Joanne Wyatt explains the basics of company accounts for new entrepreneurs and would be investors.
If you’re just starting out, or have been in business but don’t have a financial background then understanding your company accounts may seem somewhat daunting. There are different sections, a lot of financial terminology and as if that wasn’t enough there are a bunch of notes at the end too.
It’s not surprising that your accounts can seem like a world away from the coal face tasks of managing customers and making sales. Here’s the rub, the accounts are a window into how well your business is performing at a given time.
It’s why we’ve produced this blog post, to help you read and comprehend the financials in your business. We’ve even explained a few of the ratios so that you can better assess your organisation’s performance.
What are a company's annual accounts?
Company accounts are a summary of an organisation’s financial activity over a 12 month period. They are prepared for Companies House and HM Revenue & Customs every year and consist of the Balance Sheet, the Profit and Loss Statement, and the Cash Flow Statement.
The Balance Sheet
The Balance Sheet is a financial statement which will give you a snapshot insight into your business’s assets, liabilities and the shareholders’ equity at a specific point in time. It’s an indication of the financial health of your company at the time the accounts were generated being a comparison of what is owned versus what is owed.
The balance sheet deals with two categories: assets and liabilities.
An asset is something which is owned by your organisation or that you get a benefit from.
An asset will be either a:
Fixed asset - which are things that will be kept long-term such as land, factories, and vehicles.
Current asset - which are things that have a shorter life-span such as stock items, petty cash and cash in the bank.
A liability is an obligation, most likely a debt arising which will need to be repaid.
A liability will be either a:
Long-term liability - money which is not due to be repaid within the next year.
Current liability - money that is due to be repaid within a year.
From this information you can then learn how money has been spent.
Now consider the liquidity ratio, which enables you to work out your organisation’s short term viability.
Liquidity ratio = Current Assets / Current Liabilities
If it is less than 1, then that could spell bad news.
Net Asset Value = (Fixed and Current assets) – (Total liabilities)
You can also see NAV expressed as NAV per share. This is calculated by taking NAV and then dividing that figure by the total number of shares in issue.
If a business was listed and the share price was higher than the NAV per share, then that would indicate that the market was expecting the organisation to make future profits.
But if the NAV is higher than the share price, it may not be good news.
The Profit and Loss Statement
The Profit and Loss Statement differs from the balance sheet as it records performance over a period of time, rather than just a snapshot. In the Profit and Loss (P&L) Statement you will see the total revenue and total expenses of the business throughout the financial year.
How to work out profit or loss?
Calculating your gross profit is fairly straight forward. The first thing you will see on the P&L is the turnover figure, this is the value of your sales. Then, minus the cost of sales from this figure, and there you have it!
Gross profit = turnover - cost of sales
To gain a better understanding of what this figure could actually mean for your business, compare it against the gross profits of the previous year and you will see which way your profits are heading.
Look further down the P&L statement and you will see earnings before interest, tax, depreciation and amortisation (EBITDA). This quite simply subtracts administrative expenses (the next number on your Profit and Loss Statement), from gross profit. Administrative expenses include:
Rent of the building
The cost of utilities
The salaries of employees
A healthy number may be a fair indicator of your organisation’s future.
Depreciation is the falling value of fixed assets, such as vehicles and buildings. For accounting purposes it represents how much an asset’s value is used up over time. Imagine if you bought a company car which you plan on using for 5 years. You could either write the entire value of the vehicle off in the first year (which wouldn’t be accurate as it is in use for longer than a year), or alternatively you could write the cost of this asset off over the period of its lifetime (usage), 5 years.
Amortisation works in the same way as depreciation but is applied to intangible assets, think research spending, patents and intellectual property such as branding.
The Cash Flow Statement
The function of the Cash Flow Statement is to explain the cash movements in and out of the business over the financial year. Cash flow is the amount of money that actually comes in and goes out of a business during a period of time.
This differs from the Profit and Loss Statement as profit is generally recorded when the sale is made and cash flow is recorded when the money is actually received. The two in that sense are very different.
The Cash Flow Statement breaks cash up into three categories:
Operating activities – how much cash comes from sales of the company’s goods and services, less the amount needed to make and sell the product/services
Investing activities – how much cash has been spent on capital expenditure, such as new equipment
Financing activities – how much cash has been spent on outside financing activities, such as cash raised through selling stock
Tip: If a company is generating a lot of cash, this is generally seen as a healthy thing. Keep in mind that a negative cash flow isn't necessarily a bad thing. If a company invests a lot of money in IT equipment for example, that can be a positive long-term development.
However, you should note that several consecutive time periods of negative cash flow should call for further investigation. Always keep an eye on the working capital formula.
Ultimately we all want our businesses to thrive. For entrepreneurs, business owners and investors, that means having an in depth understanding of an organisation. A significant part of that is to comprehend the company accounts and what they are telling us about how well the business is doing.
This post was created on 01/09/2016 and updated on 15/11/2019.
Please be aware that information provided by this blog is subject to regular legal and regulatory change. We recommend that you do not take any information held within our website or guides (eBooks) as a definitive guide to the law on the relevant matter being discussed. We suggest your course of action should be to seek legal or professional advice where necessary rather than relying on the content supplied by the author(s) of this blog.