1. Understand the jargon

1.1. Use a profit and loss statement to monitor your trading performance.

A profit and loss statement (P&L) provides a picture of the company's trading performance over the past accounting period (usually a year).

The profit and loss statement records sales, costs, expenses and any provisions you make for tax in the period, even if you have not yet paid it. This provides you with your profit (or loss) figure.

To find out how to create a profit and loss statement, see section 2.

1.2. 1.2 Use a balance sheet to assess your business's strength at the end of a trading period.

The balance sheet summarises assets (what you own) and liabilities (what you owe). Put simply, it tells you how much your business is worth in financial terms.

This differs from the profit and loss statement in that it takes into consideration your business assets (eg stock, premises and equipment).

To find out how to create a balance sheet, see section 3.

1.3. Control your cashflow to keep trading.

Cashflow is your pattern of income coming in and out and the remaining availability of cash. Cashflow is the short-term priority for every business. If you run out of cash (and cannot raise additional finance), the company will be insolvent and will have to cease trading.

A cashflow statement shows what has happened to your cash over the accounting period (how much has come in and out, and when).

The cashflow statement differs from the profit and loss statement because it shows the timing of payments and receipts, and how much money you had available at given points.

To find out how to build a cashflow statement, see section 4.

1.4. Manage depreciation to even out the cost of buying assets.

Depreciation is an accountancy tool used to match the cost of your business assets with the period of time that you use them. For example, a £30,000 computer system that lasts for three years could be said to cost you £10,000 per year, rather than simply £30,000 when you pay for it.

Using depreciation gives you a fairer profit and loss statement because your expenditure is more evenly matched with the long-term benefits of buying the asset.

The value of the asset is transferred to the balance sheet. Using depreciation means that its value is reduced the longer you hold it.

To find out more about depreciation, see section 5.

1.5. Calculate and use margins to benchmark your profitability

Profit margins provide a benchmark against which you can judge how profitable your business or your individual products and services are.

Profit margins can be calculated from your profit and loss statement.

As a percentage of turnover, the gross profit margin is your profit before your overheads are taken in account. For example, if you sell goods worth £200,000 and the goods cost you £60,000, you have a gross profit of £140,000 and a gross profit margin of 70 per cent.

The operating profit margin compares profit (after taking account of costs such as premises and salaries) to turnover. For example, with turnover of £200,000 and operating profit of £30,000, the operating profit margin would be 15 per cent.

To find out more about using margins to monitor your business finances, see section 6.

1.6. Set and work with budgets

A budget is simply a plan forecasting what you are going to sell, when you are going to sell it, how much you expect to get paid for it and how much this is all going to cost you.

Budgets set financial targets and determine your financing requirements. An effective budget will use (and control) elements of your cashflow statement, profit and loss statement, balance sheet, depreciation and margins, to help you predict and control your business finances.

Detailed budgets (eg sales and costs broken down for each product) allow you to see where your profits and cashflow are coming from and assess your margins.

Your cashflow budget enables you to anticipate any financing requirements.

To find out more about setting and managing budgets, see section 7.

2. Create a profit and loss statement

2.1. Record all sales and purchases when the sale or purchase is invoiced.

The costs of fixed assets (e.g. vehicles or equipment) are spread over their useful working lives. Rather than charging the full cost when the asset is purchased, an annual 'depreciation' charge is made instead. For more details on depreciation, see section 5.

If you are VAT-registered, do not count the value of VAT charged when creating your profit and loss statement.

2.2. Remember to match prepayments and accruals to the period they relate to.

For example, if you have paid three months' rent in advance, attribute a third to each of the months the payment covers. If you know you have to pay interest in the future, account for it when you expect to pay it.

• Transactions that do not directly affect profits are not included. For example, financing activities (eg taking out a loan) are not included, but interest payments and bank charges are.

2.3. Split your costs into direct and indirect categories.

Direct costs (eg raw materials) usually rise in line with the volume of sales.

Indirect costs (also called overheads) include rent, rates, salaries and the depreciation you apply to your assets. You will probably also have to include non-operating income and costs (eg the proceeds from selling an asset and interest payable on bank loans).

2.4. Format your totals into a statement.

You should have three totals:

Work out your gross profit by subtracting your direct costs from your turnover.

Work out your operating profit by subtracting your direct and indirect costs from your turnover.

