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

Profit & Loss Cash Flow

Balance Sheet

Assets and liabilities

Changes in working capital, dividends, capital expenditure and financing costs

How to read company accounts

Whats 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 thats 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

Neither of these figures for profit will tie to cash Admin expenses and Cost of Sales have already had depreciation and amortisation deducted Not the best measure of profitability for small business owners

Profit for year = Turnover less Cost of sales less admin expenses less tax

So whats 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 So what are depreciation and amortisation?

plus
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

Whats the purpose of Depreciation and Amortisation and where can I find the figures for this?
Depreciation 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

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

Whats on the cash flow statement?
Profit for year Interest Taxation Depreciation Amortisation 101,550 -50 25,500 6,600 2,000

EBITDA = 135,600 (cash in)

Decrease in debtors Increase in creditors

2,680 30,810

Change in working capital = 33,490 (cash in)

Capital Expenditure is the amount of cash used to purchase fixed assets its like the real world equivalent of depreciation

Capital Expenditure Tax paid Dividends

-20,600 -15,120 -108,170

Any other cash out of the business = 143,890 (cash out

Net cash movement

25,250

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 dont routinely produce it
Note: for simplicity weve assumed that the debtor and creditor balances dont include anything other than typical working ca pital items

How to read company accounts

How does this tie to the Balance sheet?

This years cash balance = 49,450 Last years 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 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 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 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: Trade creditors: 36k Invoiced expenses: 121.2k # Trade creditor days: 108 days Looks high (30 days normal) Example: Corporation tax: 25.5k PAYE estimate: 2.9k VAT estimate: 11.4k Total estimate: 39.8k Total actual: 65.0k Example: No bank debt Higher than expected

Taxation creditors

Bank loans

So for this business, whilst profitability looks good, the time taken to pay suppliers suggests some degree of financial distress

How to read company accounts

Conclusions

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 dont routinely produce the Cash Flow statement (but we do!) The Cash Flow statement helps you keep track of all cash items that dont appear in your Profit and Loss (e.g. dividends, loan repayments, tax and change in working capital) 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) 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 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

YOUR TEAM

Thank you for reading! Need further help with understanding your company accounts or preparing annual forecast ? Please dont hesitate to get in touch: Accounts and Legal 0207 043 4000 www.accountsandlegal.co.uk

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This research has been collated by Accounts and Legal Consultants Ltd (the Accountant), solely for informational purposes w hich provides indicative and general guidance. The information provided is general and will not be applicable in all cases, and specific guidance should be sought before completing tax returns. It does not purport to offer legal, investment or commercial advice and may not be relied upon as such. The report may not be copied or distributed by recipients to third parties without the prior written consent of the Accountant. The Accountant does not make any representation or warranty (express or implied) as to the accuracy or completeness of this research or any of the information contained or referred to herein, and shall not have any liability resulting from the use of, or any omissions from it. All requests for additional information should be made to: Accounts and Legal Consultants Ltd 0207 043 4000 20 Kentish Town Road London NW1 9NX