Bookkeeping & Accounting All-in-One For Dummies (2015)

Book IV

Working to Prepare Financial Statements

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In this book …

· Produce and understand the Profit and Loss statement.

· Learn about basic ratios in order to test the profits and liquidity of a business.

· Create a Balance Sheet.

· Discover the three different types of cash flow within a business, and develop your own cash flow statement.

Chapter 1

In This Chapter

Sorting out the elements of a Profit and Loss statement

Preparing the statement

Analysing statement data

Zeroing in on profitability

Without one very important financial report tool, you can never know for sure whether or not your business is making a profit. This tool is called the Profit and Loss statement, and most businesses prepare this statement on a monthly basis, as well as quarterly and annually, in order to get periodic pictures of how well the business is doing financially.

Analysing the Profit and Loss statement and the details behind it can reveal lots of useful information to help you make decisions for improving your profits and business overall. This chapter covers the various parts of a Profit and Loss statement, how you develop one and examples of how you can use it to make business decisions.

Lining Up the Profit and Loss Statement

Did your business make any profit? You can find the answer in your Profit and Loss statement, the financial report that summarises all the sales activities, costs of producing or buying the products or services sold, and expenses incurred in order to run the business.

Profit and Loss statements summarise the financial activities of a business during a particular accounting period (which can be a month, quarter, year or some other period of time that makes sense for a business’s needs).

Normal practice is to include two accounting periods on a Profit and Loss statement: the current period plus the year to date. The five key lines that make up a Profit and Loss statement are:

· Sales or Revenue: The total amount of invoiced sales you take in from selling the business’s products or services. You calculate this amount by totalling all the sales or revenue accounts. The top line of the Profit and Loss statement is Sales or Revenue; either is okay.

· Cost of Goods Sold: How much you spent in order to buy or make the goods or services that your business sold during the accounting period under review. The later section ‘Finding Cost of Goods Sold’ shows you how to calculate Cost of Goods Sold.

· Gross Profit: How much your business made before taking into account operations expenses; calculated by subtracting the Cost of Goods Sold from the Sales or Revenue.

· Operating Expenses: How much you spent on operating the business; these expenses include administrative fees, salaries, advertising, utilities and other operations expenses. You add all your expenses accounts on your Profit and Loss statement to get this total.

· Net Profit or Loss: Whether or not your business made a profit or loss during the accounting period in review; calculated by subtracting total expenses from Gross Profit.

Formatting the Profit and Loss Statement

Here, we show you a simplified UK format for the Profit and Loss statement:

Preparing the Profit and Loss Statement

If you’re using a computerised accounting system, the Profit and Loss report is generated at the press of a button. However, if you’re operating a manual system, you need to use the figures from your Trial Balance to construct the Profit and Loss statement.

Finding Net Sales

Net Sales is a total of all your sales minus any discounts. In order to calculate Net Sales, you look at the sales account, discounts and any sales fees on your Trial Balance. For example, suppose that you have Total Sales at £20,000, discounts of £1,000 and credit card fees on sales of £125. To find your Net Sales, you subtract the discounts and credit card fees from your Total Sales amount, leaving you with £18,875.

Finding Cost of Goods Sold

Cost of Goods Sold is the total amount your business spent to buy or make the goods or services that you sold. To calculate this amount for a business that buys its finished products from another business in order to sell them to customers, you start with the value of the business’s Opening Stock (the amount in the Stock account at the beginning of the accounting period), add all purchases of new stock and then subtract any Closing Stock (stock that’s still on the shelves or in the warehouse; it appears on the Balance Sheet, which is covered in Book IV, Chapter 2).

The following is a basic Cost of Goods Sold calculation:

· Opening Stock + Purchases = Goods Available for Sale

· £100 + £1,000 = £1,100

· Goods Available for Sale - Closing Stock = Cost of Goods Sold

· £1,100 - £200 = £900

To simplify the example for calculating Cost of Goods Sold, these numbers assume the Opening Stock (the value of the stock at the beginning of the accounting period) and Closing Stock (the value of the stock at the end of the accounting period) values are the same. See Book II, Chapter 3 for details about calculating stock value. So to calculate Cost of Goods Sold, you need just two key lines: the purchases made and the discounts received to lower the purchase cost, as in the following example.

