THE BALANCE SHEET
WHY DON'T I UNDERSTAND ACCOUNTS
LIQUIDITY AND PROFITABILITY
When you are running a business you are probably much too busy on day to day entrepreneurial duties to monitor the health of your business regularly
The " commonsense method " used by most business people is to use the bank statement balance as the barometer of the business . To their way of thinking if there is a healthy balance the business must be profitable. If there is no money in the bank there cannot be any profit. Unfortunately bank statements can only monitor liquidity,they cannot monitor profitablity
The reason for a healthy bank balance is more due to money management rather than profit creation or the lack of it. A healthy balance can exist if suppliers are not paid . We have come across clients in practice who keep within the terms of their overdraft, which is impressive until the desk drawer is opened to reveal cheques drawn to all suppliers dated weeks before and not issued until the creditor telephones pressing for payment. Suppose a proper set of accounts shows that profit is £40,000 and the proprietor drew out £40,000 The bank statement shows a misleading Nil Balance . Tax is payable on £40,000 even though there is no money in the bank as income tax is levied on book profit and not as some people believe cash profit.( The cause of this misunderstand may be the different legal rules in the collection of Vat which allows Vat to be calculated on bankings less payments)
Income Tax is regulated by legally separate and distinct rules and which have no rational link with VAT law.
Only the other day a new client informed us that his 1st year of trading had been difficult so he did not expect to pay any tax. In discussion he mentioned that he had bought a van for £5000 cash at the car auctions and had lived on £400 a week which he had drawn from his bank account.He was quite taken aback when he was informed that he must have made £25,800 profit to have financed that level of spending without any financial assistance from a lender.
If you have the right professional accountants no doubt they have informed you already how to be aware of the difference between liquidity and profitability .
In the 1930 's Ivar Kreugar the Match King who owned a large number of Swedish match companies operated creative accounting schemes . One of them was to create a healthy bank balance at Balance Sheet date by giving his cashier a cheque from another subsidiary company and this amount would be included as a banking on that day as it was entered into the closing days cash book even though it was unpresented at close of business on Balance sheet date.
The next day Kreugar took it back as it would have bounced if it had been presented . Meanwhile the healthy balance remained in the Balance Sheet until the problem surfaced again 365 days later
HOW CAN I UNDERSTAND A YEAR'S PERFOMANCE ?
Unless you are a career financial officer or a journalist Balance Sheets may bore you silly. An inspection of 2 years balance sheet figures ( the annual statements with comparatives) usually fuse the mind on what is perceived as "information overload." Raw data which the mind cannot readily absorb hits you as soon as your eyes alight on the page.
Take the accounts of Complex Ltd below. What does it tell you -probably very little The best you can see at a glance is what has gone up and what has gone down. It is fairly meaningless if viewed as a list of separate items
COMPLEX LTD
Balance Sheet as at 31st December 2008 and 2009
| Description | 2008 | 2009 |
|---|---|---|
| Fixed assets | 60,234 | 70,725 |
| Stock in trade | 20,223 | 40,224 |
| Trade Debtors | 88,433 | 153,209 |
| Directors' Loans | _ | 50123 |
| Prepayments | 1,000 | 1,000 |
| Balance at Bank | 70,110 | 15,648 |
| Total Assets | 240,000 | 330,929 |
| Ordinary Share Capital | 20,000 | 20,000 |
| Preference Shares | 50,000 | 62,000 |
| Accumulated Profit and Loss Account | 30,000 | 44,789 |
| Provision for depreciation of Fixed Assets | 6,023 | 7,023 |
| 3% 2015 Debentures | 50,000 | 60,000 |
| Capital Redemption Reserve Fund | 5,000 | 5,000 |
| Business Development Loan | 9,451 | 1,351 |
| Provision for Pension Fund | 20,000 | 120,000 |
| Director's Loans | 33,963 | _ |
| Trade Creditors | 14,563 | 10,742 |
| Bank Overdraft | 1,000 | _ |
| Total Capital ,reserves provisions and Liabilities | 240,000 | 330,929 |
The way to show the information meaningfully is as follows
Complex Ltd generated profits of £115,838.in the years trading. More finance was obtained by issuing Debentures and Preference Shares of £22,000. The total of positive incoming cash was £137,838.
How was it then that the Bank account fell so drastically by £54,462
The explanation is as follows
Complex Ltd purchased £10,491 of fixed assets . Trade Debtors were given credit of £64,776 and Complex increased its stock holding in the warehouse by £20,001.The business development loan was reduced by £8,125 and the suppliers took back £4,821 of their short term credit facilities due to the extra longterm finance raised by the issue of Preference Shares and Debentures. The most interesting fact seems to be that instead of the Directors financing the company( as was the case in 2008) the policy was reversed and the Directors voted themselves loans which absorbed £84,086 (61%) of incoming funds of £137,838.
Although there is legally nothing wrong with these events. It does raise the questions
1 why did the Directors lend themselves company money and
2 have the Directors got the company's best interests at heart ?
The answers might be yes but at least this analysis identifies the possible weakness of administration and which might be exposed sooner rather than later.
AS CHARTERED ACCOUNTANTS WE CAN PROVIDE A MONITORING SERVICE OF THIS NATURE ON A PERIODIC BASIS . Please contact us with details of your problem and we shall be able to quote you a fixed fee for this assignment