Content

Accounting 101 for Entrepreneurs: Your balance sheet and P&L explained

The basics of a balance sheet and P&L explained

by Forma on

November 21, 2019

Select one of our reliable packages right away

Our Packages

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.

What is a balance sheet?

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:

  • Assets: These are resources that you own and can be sold. Examples include cash, vehicles, inventory and equipment. 
  • Liabilities: These are your business’ legal debts or financial obligations. Examples include loans, accounts payable and salaries payable. 
  • Owners’ (or shareholders’) equity: This refers to the owner’s share of the assets of a company. It includes the share capital (the amount that a company’s owners or shareholders invest in the business) and retained earnings (funds that are retained in the company’s accounts).

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.


Balance Sheet
Balance Sheet

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.

Why is a balance sheet important?

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. 

Balance sheet templates:

example of a profit and loss statement

What is a profit and loss account?

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:

  • Sales or revenue: The amount that your company earns through the sale of goods or services.
  • Cost of goods sold (COGS): The total amount of all costs involved in selling a product during a specified period of time. 
  • Gross profit: Also known as the gross margin, the gross profit refers to a business’ profit before the operating expenses, taxes and interest payments are taken into account. It is calculated by deducting the COGS from the total sales or revenue. 
  • Operating expenses: This refers to expenditures that a company incurs in performing business operations that aren’t directly related to the productions of goods or services. Some examples include salaries, utility payments, administrative expenses and rent.
  • Net profit or loss: The net profit or loss is obtained by deducting total expenses from gross profit.  

Why is the profit and loss account important?

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.

P&L templates:

Content


Know these key dates


Late filing and payment penalties

Here are some examples of taxable benefits in kind:

  • Company vehicles
  • Private health insurance
  • Non-business travel expenses
  • Non-business entertainment expenses
  • Loans

Other types of benefits in kind aren’t taxable. These include: 

  • Staff meals provided at a canteen
  • Certain types of childcare arrangements
  • Payments to a pension
  • Workplace sports facilities
  • Workplace safety equipment
  • Certain types of transportation expenses, such as subsidies for public bus services

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.

what are benefits in kind

How to file and pay


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:

  • Being timely with your bill payments
  • Keeping your credit utilisation low
  • Monitoring your credit reports regularly, and reporting any mistakes immediately
  • Avoiding unnecessary credit applications (these can trigger a credit check, which can affect your credit score) 

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.”

Additional points to note

1. Dividends can’t be paid out if a company is losing money

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. 

2. Paying a dividend doesn’t reduce your company’s corporation tax bill

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.

3. Creating different classes of shares can be an option worth exploring

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. 

4. Timing is key 

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: 

  • It can have an impact on the amount of tax you pay: Dividends can be a way for you to balance out your profits from one year to another, so you can avoid being put into a higher tax bracket. If your profits are £55,000 in the first year and £10,000 in the second year, you can declare a lower dividend for the first year so that you pay the basic rate for both years—rather than paying the higher rate for the first year.
  • It can have an impact on your HMRC deadlines: Income tax on dividends are due in January after the tax year (running 6th April - 5th April) in which the dividend was distributed. This means that tax on a dividend received in February 2019 will be due in January 2020. If the dividend was paid out on May 2019, the tax will be due in January 2021. 

5. Your personal pension can be affected

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. 

Get started with Forma today

Call Us

If you liked this article you'll also like...

Enjoy more from our series