Finance

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Contents

Page

1 Introduction 3

2 Bookkeeping Systems 5

3 Profit & Loss Account 16

4 Balance Sheet 24

5 Sources of Finance 29

6 Glossary of Terms 37

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Finance

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Good financial management is based uponthe idea of having easy access to reliableinformation about how your business isperforming on a day-to-day basis.

All of this information should be availableto the owner/manager of every smallbusiness, without having to rely upon theassistance of an accountant, financialadvisor or anybody else who is notconnected directly with the business. Thiswill ensure that all of the information anddecisions regarding financial managementare made by the people in the best positionto do so, i.e., owners/managers.

Setting up a FinancialManagement SystemA good financial management system willcollect all the information about yourbusiness and present it to you in a waythat is easy to understand.

If all of this information is presented toyou in a readable format, you can:

✧ Make all of your business decisionsbased on sound financial information.

✧ Examine the financial state of yourbusiness on a weekly or monthly basis.

✧ Maintain control of your creditors anddebtors.

✧ Plan for your business in the short tomedium-term.

✧ Present your best case to the bank.

Every owner/manager should be in theposition to do all of the above, byestablishing a financial managementsystem that can provide reliableinformation on a regular basis.

The SectionsThe aim of this publication is to providesmall business owners/managers with theskills necessary to manage the financialperformance of their business.

There are four sections in this publication,each dealing with a particular area offinancial management:

✧ Bookkeeping systems.

✧ Profit & loss account.

✧ Balance sheet..

✧ Sources of finance.

Bookkeeping Systems

In order to establish a good financialmanagement system, you need to organisethe financial information within yourbusiness in an orderly fashion. The firststep in this process is to set-up a recordand bookkeeping system that keeps trackof all transactions in your business. Thisbooklet provides an introduction tobookkeeping and explains its role in aneffective financial management system.

Profit & Loss Account

The profit & loss account is an excellentsource of information regarding theperformance of your business. Everyaspect of the financial performance of yourbusiness is summarised on one page and,when analysed properly, can be used formanaging the future performance of yourbusiness.

This section:

✧ Introduces the profit & loss account.

✧ Explains the main terms used in theaccount.

✧ Describes how owners/managers canuse the information from the accountto review the performance of theirbusiness on an on-going basis.

1 Introduction

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Balance Sheet

Interpreted properly, a balance sheet canprovide you with valuable informationabout the ability of the business to pay itsbills. Having a good idea of how to use theinformation in the balance sheet puts theowner/manager in a very good position topresent the business’ best case to the bank.This section:

✧ Explains the role of the balance sheet.

✧ Describes how the information in thedocument can be interpreted toexamine the financial state of thebusiness.

Sources of Finance

The key to good financial management isto understand each of the main sources offinance and to be able to match thesesources with the needs of your business.

This section:

✧ Introduces the main sources of finance.

✧ Provides useful information on how toidentify the most appropriate and cost-effective methods of managing yourbusiness’ finances, without puttingunnecessary strain on your short- tomedium-term cashflow.

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Setting up aBookkeeping System

Setting up a good bookkeeping system isnot as difficult as it may first appear and,when established, it provides you with agood source of sound financialinformation about your own business. Italso reduces significantly the amount oftime and effort you and your accountantneed to spend on VAT returns, PAYE/PRSIreturns, annual accounts, etc.

It is important to remember that thebookkeeping system you will use in yourbusiness will depend entirely upon yourown needs and those of your business.Apart from a few simple ground rules,every book mentioned in this section canbe adapted to your own purposes. As longas the necessary information is there, youcan format the book in any way to make iteasier to understand and read.

Not all of the books mentioned in thesection will be relevant to every business.For example, some businesses will need aSales Book, Purchases Book, Cash Bookand Cheque Journal, while others cansimply make do with a Cash Book andCheque Journal. The types of booksneeded for your business will bedetermined by your business’ size, thenumber of sales, purchases, employees,etc.

Why Have a BookkeepingSystem?Keeping up-to-date books of accountprovides you with good currentinformation on the state of your businessand, just as importantly, allows you toformat this information in a manner whichis designed specifically for your businessand can be read with ease. This includesinformation relating to the followingareas:

✧ Monitoring business profits andprojecting future earnings.

✧ Identifying the most/least profitableproducts or services.

✧ Analysing trends in sales of productsor services.

✧ Debt collection.

✧ Cashflow problems.

✧ VAT records.

✧ Costing and Pricing decisions.

✧ Increasing sales and profits.

Although they can appear as nothing morethan a set of figures on a page, a good setof books can help you to better manageand understand your business. The morecontrol you have over your books andaccounts, the easier it is to understand theinformation contained within them.

You can adapt your books to show theinformation you need, as you need it.

Bookkeeping Systems VsAnnual Accounts Bookkeeping systems can provide moreinformation to an owner/manager thanthe annual accounts. The reasons for thisinclude the following:

✧ Relevance.

✧ Presentation.

Relevance Most annual accounts are given to theowner/manager a couple of months afterthe end of the accounting year. This meansthat, during the year, manyowners/managers are unaware of the realprofitability of the business.

Furthermore, when annual accounts areprepared, the information containedwithin them is dated and may not beuseful for examining the state of thebusiness.

Presentation Annual accounts are often presented in aformat devised by the accountant. Thisformat is often devised to make it easier toprepare the accounts for the RevenueCommissioners. However, the format is not

2 Bookkeeping Systems

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always ideally suited for owners/managersand it can be difficult to extract usefulinformation about the business. Keeping anup-to-date set of books gives you a greaterunderstanding of the state of your businessand provides the information necessary tomake key decisions regarding yourbusiness’ future.

Record Systems

If you want to have a good bookkeepingsystem, then you will need to have a goodrecord system. Put simply, a record systemis a method of filing all informationregarding your business that will make iteasier for you to prepare your books.Records are the basic evidence of businesstransactions. These records include copiesof sales invoices, supplier invoices, bankstatements, cheque stubs and counterfoilsof lodgements. You need to record everytransaction which is made through yourbusiness.

A simple recording system can be set upusing the following lever-arch files:

✧ A Sales Invoices File – If you issueinvoices, the invoices should be keptin the file in numerical order – themost recent ones at the front. You cansub-divide this file into Sales InvoicesPaid and Sales Invoices Unpaid. Theunpaid section will give you a clearindication of who owes you moneyand how long it has been owed.

✧ A Purchases Invoices File – Thisshould include all purchases – forexample, equipment, ESB, telephone,insurance, stock, etc. The invoicesshould be kept in the file according tothe date they were received – the mostrecent invoices at the front. You cansub-divide this file into PurchasesInvoices Paid and Purchases InvoicesUnpaid. The unpaid section will giveyou a clear indication of who you owemoney to and how long it has beenowed.

✧ Bank Records File – This file willcontain monthly bank statements,issued on the last day of each month,showing all the transactions to/fromyour business bank account duringeach month of the year.

✧ Tax File – This file will contain allrecords of your VAT, PAYE/PRSI, taxdocuments, etc., for the year.

All of the above files should be kept foreach year of your business. Label each ofthe files and keep this year’s and lastyear’s files to hand in the office. Theprevious years can be filed in a filingcabinet. For tax purposes, you shouldkeep all records of your files for the pastsix years.

Bookkeeping System

Having established your record system,you are now in a position to develop yourbookkeeping system. A bookkeepingsystem consists of “books of account”,which is a term used to describedocuments that contain information abouttransactions within your business.

