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Understanding Balance Sheets and Profit and Loss Accounts Part 3

October 12th, 2011 by Chris Roberts in Franchise Finance
 
Chris Roberts - Director, Franchise Finance Ltd

Chris Roberts - Director, Franchise Finance Ltd

This third article which features the Profit and Loss Account follows on directly from the first two articles in the series which covered the balance sheet. If possible do read part 1 and part 2 first as there is a natural progression to this point.

The Profit and Loss Account

This is the second and an equally important part of a set of accounts. As the name suggests, the purpose of the document is to show whether the business has made a profit or a loss over a specific period of time (e.g. a month or a year). It shows the total of the sales less the direct cost of those sales (i.e. if the business sold furniture then the cost of buying or making the furniture) which gives the Gross Profit. The next part shows the deduction of the overheads such as rent, fuel, insurance, advertising etc. and also depreciation (see below), giving a Net Profit (Before Tax).

Profit and Loss Accounts 1

At this stage it is worth asking what normally constitutes an overhead for the purpose of inclusion within a profit and loss account. The answer is that these ‘expenses’ are distinguishable because once these payments are paid away they are ‘gone’ (or will shortly be gone) and nothing individually is left: e.g. electricity or rent. However, payments for assets such as vehicles, fixtures and fittings and equipment are not set against profits when they are purchased because they remain within the business to help you continue trading. They have therefore not ‘disappeared’ as you still have them.
This is a good time to mention Depreciation. We all know that at the end of the year a vehicle will be worth less than the amount of money paid for it at the start of the year. This is accounted for by charging a percentage of its value (say 20% – but this varies depending on the expected usable life of the asset) to the P&L account and reducing the value in the balance sheet by the same amount. The year-end balance sheet then gives the true value of the asset, which of course it is supposed to do.

Wages will be shown in the P&L in a number of different places depending on the nature of the business. For example if the business referred to above made the furniture, the wages paid to the manufacturing staff would be shown with the cost of sales and therefore be included in the Gross Profit calculation. Wages relating to say admin or sales staff would be included with the other overheads and therefore within the ‘net profit’ calculation.
In a sole trader or partnership business the owner’s wages are often referred to as drawings and are normally shown after the Net Profit figure. The remaining amount, which is called the ‘Retained Profit’, is then transferred to the owners ‘Capital’ part of the Balance Sheet. In a Limited Company, the ‘drawings’ are called Dividends and the owners are called Shareholders. The shareholders decide how much of the Net Profit after tax they want to pay themselves and make a Dividend payment (which is normally in proportion to the number of shares they hold) and if there is any money left over (Retained Profit) this is transferred to the Capital part of the balance sheet as part of the Profit Reserves.  A more detailed example Profit and Loss Account is shown below.

Profit and Loss Accounts 2

VAT is a highly technical subject but for the purposes of this article and assuming your franchise is (or will be) registered for VAT, then you need to know that you exclude VAT in the Profit and Loss Account. The reason for this is that you are simply acting as a VAT collector for the Tax Authorities. The VAT you charge does not belong to you so it does not form part of your profits. However, in most cases, you are able to offset the VAT you pay against the VAT you charge and only pay over the difference. Do please always refer to your accountant though, to ensure you are dealing correctly and efficiently with VAT in your particular set of circumstances.

If you have been brave enough to read through the three articles I have written so far in an attempt to dispel some of the fears or concerns that people sometimes have about reading or understanding a set of accounts then I thank you. Do please drop me a line by email at chris.roberts@franchisefinance.ltd.uk and let me know if this is the case. I am planning next to write about how you can use this knowledge to monitor and improve the performance of your business. Watch this space!

The author, Chris Roberts, runs a series of one to one and group courses and Franchise Finance also prepare full business plans and financial projections for their clients.

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Understanding Balance Sheets and Profit and Loss Accounts Part 2

September 23rd, 2011 by Chris Roberts in Franchise Finance
 

This second article follows on directly from the first article (which should be read first) and starts by showing how the more easier to understand ‘side by side’ (Assets on one side and liabilities on the other) style of balance sheet has over time been replaced by the now commonly used ‘vertical’ style, so as to make the document more useful and highlight certain useful things (see later).

Therefore the old style balance sheet shown below…

Old style Balance Sheethas now been replaced by this…

New style balance sheet

Please note, in the first instance, that all the same category headings and related blocks of figures are used. The next thing to note is that it can still be described as a ‘Balance Sheet’. It’s just that by changing the layout and ‘doing sums within sums’, we are looking at two different balancing figures. In fact the figures immediately tell us, at first glance what the business is worth, on paper, on the balance sheet date: i.e. in this case £12,500.

Chris Roberts - Director, Franchise Finance Ltd

Chris Roberts - Director, Franchise Finance Ltd

This is because the difference between the Total of the Assets less the total of the Current and Long Term Liabilities is what is left as the owners share. Put another way, if all the assets were sold at their book value and all the liabilities were paid (£56,000-£43,500,000) the amount left, or ‘paper value’ of the business, is £12,500. This is sometimes referred to as the ‘Surplus Resources’ of the business.

The next most useful thing to consider is the amount of ‘Working Capital’. This is the difference between the Current Assets and the Current Liabilities i.e. in the short term, is it likely that the business will have enough cash or be able to generate enough cash (by collecting in debtors or selling more stock) in order to pay its short term liabilities. Normally, the bigger the amount of working capital the safer the business is. However if the make-up is a small amount of cash, old or doubtful debtors and say outdated or slow moving stock, then obviously this won’t help much!

