The basics of a balance sheet and P&L explained
For small business owners and freelancers who have just started out, staying on top of your business finances and documents can be daunting. Here’s where our article comes in, so you can quickly get a grip on the basics.
A balance sheet provides a snapshot of the financial condition of a company, showing how much it owns (assets), owes (liabilities) and the amount that is left over for its owners (owners’ equity) at a specific point in time.
The balance sheet is typically completed at the end of a month or a financial year. It is comprised of three main elements:
The balance sheet is divided into two sections: the left side shows the assets of the company, while the right side shows the liabilities and shareholders’ equity.
Assets are listed in order of liquidity. For example, cash or inventory are listed above less liquid assets like property or equipment.
Liabilities are listed in order of maturity; current liabilities, which will come due within a year are listed above long-term liabilities. The latter refers to liabilities that will remain outstanding for longer than one year.
The total sum of all assets, less a business’ total liabilities is equivalent to the owners’ equity. This represents the amount that would be available for a business owner to draw out.
The balance sheet lets a business owner and investors see what the company owns and owes, and to understand its net worth. It also indicates the financial health of a business.
For example, a balance sheet that shows a negative balance in owners’ equity indicates that liabilities exceed assets. This can be a warning sign that the company is in a bad financial situation, and should prompt business owners to dive deeper, and uncover the causes for the negative balance.
A balance sheet can also be used to calculate important financial ratios. One example would be the working capital ratio, which is obtained by dividing the current assets by current liabilities. This ratio measures a business’ efficiency, and shows how well it is able to meet its short-term obligations.
And for small business owners seeking external financing, the balance sheet —along with financial statements like your cash flow and P&L—are required documents when you apply for a bank loan.
The profit and loss account (P&L) is a financial report that shows the revenue, expenses and profit or loss of your company over a specific accounting period.
This period can be a month, a quarter or a year. A P&L is also commonly referred to by other terms, such as the income statement, statement of operations, financial results statement and earnings statement.
A P&L is comprised of the following key elements:
The P&L is a key financial statement in a business plan, as it quickly shows how much money your business has made or lost.
What’s important is to compare your P&L across different accounting periods. In doing so, you’ll be able to identify business cycles and trends—such as the peak and trough periods that occur across the year, or aspects of your business that generate the most profit or costs.
You may also identify changes that are not immediately apparent, such as periods where your expenses are growing at a faster rate compared to your revenue. With these insights, you’ll be better-positioned to make improved business and financial decisions.
And lastly, information from your P&L can also be used to calculate metrics that are important indicators of your company’s financial health. These include the operating ratio, gross profit margin and net profit margin.
Here are some examples of taxable benefits in kind:
Other types of benefits in kind aren’t taxable. These include:
You can check out HMRC’s resource for further information on the different types of expenses and benefits, plus the associated tax treatment.
The rules surrounding each type of benefit can be complicated. Depending on the context, HMRC may decide to impose a tax charge. As such, we recommend speaking to an accountant about your situation if you need specific advice.
Speak to a mortgage broker
Each lender will have their own lending criteria; some are willing to take into account your retained profits, while others will accept applicants with less than one or two years of self-employment history. A mortgage broker can save you time by pointing you in the right direction, so you know right away which lenders are a good fit with your needs.
Think twice about switching your business structure prior to your application
Moving between two types of self-employment income just before you apply for a mortgage can complicate matters, and reduce your chances of securing a loan.
If you’re thinking about going from being a sole trader to a limited company director, it’s best to delay your application until you have one year’s worth of books. If you apply before that, you may be offered a smaller mortgage, or have to choose from a limited selection of lenders.
Ensure that your credit history is in good shape
Having a pristine credit history will boost your chances of securing a mortgage and getting access to favourable rates. Your lender may check both your personal and business credit history, so it’s best that you keep a close eye on your credit reports regularly. At a minimum, you should be checking your credit reports once every year.
If your credit score isn’t yet where you want it to be, there are steps you can take to improve it before your mortgage application. These include:
Keep tax deductions to a minimum
Nikki Merkerson, Community Reinvestment and Community Partnership Officer at JPMorgan Chase advises that self-employed workers should “write off fewer expenses for at least two years before applying for a mortgage”.
Lenders look at your net business income—so individuals who deduct a lot of expenses show an income that appears much lower than it actually is. This works against you when you apply for a mortgage, as you “need to show more money to afford more house”, states Merkerson.
Obtain an agreement in principle
Having an agreement in principle can help speed up your home-buying process. It’s an indicator that your credit is in good shape, and conveys to your seller and estate agent that you’re a serious buyer.
Understand your finances
Make sure you understand your business finances, and are able to provide further details when asked to by your lender.
If you’ve experienced a dip in your income or cash flow, make sure you’re able to explain these fluctuations—such as why and how it happened, and what are the measures you’ll implement should you experience cash flow issues or a fall in income in the future.
Showing that you have a plausible reason, and that you’re well-prepared to deal with similar circumstances down the road will increase your chances of securing a mortgage.
Keep up-to-date records and accounts
Don’t underestimate the importance of keeping good records. Dominik Lipnicki, director of brokerage Your Mortgage Decisions explains that it can make all the difference, as even applicants with stable earnings and a good credit history are rejected due to poor records.
“It really pays to have up-to-date accounts prepared by a qualified accountant,” he adds. “If you scrape through with the bare minimum of paperwork, your options will be very limited and you’ll probably end up paying a higher rate.”
Dividends can only be paid on profits that a company has earned during the year, or from accumulated profits from previous years. On the other hand, salaries can be paid out even when a company has made a loss.
Companies pay Corporation Tax on its profits before dividends are distributed, so paying a dividend doesn’t affect your company’s corporation tax bill. On the other hand, salaries are considered as business expenses. These reduce your profit, and subsequently your Corporation Tax.
Does your company have working and non-working partners? Creating different classes of shares may be an option you might want to explore, so that both types of partners don’t wind up receiving the same dividend rate.
In general, companies distribute dividends every quarter or half year. There aren’t any hard and fast rules when it comes to how often dividends are paid out—and this is something your need to consider carefully. That’s because:
Receiving income as dividends (rather than a salary) can help reduce your tax load. Yet, it’s important to keep in mind that your personal pension will be affected, as getting a salary increases contributions that can be paid into your personal pension.
We recommend checking in with your accountant about minimum salary requirements that may be imposed if you want to make contributions to a personal or executive pension plan. You may also want to discuss whether setting up a company pension scheme is an option you should consider.