When most business owners are quizzed on their accounts and numbers, a common response you hear is “My accountant looks after the numbers.” Yet numbers are the language of business, and unless you understand the story your numbers are telling you, you are likely to be running your business on luck or flying blind in business, writes Jonathan Amponsah …
This article looks at how to understand your year-end or management accounts, what you need to know and what red flags to look for. The aim is to try to take the fear out of accounting and help you connect with your numbers.
1. Are you making money?
The first thing you want to do is check if you’re making profit and see if that profit figure makes sense. This is done by looking at the profit and loss account and scrolling down to the bottom figure which will show a profit (positive figure) or a loss (negative figure). Then look at the top figure (the sales) and quickly glance through the list of expenses.
Take the bottom figure (let’s assume its £15,000 profit) and divide it by the top figure (assume £100,000 sales). This will give you 0.15, which means for every £1 of income, you are generating 15p in net profit.
How does the £15,000 profit compare with what you had in mind? And does the 15% net profit margin deliver the right return for you?
2. Is your business in a good state?
The next thing you want to check is that the business has a positive balance sheet value. You do this by looking at the balance sheet statement which shows what your business has and what it owes. Scroll down to the bottom and make a note of the last number. It’s normally called capital and reserves. Is that figure positive or negative? A positive figure means your business has some value.
A negative figure is a red flag and means if things carry on as they are, you will not have a business for very long. Take action to improve this. Start by improving profits.
Because the balance sheet tells you about your assets and liabilities, your debtors and creditors, when you look it try to ask simple questions like 'Is this how much I owe my creditors?' and 'Is this how much my customers owe me?' If the amount your customers owe you is higher, this is a red flag. Get the debtors list, review and start making some calls.
3. Where did the cash go?
So, your profit figure shows £15,000 as above but your bank balance is only £3000. Where did the £12,000 go? There is another financial statement called cashflow statement which reconciles your cash to your profit. But if you don’t get this, no need to panic. Here is what you can check: have your customers paid you late?; have you drawn more money or dividends out?; have you paid your suppliers early?; and have you purchased some equipment?
If you answer yes to any of the above, then chances are that’s where the £12,000 is sitting.
4. What are the trends telling you?
Trends are your friends when it comes to reading and understanding your accounts. Compare the current year or the current month’s figures to the previous year or month to make sure you are making progress towards your milestones and also to help spot any anomalies. In business nearly every decision you make gets turned into a number. For instance, if your phone costs or utility costs have gone down by, say -30%, compared to last year, ask yourself why. What is the story behind this number? Is this because of the cost-cutting decision you made a year ago? Or the change in tariff decision? Once you start seeing the numbers this way, you take the fear out of accounting.
5. Where are the margins?
Gross profit margin is an important number to calculate from your accounts, but it’s vastly ignored or misunderstood among most entrepreneurs. So the next time you get your accounts, take the direct costs of sales or direct expenses (what we call variable costs) out from the revenue. Then divide that number by the revenue. That is your gross profit margin.
Let’s say your revenue is £100,000 and your materials or direct labour or direct expenses cost you £70,000. The difference of £30,000 divided by £100,000 revenue gives you a margin of 30%. This means that for every £1 of sale, you are making 30p in gross profit. This tells you how profitable you are at the gross margin level. It also tells you whether your business model works or not.
Here are two red flags. If you’re making £30,000 in gross profit but your fixed costs are, say, £35,000, something needs to change if you’re to remain in business for long. In addition, if your margin is far below the industry average, you need to understand why and take the necessary corrective action.
6. What is your break-even point?
In other words, how much income do you need to make to reach zero profits? This is the point where your total income equals your total costs.
The reason you need to have an idea of your break-even number is so that you know how much income to make to cover all your costs.
How do you get this number from your accounts? You will first need to know your total fixed costs. These are the costs that do not change regardless of the amount of sales you make. So, things like rent, admin team costs, rates and fixed line contracts. In your profit and loss account, it should be most items listed under admin expenses (although do watch out for any variable costs that find their way into admin costs).
You then need to know the gross profit margin. You divide the total fixed costs by the gross profit margin, and this tells you the amount of sales you need to make at any given period to cover all your costs.
Let’s boldly assume you’re now falling in love with your numbers and you have calculated the margin as 30% and your fixed costs as £35,000, as per the example above. So, £35,000 divided by 30% gives you a figure of £116,667. Remember the income is currently £100,000. This tells you that your business needs to grow its income or review its costs if you’re to stay in business for long. Armed with this number, you’re no longer flying blind or fearful of the numbers. You know what to and you’re back in control.
7. How much is your business worth?
You now know how to get and make sense of your profit figure. You also know what to look out for when you review your balance sheet and the meaning of the balance sheet value. And how to look out for the cash drain in your business. Did you know that these give you a starting point in measuring the value of your business?
Healthy profits, good cashflow and positive balance sheet values are all good signs of a valuable business. Of course, there are many other factors to consider when valuing your business and other key drivers of business value. However, knowing how to read your accounts and what the numbers mean certainly puts you in pole position. It also helps you make the right decision with regards to building the value of your business.
Numbers are the language of business. It’s important that you, or someone skilled in numbers, interpret them so you can understand the story and power behind the numbers and make the right decision. Hopefully the above seven areas would help you make sense of your numbers. And there are other key numbers to review. Having regular sessions (not once a year) with your accountant and asking the right questions is strongly advised.
Jonathan Amponsah CTA FCCA is an award-winning chartered accountant and tax adviser who advises entrepreneurs on business improvement and tax optimisation. He is the founder and CEO of The Tax Guys.