Something else that is of interest to lenders, investors and other trading companies who are checking your franchise business out (this may be suppliers or existing or potential customers) is the Gearing Ratio shown by your balance sheet. This is the relationship between the ‘Surplus Resources’ mentioned above and any borrowed money (e.g. bank loans, overdrafts, leasing, HP, factoring etc.).

Gearing is normally expressed as a percentage e.g. where the surplus resources are £50,000 and the borrowing is £50,000 i.e. a ratio of 1:1 this is 100%. This means that the lenders do not have more than you invested in the business and is a good bench mark because most lenders start to become concerned when the ratio starts to get much bigger than this, particularly if they do not have any security.

Balance Sheet Summary

Now you understand what a balance sheet is and are beginning to see what it tells you about your franchise business, you can see it is a very useful document. It becomes even more useful when you look at trends over say three consecutive balance sheets (and this aspect will be referred to further in a separate forthcoming Article next month). Also, you can use your increasing knowledge to investigate the financial strength of your customers, potential customers or even your suppliers to help you make safer decisions on who you should be doing business with.

However, the third and final Article in this series will cover the Profit and Loss Account which is the second and equally important part of a set of accounts. This will be published next week.

The author, Chris Roberts, runs a series of one to one and group courses and Franchise Finance also prepare full business plans and financial projections for their clients.

 

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Understanding Balance Sheets and Profit and Loss Accounts

September 15th, 2011 by Chris Roberts in Franchise Finance
 
Chris Roberts - Director, Franchise Finance Ltd

Chris Roberts - Director, Franchise Finance Ltd

This is the first part of a series of three articles written on the above subject by Chris Roberts of Franchise Finance and provides an introduction to the balance sheet.

“A Balance Sheet, in simple terms, is a list (or a snap-shot in time) of the Assets and Liabilities of your business. Right at the outset it will help if you accept and understand three fundamental things.

 

1.    It is called a Balance Sheet, because the value of the Assets will always equal the value of the Liabilities (assuming you have correctly completed your accounts!).

You can think of it as a set of scales or a seesaw – see below.

2.    YOU are not the business (even if you are a sole trader). Look at it as a separate thing. It is, for arguments sake, sitting in a box on the other side of the room. If you invest £1,000 into your new business on day one, that investment in the accounts of the business is a Liability, because ultimately the business (sitting on the other side of the room) owes it back to you. The corresponding entry, i.e. to make the balance sheet balance, is that the business now has an Asset of £1,000 sitting in its bank account.

3.    There is a concept in book-keeping called ‘Double Entry’. This means that every time you undertake a business transaction there will be two entries to be made in your accounts. The above example shows this.
If the next day the owner of the business takes a loan of £500 in the name of the business and buys some equipment worth the same amount, the balance sheet will be updated with two more entries (in this case, once again, one on each side). It will look like this:

However, if the business owner had used the money in the business bank account, rather than a new loan, it would have looked like this, with two entries being made on the same side (plus 500 and minus 500) ensuring that the Balance Sheet still balances.

So, to sum up the 3rd fundamental point, every business transaction will have 2 entries on the Balance Sheet; one on each side or a plus and a minus on the Asset side or a plus and a minus on the Liability side. The end result is that both sides will continue to balance.

Most assets and liabilities that you will come across will fall into one of the following categories. You need to understand which and why so that you can then use your balance sheets, in due course, to help you run your business more efficiently (see forthcoming Articles). The headings are shown below:

Current Liabilities are Liabilities that need to be paid within the short term (strictly speaking 12 months from the balance sheet date). Therefore they would normally include Trade Creditors, Bank overdrafts, VAT and most other taxes. Long Term Liabilities are therefore anything due for payment after 12 months, e.g. a long term mortgage or bank loan.

Capital is the amount of money permanently invested in the business by the owner (or owners) and Reserves include things like past profits that have not been drawn out and a revaluation upwards of say a property owned by the business.

If you are asking yourself ‘How can PROFIT be a liability?’ the answer is that any profit made by the business is owed back to the owner of the business (in the same way as the capital invested is also owed back to the owner/investor. It is therefore a liability of the business.

Current Assets are money (cash or positive bank balances) or things that are ‘nearly money’, i.e. that can be turned into money in the short term e.g. debtors (people who owe the business money) or stock (when it is sold). Current Assets will come and go, i.e. regularly change around as for example when cash is used to buy stock which is sold on credit thereby creating a debtor, which when paid is turned back into cash (this is called the ‘Working Capital Cycle’ and is covered in more detail in a forthcoming article).

Fixed Assets, by contrast and as the name suggests, stay in the business because they are needed to run the business on an ongoing basis. They therefore include things like property, vehicles, equipment and fixtures and fittings.

The concept of a Balance Sheet is a lot easier to understand, in the first instance, when it is viewed on this ‘seesaw’ side by side basis, and indeed, many years ago this is how balance sheets were actually prepared. However today the figures are arranged in a slightly different format and this will be explained in Article No. 2 next week, along with some examples of how to interprate and use the information contained in a balance sheet to help run your business.

The author, Chris Roberts, runs a series of one to one and group courses and Franchise Finance also prepare full business plans and financial projections for their clients.

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