Are managers frightened of finance? Martin Addison, CEO of training content specialist Video Arts, sheds light on the three crucial financial statements
Many managers understand a great deal about management but precious little about the meaning and purpose of financial statements. They don’t like to admit this, in case they lose face. Some even have a gentleman’s agreement not to discuss the subject. They’re happy to leave the financial arrangements to the accountants, just as they’d leave the cleaning arrangements to the cleaners.
However, if you understand the essentials of finance, you can gain a greater insight into your business and you might feel less embarrassed about discussing financial issues with your accounting colleagues.
Three documents are worthy of your attention: the profit and loss and account (which tells you what happened to your money in the past), the balance sheet (which tells you where your money is now) and the cash flow forecast (which shows you where your money will be coming from in the future).
But let’s start with money. In business, money only does two things: it comes in and it goes out. So all you need to understand is where did it come in from? And where does it go out to?
If you’re starting a business, there are only two places where money can come from. You can risk your own or perhaps get other people to share the risk with you. That money is called Share Capital. The shareholders are the owners of the business and they share all of the profits … or lose all of their money. The second way to get money is to borrow it from someone else and pay interest. That’s called Loan Capital. So Share Capital and Loan Capital are the two places that money can come from.
In the same way, there are only two places that money can go out to. You can put it into things you want to keep: buildings, machinery, furniture etc. All of these are called Fixed Assets. Or you can put it into things you want to sell: raw materials, piece parts, packaging materials etc. That money is called Working Capital.
That’s the basis of every business. These items are listed on a balance sheet. A balance sheet is a window which reveals a snapshot of the business frozen in a single moment in time. It gives a value for the current assets and current liabilities of the business. Your assets include raw materials, which may be in the middle of being processed at that moment. They’re just as much of an asset as cash but they’re in a different form.
Your current liabilities are the bills you haven’t paid yet, so that is the money you owe your creditors.
Fixed assets, the things you need to keep, cannot make money on their own. To make money, you need working capital. You need it to buy raw materials and you need it to pay the workforce to turn those raw materials into something you can sell at a profit. You need it to pay the overheads (administrative staff, electricity, rates, insurance, postage, telephone etc), not to mention the interest on the money you borrowed. Then you can start to make money.
Overheads don’t multiply like materials and labour. So the more consignments you produce each week, the more profit you make on each consignment (because the overhead gets divided up into smaller portions).
Profit and loss account
I said earlier that there are only two places that money can come from when a business is starting up (your own money and money you’ve borrowed). However, once the business makes a profit, there’s a third place that money can come from: the profit you put back into the business. It’s called Reserves. ‘Reserves’ is an entry in the ‘In’ column in a profit and loss account. It merely refers to money that’s been retained in the business.
Cash flow forecast
A cash flow forecast is like a financial crystal ball. It helps you calculate your weekly costs and how much money you’ll receive each week. This can help you to make decisions about when you’ll pay bills and buy raw materials.
If your customers don’t pay you on time, you might experience a cash deficit. You could either negotiate new payments or borrow some more working capital.
So, in business, money goes into fixed assets (things you mean to keep), working capital (things you mean to sell) and investments (savings for a rainy day). Working capital starts with raw materials, it then goes into labour to produce the goods and it goes into overheads to pay the bills. Then, when the goods are sold, you make a profit. Some of the profit goes in tax, some goes into dividends, the rest goes to making the business grow.
That’s it. Finance doesn’t have to be all mumbo jumbo. You simply need to understand that your profit and loss account tells you what’s happened to your money in the past; your balance sheet tells you where your money is now and your cash flow forecast tells you where it will be coming from in the future.
Martin Addison is CEO of Video Arts, the learning content specialist. He can be contacted on 020 7400 4800 or via email@example.com