There are a number of books of accountthat form the basis of a bookkeepingsystem within most businesses. Not all ofthese books are essential to every businessand their use will depend on the needs ofthe particular business in question. Themost important of these books include thefollowing:

✧ Sales Book.

✧ Purchases Book.

✧ Cash Book.

✧ Cheque Journal.

✧ Debtors Ledger.

✧ Creditors Ledger.

The diagram on the next page shows howthese books fit into the overallbookkeeping system. Don’t let thediagram worry you, as it is only a pictureof how all of these books would fit into afully-integrated system. Most smallbusinesses will pick and choose amongstthese books to decide which suit theirbusiness best. Other items displayed in thediagram, such as the Profit and LossAccount and Balance Sheet, will bediscussed later.

The better your record system, the easier it is for you, yourbookkeeper or your accountant to prepare your books. Thiswill save you time, money and effort. In other words, startfiling your receipts and invoices in lever-arch files and getrid of the old shoebox, if you are still using it.

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Most manual systems consist of a SalesBook, Purchases Book, Cash Book andCheque Journal. An accountant takes theinformation from these books anddevelops a Nominal Ledger, Profit & LossAccount and Balance Sheet at the end ofthe year for the business.

As businesses grow, however, the need formore detailed and up-to-date informationfrom the bookkeeping system becomesmore of a priority.

This results in the development ofNominal Ledgers and Profit & LossAccounts on an on-going basis throughoutthe year.

Due to the cost involved in developingthese documents on a regular basis, mostbusinesses in this situation will use acomputerised accounting package, whichupdates all of the books automatically astransactions are entered on the system.

In this publication, we will focus on amanual bookkeeping system. This is aneasier way to explain how a bookkeepingsystem works and can also be used tomanage a business.

We will provide a summary ofcomputerised accounting packages at alater stage.

Figure 1: Example of a Fully Functioning Financial System

PurchasesBook

Sales Book Cash Book

ChequeJournal

NOMINAL LEDGER

PROFIT & LOSS ACCOUNT

BALANCE SHEET

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Itemised Sales (Excluding VAT) VAT Analysis

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Sales Book

A Sales Book records all the sales that havebeen made by the business. Theinformation in the book is taken from yoursales invoices and it can be updated eachweek or month, using the documents keptin your Sales Invoices lever-arch file. Theinformation in the Sales Book will enableyou to:

✧ Identify the most profitableproducts/services by item.

✧ Plan for the business and projectfuture sales.

✧ Prepare VAT reports and forms.

There is no need to keep a separate SalesBook and Sales Returns book.

For sales returns, issue a credit note andenter the details and amount as a minusfigure in the Sales Book.

If you are not issuing many invoices oryou have mainly cash sales, it may beconvenient for you to combine your CashBook and your Sales Book. This reducesthe number of books you have to keep andmakes them easier to read.

The Cash Book will be described later inthis chapter.

DateInvoice

CustomerTotal

VAT Appliances TVs Hardware Other 13.5% 21%No. Amount

Figure 2: Sample Sales Book

Enter Invoice Date,Invoice Number andname of Customer

Enter TotalAmount of

Sale,INCLUDING

VAT

Enter Amountof VAT

charged onSale

Enter Amount of Sale foreach item,

EXCLUDING VAT

Enter Amount ofSale,

EXCLUDING VATunder the

appropriatecolumn

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Purchases Book

This book records all the purchases madeby the business, including stock,electricity, services, equipment, insurance,etc. The normal source of information issuppliers' invoices, which you will file inyour current year’s Purchases Invoicelever-arch file. All purchases should berecorded in the Purchases Book. Theinformation in the Purchases Book willenable you to:

✧ Review purchase costs by item.

✧ Prepare cashflow forecasts, profitprojections, etc.

✧ Prepare VAT returns and forms.

There is no need to keep a separatePurchases Book and Purchases Returnsbook. For purchases returns, get a creditnote from the supplier and enter thedetails and amount as a minus figure inthe Purchases Book.

If you do not have many purchases andyou are not registered for VAT, you mightfind it convenient to combine yourCheque Journal and Purchases Book. TheCheque Journal will be described later inthis section. If you are registered for VAT,you are required to analyse yourpurchases at the different VAT rates. Inmost cases, this means it is moreconvenient to keep a separate PurchasesBook.

Figure 3: Sample Purchases Book

VAT Analysis

Itemised Purchases Resale Not for resale(Excluding VAT)

DateInvoice

SupplierTotal

VAT Goods Transport Postage 13.5% 21% 13.5% 21%No. Amount

Enter Invoice Date,Invoice Number and

name of Supplier

Enter TotalAmount ofPurchase,

INCLUDINGVAT

Enter Amountof VAT

charged onPurchase

Enter Amount ofPurchase for each item,

EXCLUDING VAT

Enter Amount ofPurchase, EXCLUDING

VAT under theappropriate VAT column,

(distinguish betweengoods for resale and not

for resale)

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Cash Book

This is a record of all cash receipts andpayments within the business. You shouldremember that the term “cash” includescheques as well as ordinary cash receipts.The book is divided into two sections,Money In and Money Out. The Money Insection shows all of the money received bythe business, including the following:

✧ All money received from customers,both cash and cheques.

✧ Refunds of VAT.

✧ All grants received.

The Money Out section shows:

✧ All cash payments (excludingcheques).

✧ All money lodged to the business bankaccount.

While the receipts and payments areitemised to allow you to examine the mainsources of money in and money out, it isnot necessary to itemise all transactions.

Small transactions can be entered under an“other” or “miscellaneous” column andidentified in the ‘details’ column.

The difference between the totals of theReceipts and Payments sections shows theamount of money left in the till/cash box.

The only payments that are recorded inthe Cash Book are small cash payments,not cheques. Cheque payments will berecorded in the Cheque Journal,described in a later section. Keep cashpayments to a minimum.

To reduce the number of cash payments,you could pay for small cash paymentsyourself, keep the receipt, and payyourself a cheque from the business tocover the expenses each month. This willreduce the number of cash payments bythe business. Just remember to keep arecord of the expenses paid to you eachmonth in a simple report, including thereceipts for each payment, which can bestapled to the monthly expense report.

MONEY IN MONEY OUT

Date Details Total Grants Debtors Cash Misc. Total Cash Lodged to TotalSales IN Payments Bank OUT

Enter date,details andamount of

money goingin or out

Money IN isrecorded as a“plus” total andMoney out isrecorded as a“minus” total.

The monthly totaltherefore givesyou the openingbalance for the

next month

Itemise allmoney going

in or out

Figure 4: Sample Cash Book

The difference between thetotals of the Money IN and

Money out columns should beequal to the amount of money in

the cash box/till - the openingtotal for the next month (which

will equal the amount in theTOTAL column)

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Cheque Journal

The Cheque Journal records all amounts ofmoney paid out of your bank account.These are also called “debits” to your bankaccount and include the following:

✧ Cheques paid out of the account.

✧ Direct debits & standing orders.

✧ Bank fees & interest.

Remember, the Cheque Journal onlyrecords money going out of your bankaccount. The amounts going in arerecorded in the Cash Book in thelodgements column.

The information in the Cheque Journalwill enable you to:

✧ Analyse all bank payments.

✧ Prepare a Bank ReconciliationStatement, which will be discussed in alater section.

✧ Monitor and predict cash flow.

✧ Manage cash resources effectively.

Always keep a separate bank account foryour business. Don’t mix your personalaccount with the money coming in andout of your business at any stage. Thismakes it easier to keep an eye on yourbusiness finances, without them gettingmixed up with your own personalfinances.