You will be taxed on your operating profit. Work out how much tax you will owe and subtract it from your operating profit. This shows your net profit.

Show your turnover, direct costs, indirect costs, gross profit, operating profit and net profit on your profit and loss statement.

• Turnover (or sales) excluding VAT.
• Direct costs.
• Indirect costs.

2.5. Analyse your profit and loss statement.

Ask questions to get a clear understanding of what the profit and loss statement is telling you about your business's financial health.

Remember that any choices you make will probably also affect the balance sheet (see section 3).

• Use your judgement to refine areas of the profit and loss statement. For example, how much of the income from a long-term contract (eg five years) should be included in that year's profit? What adjustments should you make for customers unlikely to pay? How quickly should you depreciate fixed assets?

3. Produce a balance sheet

3.1. Summarise your assets and liabilities.

Fixed assets include such things as plant and machinery.

Current assets (short-term assets) include stock and work in progress, debtors (customers who owe you money) and cash.

Current liabilities are amounts you owe that are due for payment within one year.

Long-term liabilities (creditors due after more than one year) can include bank and directors' loans.

Shareholders funds include share capital (amounts paid into the company for shares) and reserves (including retained profit).

• Show fixed assets at their depreciated values. These include intangible assets, such as licences and intellectual property rights.
• For example, trade creditors (suppliers you owe money to), bank overdraft and hire purchase payments.

3.2. Work out the capital employed.

The total financial value of the business is called capital employed.

Find the figure for capital employed by adding the value of your fixed assets to current assets, then subtract current liabilities.

• Capital employed includes long-term financing (eg bank loans) plus shareholders funds.

3.3. Remember that the balance sheet will reflect an element of judgement rather than cold fact.

For example:

These choices made will also affect the profit and loss statement (see section 1.2).

• How quickly to depreciate fixed assets.
• How to value intangible assets (eg licences, where a value could be attributed but its validity would depend on the state of the market when the licence was sold).
• How to value stock and work in progress.
• What adjustments to make for customers who are unlikely to pay.

3.4. Use the balance sheet.

Alongside information about the firm's cashflow, profitability and budget, the balance sheet can also be useful when making management decisions. For example, whether it would be beneficial to make a long-term investment in plant, or if it might be more suitable to sell some assets to provide a cashflow boost.

If your business is a limited company, the profit and loss account and balance sheet form part of your statutory accounts for Companies House.

4. Control cashflow

4.1. Use a cashflow statement to show what has happened to your cash position over the accounting period.

'Cash' includes money in the bank, overdrafts, short-term loans, foreign currency, and coins and notes.

The cashflow statement differs from the profit and loss statement because it shows the timing of payments and receipts

4.2. Create your cashflow statement by adjusting your profit and loss statement for non-cash items.

Typically, non-cash items include:

• Depreciation
• Changes in debtors and creditors. For example, if the amount you are owed for sales has increased, your cash position will be reduced (all other things being equal)
• Financing activities (eg new loans).

4.3. Analyse what the cashflow statement tells you.

The cashflow statement can look complicated, but it carries a simple message. It tells you whether your business is generating cash or using it up.

A mature, profitable business will usually be 'cash generative' (consistently bringing in more cash that it is spending).

A younger, growing business might be using up cash even if it is profitable. The business might need to raise additional financing to keep growing.

5. Manage depreciation

5.1. Use depreciation to get a more realistic picture of your profitability.

Depreciation simply spreads the cost of fixed assets over their working life. For example, a £30,000 computer system that lasts for three years could be said to cost you £10,000 per year. Without depreciation, you would have to:

• Charge the full £30,000 against profits in the year you purchase the system. This would give unrealistically low profits for that year.
• Charge nothing against profits for the remainder of the computer system's life. This would give unrealistically high profits for these later years.

5.2. Get advice from your accountant.

Your accountant will give you guidance on what depreciation rates to use. The key decision is how quickly to depreciate an asset. For example, you might choose to charge:

• 33 per cent of the cost of a computer system against profits over three years.
• Two per cent of the balance sheet value of a building you own against profits each year.

5.3. Remember, depreciation might occasionally lead to unrealistic profits or losses and an unrealistic balance sheet.

For example, if an asset becomes obsolete before you expected it to, it will lead to an additional charge on profits.