· Purchases - Purchases Discounts = Cost of Goods Sold

· £8,000 - £1,500 = £6,500

Drawing remaining amounts from your Trial Balance

After you calculate Net Sales and Cost of Goods Sold (see the preceding sections), you can use the rest of the numbers, usually overheads, from your Trial Balance to prepare your business’s Profit and Loss statement. Figure 1-1 shows a sample Profit and Loss statement.

Figure 1-1: A sample Profit and Loss statement.

You and anyone else in-house are likely to want to see the type of detail shown in the example in Figure 1-1, but most business owners prefer not to show all their operating detail to outsiders: they like to keep the detail private. Fortunately, if you operate as a sole trader or partnership, only HM Revenue & Customs needs to see your detailed Profit and Loss figures. If your turnover is less than £79,000 per annum, HM Revenue & Customs allows you to file an abbreviated set of accounts for the purpose of completing your Self-Assessment Tax return (SA103S), only requesting the following headings:

· Turnover

· Other Income

· Cost of Goods Sold

· Car, Van and Travel Expenses (after private-use deduction)

· Wages, Salaries and Other Staff Costs

· Rent, Rates, Power and Insurance Costs

· Repairs and Renewals of Property and Equipment

· Accountancy, Legal and Other Professional Fees

· Interest, Bank and Credit Card Financial Charges

· Phone, Fax, Stationery and Other Office Costs

· Other Allowable Business Expenses

Also, if you’re a small limited company, when you file your accounts at Companies House you can file abbreviated accounts, which means that you can keep your detailed Profit and Loss figures secret. Speak with your external accountant about whether you qualify as a small company because the exemption levels do change from time to time.

Deciphering Gross Profit

Business owners must carefully watch their Gross Profit trends on monthly Profit and Loss statements. Gross Profit trends that appear lower from one month to the next can mean one of two things: sales revenue is down, or Cost of Goods Sold is up.

If revenue is down month to month, you may need to quickly find out why and fix the problem in order to meet your sales goals for the year. Or, by examining sales figures for the same month in previous years, you may determine that the drop is just a normal sales slowdown given the time of year and isn’t cause to hit the panic button.

If the downward trend isn’t normal, it may be a sign that a competitor’s successfully drawing customers away from your business, or it may indicate that customers are dissatisfied with some aspect of the products or services you supply. Whatever the reason, preparing a monthly Profit and Loss statement gives you the ammunition you need to find and fix a problem quickly, thereby minimising any negative hit to your yearly profits.

The other key element of Gross Profit - Cost of Goods Sold - can also be a big factor in a downward profit trend. For example, if the amount you spend to purchase products that you sell goes up, your Gross Profit goes down. As a business owner, you need to do one of five things if the Cost of Goods Sold is reducing your Gross Profit:

· Find a new supplier who can provide the goods cheaper.

· Increase your prices, as long as you don’t lose sales because of the increase.

· Find a way to increase your volume of sales so that you can sell more products and meet your annual profit goals.

· Find a way to reduce other expenses to offset the additional product costs.

· Accept the fact that your annual profit is going to be lower than expected.

The sooner you find out that you have a problem with costs, the faster you can find a solution and minimise any reduction in your annual profit goals.

Monitoring Expenses

The Expenses section of your Profit and Loss statement gives you a good summary of how much you spent to keep your business operating that wasn’t directly related to the sale of an individual product or service. For example, businesses usually use advertising both to bring customers in and with the hope of selling many different types of products. That’s why you need to list advertising as an expense rather than a Cost of Goods Sold. After all, rarely can you link an advertisement to the sale of an individual product. The same is true of all the administrative expenses that go into running a business, such as rent, wages and salaries, office costs and so on.

Business owners watch their expense trends closely to be sure that they don’t creep upwards and lower the business’s bottom lines. Any cost-cutting you can do on the expense side is guaranteed to increase your bottom-line profit.