If you want to take some money out ofthe business for your own private use,write a cheque from the business bankaccount to yourself. However, try to avoiddoing this in a haphazard fashion. It is agood idea to decide on a weekly ormonthly salary to pay yourself and stickto this figure. Review the figure everycouple of months and decide whether itneeds to be increased or decreased.

Remember, the business should be ableto pay you a salary. If it cannot, it is notfinancially viable.

Analysis of Payments

Date Details Cheque Amount Wages Creditors Telephone ESB Rent Misc.No.

Enter date anddetails of payment

Figure 5: Sample Cheque Journal

Itemise the totalpayments

Enter chequenumber andcheque total.

Standing Orders,Direct Debits,

Bank Charges etc.can be entered asSO, DD, BC etc.

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Ledgers

Ledgers keep a detailed account of therunning totals of transactions involvingindividual debtors, creditors, expenses,assets and liabilities.

All of the information is taken from thebooks mentioned earlier – for example,Sales Book, Purchases Book, Cash Book,Cheque Journal.

Ledgers are normally prepared for smallbusinesses as follows:

✧ A bookkeeper or accountant preparesthe ledgers for the business at the endof the year.

✧ A bookkeeper prepares the ledgers forthe business on an on-going basisduring the year.

✧ The business prepares its own ledgers,using a computerised accountingpackage, which provides access to theledgers throughout the year.

This publication is not going to discussledgers in detail, primarily because, inmost cases, businesses that need access totheir ledgers on an on-going basisthroughout the year will do so by using acomputerised accounting package. Toprepare the ledgers on an on-going basismanually often uses more time and moneythan would be spent on installing acomputerised package.

There are three main types of ledger:

✧ Sales (Debtors’) Ledger.

✧ Purchases (Creditors’) Ledger.

✧ Nominal Ledger.

Examples of each of these are given below.

Sales (Debtors’ Ledger)The Sales Ledger is a record of all moneyowed to you by your debtors. Theinformation contained in the Sales Ledgeris taken directly from the Sales Bookand/or Cash Book. Each debtor is givenhis/her own ledger account.

In this case, the Debtor’s name is PaulKearns. On 06/08/03, we issued him aninvoice no. 2056 for €1,200, which wasrecorded in the Sales Book (SB.) Thismeant he owed us €1,200, so werecorded that on the Debit side of hisaccount. This created a debit balance of€1,200.

On 08/08/03, he paid us with cheque no.105246 for €1,000, which was recordedin the Cash Book (CB.) We recorded thison the credit side of his account and itreduced the balance to €200.

1 The letter F in this column is short forfolio. It is simply a column that is usedto record any references you want tomake to the entries in the account.For example, in this case, the foliocolumn shows where the entries weretaken from, e.g., Sales Book (SB) andCash Book (CB).

Debtor: Paul Kearns

Date Details F1 Debit Credit Balance

06/08/03 Sales Invoice 2056 SB 1,200 1,200

08/08/03 Cheque 105246 CB 1,000 200

Figure 6: Sample Sales Ledger

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Purchases (Creditors) Ledger

The Purchases Ledger is a record of all themoney owed by you to your suppliers.

All the information is taken from thePurchases Book and/or Cheque Journal.Each creditor is given his/her own ledgeraccount.

Nominal Ledger

Every transaction in the business isrecorded somewhere in the NominalLedger.

All the information is taken from the SalesBook, Purchases Book, Wages Book, CashBook and Cheque Journal (see next page).

Computerised AccountingPackagesAt some stage, most businesses willconsider moving from a manualbookkeeping system to a computerisedaccounting package.

The main reasons for this move include:

✧ Saving time in the preparation ofbooks and accounts.

✧ Ease of numerical calculations.

✧ Management reports are updatedautomatically.

✧ Presentation and formatting ofdocuments.

Before you set up your own computerisedbookkeeping system it is a good idea tospeak to your accountant, to discuss anyissues that may specifically affect the waythat you run your accounts.

Issues to consider would be as follows:

✧ Type of Business – LimitedCompany/Sole Trader/Partnership.

✧ Nature of Business – Shop/Distribution/Manufacturing/Service.

✧ Accounting Periods – 12 Months/13Periods.

✧ Accounting Dates – Financial YearStart Date.

✧ Type of VAT – Standard/CashAccounting/Mark-up.

✧ Accountant’s familiarity withaccounting software package.

In a computerised accounting package,any entry in, for example, the Sales Bookwill be automatically recorded in theDebtors and Nominal Ledger. A similarprocess will occur when the customerpays. For example, any entry in the CashBook will also be automatically recordedin the Debtors and Nominal Ledger. Thismeans that the accounting package canprepare an updated Profit & Loss accountfor the owner/ manager at the end of anymonth.

In this case, the Creditor’s name is MaryEvans. On 09/08/03, she issued us withinvoice no. 215 for purchases totalling€2,000, which was recorded in thePurchases Book (PB.) This meant weowed her €2,000, so we record that onthe Credit side of her account. Thiscreates a credit balance of €2,000.

On 14/08/03, we paid her with chequeno. 203215 for €1,900, which wasrecorded in the Cheque Journal (CJ.) Werecorded this on the debit side of heraccount and it reduced the balance to€100.

Figure 7: Sample Purchases Ledger

Creditor: Mary Evans

Date Details F Debit Credit Balance

09/08/03 Purchases Inv. 215 PB 2,000 2,000

14/08/03 Cheque 203215 CJ 1,900 100

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Nominal Account: Sales

Date Details F Debit Credit Balance

31/08/03 Sales (August) SB 1,200 1,200

14/08/03 Cheque 203215 CJ 1,900 100

Figure 8: Sample Nominal Ledger

The Sales entry in the SalesAccount is the total sales forAugust.

It is taken from the monthlyfigure in the Sales Book.

Nominal Account: Purchases

Date Details F Debit Credit Balance

31/08/03 Purchases (August) PB 2,000 2,000

The Purchases entry in thePurchases Account is the totalpurchases for August.

It is taken from the monthlyfigure in the Purchases Book.

Nominal Account: Bank Account

Date Details F Debit Credit Balance

31/08/03 Lodgements CB 2,000 2,000

31/08/03 Payments CJ 1,900 700cr

The entries in the BankAccount are taken from theLodgements column in theCash Book and the TotalPayments column in theCheque Journal. In this case,the balance at the end of themonth in the account isrecorded as a credit, becauseit is overdrawn.

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Selecting an accountingpackage

Each of the accounting packages availableon the market varies in terms of technicaland functional capabilities. Before makinga decision on which one you want to buy,you should consider the following:

Technical issues:

✧ Ease of use – the packages varysignificantly in style and some peoplefind one package easier to use andread than others.

✧ Statutory requirements – the packagemust be able to meet statutoryrequirements, especially if it is aforeign-based package.

✧ Accountant’s and other users’opinion.

✧ Type of installation & trainingprovided – installation and trainingfees can be as expensive as thepackage itself.

✧ Accessibility and cost of support –more than likely, you will need to callthe support line, particularly duringthe first year.

✧ Experience of your accountspersonnel.

✧ Your budget.

✧ E-commerce – is the packagecompatible with any e-commercefacilities you offer customers?

✧ Back-up facilities – for safety, thepackage should provide an easy back-up facility that enables you to copyany existing files.

Function capabilities: Function capabilities refer to the level ofdetail you require from the accountingpackage. These include:

✧ Basic books of account – Cash Book;Cheques Journal; Sales Book;Purchases Book; Bank Accounts;Debtors’ Ledger; Creditors’ Ledger.

✧ Bank Reconciliation.

✧ Facility to print Invoices andStatements.

