HOW TO READ COMPANY ACCOUNTS Tips for understanding Profit and Loss statement, Cash Flow and Balance Sheet AUGUST 2013
How to read company accounts There are 3 key components of company accounts: Profit and Loss statement, Cash Flow and the Balance Sheet
Revenue and expenses
Balance Sheet
Profit & Loss Cash Flow
Changes in working capital, dividends, capital expenditure and financing costs
Assets and liabilities
How to read company accounts What’s on the Profit and Loss Statement?
Turnover everything sold by the company excluding VAT
minus Cost of Sales direct costs e.g. materials or commission paid
minus Admin Expenses all other operating costs Excluding VAT
equals Profit before tax But that’s not the only profit figure on the P+L
How to read company accounts What are the different types of profit and which one is most useful?
Profit on ordinary activities before taxation = Turnover less Cost of sales less admin expenses
Profit for year = Turnover less Cost of sales less admin expenses less tax
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Neither of these figures for profit will tie to cash
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Admin expenses and Cost of Sales have already had depreciation and amortisation deducted
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Not the best measure of profitability for small business owners
So what’s the best measure of profit for small business owners to use?
How to read company accounts EBITDA is the cleanest method of calculating cash profit
Profit on ordinary activities before taxation
plus Depreciation
plus Amortisation
So what are depreciation and amortisation?
plus Interest
equals EBITDA Earnings before interest, tax, depreciation and amortisation
EBITDA is also the method of profit that is most easily reported in management accounts (because it ignores depreciation and amortisation)
How to read company accounts What’s the purpose of Depreciation and Amortisation and where can I find the figures for this? • • Depreciation •
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Amortisation
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Depreciation is an accounting measure of how much of your fixed assets have been "used up" in that financial year Entirely academic figure and isn't generally very useful because the assets in question don't tend to get used up in the way calculated by accountants Often more useful to consider the forward looking value of assets that need to be purchased
Amortisation refers to how much of the company's "know-how" or goodwill has been used up in that year This "know-how" might end up on the balance sheet as an intangible asset if the company in question has at any point bought another business or developed some technology or intellectual property.
How to read company accounts What’s on the cash flow statement? Profit for year Interest Taxation Depreciation Amortisation Decrease in debtors Increase in creditors Capital Expenditure Tax paid Dividends Net cash movement
£101,550 -£50 £25,500 £6,600 £2,000 £2,680 £30,810 -£20,600 -£15,120 -£108,170 £25,250
EBITDA = £135,600 (cash in)
Change in working capital = £33,490 (cash in)
Capital Expenditure is the amount of cash used to purchase fixed assets – it’s like the real world equivalent of depreciation
Any other cash out of the business = £143,890 (cash out
This is the figure by which your cash balance will change from last year to this year on the balance sheet
The cashflow is the most useful financial statements: but most accountants don’t routinely produce it Note: for simplicity we’ve assumed that the debtor and creditor balances don’t include anything other than typical working capital items
How to read company accounts How does this tie to the Balance sheet?
This year’s cash balance = £49,450 Last year’s cash balance = £24,200
Difference is = £25,200 as per the cash flow statement Conclusion: Cash Flow statement links the Profit and Loss statement to the Balance Sheet
How to read company accounts What is important on the Balance Sheet?
Working Capital
Amount owed To HMRC
Amount owed by company to directors
In addition to Cash, Working Capital and Current Creditors are the key items on the balance sheet
How to read company accounts How can you spot a healthy Balance Sheet? Three quick checks • • Trade creditors •
Taxation creditors
• • • •
• Bank loans
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Trade creditors measure the amount owed to suppliers Take the number in the accounts, then divide by expenses (excluding property and employees), then multiply by 365 This gives you the average time taken to pay suppliers
Example: Trade creditors: £36k Invoiced expenses: £121.2k # Trade creditor days: 108 days
This is the total amount owing to HMRC Add up corporation tax plus an estimate for the PAYE and VAT bills PAYE is roughly 45% of the monthly payroll VAT is roughly revenue less VATable expenses multiplied by 20% divided by 4
Example: Corporation tax: £25.5k PAYE estimate: £2.9k VAT estimate: £11.4k Total estimate: £39.8k Total actual: £65.0k
Comparing bank loans to EBITDA is a good way to benchmark debt affordability Small business lending in the current climate tends not to exceed 2.25x EBITDA
Example: No bank debt
Looks high (30 days normal)
So for this business, whilst profitability looks good, the time taken to pay suppliers suggests some degree of financial distress
Higher than expected…
How to read company accounts Conclusions
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There are three key financial statements: Profit and Loss, Cash flow and Balance Sheet • The Cash Flow statement is fundamental to understanding how cash flows through your business because it links the Profit and Loss to the Balance Sheet • Most accountants don’t routinely produce the Cash Flow statement (but we do!) • The Cash Flow statement helps you keep track of all cash items that don’t appear in your Profit and Loss (e.g. dividends, loan repayments, tax and change in working capital)
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Annual accounts use several definitions of profit • The contain estimates for depreciation and amortisation which makes them difficult to interpret • A more transparent measure of profit is EBITDA (which is also best for mgmt accounts)
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Depreciation and Amortisation are not very useful in the real world • They were designed by accountants to try to show how much of your assets have been used up in a given year • A more practical approach is to try to forecast likely capital expenditure costs
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The most important parts of the balance sheet for small business owners are: • Cash balance • Working capital balance • Current and long term creditors (including debts to HMRC, banks and investors)
How to read company accounts Thanks
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Thank you for reading! Need further help with understanding your company accounts or preparing annual forecast ? Please don’t hesitate to get in touch: Accounts and Legal 0207 043 4000 www.accountsandlegal.co.uk
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