Understanding Your Balance Sheet & Profit and Loss

Most owner managers profess to understand very little about the balance sheet and profit and loss that appears in their year-end accounts. This article is designed to remove some of the mystery surrounding the balance sheet and profit and loss to help you understand it a little bit more. But mostly importantly, this article will help you to review these year-end accounts and use them to make decisions on your business.

Why is the balance sheet so important? 

A balance sheet gives analysts, investors, and creditors a snapshot of how effectively a company’s management uses its resources.

The balance sheet is so important because it reflects the solvency of your business. If it’s going up, your company is getting financially stronger.

For most owner-managed businesses, the balance sheet is the only piece of information that outside world knows about your company. It is filed at Companies House which means credit checking agencies draw all their conclusions from this one document.

Read here how filing can impact your credit score.

It also means others can analyse where your business is for other reasons such as for mergers, asset liquidations or a potential investment in the company.

Some other reasons the balance sheet is so important:

• You can gauge how well your business is performing financially, whether you have enough assets to cover liabilities, and if you have enough equity to meet future obligations, where your cash has been used in the year
• It provides a snapshot of your business at a specific point in time which can help you make important decisions about your operations, investments and financing. The only issue is many businesses still don’t have these produced until close to deadline, which is 9 months after the year end, making the information so historic it losses its relevance to you.
• Instead we would recommend you follow in the footsteps of our most successful clients and embrace having monthly or quarterly management accounts prepared so you have up-to-date data, not data that is a year old!
• You can use it to benchmark with your competitors in the industry and identify areas of strength and weakness in your strategic plan and constantly look to make 1% improvements across multiple areas which have a significant compound effect over time.

What appears on the balance sheet?

The balance sheet typically compromises of:

• Assets: These are resources owned by the company. They can be tangible assets like property, equipment, and inventory, or intangible assets like patents, trademarks, and goodwill. This also includes your cash and money owed to you by customers.
• Liabilities: These are the company’s obligations, including loans, accounts payable, and other debts.
• Equity: This represents the ownership interest in the company. It includes the initial investment by shareholders plus retained earnings or losses.

Additionally, the balance sheet may include other items such as:

• Current Assets: These are assets that are expected to be converted into cash or used up within one year, such as cash, accounts receivable, and inventory.
• Non-current Assets: These are assets that are expected to provide benefits for more than one year, such as property, plant, and equipment.
• Current Liabilities: These are obligations that are due within one year, such as accounts payable and short-term loans.
• Non-current Liabilities: These are obligations that are due beyond one year, such as long-term loans and deferred tax liabilities.
• Shareholders’ Equity: This includes the capital contributed by shareholders plus retained earnings or losses.

What is not included on a balance sheet?

What doesn’t appear on the balance sheet is a liability for the costs of closing the business down such as redundancy. This means the common assumption that the net assets figure on a balance sheet is the figure that the owners will be left with if they were to shut the business down is incorrect.

Ultimately there were only three ways that the business can increase the net assets on its balance sheet:

1. The first way is to make a profit; that profit will turn itself into assets or will contribute to reducing liabilities.
2. The second way is for further capital to be introduced by the owners.
3. The third way is to revalue items on the balance sheet to ensure they show true and fair value a common thing that is missing, is the increase in property values.

What is a profit and loss (P&L) statement?

A profit and loss statement, on the other hand, summarises the revenues, costs, and expenses incurred during a specific period.

The profit and loss typically includes several key components:

• Turnover: This section shows the total income generated from sales of goods or services. It may be broken down further by product or service categories if applicable.
• Cost of sales: This represents the costs of goods sold which can be directly associated with producing goods or delivering services. It includes expenses such as materials, labour, and manufacturing overhead.
• Gross Profit: Gross profit is calculated by subtracting the COGS from the revenue. It reflects the profitability of the company’s core business operations.

Spending your time influencing this part of your accounts, has the biggest impact on your profitability as a business but is often ignored for trying to reduce overheads by pennies by comparison.

• Administrative Expenses: This section includes all expenses incurred in the day-to-day operations of the business, such as salaries, rent, utilities, marketing, and administrative costs. These are often harder to reduce quickly.
• Operating Profit (or Loss): Operating income is calculated by subtracting the total operating expenses from the gross profit. It indicates the profitability of the company’s core business activities before taking into account non-operating items.
• Non-operating Income (or Loss): This includes income or expenses that are not directly related to the core business operations, such as investment income, interest expenses, or gains/losses from asset sales.
• Tax on profit: This represents the company’s tax obligation based on its taxable income.
• Net Profit (or Loss): Net income is the final figure after subtracting taxes and non-operating expenses from operating profit. It indicates the overall profitability of the company.

Additionally, some profit and loss statements may include other items such as extraordinary gains or losses, discontinued operations or prior year adjustments.

Why is the profit and loss so important?

The profit and loss statement provides crucial insights into the financial health and performance of your business over a specific period. It indicates whether your business is making a profit or incurring losses. By reviewing P&L statement, you can evaluate your business’s profitability, identify trends, and make informed decisions about your company’s future.

Understanding your business’s financial performance helps you set realistic goals, allocate resources efficiently, and prioritise strategic initiatives.

By reviewing your profit and loss (P&L) statement, it also:

• Helps identify strengths and weaknesses – Regularly reviewing your P&L statement allows you to identify areas where your business is excelling and areas that need improvement. By examining your revenues and expenses, you can pinpoint the products or services that generate the most profits and the ones that are underperforming.

This insight can guide your marketing and sales strategies, enabling you to focus on high-margin products or services and improve or discontinue underperforming ones.

• Facilitates tax planning – By regularly tracking your profit and loss, you can identify tax-saving opportunities, such as deductions for business expenses.
• Attracts lenders, investors and buyers – Lenders, investors and buyers can use your profit and loss to assess your business’s financial health and determine its ability to generate profit and repay debts.
• Enhances decision making – Perhaps the significant benefit of a profit and loss statement, and why we recommend you have monthly or quarterly statements, is the ability to enhance your decision making. By monitoring your revenues and expenses, you can make more informed choices about resource allocation, pricing strategies, cost-cutting measures, and overall business strategy.

Key takeaways:

• Understanding your balance sheet and profit and loss is essential for effectively managing your business’s financial health and will help you make changes during challenges times
• The balance sheet reflects the financial strength of your business and is a crucial document for stakeholders such as, investors, creditors, and potential partners
• The profit and loss statement enables you to identify strengths, weaknesses, cash flow patterns and tax-saving opportunities
• It’s crucial you compare your year-end accounts with previous periods
• If you aren’t already, start with quarterly management information you will find it much more interest!

For help in reviewing your year-end accounts, get in touch with us. Email enquiries@a4g-llp.co.uk or call 01474 853 856.