✧ Management Accounts – TradingProfit & Loss Account; Balance Sheet.

✧ Additional features – Point of sale;Multi-currency; Full Sales Analysis;Multi-location stock control;Quotations; Sales & Purchase OrderProcessing; Job costing; ElectronicDocument Transfer; Thin ClientRemote Access.

Summary

In summary, a good bookkeeping systemshould:

✧ Be simple.

✧ Require as few books as possible.

✧ Save time and not be time-consuming.

✧ Provide ease of access to information.

✧ Be accurate.

✧ Satisfy the Revenue Commissioners’requirements.

✧ Provide you with the sound financialinformation you need to manage thebusiness.

Remember, apart from a few simpleground rules, the bookkeeping system canbe adapted by you to suit your own needs.Keeping an up-to-date, simple set of booksgives you a greater understanding of thestate of your business and provides theinformation necessary to make keydecisions regarding your business’ future.

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A Profit & Loss Account is a documentthat tells you whether your business madea profit or a loss during a particular periodof time. For example, the Profit & LossAccount takes all of the sales you madeduring the year and deducts any costs orexpenses that the business incurred inmaking those sales. The differencebetween the total sales and the total costsgives you the business’ profit or loss forthat period of time.

All of the information contained in theProfit & Loss Account is taken from yourbookkeeping system, computerised ormanual, and summarised in onedocument.

For most small businesses, the informationis drawn from the following documents:

✧ Sales Book.

✧ Cash Book.

✧ Purchases Book.

✧ Cheque Journal.

✧ Nominal Ledger.

✧ Profit & Loss Account.

The better organised your bookkeepingsystem, the easier it is for you and/or youraccountant to prepare a Profit & LossAccount. This enables you to access apreliminary Profit & Loss Account at anytime of the year and puts you in anexcellent position to implement decisionsbased on sound financial informationregarding the performance of yourbusiness.

Use of the Profit & LossAccount

A Profit & Loss Account has two mainuses:

✧ Financial management of yourbusiness.

✧ Submission to the RevenueCommissioners.

Financial managementThe Profit & Loss Account is an excellentsource of information regarding theperformance of your business. Everyaspect of the financial performance of yourbusiness is summarised on one page and,when analysed properly, can be used formanaging the future performance of yourbusiness.

Submission to the RevenueCommissionersIn this case, the Profit & Loss Account isprepared by an accountant, once a year, forsubmission to the Revenue Commissioners.In turn, the Revenue Commissionersreview the Profit & Loss Account and,based upon the Net Profit or Loss(explained later), decide on the tax liabilityof the business. From the point of view of an owner/manager, the role of the Profit & LossAccount as a tool in the financialmanagement of your business is moreimportant than its use merely forsubmission to the RevenueCommissioners. While the use of the Profit& Loss Account

3 Profit & Loss Account

PurchasesBook

Sales Book Cash Book

ChequeJournal

NOMINAL LEDGER

PROFIT & LOSS ACCOUNT

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for tax purposes is obviously an importantone, it is also a very limited one. Theaccountant prepares this Profit & LossAccount at the end of the business year and,as a result, some of the informationcontained in the document, when given tothe owner/manager, is over 12 months old.Furthermore, the detailed layout of theProfit & Loss Account for tax purposes canmake it difficult to read and understand,two elements which are important in the useof the document for the management ofyour business.

If you have a good financial managementsystem, which allows you to use the Profit &Loss Account to its full effect, itsadaptability for use at the end of theaccounting year for tax purposes will comeas an added bonus.

Accessibility

To use a Profit & Loss Account effectively inmanaging a business, the owner/ managershould be able to access the information inthe document every 3 to 6 months, if notmore frequently. Furthermore, as indicatedabove, the information must also be easy toread and understand. To have an accountantprepare a Profit & Loss Account on such aregular basis might cost the business toomuch in terms of time and money. Instead,the owner/manager should becomeaccustomed to the idea of preparing andreading their own preliminary Profit & LossAccount every 6 months, at a minimum.

Guidelines

The main guidelines to remember whendealing with the Profit & Loss Accountinclude the following:

✧ The Profit & Loss Account onlyincludes details of sales, cost of salesand expenses (explained later) thatactually occurred during the relevantaccounting period, regardless of whenyou pay for them. For example, a Profit& Loss Account for 2003 will notinclude insurance expenses relating to2002 or 2004, even if you pay for themin 2003. Always remember that eachProfit & Loss Account only relates to aspecific period of time, whether it is 1year, 6 months or 3 months. The aim isto tell you how much it cost you to

make your sales during that particularperiod of time. Expenses or salesoutside that period of time are of norelevance. If it cost you more to makeyour sales than you received inincome, then you made a loss, if it costyou less, then you made a profit. Thisis a simple guideline, but it willcontinually repeat itself throughoutthe remainder of this section.

✧ The Profit & Loss Account onlyincludes sales and expenses incurredduring the normal day-to-dayoperations of the business. For example,rent, rates, insurance, electricity, stock,etc., all relate to the day-to-dayoperations of the business and will goin the Profit & Loss Account. Capitalexpenses, such as buying a building,building an extension, buyingequipment or a van for the business arenot part of the normal operations of thebusiness and will not be included in theProfit & Loss Account. If you buy a vanin 2003 for €10,000, can you put all ofthe €10,000 in the Profit & LossAccount in 2003? The total cost of thevan, €10,000, will not go in the 2003Profit & Loss Account because thetotal cost does not just relate to 2003.The van will be in the business for thenext 6 or 7 years, therefore putting thefull €10,000 in one year, 2003, does notaccurately reflect the effect on thebusiness. Only some of the €10,000relates to the sales in 2003, theremaining proportion affects salesover the next few years. As a result,you are only allowed to put in aproportion of the cost of the van for2003 and each of the following years,e.g., 15%, until the total cost of the vanhas been accounted for. This isdescribed in more detail in theDepreciation section on page 20.

✧ If you are repaying a bank loan, onlythe interest portion of the loan goes inthe Profit & Loss Account. The capitalrepayment portion is not included inthe Profit & Loss Account.

✧ If your business is VAT registered, thenthe figures used in the Profit & LossAccount, including sales and expenses,will not include VAT. If your business isnot VAT registered, then the figures inthe Profit & Loss Account will includeVAT.

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Layout

Examples of Profit & Loss Accounts aregiven on this page and the next two pages.The first – John Taylor Repairs – is anexample of a service business. The second– Cornershop – is an example of a retail

business and the third is a manufacturingbusiness, Lowland Ltd. For the moment,don’t worry about the terms that are usedon the three Profit & Loss Accounts andjust get used to looking at the layout. Theterms will be explained later in thissection.

The Profit & Loss Account forCornershop contains slightly moredetail than the one for the servicebusiness. Like the service business,the Sales are shown at the top andthe Expenses are shown at thebottom. However, in between theSales and Expenses are two newterms, Cost of Sales and Gross Profit.Cost of Sales refers to costs incurredby the business that can be directlyrelated to each item that was sold bythe shop. For example, a paper whichwas sold for €1 may have cost theshop 60c to buy from the distributors.As a result, the 60c can be directlyrelated to the €1 in sales from thepaper. Other expenses, e.g.,electricity, are more general andcannot be allocated to each item soldin the shop; therefore, they areincluded in general expenses. GrossProfit is the result of deducting Cost ofSales from Sales. Gross Profit andCost of Sales are described in moredetail later in the section.

