Many businesses review their financial documents only once a year, typically when their accountant provides them at year-end. By then, the information may be months old, and it’s easy to overlook it. Taking a closer look at these documents can offer insights into the ongoing health of your business.

The Difference Between a Profit and Loss Statement and Balance Sheet

A profit and loss statement winds back to zero at the end of each financial year, recording sales and expenses for a fixed period of time only.

A balance sheet is a cumulative record of what has happened in your business from when you first started. The balance sheet summarizes your assets and liabilities. The difference between the two is what you’re worth.

How to Understand a Balance Sheet

It shows how sound and financially viable your business is, and the structure of debt. Your balance sheet provides a snapshot of your business’s financial strength at the end of a quarter or a full financial year. It summarizes the:

• Assets that you own.
• Liabilities that you owe.

The difference between your assets and liabilities can tell you what your business is worth.

On the assets side of the balance sheet are:

• Fixed assets, such as machinery. These are generally longer-term assets and include intangible assets such as goodwill and intellectual property rights.
• Current assets are short-term assets and includes stock, debtors, and cash.

Liabilities are divided into short and longer-term items:

• Current liabilities are amounts you owe that are due for payment within one year such as suppliers’ bills and overdrafts.
• Long-term liabilities fall due after more than one year, for example, long-term bank loans and leases.
• Shareholder funds include share capital, which are amounts paid into the company for shares, and reserves.

The capital employed in the business will always equal fixed assets, plus current assets, less current liabilities.

Using Your Balance Sheet

Utilize the information and figures in your balance sheet to measure the health of your business. These are called key performance indicators (KPIs).

Examples of KPIs include your:

• Return on capital employed. For example, if you have $2 million in capital, and earn $200,000 a year in profit, this is a 10% return on capital employed. Ideally your return is more than you’d get from a savings account.
• Return on equity. This is profit before tax as a percentage of shareholders’ funds employed in your business. It’s how to tell if the business is generating enough profit to justify the amount of money you’ve invested.
• Financial strength. This looks at how large a proportion of your financing is borrowed, and how well you could cope if business conditions became difficult.
• Control of working capital. This is current assets minus current liabilities to determine if you can pay suppliers if they suddenly all wanted payment.

By regularly monitoring these KPIs, you can gain a clearer picture of your business’s financial health and make more informed decisions to drive growth and sustainability.

Understanding Your Profit and Loss Statement

This shows you how much money you’re making, and the amount of tax you owe. You can see how your business is performing over a specific period.

A typical statement includes the following:

• Sales, which is he total revenue from your business.
• Cost of sales, including direct costs like raw materials or production expenses.
• Gross profit, which is sales minus cost of sales.
• Overheads like rent, utilities, and salaries.
• Operating profit, which is the profit before tax, after deducting overheads.
• The amount of tax owed.
• Net profit, which is he final profit after tax.

This breakdown provides a clear view of how your business is performing financially.

Gross Profit Margin

This is your gross profit as a percentage of turnover. For example, if your turnover is $2 million and your cost of sales is $600,000, you’ve made a gross profit of $1.4 million, a gross margin of 70%.

That means that every $100 of sales generates $70 that goes towards paying for expenses and towards your net profit. If your gross margin percentage starts to fall, it might be because:

• Rising inventory costs.
• Offering discounts.
• Theft by customers or staff.
• Selling an increased proportion of products that have lower margins.

Monitoring your gross profit margin closely allows you to identify any potential issues early and take corrective actions to maintain profitability.

Net Profit Margin

This compares your net profit, which is gross profit less fixed or indirect costs, to turnover. For a business with a turnover of $2 million and a net profit of $300,000, the net profit margin would be 15% ($300,000 ÷ $2,000,000).

If your net profit margin falls, it could mean you’re paying proportionately more in expenses than you should be.

If your turnover increases from $2 million to $3 million but your net profit only goes up from $300,000 to $350,000, this can look good until you see your net profit percentage:

• $350,000 ÷ $3,000,000 = 11.6%.

That means your net profit margin has actually dropped from 15% to 11.6%. Your profit has increased by $50,000, but you’re not making as much profit as a ratio from that increased turnover. This could be fine, and you may have reasons this occurred. The key is to be aware of it.

Next Steps

• Determine which KPIs are important to your business and how to use the information in your financial documents to monitor them.
• Use accounting software to generate more frequent profit and loss accounts, such as monthly or quarterly statements.
• Ask your accountant or business adviser to help you understand how to get the information you need from your balance sheet and profit and loss statement.
• Use your gross profit and net profit margins as benchmarks to set improvement goals.

Take time to understand your financial statements. Inside each you will find trends that can indicate if your business is financially sound and structurally secure. If not, you should have time to make changes.

Diamond’s Business Services division is here to help. If you’re looking for business guidance, or for ways to grow your business, you can contact them here.