Using the Profit and Loss Statement to Make Business Decisions

Many business owners find it easier to compare their Profit and Loss statement trends using percentages rather than the actual numbers. Calculating these percentages is easy enough - you simply divide each line item by Net Sales. Figure 1-2 shows a business’s percentage breakdown for one month.

Figure 1-2: Percentage breakdown of a Profit and Loss statement.

Looking at this percentage breakdown, you can see that the business had a Gross Profit of 65.6 per cent, and its Cost of Goods Sold, at 34.4 per cent, accounted for just over one-third of the revenue. If the prior month’s Cost of Goods Sold was only 32 per cent, the business owner needs to find out why the cost of the goods used to make this product seems to have increased. If this trend of increased Cost of Goods Sold continues through the year without some kind of fix, the business makes at least 2.2 per cent less Net Profit.

You may find it helpful to see how your Profit and Loss statement results compare to industry trends for similar businesses with similar revenues, a process called benchmarking. By comparing results, you can find out whether your costs and expenses are reasonable for the type of business you operate, and you can identify areas with room to improve your profitability. You also may spot red flags for line items upon which you spend much more than the national average.

To find industry trends for businesses similar to yours with similar revenues, visit www.bvdinfo.com . The FAME database contains full financial data on approximately 2 million active companies in the UK and Ireland that file their accounts at Companies House. A word of warning, though: small companies are required to file very little financial information - typically, just a Balance Sheet. This fact means that if you want to see detailed Profit and Loss information, you have to look at the big businesses with turnover above £6.5 million and a Balance Sheet greater than £3.26 million.

However, the information available for all the companies on this database is useful and can be searched in a number of ways. For example, you can compile industry-average statistics, which can be a useful way to see how your business compares with others in the same line of business. You can take this compilation a stage further and compare your business to other businesses that you already know or have found on this database.

You can also find out how your business looks to the outside world if you use FAME to dig out the financials for your business. A credit rating, details of any court judgements and other interesting information are all included in the reports.

FAME is available by subscription, which may make it expensive for the occasional user. That said, we noticed a free trial is available, so check the website for more details (www.bvdinfo.com). You may find that a regional library has FAME available to the public on a free basis or through a per-session cost. Most of the UK universities have FAME, so if you can access one of their library services you can also use this facility. This service may be available through an annual library subscription.

Testing Profits

With a completed Profit and Loss statement, you can do a number of quick ratio tests of your business’s profitability. You certainly want to know how well your business did compared to other similar businesses. You also want to be able to measure your return (the percentage you made) on your business.

Three common tests are Return on Sales, Return on Assets and Return on Shareholders’ Capital. These ratios have much more meaning if you can find industry averages for your particular type of business, so that you can compare your results. Check with your local Chamber of Commerce to see whether it has figures for local businesses, or order a report for your industry online from FAME (see the preceding section).

We look at ratios in a lot more detail in Book VI, Chapter 2, where we examine how investors typically read and interpret financial reports.

Return on Sales

The Return on Sales (ROS) ratio tells you how efficiently your business runs its operations. Using the information on your Profit and Loss statement, you can measure how much profit your business produced per pound of sales and how much extra cash you brought in per sale.

You calculate ROS by dividing Net Profit before taxes by Sales. For example, suppose that your business had a Net Profit of £4,500 and Sales of £18,875. The following shows your calculation of ROS:

· Net Profit before taxes ÷ Sales = Return on Sales

· £4,500 ÷ £18,875 = 23.8%

As you can see, your business made 23.8 per cent on each pound of sales. To determine whether that amount calls for celebration, you need to find the ROS ratios for similar businesses. You may be able to get such information from your local Chamber of Commerce, or you can order an industry report online from FAME.

Return on Assets

The Return on Assets (ROA) ratio tests how well you’re using your business’s assets to generate profits. If your business’s ROA is the same or higher than other similar companies, you’re doing a good job of managing your assets.

To calculate ROA, you divide Net Profit by Total Assets. You find Total Assets on your Balance Sheet, which you can read more about in Book IV, Chapter 2. Suppose that your business’s Net Profit was £4,500 and Total Assets were £40,050. The following shows your calculation of ROA:

· Net Profit ÷ Total Assets = Return on Assets

· £4,500 ÷ £40,050 = 11.2%

Your calculation shows that your business made 11.2 per cent on each pound of assets it held.