Figure 9: Profit & Loss Account for John Taylor Repairs

2003 2004 SalesMaintenance Services 90,000 125,000 Operating ExpensesEmployee Wages 48,000 63,000 Electricity 6,000 8,500 Rent and Rates 3,000 3,500 Insurances 2,500 4,000 Advertising 1,200 2,250 Postage and Stationery 800 950 Motor Expenses 8,500 13,000 Bank Interest 1,000 1,600 Bank Fees 600 650 Audit Fees 900 920 Depreciation 4,000 6,630 Total Overheads 76,500 105,000

Net Profit 13,500 20,000

2003 2004

Shop sales 120,000 126,000 Cost of Sales Opening Stock 12,000 8,000 Purchases 44,000 50,100

56,000 58,100 Closing Stock 8,000 14,000 Cost of Sales 48,000 44,100 Gross Profit 72,000 81,900

Operating ExpensesEmployee Wages 20,000 22,000 Electricity 6,000 6,500 Rent and Rates 4,150 4,870 Insurances 2,500 4,000 Advertising 3,200 4,250 Postage and Stationery 800 1,950 Bank Fees 450 650 Audit Fees 900 920 Depreciation 4,000 4,000 Total Overheads 42,000 49,140

Net Profit 30,000 32,760

Figure 10: Profit & Loss Account for Cornershop

This is a simple form of Profit & LossAccount that is common for mostservice businesses. The sales for theperiod are shown at the top, while theexpenses that were incurred ingenerating those sales are shown atthe bottom section. Deducting theexpenses from the sales tells youwhether your business made a profitor not. All of the informationcontained in the Profit & LossAccount, such as the one above,should be readily available tobusinesses with good bookkeepingsystems.

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2003 2004 Income Sales 700,000 805,000 Cost of Sales Opening Stock & Work in Progress 90,000 110,000 Materials 120,000 153,950 Labour 180,000 200,000

390,000 463,950 Closing Stock & Work in Progress 110,000 150,000 Cost of Sales 280,000 313,950

Gross Profit 420,000 491,050

Overheads Salaries 80,000 84,900 Electricity 22,000 25,000 Postage & Stationery 1,000 2,500 Rent and Rates 5,000 5,500 Insurances 15,000 19,000 Advertising 10,000 12,250 Motor Expenses 27,500 30,750 Bank Interest 9,000 9,500 Audit Fees 2,000 2,100 Depreciation 50,000 50,000 Total Overheads 220,500 241,500

Net Profit 199,500 249,550

The Profit & Loss Account forLowland Ltd. is slightly moredetailed than the previous twoexamples. Like the Profit & LossAccount for Cornershop, LowlandLtd. has a Cost of Sales, becausethey are buying in stock for use inmanufacturing their products. But,they also have another term in theCost of Sales, i.e., manufacturingwages. This figure is included inCost of Sales because the cost ofpaying employees to manufacturethe item is directly related to theincome from each itemmanufactured. This is discussed inmore detail later.

Main Terms UsedIncomeThis refers to the income received from thesale of goods/services normally traded bythe business. It includes cash sales madeand credit sales invoiced during thebusiness period.

Remember, only sales from the periodrelevant to the Profit & Loss Account areincluded. The terms income, sales,revenue and turnover are virtuallyinterchangeable.

Cost of Sales Cost of Sales refers to costs that can beallocated directly to each productmanufactured and/or sold by thebusiness. These costs are often calleddirect costs.

If a business has a Cost of Sales, it is veryimportant for that business to distinguishbetween the Cost of Sales and the generalexpenses or overheads. The termsoverheads and expenses are ofteninterchangeable. From a practical point

of view, service businesses tend to usethe term expenses and manufacturingbusinesses use the term overheads.

The reason for this is that knowing yourCost of Sales allows you to identify thedirect cost of manufacturing or sellingyour product. Knowing this cost helps youidentify how much you have to sell eachproduct for, before you have covered yourdirect costs. Any money received abovethis point will go towards meeting yourgeneral expenses. This information alsohelps to identify your “break-even point”,which is discussed later.

The two main types of Cost of Sales are thefollowing:

✧ Stock or Materials – If a business isbuying stock for resale – for example,a fruit & vegetable shop, newsagent,arts & crafts shop, pub, etc., the cost ofbuying stock is included in the Cost ofSales. If a business is manufacturing aproduct, the cost of buying the rawmaterials for inclusion in themanufacturing process is included inthe Cost of Sales – for example,fabrication, mould-making,

Figure 11: Profit and Loss Account for Lowland Ltd.

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engineering, etc. The cost of stock ormaterials is included in the Cost ofSales because it can easily be allocatedto each item manufactured or sold.This is in contrast to expenses such asrent, electricity, insurance, telephone,audit fees, bank fees, etc., whichcannot be directly allocated to eachitem.

✧ Manufacturing Wages – If a businessis manufacturing a product, the costof paying employees directly involvedin the manufacturing process isincluded in Cost of Sales. The reasonfor this is because all of their wagesare directly related to the cost of eachitem manufactured. This is in contrastto other salaries – for example, officesalaries, etc. – which are not directlyinvolved in manufacture and do notadd to the direct cost ofmanufacturing the product. Theseother salaries are instead included inthe general expenses or overheads.

Remember, not all businesses have a Costof Sales. If you are not buying stock for re-sale or manufacture then, in most cases,you will not have a Cost of Sales.

Gross Profit Gross Profit is Sales less Cost of Sales. Asexplained above, the Cost of Sales is thedirect cost of manufacturing and/orselling your products. Therefore, GrossProfit represents the income that is leftover, to cover all remaining expenses oroverheads in the business after these directcosts have been accounted for.

If you have a Cost of Sales, it is veryimportant for you to know your GrossProfit, particularly as a % of your totalSales. In general, the Gross Profit as a % ofSales for businesses in each sector tends tobe the same – for example, public houses,restaurants, engineering, etc. This allowsyou to identify a target Gross Profit % andattempt to improve it.

You should also keep track of your GrossProfit % over a period of years to judge theeffect of improvements/changes inbusiness. Increasing your Gross Profit isthe key to improving profitability because,in most cases, general expenses, such aselectricity, rent, rates, etc., tend to remainsomewhat the same over the years.Therefore, if you can improve Gross Profit,

you can improve the overall profitabilityof the business.

General Expenses orOverheadsOverheads represent the general costs ofrunning a business which cannot beallocated directly to the products orservices – for example, insurance,electricity, telephone, marketing,accountancy expenses, etc. It includes themajority of all expenses of the business.Larger businesses often break downoverhead expenses further to show howcosts arise in different sections of thebusiness – for example, differentdepartments, etc. However, this is notnecessary when dealing with a small tomedium-sized business.

As mentioned earlier, reducing yourgeneral expenses or overheads is a verylimited way of increasing yourprofitability because these expenses tendto remain the same. In other words, nomatter what happens to sales, significantreductions in this area are very hard toachieve.

Depreciation You cannot put all of your capital costsinto the Profit & Loss Account. However,you are allowed to put a portion of thecapital costs into the Profit & Loss Accountin the form of what is known as“depreciation”. There are two types ofdepreciation, examples of which are givenin Figure 12.

One is called “straight line” depreciation,.In “straight line” depreciation, the same %is deducted each year until the value of theasset has been written off completely. Thesecond method of depreciation is called“reducing balance”. In “reducingbalance”, the depreciation figure is basedon the written down value (WDV) of theasset in the current year.

Your accountant will decide on the mostappropriate method of depreciation to usefor your business.

Net Profit This is the difference between the Salesrevenue and all costs, including Cost ofSales and general expenses. Your taxliability is based upon your Net Profitfigure.

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If your business is a Company, yoursalary will be deducted from the profitsof the company before the profit is taxedby the Revenue.

