have increased out of proportion to the rise in sales, so you can stop the slippage.

Next steps

This guide is intended as general advice only, and not intended to cover specific circumstances and needs. The information in this article is also not linked to any of the products offered by Clydesdale Bank PLC.

  • Ask your accountant or business advisers to help you understand how to get the information you need from your balance sheet and profit and loss statement.
  • Find out which key performance indicators are important to your business and how to use the information in your financial documents to monitor them.
  • Take a look at Clydesdale Bank’s small business solutions that can help your business succeed.

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