ROA can vary significantly depending on the type of industry in which you operate. For example, if your business requires you to maintain lots of expensive equipment, such as a manufacturing firm, your ROA is much lower than a service business that doesn’t need as many assets. ROA can range from below 5 per cent for manufacturing businesses that require a large investment in machinery and factories, to as high as 20 per cent or even higher for service businesses with few assets.

Return on Shareholders’ Capital

To measure how successfully your business earned money for the owners or investors, calculate the Return on Shareholders’ Capital (ROSC) ratio. This ratio often looks better than Return on Assets (see the preceding section) because ROSC doesn’t take debt into consideration.

You calculate ROSC by dividing Net Profit by Shareholders’ or Owners’ Capital. (You find capital amounts on your Balance Sheet; see Book IV, Chapter 2.) Suppose that your business’s Net Profit was £4,500 and the Shareholders’ or Owners’ Capital was £9,500. Here’s the formula:

· Net Profit ÷ Shareholders’ or Owners’ Capital = Return on Shareholders’ Capital

· £4,500 ÷ £9,500 = 47.3%

Most business owners put in a lot of cash up front to get a business started, so seeing a business whose liabilities and capital are split close to 50 per cent each is fairly common.

Branching Out with Profit and Loss Statement Data

The Profit and Loss statement you produce for external use - financial institutions and investors - may be very different from the one you produce for in-house use by your managers. Most business owners prefer to provide the minimum amount of detail necessary to satisfy external users of their financial statements, such as summaries of expenses instead of line-by-line expense details, a Net Sales figure without reporting all the detail about discounts and fees, and a Cost of Goods Sold number without reporting all the detail about how that was calculated.

Internally, the contents of the Profit and Loss statement are a very different story. With more detail, your managers are better able to make accurate business decisions. Most businesses develop detailed reports based on the data collected to develop the Profit and Loss statement. Items such as discounts, returns and allowances are commonly pulled out of Profit and Loss statements and broken down into more detail:

· Discounts are reductions on the selling price as part of a special sale. They may also be in the form of volume discounts provided to customers who buy large amounts of the business’s products. For example, a business may offer a 10 per cent discount to customers who buy 20 or more of the same item at one time. In order to put their Net Sales numbers in perspective, business owners and managers must monitor how much they reduce their revenues to attract sales.

· Returns are transactions in which the buyer returns items for any reason - not the right size, damaged, defective and so on. If a business’s number of returns increases dramatically, a larger problem may be the cause; therefore business owners need to monitor these numbers carefully in order to identify and resolve any problems with the items they sell.

· Allowances cover gifts cards and other accounts that customers pay for up front without taking any merchandise. Allowances are actually a liability for a business because the customer (or the person who was given the gift card) eventually comes back to get merchandise and doesn’t have to pay any cash in return.

Another section of the Profit and Loss statement that you’re likely to break down into more detail for internal use is the Cost of Goods Sold. Basically, you take the detail collected to calculate that line item, including Opening Stock, Closing Stock, Purchases and Purchase discounts, and present it in a separate report. (We explain how to calculate Cost of Goods Sold in the section ‘Finding Cost of Goods Sold’, earlier in this chapter.)

No limit exists to the number of internal reports you can generate from the detail that goes into your Profit and Loss statement and other financial statements. For example, many businesses design a report that looks at month-to-month trends in revenue, Cost of Goods Sold and profit. In fact, you can set up your computerised accounting system (if you use one) to generate this and other custom-designed reports automatically. Using your computerised system, you can produce these reports at any time during the month if you want to see how close you are to meeting your month-end, quarter-end or year-end goal.

Many businesses also design a report that compares actual spending to the budget. On this report, each of the Profit and Loss statement line items appear with its accompanying planned budget figures and the actual figures. When reviewing this report, you flag any line item that’s considerably higher or lower than expected and then research it to find a reason for the difference.

I look at budgeting in more detail in Book V, Chapter 5.