If your business is a Sole Trader, yoursalary and the profit of the business arethe same thing in the eyes of theRevenue. This means that your ownsalary is not deducted from the profit ofthe business for the purposes of tax.

However, when you are calculating theprofit of the business to see how youhave done during the year, you shoulddeduct your salary as this gives a truerpicture of your business’ profit. This isfor your own benefit as opposed to thereturns you have to send to the Revenue.

Information Available

The information in the Profit & LossAccount is at its most revealing whenpresented in the form of ratios or formulasthat can be compared over a number ofyears or with ratios in other businesseswithin the industry/service sector.

Profitability ratios

These ratios are used to show how thebusiness is performing in terms of profit.

Gross Profit %

This shows how much Gross Profit isearned on each € of sales.

Gross Profit % = Gross Profit / Sales x 100

For businesses with a Cost of Sales, theGross Profit % is one of the most importantcalculations in financial management.Improving the Gross Profit % is the realkey to increasing profitability.

In general, the Gross Profit % forbusinesses in the same industry or servicesector tends to be the same, for example,restaurants, pubs, engineering firms, etc.,all tend to share a similar Gross Profit % intheir respective sectors.

When you have calculated the Gross Profit%, you cannot just say if it is good (high)or bad (low), without considering the typeof business involved. The Gross Profit %

varies according to a number of externalfactors – for example, size of firm, type ofindustry, target market, as well as internalfactors, such as quality of stock control andwastage of stock.

This difference in expected Gross Profit %becomes clearer if we look at 2 businessesselling groceries. A large supermarketchain will have a relatively low GrossProfit %; it may buy a can of beans fromthe manufacturer for 10c and sell it at 13c.Many supermarket chains have a GrossProfit % of around 18%. On the otherhand, a corner shop may have a relativelyhigh Gross Profit % because it may buy acan of beans from the wholesaler at 12cand sell it at 20c. The supermarket tradeswith a lower Gross Profit % because it canspread its other costs over a large numberof sales, on the other hand the corner shopwill have relatively high expenses(overheads), and these have to be coveredby a high Gross Profit % because there arelower sales.

Figure 12: Depreciation

A business buys a van for €12,000. The business willinclude a portion of the cost of the van for each year in theProfit & Loss Account, until the full price has been includedin expenses over a number of years. For example, thebusiness includes depreciation of 15% per year for 6 yearsand 10% in the seventh year.

Under “straight line” depreciation, the calculation is asfollows:

DepreciationYear 1 @ 15% €1,800 Year 2 @ 15% €1,800 Year 3 @ 15% €1,800 Year 4 @ 15% €1,800 Year 5 @ 15% €1,800 Year 6 @ 15% €1,800 Year 7 @ 10% €1,200 Total depreciation €12,000

The amount of % depreciation is worked out with youraccountant, who bases his calculation in accordance withthe guidelines of the Revenue Commissioners. Under “reducing balance” depreciation, the calculation isas follows:

Depreciation WDVValue at purchase €12,000 Year 1 @ 15% €1,800 €10,200 Year 2 @ 15% €1,530 €8,670 Year 3 @ 15% €1,301 €7,369

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It is also difficult to compare the GrossProfit % of businesses in differentindustries. For example, a jeweller willhave a very high Gross Profit % – forexample, 60% to 80% – because he/shemay sell his/her goods at two or threetimes the price paid, but, on the otherhand, a dairy farmer might find that theprice he/she receives for his/her milk islittle more than the cost of producing it.

The Gross Profit % for Cornershop in 2003in Figure 10 is as follows:

Gross Profit % = €72,000 x 100 / €20,000 = 60%

Calculate the Gross Profit % for LowlandLtd. in 2003 in Figure 11.1

Net Profit Margin

This shows how much profit is earned oneach € of sales.

Net Profit Margin = Net Profit before tax / Sales x 100

The Net Profit Margin (NPM) does notvary by as much as Gross Profit % overdifferent industries and sizes of business.This limit on variation occurs because thedifferences in Gross Profit % are oftenevened out because of differences inexpenses. For example, a firm with a highGross Profit % often has proportionatelyhigh expenses, whilst a firm with a lowGross Profit % often has proportionatelylow expenses.

One important factor that will lower NPMis if the business is relatively young. A newbusiness, in its first years of trading, mayhave high expenses as it tries to establishitself. A good example of this would behigh expenditure on advertising. Becauseof this a new business could have a lowNPM, but this may not necessarilyindicate problems.

Perhaps the easiest way to judge NPM is toconstruct bands of performance, such asthe following:

✧ NPM of 18% + is good, indicatingeffective business management ofcosts and expenses. 1 The Gross Profit% is 60%.

✧ NPM of 10% to 17% is satisfactory, butcost or expenses management couldbe improved.

✧ NPM of less than 10% could beregarded as poor, indicating that thereare real opportunities for improvingcost and expenses management.

Do not be overly critical about yourbusiness, unless you are looking at a verylow NPM. Also, you should look for themain causes of poor performance. Is Costof Sales high? This would lead to a lowGross Profit %, which in turn will lead to alow NPM. Do some expenses seem out ofproportion? Work your way down theProfit & Loss Account and see what standsout.

The Net Profit % for Cornershop in 2003 inFigure 10 is as follows:

Net Profit % = €30,000 x 100 / €120,000 = 25%

Calculate the Net Profit % for LowlandLtd. in 2003 in Figure 11.2

Interest Cover

This ratio measures the number of times abusiness can repay its yearly interest bill,on its borrowings, from its trading oroperating profits. It is of importance tocreditors and investors as it indicates thepotential long-term financial stability of abusiness.

The Interest Cover is measured as amultiple, formula below, so firms couldhave an Interest Cover of 6 times, or 3times and so on. The higher the InterestCover, the greater the firm’s financialstrength, all other things being equal.Firms with low Interest Cover may havedifficulty in meeting interest payments ifeither interest rates rise, or profits fall.

Interest Cover = Annual Interest Payments / Net Profit

A low ratio would be in the region of 2 orless. Below this level, the majority ofprofits earned are going to cover interestpayments, and are not being used forpayments to the owners or reinvestment inthe business.

2 The Net Profit % is 28.5%.2 The Gross Profit % is 28.5%.

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Break-Even analysis

The Break-Even Point is described as theminimum level of sales at which thebusiness is covering all of its costs,including Cost of Sales and expenses, i.e.,making neither a profit nor a loss. Intheory, the first step in identifying theBreak-Even Point is to identify the Fixedand Variable costs involved in thebusiness. Fixed costs are defined as coststhat tend to remain the same at any level ofsales – for example, rent, insurance, officesalaries, etc. Variable costs are defined ascosts that vary directly in line with thelevel of sales – for example, materials,production wages, etc. The following is thetheoretical formula for the Break-EvenPoint:

Break-Even Point = Fixed costs x 100 / 1 – Variable costs

divided by Sales

In practice, however, the easiest way tocalculate Variable costs is by using theCost of Sales figure in the Profit & LossAccount, while Fixed costs can becalculated by using the OverheadExpenses, also shown in the Profit & LossAccount. The rearranged formula, can bewritten as:

Break-Even Point = Overhead Expenses / Gross Profit % 3

The theory behind the Break-Even Point isthat, as sales vary, the only costs to varyare the Cost of Sales – Overhead Expensesare expected to remain somewhat thesame, regardless of sales. As a result, thetheory is that there is a point at which thebusiness’ Gross Profit is exactly the sameas the Overhead Expenses. Any salesbeyond that point represent a profit to thebusiness.

