What your accounts say about your business

Emily Coltman, Chief Accountant at online accounting system provider FreeAgent (www.freeagentcentral.com), suggests five clues to look for in your accounts in order to reveal how successful your business really is.

We’re one month into the new tax year so, if your business usually prepares accounts to 31 March or 5 April, you may very soon be presented with a profit and loss account and balance sheet, either by your accountant or from your accounting software.

What do these actually tell you, and how can they show you whether your business is successful?

Your accounts can help you in terms of two measures:

• Is your business making enough sales to cover its costs and more: i.e. is it making a profit?
• Is it bringing in enough actual money to cover its bills: that is, is its cashflow healthy?

Here are five clues to look for in your accounts to gauge how your business is doing in terms of profit and cashflow.

Profit: Clue 1 - Are your sales growing?
Your profit and loss account is most useful when you look at this year’s figures and compare them to last year’s, or to your planned figures.

If you compare your business’s sales for this year to last year, you can tell whether your sales are going up or down, especially if you can do that comparison on an ongoing basis for several years.

This can help you judge whether your business is growing as you hoped, or whether you need to possibly put up your prices, or look for more customers.

Let’s take an example.

Alice is a self-employed web designer. She looks at her profit and loss account for the years ended 5 April 2011 and 5 April 2010.

Her business made sales of £60,000 in the year to 5 April 2011, compared to £55,000 in the year ended 5 April 2010.

Alice is pleased that her sales income has grown, but realises that it doesn’t actually reflect the big increase in volume of sales she has achieved.

She thinks that she may not be charging enough to some customers, because they are personal friends as well as business friends.

Are you, like Alice, being too nice to some of your customers and not charging them enough? Software tools are available to help you see whether some projects are bringing in less sales and profit than others.

Checking your sales regularly is also a very useful measure if you think you might need to register for VAT. Remember that each month you need to check your taxable sales and see if you’re going to go over the limit (which is £73,000 at the moment) for the past 12 months, or in the next 30 days.

Profit: Clue 2 - Are individual costs going up?
When you compare this year’s profit and loss account to last year’s, you can also see which individual costs might have gone up this year compared to last year.

Which suppliers are stopping you making more profit?

Alice checks her individual cost lines. She sees that suddenly she has a new line for bank charges.

Many banks will give free banking to new businesses for a couple of years, then stop – and some banks put in their account terms and conditions that their free banking will apply only to businesses that pay a certain amount into their bank accounts each month.

As Alice has now had her business bank account for over three years, her free account period has expired.

She will need to expect bank charges to be part of her on-going costs and plan for this. This is another reason why she will need to put up her sale prices.

Profit: Clue 3 - How much of your sales income is your business keeping?
It’s also very useful to work out what accountants call your business’s “profit margin”.

That just means taking your profit and dividing it by your sales.

You can also work out your “gross margin” or “gross profit margin” if your business has cost of sales.

Your business’s gross profit is its sales less its cost of sales – and the gross margin is its gross profit divided by its sales.

Alice’s business made sales of £60,000 in the year to 5 April 2011, gross profit of £50,000, and final profit of £40,000. Margins are always given as a percentage so Alice’s business’s gross margin for that year was 83.3 per cent, and final profit margin was 66.7 per cent.

What information does the margin give you?

Like any other profit and loss measure, it’s most useful when you compare it to your margin for previous years.

Alice looks at her profit and loss account for the years to 5 April 2011 and 5 April 2010, and works out her margin.

It’s been going down steadily for the last couple of years, so this means that for every pound of sales Alice makes, she’s earning less profit, so getting to keep less of what she’s earned.

That’s not good news. Alice investigates further.

She realises that, while her suppliers have put up their prices, she hasn’t, because she doesn’t want to upset her customers, some of whom are her friends (see Profit: Clue 1).

Also, one of Alice’s larger suppliers has registered for VAT, and because Alice isn’t registered, that’s effectively a price increase as far as she’s concerned.

Alice needs to consider either registering for VAT herself, or changing her supplier to a non-registered business.

She also needs, again, to consider putting up her prices.

Profit: Clue 4: Save up to pay your tax
Looking at your profit and loss account shows you how much profit your business has made, which can help you work out how much tax you’ll have to pay.

If you’re a sole trader or in partnership, you can then start putting money aside for your tax payment on 31 January 2012, and possibly also 31 July 2012.

It’s never too early to do this – you don’t want to be saving for your tax bill at the same time as saving for Christmas!

Cashflow: Clue 5: Does your business own enough to pay its debts?
Alice looks at her balance sheet as at 5 April 2011.

She sees that its total figure is positive. This is a good sign, as it means she should have enough to pay what her business owes.

But, as a sole trader, she needs to remember that the tax on her business’s profit doesn’t show up as something her business owes – because that’s something she has to pay as an individual. She needs to keep enough cash for her tax.

She also sees that, although her balance sheet total is positive, that is in a large measure because she has an expensive iMac. Her business’s current assets – cash at the bank, and money her customers owe her – are actually lower than its current liabilities: debts due in the short term such as money she owes to her suppliers.

That means that, if all Alice’s suppliers suddenly asked her to pay everything she owed them, and the bank asked her to repay her business overdraft, she would have to sell her computer in order to do that, effectively putting herself out of business.

That’s not good news – and is yet another reason why Alice needs to put up her prices, so that her customers will pay her enough to cover her dues.

What if putting up my prices loses me customers?
Many business owners have that worry and consistently undercharge.

But when they come to put their prices up, they actually lose very few customers. You need to judge how price sensitive your market is and what the market rate for the service you are providing is.

Are you like Alice? Do you need to put your prices up to help your business succeed? Check your accounts for tell-tale clues.