Have a Go

This section tests your knowledge about the Profit and Loss statements.

1. Your Purchases account shows that you purchased £10,000 worth of paper goods to be sold during the accounting period. In which section of the Profit and Loss Statement would you include that account?

2. Your Telephone Expenses account shows that you paid a total of £2,000 for your company’s telephones during the accounting period. In which section of the Profit and Loss Statement would you show that account?

3. Your Sales Discounts account shows that you offered customers a total of £1,500 in discounts during the accounting period. In which section of the Profit and Loss Statement would you put that information?

4. In the space below, describe how you would calculate Gross Profit. Show the calculation required if it helps.

5. In the space below, explain how you would calculate Net Profit. Show the calculation required if it helps.

6. Using the figures given below, prepare a Profit and Loss statement using the format shown earlier in this chapter.

7. Looking at your accounts, you find that you’ve the following balances at the end of an accounting period:

8. Using these figures, calculate your Net Sales in the space below.

9. Suppose that you started the month of June with £200 of stock in hand. You purchased £2,000 of stock during June and you’ve £500 of stock left to sell at the end of June. You’re preparing a Profit and Loss statement for the month of June. What would your Cost of Goods Sold be for the month of June?

10. Suppose that you started the month of July with £500 of stock on hand. You purchased £1,500 of stock during July and you’ve £100 of stock left to sell at the end of July. You’re preparing a Profit and Loss statement for the month of July. What would your Cost of Goods Sold be for the month of July?

11. Suppose that your company had a net Profit and Loss of £10,595 and sales of £40,500 for the month of June. Calculate the ROS ratio.

12. Suppose that your company had a net Profit and Loss of £13,565 and sales of £75,725 for the month of July. Calculate the ROS ratio.

13. Your company’s Net Profit for the month of May is £5,300 and its Total Assets are £75,040. What’s the ROA ratio?

14. Your company’s Net Profit for the month of May is £10,700 and its Total Assets are £49,650. What’s the ROA ratio?

15. Your company earned a Net Profit of £75,750 and its Shareholders’ or Owner’s Equity is £500,000. Calculate the Return on Equity ratio.

16. Your company earned a Net Profit of £52,500 and its Owner’s Equity is £375,000. Calculate the Return on Equity ratio.

Answering the Have a Go Questions

1. Purchases are included as part of your calculation for Cost of Goods Sold.

2. Telephone Expenses are part of Operating Expenses for a business.

3. Sales Discounts are included as part of your calculation for Net Sales.

4. Gross Profit is calculated as follows:

5. The actual Gross Profit figure is often expressed as a percentage of sales to provide you with a Gross Profit margin.

6. For example:

7. Gross Profit margin would be 25,000 ÷ 100,000 = 0.25 (25 per cent expressed as a percentage).

8. Net Profit is often described as the ‘bottom line’, because it’s the profit after all Operating Expenses have been taken from your Gross Profit.

You can express the Net Profit as a percentage of sales to provide you with a Net Profit margin.

For example:

The Net Profit margin would be 10,000 ÷ 100,000 = 0.10 (10 per cent expressed as a percentage)

9. Using the figures given in the example, the Profit and Loss statement would appear as follows:

10. The net sales are calculated as follows:

11. Your Cost of Goods Sold for the month of June would be:

12. Your Cost of Goods Sold for the month of July would be:

13. The ROS ratio would be:

£10,595 ÷ £40,500 = 26.2%

So, in this case the company made 26.2 per cent for each pound of sales.

14. The ROS ratio would be:

£13,565 ÷ £75,725 = 17.9%

So, in this case the company made 17.9 per cent for each pound of sales.

15. The ROA ratio is:

£5,300 ÷ £75,040 = 7.06%

16. The ROA ratio is:

£10,700 ÷ £49,650 = 21.55%

17. The Return on Equity ratio would be:

£75,750 ÷ £500,000 = 15.15%

So the owner’s return on his investment is 15.15 per cent.

18. The Return on Equity ratio would be:

£52,500 ÷ £375,000 = 14%

So the owner’s return on his investment is 14 per cent.