While the theory behind the Break-Evenpoint is slightly flawed – not all OverheadExpenses are going to remain the sameregardless of sales – for example,electricity – this does not affect thelegitimacy of use for the Break-Even Pointas a tool in the financial management of abusiness. Using the Break-Even Pointencourages owner/ managers to examinethe different costs involved in running the

business, particularly Cost of Sales, andidentify the approximate level ofminimum sales necessary to make a profitin the business. This is also vital forentrepreneurs in the pre- or early start-upphase of business development – howmuch do you have to sell before youbreak-even?

The Break-Even Point for Cornershop in2003 in Figure 10 is:

Breakeven Point = €42,000 / 60% = €70,000

This means that, based upon the currentprices, Gross Profit % and OverheadExpenses, Cornershop needs to create atotal sales of €70,000 to break-even – profitwould be €0. Any sales made above thatpoint at the current prices produce a profit.

The difference between the existing levelof sales and the Break-Even Point is calledthe Break-Even Gap – in this case, it is€50,000 – €120,000 less €70,000. This isthe amount of sales on which the businessis making a Gross Profit above and beyondthe Overhead Expenses.

Calculate the Break-Even Point and Break-Even Gap for Lowland Ltd. in 2003 inFigure 11.4

SummaryThe Profit & Loss Account tells you howwell your business has traded over aspecific period of time. It shows you howmuch your business has earned fromselling its product or service, and howmuch it paid out in costs. The differencebetween the earnings and the costs is theprofit or loss. While most businessesprepare the Profit & Loss Account once ayear for tax purposes, it is most useful as atool to review the on-going financialperformance of the business. This meansthat a draft Profit & Loss Account shouldbe prepared by the owner/managerthemselves a number of times during theyear and reviewed on a regular basis. Thisdraft Profit & Loss Account should beused in conjunction with the projectionsand budgets of the business, discussed inanother publication in this series.

4 The Break-Even Point is €367,500 and theBreak-Even Gap is €332,500.

3 (1-variable costs divided by sales) x 100 can berewritten as the Gross Profit %.

The Balance Sheet is a statement thatshows the assets and liabilities of abusiness – what the business owns andwhat it owes. The financial health, or lackthereof, is represented within thisdocument through the provision of thefollowing information:

✧ It shows the value of the business’assets, the extent of liabilities and theamount of owner’s funds invested inthe business.

✧ It shows the financial position of yourbusiness at a single point in time.

✧ It identifies your working capitalposition and funding needs.

The Balance Sheet is normally preparedonce a year, by an accountant, forpresentation to the owner/manager andthe Revenue Commissioners.

Terms Used

The main terms used in the Balance Sheetinclude the following:

✧ Assets – When money is invested in abusiness, it is spent on either long-term or short-term assets. Short-termassets are used on a day-to-day basisby the business, while long-termassets remain in use by the businessfor a number of years. In the BalanceSheet, short-term assets are calledCurrent Assets, while long-termassets are called Fixed Assets.Examples of fixed assets includevehicles, equipment, office equipment,computers, furniture and fittings,premises, etc. These are permanentassets, whose value can only berealised by their sale. The value ofmost fixed assets is reduced each year

to reflect wear and tear during thecourse of running the business. Thisreduction is called Depreciation andis calculated at a fixed percentage ofthe value of the asset. The actualpercentage figure to be used will beworked out by an accountant.5 Thefigure for depreciation is deductedfrom the cost of the assets, to providewhat is called the Net Book Value.

✧ Current Assets – This refers to short-term assets that are owned by thebusiness and can be readily turnedinto cash. Examples include stocks,debtors, cash at bank, VAT refundable,etc.

✧ Current Liabilities – Currentliabilities are liabilities that, by theirnature, must be paid in the nearfuture – generally within 30 days or 1year of the Balance Sheet date. Theseinclude trade creditors, overdraft,expenses due, VAT payable, etc.

✧ Working Capital – This is thedifference between current assets andcurrent liabilities: Current Assets lessCurrent Liabilities. Working capitalrepresents the business’ ability to meetits short-term debts with its currentassets.

✧ Net Assets – The figure for Net Assetsis arrived at by adding WorkingCapital to Fixed Assets.

✧ Long-Term Liabilities – Long-termliabilities generally refer to debts thatare repayable in a period greater than1 year of the date of the Balance Sheet– for example, commercial loans.

✧ Capital Employed – This refers to thesources of finance that fund thebusiness’ operations. One of the firstsources of capital is money invested inthe business by the owner(s) and/orother people. Another common sourceis money that has been reinvested inthe business from profits – retainedprofits from previous years and thisyear’s profit.

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4 Balance Sheet

5 The percentage figure used for depreciationwill be given in the financial notes given bythe accountant to accompany the BalanceSheet.

Unlike the Profit & Loss Account, the BalanceSheet refers to a specific time and not to aperiod of time.

For example, while a Profit & Loss Account maybe prepared for January to December 2004, aBalance Sheet will be prepared for 31December 2004.

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Figure 13: Balance Sheets as at31/12/2003 and 31/12/2004 for Print Ltd.

2003 2004 Fixed AssetsEquipment 115,000 115,000 Furniture & Fittings 25,000 25,000 Less Depreciation to Date 15,000 30,000 Net Book Value of Assets 125,000 110,000

Current Assets Stock 15,000 17,500 Debtors 25,000 35,000Bank 5,000 12,500

45,000 65,000 Current LiabilitiesCreditors 20,000 15,000

20,000 15,000Working Capital (CA less CL) 25,000 50,000 Net Assets 150,000 160,000

Financed By: Long-term Loans 76,000 70,000 Share Capital 20,000 20,000 Add Retained Profit a 40,000 54,000

136,000 142,000 Add Net Profit b 14,000 16,000

150,000 160,000

a This figure refers to profits kept in the business from previous years. The Retained Profit in2004 includes the Retained Profit for 2003 plus the Net Profit for 2003, i.e., €40,000 +€14,000.

b This figure refers to this year’s profit.

The Balance Sheet

There are two halves to a Balance Sheet(the layout of the Balance Sheet will varydepending on the accountant and thebusiness, but the basic information isalways the same).

The top half shows how the money isbeing used in the business – the Net Assets– while the bottom half shows where thatmoney came from – Capital Employed.

The totals of the two halves must be equal,giving the Balance Sheet its name.

Information Available

The information provided in a BalanceSheet gives a good indication of the stateof a business’ finances. It can be read in 2ways:

✧ By using the general informationprovided on the Balance Sheet – forexample, looking at total fixed assets,comparing current liabilities withcurrent assets, comparing figures fromdifferent years, etc., and/or

✧ By using a number of ratios developedto help owner/managers assess thestate of their business. These ratios usethe information provided in the BalanceSheet and allow the performance of thebusiness to be measured against otherbusinesses or the general industry. Anumber of the most common ratios aredescribed below.

The information extracted from theBalance Sheet should be used inconjunction with the information from theProfit & Loss Account.

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Ratio Analysis

Ratio analysis is a technique for analysingfinancial accounts. The ratios can becompared on a yearly basis to track thefinancial performance of the company, orthey can be compared to ratios in othercompanies or against the industry/servicesector.

Financial or creditor ratios would be usedby the owner/manager or any person orbusiness that may be consideringbecoming financially involved with thebusiness – for example, banks, othercommercial lenders, leasing companies,and potential creditors. The use of theseratios would be to consider the financialstrength of the business in the followingcircumstances:

✧ Granting of credit.

✧ Likelihood of a bank loan.

✧ Financial constraints of the business.

✧ Potential of investing for growth.

