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Understanding key financial documents

Make sure you understand your balance sheet and profit and loss account. Learn how to read and use this essential financial information.

Understand and use your financial documents

By understanding your financial documents you’ll have a better idea of how your business is performing, keeping you in control of your company. Your profit and loss statement shows how much you're making (and what tax you owe) and your balance sheet shows the financial viability of your business.

Understand your balance sheet

Your balance sheet shows your financial strength. This is normally prepared at the end of a financial quarter or a full accounting year.

It’s a cumulative record of what’s happened in your business right from the start and summarises your assets (what you own) and liabilities (what you owe). The difference between the two is what your business is worth.

The assets side of your balance sheet includes:

  • Fixed assets — generally longer-term assets such as equipment and intangible assets like goodwill and intellectual property
  • Current assets — short-term assets that include stock, debtors (customers who owe you money) and cash

The liabilities side of your balance sheet includes:

  • Current liabilities — amounts you owe that are due to be paid within one year, such as suppliers' bills and bank overdrafts
  • Long-term liabilities — amounts that fall due after more than one year, such as long-term bank loans and leases
  • Shareholder funds — share capital (amounts paid into the company for shares) and reserves (including retained profit)

The capital figure in your balance sheet will always equal fixed assets, plus current assets, less current liabilities.

Using your balance sheet

Your balance sheet is a summary of your business performance, and lets you compare your performance with past years. This lets you see any trends that develop. It contains information that gives you an indication of the health and profitability of your business. These are called key performance indicators. Some examples of these indicators or ratios include:

  • Return on capital employed is net profit (before tax) as a percentage of capital employed. This shows the return you make on the money that finances the business (loans and shares). If you have capital of £2 million, and earn £100,000 profit in a year, this is a 5% return on capital invested.
  • Return on equity is profit before tax but after interest has been deducted. It’s expressed as a percentage of shareholders' funds employed in the business.
  • Financial strength looks at how much of your financing is borrowed, and how well you could cope if business conditions became difficult. Are you funding growth from debt or business reserves?
  • Control of working capital is current assets less current liabilities. For example, how much money do you have tied up as stock, how efficient are you at collecting debts and how quickly can you pay suppliers? If you need to pay everyone back now, do you have enough cash?

Your business adviser or accountant will be able to tell you which key performance indicators you should monitor. By comparing key ratios with other businesses, and against the same figures for previous periods, you can identify areas where you need to make changes.

Understanding your profit and loss statement

Your business’s trading performance is shown by your profit and loss statement. It deals with a defined period, such as a month, a quarter or financial year. It records sales, expenses, profits and losses, and any tax payments made during the period. It returns to zero at the end of each financial year, recording sales and expenses for a fixed period of time only.

A profit and loss statement typically follows this format:

  • Sales (turnover)
  • Less cost of sales (your 'direct' costs, such as raw materials)
  • Equals: Gross profit
  • Less fixed or 'indirect' costs (overheads, such as rent, rates and salaries)
  • Equals: Operating profit (profit before tax)
  • Less tax payable
  • Equals: Net profit

Using your profit and loss statement

Your profit and loss statement can reveal trends in your gross profit and net profit margins, and let you make changes before things become critical to your business.

Gross profit margin

You calculate your gross profit margin by showing your gross profit as a percentage of your turnover. If you have turnover of £2 million and cost of sales of £600,000, you’ve made a gross profit of £1.4 million. As a percentage this is 1,400,000 ÷ 2,000,000 x 100 = a gross margin of 70%.

So every £100 of sales you make generates £70 towards expenses and towards your net profit. If your gross margin percentage starts to slip you need to find out why, and make changes to stop the erosion of your profit margin.

The reasons may include:

  • Rising inventory costs
  • Offering discounts
  • Theft by customers or staff
  • Selling products that have lower margins

Net profit margin

Your net profit margin shows, as a percentage, your net profit (gross profit less fixed or indirect costs) to turnover. If your business had a £2 million turnover and a net profit of £300,000, the net profit margin would be £300,000 ÷ £2,000,000 x 100 = 15%.

If you notice your net profit margin falling, it means you’re paying proportionately more in expenses than previously. It can also help you spot other problems. If your turnover increases from £2 million to £3 million and your net profit goes up from £300,000 to £400,000. This looks good until you look at your net profit percentage: £400,000 ÷ £3,000,000 x 100 = 13.3%. That means your net profit margin has actually dropped from 15% to 13.3%. It shows that even though your turnover has increased by £1 million, and your net profit by £100,000, you’re not making as much profit from that increased turnover. You can then investigate what’s causing the reduction in the profit margin and make changes to stop the slippage.

Benchmark your business

There are two ways you can get a clearer picture of your performance — using your gross and net profit margins as benchmarks.

  • Compare current and previous profit margins to see where your selling prices are coming under pressure or costs are increasing
  • See which individual product lines are most profitable by comparing their relevant profit margins

External benchmarking

  • By comparing your profit margins with those of similar businesses you can see where you’re performing well and where you can make some improvements

Financial documents tip

Make sure you know how to read your key financial documents and you’ll be rewarded with better money management skills.

Financial documents support

  • Your accountant or business adviser can help you understand the information you need from your balance sheet and profit and loss statement
  • Make sure you know which key performance indicators are important to your business and use the information in your financial documents to monitor them, and the performance of your business
  • Check out our Business Monitoring service, part of our Better Business Support service
  • Use our Financial health check online tool to get a better idea of your business's performance

This guide is intended as general advice only, and not intended to cover specific circumstances and needs. The information in this article is also not linked to any of the products offered by Clydesdale Bank PLC.

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