As a bookkeeper, obviously, numbers are my thing. I love running the reports and seeing how a living and breathing complicated machine of a business can be so well represented on a couple of reports. Two, to be exact. Profit & Loss and Balance Sheet. That’s really all you need, isn’t it? The cashflow projection and the budgets and the nitty-gritty reports are all the underlings of the King (Balance Sheet) and Queen (Profit & Loss) of financial reports.
As a King, the buck stops with you. You’re the final move in the chess game, it’s your head that gets chopped off if you lose a war (maybe not these days, but you know what I mean). A King must rule his subjects with wisdom and equity, and every move he makes will impact the kingdom in a positive or negative way. His actions on the world stage can create allies or enemies wherever he goes.
As a Queen, her main role – being entirely pragmatic about it – is to produce an heir. Beyond that, she stands by her King at all the public events, she privately counsels the king in their personal quarters. Her influence on the King could be subtle, the gentle touch or a look that may soften a harsh punishment on a foolish boy, a different perspective on a matter that requires great diplomacy.
As far as financial reports go, the Profit & Loss is the one that provides insight into the performance of the business over a given period of time. This could be a day, week, month, quarter, or a year. It specifies the relationship between the income, the cost of sales, and the expenses incurred in running that business. The tax office is mainly interested in the Profit & Loss, as your tax bill is based on the actual net profit of that year, usually irrespective of the figures on the Balance Sheet.
The Balance Sheet – as my dad described it to me many years ago when introducing me to accounting – is a snapshot of the overall worth of the business at one specific point in time. When the Balance Sheet and Profit & Loss reports are provided together, the date of the Balance Sheet is the last date of the Profit & Loss period. The Balance Sheet lists the assets of the business, then after subtracting the value of the liabilities, you are left with a figure of net assets. This is then balanced by the identical figure of equity, being a combination of the retained earnings, the owner’s interest, any reserves or other considerations, and then finally the net profit/loss of the current financial year.
The strength of a business is provided through the Balance Sheet. A strong net profit is always good, but if the business has such significant liabilities that it still shows negative net assets, it’s not enough to say a business is viable. How could a business end up with excessive liabilities? Perhaps the owner spent all the profit, or didn’t maintain the tax obligations or other debts incurred. Perhaps the value of the assets are depreciating faster than the loans to purchase those assets are repaid.
Another example would be if a business has insufficient assets to be able to maintain the level of activity required to produce a profit. What would this look like in a real-world situation? Let’s look at the business of a builder. Building a house is a big deal. Lots of money goes into building a house. This builder may be really good at his job, but it could all come unstuck if the balance between the purchasing of materials and the income from the client’s progress payments don’t match up. A builder needs to have sufficient cash or liquid assets to maintain the operation of the business until the payments are received. If you have a big job to do, you really need to have a big bank account to cover yourself, to do the job before you get paid for it. The Profit & Loss report might be showing that in that given period of time, yes, the income was more than the outgoings. But if the expenses were incurred at the beginning of the quarter, and the income not received until the end of that quarter, you can see that without sufficient liquid assets to cover the purchases, the creditors may have already taken steps that would cost the business its ability to trade. With this perspective, you can see how critical it is to maintain a Balance Sheet that is King. Strong, good defences, wise actions that solidify the business’s standing in the marketplace.
Let’s now look at the Profit & Loss report. You could just look at the bottom line – that all-powerful “Net Profit” at the end of the report, but then you would be missing all the magic that happens beforehand. The first thing I do when running a Profit & Loss report for the purpose of analysis is to represent all the figures as a percentage of sales. Keeping it all relative to the level of sales is crucial to understanding the true nature of the beast. Also, one Profit & Loss report is OK, but these reports are best in a progression. You need to be able to compare one period with another. Yes, you made a good profit this month, but is it enough to make up for the 6 months of prior losses? Or, how does it compare to this time last year?
Look at how the figures are distributed between income, cost of sales and expenses or overheads. The cost of sales is what it takes to produce the thing you sell. If you’ve done this correctly, it should be the same percentage of sales in each report, no matter the length of time it covers. The costs will be a predictable percentage of the sales. The expenses or overheads are your fixed costs that are incurred regardless of the level of sales activity, and so the percentage of these overheads in relation to the sales can change from one report to another as the sales rise or fall. This is where your break even point comes into play. There is a simple formula to determine what your break even point is, all you need to know is the percentage of your costs of sales, and the actual figure of fixed costs
In analysing your Profit & Loss, you’re able to see any unusual activity in specific expenses. Have your freight or wages costs spiked? Or is there a drop in an expense that should be more? In looking at the specific expenses from one period to another, you have a direct link to the actual activity going on in the business, and you can highlight with a remarkable degree of accuracy an area that needs attention.
So this is our Queen. She provides valuable support to her King to fine-tune the overall kingdom, adding a different perspective, highlighting things needing attention, and ensuring that a strong heir (net profit) is produced, to ensure the continuing prosperity for all.
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