What is Profit?

Most owners of small businesses are not accountants, and, they do not need to be as it is more cost effective for them to employ a professional whilst they concentrate on what they are most skilled at – their every day work.

The accountant will, if required, carry out the entire accounting function – producing the maintaining the cash book, producing VAT and tax returns and producing management accounting figures, as well as producing the annual financial statements (the Trading, Profit and Loss Account and the Balance Sheet). Obviously it is cheaper for the business if they carry out the basic day to day book keeping themselves.

All too often the reader of the statement can be easily mistaken into thinking that if the figure at the end of the accounts is positive (a profit), it is “money in the bank”. This is not necessarily the case. It is possible to show a profit in a set of accounts whilst the amount of money in the bank has declined during the accounting period in question. Therefore, although, as I have said it is not necessary for the business owner to undertake these functions for themselves, it IS essential that the owner understands the information that is within these statements.

What are the main statements that the small business owner will encounter? They are the Profit and Loss Account and the Balance Sheet.

As an effective manager one must be able to utilize the information that these documents contain.

The balance sheet is essentially a snapshot of a business at a precise moment in time, showing the business’ actual value at that time. It lists the total value of the business’ assets against the total value of the business’ liabilities. To the business owner the most important part of the balance sheet is the figure at the bottom which shows the net assets of the business… or, to the business owner, the value of the business if it is sold at that moment in time – essentially this is the amount of cash that would belong to the owners of the business if all of the business’ liabilities were cleared. If the total liabilities exceeds the total value of the assets the business clearly owes more money than the whole business is worth if it were to be sold. At this time the business is insolvent and should not be trading.

When the Profit and Loss Account is considered, a business owner will easily recognise that if the expenditure of a business exceeds the income, then that business has made a loss, and visa versa. But, remember that this is not the actual amount of cash received by the business – this figure will be based on the value of sales and purchases made and will not take account of any monies owed either to the business or by the business (by debtors and to creditors). To get a true picture of the monies that the business has in the bank then the business owner must look at the cash flow (which we discussed a couple of issues ago).

Neither the Profit and Loss account or the Balance sheet are highly detailed documents. However, it is possible to extract useful information from them which will help the business owner to determine how well the business really is doing. For example, we can extract sufficient information from them to allow us to compare the performance of the monies invested in the business against investing the same amount of monies elsewhere, for example, in the bank. This is called the Return on capital employed and is calculated as follows:-

(Profit before tax and interest / Capital Employed)x 100 = Return on Capital Employed

This is a useful and quick way of determining the effectiveness of an investment in a business.

Useful definitions

Assets – The elements of the business which are owned by the business and worth money. For example Land, machinery, cash in the bank, debtors and goodwill.

Liabilities – What the business owes. For example mortgages, loans, and creditors.

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