A Guide to Finance for Non-financial Managers
A small business guide to measuring and establishing your financial position.
Learning how to survey and manage your financial position is perhaps the most important part of running a successful business.
Whatever your background, you will need to know how to collect figures and use them to establish your performance, your problems, and your opportunities for growth.
This guide will help you to manage your profits and losses plus your cashflow and profitability, by carefully preparing balance sheets and realistic budgets.
How do I manage my profits and losses?
You need to compose a profit and loss statement.
This records all the sales, expenses, costs, profits and losses for the previous ‘accounting period’ (commonly one year) , as well as any tax provisions.
It gives you a picture of your trading performance, and allows you to identify any growth or problem areas.
Take the following steps and record as follows:
- Turnover, not including VAT.
- Direct costs. These are costs that rise in line with volume of sales (e.g. raw materials, etc).
- Gross profit. I.e. turnover minus direct costs/cost of sales.
- Indirect costs. I.e. Overheads – rent, salaries, depreciation of fixed assets, etc.
- Operating profit. Or PBIT – your profit prior to tax and interest, including any income or costs not related to your operations (e.g. money made when selling off an asset, etc). If you have a long term contract, decide how much from it to include in that years contract.
- Net interest payable. E.g. interest payable on bank loans, etc.
- Profit before tax. Take away interest charges from PBIT to reach this figure.
- Tax payable.
- Net profit.
Remember, regardless of whether they are invoices or not, record sales and purchases. Similarly, record prepayments and accruals in the relevant period. For example, any rent paid in advance, or payable interest, should be added later. Finally, spread out the costs of fixed assets. Instead of charging the full cost upon purchase, add a ‘depreciation’ charge in every period over the asset’s lifetime. You will need to work out yourself the likely rate of depreciation.
What is a balance sheet?
A balance sheet is a summary of your assets and liabilities – the value of what you own, and the price of what you owe.
Creating one gives you an idea of what position your business is in at the end of an accounting period.
You should record:
Fixed assets – These are any assets you hold for the long term – machinery, equipment, plus intangible assets such as licenses and intellectual property (you will have to calculate their value yourself). Record these at their values of depreciation, after having worked out their rate at which they depreciate.
Current assets – These are any assets you hold in the short term – stock, inventory, capital and any debtors (customers who owe you money). Again, you will have to value these yourself.
Long-term liabilities – These are any liabilities you owe that are due after more than a year – bank loans, director’s loans, etc.
Current liabilities. – These are any payment due within the year – trade creditors, hire purchase, and your overdraft.
Shareholder funds – These is a record of the value of your shareholders’ interest in the company – retained profit and any money paid into the company for shares.
Use these to get the figure of your ‘capital employed’ – i.e. the total amount of financing available for the business. Capital employed = assets – liabilities.
How should I measure my cashflow?
Prepare a cashflow statement.
This is a record of how your cash position has altered over the course of the accounting period.
Adjust your P&L statement for non-cash items and make sure to record any new financing activities, depreciation, and the movement of debtors and creditors.
For example, you cash position will be reduced if you are owed an increased amount by creditors.
Show the timings of payments and receipts, though these are not usually recorded on P&L statements, they should be on your cashflow statement.
The statement will show you whether you are generating cash or swallowing it up.
If you are a newly established business, it is likely that you will be using up more cash than you are making, even if you are profitable – consider ways of raising additional finance if you wish to maintain your current growth.
How do I measure my profitability?
Firstly, use your P&L statement to work out your profit margins.
Generally, you will have two types of profit –
Gross profit margin
Operating/Net Profit Margin
Gross profit margin is your growth profit as a percentage of your turnover. Subtract your direct costs from your turnover to get the figure – e.g. a turnover of £100,000 and direct costs of £30,000 would give you a gross profit of £70,000 and a margin of 70%.
Operating/Net Profit Margin is your operating profit (your growth profit minus your indirect costs) as a percentage of your turnover. Subtract your direct and indirect costs from your turnover to get the figure – e.g. a turnover of £1000 and direct/indirect costs of £65,000 would give you and operating profit of £35,000 and a margin of 35%.
How can I use profit margins to aid my operations?
By comparing your margins to other relevant figures you can build up an idea of your performance. Compare them to:
1.Previous periods to establish where your costs are increasing, or where selling prices are facing pressure.
2.Individual product lines to establish which of your products are profitable, and which are not. Use your internal management accounts to get the relevant figures.
3.Other companies to establish how you are performing when compared to your competitors. To measure your profitability, you can compare your profits to your assets.
4.Work out your profit before interest/tax as a percentage of your capital employed. This will give you your return on capital employed – the return you are making on your financing.
5.Work out your profit before tax (but after interest) as a percentage of shareholders’ funds. This will give you your return on equity. They can also tell you how to manage your pricing.
6.Divide your overheads by your gross margin to get your break even figure. E.g. with overheads of £30,000 and a margin of 40%, you need to reach a turnover of £750,000 to break even (30,000/40 x 100).
7. Your financial strength. Establish how much of your financing is borrowed and must be paid back. How well could you manage if conditions worsened?
8.Your growth. Establish how you sales are changing on a period to period basis.
9.Your control of working capital. Establish hoe much of your money is tied up in stock, the rate at which suppliers are paid, and how quickly you collect the debts you are owed.
What else must I do?
Whilst making annual statements can give you a picture of your performance, they cannot give you financial control over your business. To do so, you must prepare budgets based on these statements to forecast your future performance. Prepare:
- A profit forecast.
Base this on your P&L statement.
- A balance sheet forecast.
Base this on your balance sheet.
- A cashflow forecast.
Base this on your cashflow statement. Use this to anticipate any financing you will require for the coming year.
- Detailed budgets.
Break down the sales and costs of each product, and establish where your profits and cashflow are stemming from.
Your budgets should be realistic – avoid the temptation to assign more money than you have/can afford.
- Forecast figures monthly.These should take seasonal variance into account.
- Take relevant changes into account. E.g., if new competition arises.
- Take timing effects into account. E.g. if there is a significant gap between customer purchase and payment.
- Use budgeting software. A good program can help you see how you will be affected by various scenarios – e.g. if your actual sales are 20% lower than are forecast.
Compare these budgets to your actual performance.
- Compare budgeted figures to actual counterparts. Express variances as percentages.
- Establish the causes of variances. E.g. Differences in volume or in price.
- Update budgets regularly. They should reflect your actual performance as closely as possible.
Avoid overambitious budgets that don’t accurately reflect your performance, or under ambitious ones that stilt your potential growth and motivation.