Introduction to financial management Good financial management includes three essential elements –
realistic budgets, up-to-date financial records and healthy cash flow. • Budgets illustrate the predicted income and expenditure of a company or project over a specific period of time, e.g. a
twelve-month period. • Financial records and accounts illustrate the actual income and expenditure over that same period of time and what the company owns and owes at the end of it. • Cash flow relates to the activity of the bank account over that same period of time and how well the account can maintain a positive balance.
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All three elements will provide a full and detailed picture of how the
business is doing financially and how it is likely to do in the future. They are essential tools in managing the business on a day-to-day basis, providing information to support key decisions, highlighting
potential problems and providing an opportunity to avoid them. They are also powerful tools with which to persuade others to lend or give you money and to show that you have a viable and successful
business.
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This guide focuses on the second element - financial record keeping, and how to produce a summary of these records throughout the year.
It provides an introduction to Financial records Management accounts The profit and loss account The balance sheet
Financial records and the law Balance sheet glossary
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Financial records Typical financial records include the following: •
supplier invoices (charged to you)
•
customer invoices (charged by you)
•
petty cash receipts
•
written proof of any funding or loans
•
bank statements, cheque books and paying-in books
Make sure you get some form of documentation for every financial transaction to do with the business and file them carefully, sorting records by calendar month and financial year.
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As well as the actual documentation, you will also need to record them in a series of ‘books’, (hence the term ‘bookkeeping’), kept
either manually or on computer. These normally comprise: •
a sales ledger (itemising all income earned by the business)
•
a purchase ledger (itemising all costs to the business)
•
a nominal ledger (which itemises both under headings e.g. grants,
materials, postage etc., which are ideally the same headings as those used in your company budget) •
a cash ledger (recording all receipts and payments through the 5/26
bank account)
Summary information from all of the previous will then assist you in producing your management accounts.
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Management accounts Throughout the year, a suitably trained member of staff or a freelance bookkeeper can prepare the management accounts. Monthly management accounts are useful for senior management and boards to monitor how a business is doing during the year and whether any action is required as a result. Many companies use accounting software, (e.g. SAGE) to do this, but small companies can record the same information and produce the same reports using a spreadsheet package, (e.g. MS Excel), or using a manual system on paper. Although the latter can be practical and easy to use, it is strongly advised that a computerised system is adopted when the business becomes more complex.
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Management accounts are made up of two parts: •
the profit and loss account
•
the balance sheet
An example of monthly management accounts for a small arts company are given on the next page
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Sample Profit and Loss Account
Sample Balance Sheet
Income Grants
May 10 £10,000
Tutor Fees
£3,000
Workshops
£5,000
Fixed Assets Property
Equipment
31 May 10 £0
£2,000
£2,000
£18,000 Current Assets
Direct Costs
Stock
£0
Materials
£2,000
Debtors
£1,000
Project Staff
£2,000
Cash in the Bank
£1,360
Equipment Hire
£500
Gross Profit1
£4,500
£13,500
Overheads Staffing
£8,000
Rent, Rates, Insurance
£2,000
Heat & Power
£400
Telephone & IT
£400
Stationery & Postage
£500
Travel & Subsistence
£800
Bank Charges
£75
£12,175
Petty Cash
£2,385
Short-Term Liabilities
Creditors
£550
HM Revenue & Customs
£260
Bank Loan (10/11)
£400
£1,210
Net Current Assets3
£1,175
Total Assets – Current Liabilities
£3,175
Long-Term Liabilities Bank Loan
Net Profit / Loss2
£25
£1,600
£1,600
£1,325 Total Assets – Total Liabilities
£1,575
9/26 1Income – Direct Costs = Gross Profit 2Gross Profit – Overheads = Net Profit / Loss 3Current Assets – Short Term Liabilities = Net Current Assets
Capital & Reserves Equity / Investment P&L Account
£250 £1,325
£1,575
The profit and loss account The profit and loss account (P&L account) shows the actual income and expenditure over a given period e.g. monthly, quarterly or annually, and the resulting profit or loss. All the information recorded in your nominal ledger is summarised on the P&L account. As a starting point, the structure of your P&L account should closely follow the structure of your company budget, (see our Budgets Guide).
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The profit and loss account continued This will enable you to compare the actual income and expenditure against your original budget – often a useful analysis for you, your board and / or funders. All individual records of income and expenditure will be summarised on the P&L account. As in your budget, separate expenditure into ‘direct costs’ for those costs that relate directly to the work you’ve carried out on projects, commissions etc. (and where you’ve earned money as a result of this work) and ‘overheads’ which relate the cost of running your business on a day-to-day basis e.g. your rent, office costs, insurance etc. 11/26
The profit and loss account continued There are certain conventions that require you to include and exclude particular transactions, for example: •
The P&L account will show income earned during the month that you raise the invoice, not the month that you receive payment. Similarly, it will show expenditure during the month that you incurred it, not the month you paid it. Although the cash aspect of this is not
shown here, the balance sheet (see below) will reflect the fact that monies are still due to be received or paid after the period end.
