Your balance sheet and profit and loss account explained

You may have heard your accountant or lender talk about your “balance sheet” and “profit and loss account”. What do these terms mean, and what information can these documents provide you about your company?

Emily Coltman FCA, Chief Accountant at FreeAgent – which provides online accounting software for small businesses and freelancers – explains.

Balance sheet

The balance sheet gives you a snapshot of how much your business owns (its assets) and how much it owes (its liabilities) at a given point in time. That might be today, or it might be at the end of your business’s accounting year.

The top half of the balance sheet starts with the business’s assets. These are divided into fixed assets, such as large items of equipment such as computers and furniture, and current assets.

Current assets are more easily and quickly converted into cold, hard cash, like money owed by customers and money in the bank.

The balance sheet then shows the business’s liabilities, which are divided into current liabilities, money due within a year, like tax bills, and money owed to staff. Long-term liabilities are those due in more than a year, like a mortgage or a bank loan.

There will then be a total of all the business’s assets minus its liabilities.

The difference between the company’s assets and liabilities represents its net assets, which form part of shareholders’ funds on the balance sheet.

The bottom half of the balance sheet may therefore be headed something like “Owners’ Equity”, “Owners’ Capital”, or “Shareholders’ Funds”.

The figures ultimately reflect the basic accounting equation: assets equal liabilities plus equity.

Here is an example of a typical balance sheet for a small limited company:

What does your balance sheet tell you?

If your business owns more than it owes, its net assets will be positive. If it owes more than it owns, it will have negative net assets. Negative net assets can be a warning sign, but they don’t necessarily mean the company is unable to pay its debts as they fall due. Its cash flow and ability to meet liabilities as they come due also matter.

Using your balance sheet to check liquidity

In addition to this quick check, you can use your balance sheet to calculate useful ratios.

For example, if you divide the current assets figure by the current liabilities, you’ll get the company’s current ratio. This indicates whether the business has sufficient current assets to cover its current liabilities.

A figure below 1 means current liabilities exceed current assets, though whether this is a problem depends on the company’s circumstances and cash flow.

If your business sells goods, you can also calculate the ratio using current assets, excluding stock. This is known as the quick ratio or acid-test ratio.

It gives you a stricter measure of short-term liquidity because it doesn’t assume that stock can be sold quickly to meet the company’s debts.

Profit and loss account

This is often called the P&L for short, and it shows your business’s income, less its costs, over a given period of time – often a year, month, or quarter.

The day-to-day running costs divide into direct costs, which relate directly to sales, and overheads, which are general running costs.

For example, the cost of purchasing materials to make goods for sale and the cost of delivering finished goods to customers would be direct costs.

Renting an office would be an overhead. If your business sells services, it may incur no direct costs.

Your business’s income from sales is called turnover.

Turnover minus direct costs gives a figure called gross profit. After the company’s other costs are accounted for, the P&L shows the profit or loss for the period.

Here is an example of a typical P&L account for a small limited company:

What do your profit margins tell you?

You can work out your business’s gross profit margin by dividing the gross profit by turnover, and the net profit margin by dividing its net profit by its turnover. This shows you how much profit your business makes for every pound of sales.

These calculations are most valuable when you compare the margin for one period to another.

For example, if your margin has gone up from one year to the next, that means you’re keeping more of your income from sales than before, perhaps because you’ve raised your prices or are saving money on a cost.

If, on the other hand, your margin fell from one year to the next, you’re not keeping as much of your income from sales as before, and you may need to take action to remedy that.

Tracking these margins over time can help you spot changes in your company’s profitability.

As you can see, the balance sheet and P&L aren’t just for your accountant!

You can use them to collate a lot of useful information about your business’s financial health and to help you make essential business decisions.

Further Information

Emily Coltman FCA is Chief Accountant to FreeAgent, which provides online accounting software for small businesses and freelancers. Try it for free at here.