Your accountant can make one-off adjustments to correct this.

6. Measure your profitability

6.1. Calculate your margins using your profit and loss statement.

The gross profit margin is gross profit as a percentage of turnover. For example, if your turnover is £200,000 with a cost of sales of £60,000, you have a gross profit of £140,000 and a gross profit margin of 70 per cent.

The operating (or net) profit margin compares operating profit (ie after taking account of indirect cost) to turnover. For example, with turnover of £200,000 and operating profit of £30,000, the operating profit margin would be 15 per cent.

6.2. Compare profit margins to get a clearer picture of your performance.

Compare profit margins to other companies to highlight where you are doing well and where you should improve.

Compare profit margins to previous periods to see where your selling prices are coming under pressure, or where your costs are increasing.

Compare profit margins on individual product lines to see which products are the most profitable. Although the formal profit and loss statement will not give this level of detail, your internal management accounts should.

6.3. Use your analysis to refine your sales and marketing efforts.

Profit margins tell you how much room for manoeuvre you have on pricing and what sales you need to break even.

As long as you have a positive gross margin, each sale will make some contribution to covering your overheads.

Dividing your total overheads by your gross margin shows what sales you need in order to break even. For example, with overheads of £50,000 and a gross margin of 25 per cent, you will reach breakeven with turnover of £200,000 (ie £50,000/25 x 100).

6.4. Compare your profits to your assets.

If you decrease your margins (eg by reducing prices), you will need to increase sales to maintain the same profits.

This can provide another measure of profitability.

Return on capital employed is your net profit before tax as a percentage of capital employed. This shows what return you are making on the money financing the business (both as loans and shares).

Return on equity is profit before tax (but after interest has been deducted) as a percentage of shareholders' or owners' funds.

These percentages can be compared with the same figures for other companies as an indication of how effectively your business is using the money invested in it.

6.5. Consider the best profitability benchmarks for your type of business.

For example, a business that depends heavily on its employees (eg an IT consultancy) might focus on profitability per employee. A retail business might focus on profits per square foot of shop space.

6.6. Use your accounts to refine your financial position.

Areas which businesses focus on include:

As with the measures of profitability, comparing key ratios to other businesses, and against the same figures for previous periods, helps to highlight areas where you need to take action.

• Growth. For example, comparing sales from one period to the next.
• Financial strength. For example, looking 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 (ie current assets less current liabilities). For example, how much money you have tied up as stock, how efficient you are at collecting debts, and how quickly you pay suppliers.

7. Set and work with budgets

7.1. Prepare budgets to set financial targets and determine financing requirements.

Annual financial statements are not enough to control your business. You also need to forecast what will happen, and to have up-to-date information on recent performance.

You must produce a cashflow forecast. It is good practice to produce profit and balance sheet forecasts as well.

Detailed budgets (eg sales and costs broken down for each product) allow you to see where your profits and cashflow are coming from.

Your cashflow budget enables you to anticipate any financing requirements.

7.2. Create realistic budgets.

If you have been trading for some time, your previous year's figures provide a guide. But forecasts must also take into account changes (eg new competition).

Forecast monthly (or weekly) figures that take account of seasonal variations.

Include timing effects (eg if customers pay 60 days after purchasing).

Calculate a range of forecasts and the probability of achieving them.

Computers can make budgeting and investigating 'what-if' scenarios easier. For example, what the effect will be if your sales are ten per cent lower than forecast.

7.3. Compare actual performance against budgets to identify problems and opportunities.

Record actual outcomes and compare them to budgeted figures. It is easier to see how significant the variances (ie differences) are if they are expressed as percentages.

Identify the cause of the variance. This could be a different volume (eg sales of 1,100 against 1,000 budgeted), a different price or a combination of both.

Update budgets regularly to take account of actual performance.

7.4. Be aware of real-world problems.

Imposing a budget (eg demanding cost cuts of ten per cent) often fails. Managers and employees are more likely to meet targets they have agreed.

Budgets can build in assumptions rather than questioning them. For example, always budgeting for a wastage level of two per cent, or sales growth of ten per cent, without investigating whether this could be improved.

Aggressively controlling performance against budgets can lead to managers setting comfortable budgets. These represent targets that are easy to meet, so that no one pushes themselves.

Avoid setting over-ambitious and unrealistic budgets.