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The profit and loss account continued •
The P&L account will not show any loans made from the business or to the business. Again, this is because loans are not concerned with actual trading. However, they will be reflected on the balance sheet.
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The profit and loss account continued In order to create a monthly P&L account, add up all income and all expenditure that relates to that month and record the totals against the relevant heading. Your standard formula will be:
Total Income less Expenditure (Direct Costs + Overheads) = Net Profit (or Loss)
At the end of the year, add all months together and you have a full year’s profit and loss account.
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The balance sheet For most people, the balance sheet is not as straightforward as the P&L account, but it can give a far more illuminating picture of how well the company is doing. Rather than illustrate how much business the company has brought in and how much it has spent doing that, the balance sheet is a snapshot of how much money the company has at a particular point in time: how much it owns e.g. cash in the bank, property, equipment; and how much it is still due to be paid. It also shows how much money is owed to other people e.g. suppliers, lenders and the HM Revenue & Customs. It takes into account any money that has been invested in the company and any profit (or loss) achieved in the year so far.
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The balance sheet continued To the trained eye, a company’s balance sheet can show whether the company is in financial difficulties, or is likely to be in the near future, and could, therefore, be too high a risk for lenders or funders. Conversely, it can show that the company has money in the bank, is good at getting paid and paying its own bills quickly and, therefore, an attractive prospect to lenders and funders.
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The balance sheet continued The balance sheet, like the P&L account, always follows a set format and it always balances (see the example below), which is a useful test of whether you are doing it properly! It is strongly recommended that you get some help with producing your first balance sheet and it may be worth getting some initial advice on how to structure and maintain your accounts. Consider employing a bookkeeper on a part-time basis if you really find it difficult to do this on your own, but there is no reason why you cannot do this in-house, as long as you take the time to set things up properly from the start and you allocate time once a month to update all your records.
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Financial records and the law Anyone who becomes self-employed, or forms a partnership or limited company must, by law, keep accurate financial records and submit a summary of these each year, either in the form of a self-assessment tax return or corporation tax return to the HM Revenue & Customs. In addition limited companies must submit statutory accounts to Companies House and file an annual return.
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As soon as you start trading, you must keep accurate records of all income and expenditure and any other financial activity relating to the business. At the end of the year, don’t throw them away as you are required to keep financial records for at least seven years! Limited companies must also set up a separate bank account in the name of the company and use this account for all company transactions.
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The government, through agencies such as the HM Revenue & Customs, want to make sure they are collecting the necessary tax incurred by your business and they are entitled to inspect your financial records at any time, so it is essential that you take the time to maintain your records properly.
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Limited companies must produce statutory accounts each year and these are submitted on an annual basis to Companies House. Once submitted, these become public documents available to anyone on request (for a small set fee). Due to the complexity of UK tax law, companies normally use a qualified accountant to prepare their statutory accounts at the end of the year. Companies with a turnover of over £5.6 million must have their accounts audited, (a much more in-
depth analysis), by a registered auditor each year. Charities with a turnover of more than £250,000 require an audit, while those with turnover between £90,000 and £250,000 require an independent
accountants report.
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Individuals and partnerships are only required to complete a tax return each year rather than a set of statutory accounts, but many prepare sole trader or partnership accounts, both to enable them to complete their tax returns, and also as an effective means of monitoring and reporting trading during the year.
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Balance sheet glossary •
Fixed assets – this is typically anything that you have bought but are not likely to sell within twelve months e.g. property, equipment, vehicles and computers
•
Current assets – anything that either is or can be released into cash within twelve months
•
Stock – any materials / goods that can be sold or made into something that can be sold within twelve months
•
Debtors – anyone that owes you money i.e. customers that you have sent invoices to 23/26
•
Creditors – anyone that you owe money i.e. suppliers that you have received invoices from
•
Current liabilities – anything that you owe that is payable within one year
•
Net current assets – a useful figure to calculate as it will show whether you could pay your short terms debts quickly if they were all called in at once
•
Long-term liabilities – anything that is due to paid off beyond twelve months e.g. a loan 24/26
•
Equity / Investment – any money put into the business to help set it up initially
•
Profit / Loss – the total brought across from the profit and loss account on the same date
•
Remember, the balance sheet must always balance: Total Assets less Total Liabilities = Total Capital and Reserves
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Next steps For further information on this subject, please refer to the following resources: Budgets Guide Cash Flow Guide Cash Flow Template - an MS Excel workbook with cash
flow, profit and loss, and balance worksheets
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Disclaimer: Cultural Enterprise Office is not responsible for any advice or information provided by any external organisation referenced in this document.