✧ Working capital/liquidity analysis.

The notes accompanying each of the ratiosbelow will indicate how and when theyare usually used by businesses or lenders.

Profitability Ratios

These ratios are used to show how thebusiness is performing in terms of profitand are usually considered in relation tothe Profit & Loss account. But, since wealso use information drawn from thebalance sheet, they are included in thissection.

Return on capital (ROCE) This measures the return that can beachieved from the business, relative to theamount of money invested in it. TheReturn on Capital can be compared withthe return offered by risk-free investmentssuch as bank deposits or building societies– for example, the interest rate. As ageneral rule, the return should be at least3% above the cost of long-term borrowing.

Return on Capital = Net Profit before tax x 100 / Capital

employed

The ratio shows the Net Profit of thebusiness as a percentage of the amount of

money invested. The return should begreater than that offered by risk-freeinvestments – for example, buildingsocieties – in order to justify theinvestment of money in the business asopposed to other options. The return isgenerally lower in the early years ofbusiness.

The Return on Capital Employed for PrintLtd. in 2003 is as follows:

Return on Capital =14,000 x 100 / 150,000 = 9.33%

Calculate the figure for 2004.6

Net Profit margin This shows how much profit is earned oneach € of sales.

Net Profit Margin = Net Profit before tax x 100 / Sales

This ratio can also be used to compare andcontrast the profitability of differentproducts/services. Net Profit Margin isdescribed in greater detail in Chapter 3.

Liquidity Ratios A business is liquid if it has enoughavailable assets that it can convert to cashto meet its immediate commitments – if allthe business’ short-term credit was calledin, could the business raise the cash fromits own current assets to meet thepayments?

Current ratio This gives a general picture of liquidity – itshows the ratio of your short-term assetsto your short-term liabilities.

Current Assets / Current Liabilities =(Stocks, debtors and cash) / (Trade

creditors, overdraft and short-term debts)

Since stocks and debtors may not be easilychanged into hard cash, this ratio may notgive a reliable measure. Generally, a ratiothat is less than 3:1 may give cause forconcern.

The Current Ratio for Print Ltd. in 2003 is:

6 The ROCE for 2004 is 10%.

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Current Assets / Current Liabilities =45,000 / 20,000 = 2.25

Calculate the figure for 2004.7

Acid test or Liquidity ratio This is more commonly used to measureliquidity. Liquid assets are current assetsthat would not be difficult to convert tohard cash if needed. As a result, stock andany doubtful debtors are excluded fromthis ratio.

Liquid Assets / Current Liabilities =(Debtors and cash) / (Trade creditors,

overdraft and short-term debts)

A ratio of 1:1 is the general requirement forliquidity. If the ratio is less than this, theremay be cause for concern because it wouldindicate that there are not enough liquidassets to meet short-term liabilities if thosearose immediately. Alternatively, a ratiothat is considerably higher than 1:1 wouldindicate that the business is not using itscash to best effect. The point should bemade, do not be overly prescriptive, a lowratio does not mean impending financialdisaster. Consider the type of business – isit cash rich?

The Acid Test Ratio for Print Ltd. in 2003is:

Liquid Assets / Current Liabilities =30,000 / 20,000 = 1.5

Calculate the figure for 2004.8

Other Ratios

Other ratios that are useful for analysingthe Balance Sheet include the following:

Gearing Gearing, sometimes called the debt-equityratio, is a measurement of the degree towhich a business is funded by outsideloans rather than shareholders’ equity –Share Capital and Reserves plus Profit &Loss Account.

A business with low Gearing is one that isfunded (financed) in the main by share

capital (equity – for example, owner’sinvestment) and reserves (money retainedin the business from profits made inprevious years), whilst one with highGearing is funded in the main byborrowings.

Gearing = (Interest-bearing debt lessCash x 100) / Equity

Interest-bearing debt includes, forexample, bank loans, commercialmortgages, leasing, etc. When times aretough, highly geared companies are seenas vulnerable.

As a result, investors and banks oftenshow a preference for businesses without ahigh gearing. As a guide, a gearing ratio ofabove 60% is high, while below 40% is low.However, do not be too prescriptive, theratio is only a guideline, to be consideredin light of all the circumstancessurrounding the business.

The Gearing for Print Ltd. in 2003 is:

(Interest-bearing debt – Cash x 100) /Equity = (71,000 x 100) / 74,000 = 95%

Calculate the figure for 2004.9

Debtor and Creditor Days ratio

These ratios are measures of how long ittakes on average to pay debts and tocollect debts. When looking at these ratios,two points must be considered.

First, it is normal to offer 30 or 60 days’trade credit, and second, the type ofbusiness will affect the Debtor Days Ratio– businesses that deal in cash, for example,taxis, fast-food take-always, supermarkets,etc., will have Debtor Days’ Ratios ofvirtually nil as normal. You should lookfor a falling collection period in DebtorDays, and anything above 60 days, in anytype of business, is a cause for concern.

When examining trade creditors, we wouldexpect most firms to be paying in around 30to 60 days. If the figure is below this, wewould look at Debtor Days for acomparison and, if creditors are being paidbefore debtors are paying, then there might

9 The Gearing is 77%.7 The Current Ratio is 4.33. 8 The Acid Ratio is 2.

28

be liquidity problems. If Debtor andCreditor Days are in approximate balance,this indicates effective management ofworking capital – as creditors are beingused to fund debtors.

If the Creditor Days Ratio is above 60 days,then the firm may be in a situation wheresuppliers do not want to extend furthercredit, but on the other hand if the firm isa large one, and the suppliers relativelysmall companies, then there may be littlethe smaller suppliers can do to encouragequick payment. Any pressure for paymentmay be met with a threat to end purchases.

Debtor Days Ratio = (Debtors x 365) / Credit Sales

Creditor Days Ratio = (Creditors x 365) / Credit Purchases

As with other ratios, the absolute level ofDebtor and Creditor Days is lessimportant than the trend over time andhow the business compares withcompetitors.

Stock turnover ratio This indicates the number of times stock isbeing turned over within the business in 1year.

Stock Turnover Ratio = Cost of Sales /Average stocks held

In general, the higher the stock turnoverratio, the higher the profitability and thegreater the cash flow.

For manufacturing businesses, a stockturnover figure of around 20% is the norm,but figures have been falling, and withmanagement efficiency in mind, youshould always look for a pattern of lowerratios over a number of years.

Summary

The Balance Sheet is normally providedonce a year by an accountant for use by theowner/manager and for submission to theRevenue Commissioners. Interpretedproperly, a Balance Sheet can show:

✧ The liquidity of the business, itsability to sustain operations and paybills.

✧ The burden of debt carried by thebusiness.

✧ The invested capital of the owners,and the return on this capital.

The information extracted from theBalance Sheet should be used inconjunction with information from otherfinancial documents within the business aspart of a fully integrated financialmanagement system.

Finance

29

Introduction

Owner/managers have access to severaloptions in financing their businessactivities. Among these are debt finance –loans, investment by others in return forownership of a portion of the business,and grant funding, which may or may notrequire repayment. The key to goodfinancial management is to understandeach of the main sources of finance and tobe able to match these sources with theneeds of your business. Doing so willenable you to identify the mostappropriate and cost-effective methods ofmanaging your business’ finances,without putting unnecessary strain onyour short- to medium-term cashflow.

Types of Sources ofFinance

The four main sources of finance forbusinesses include the following:

✧ Owner’s capital.

✧ Outside equity.

✧ Debt finance.

✧ Grant funding. Each of these isdescribed in detail below.

Owner’s Capital 10

By owner’s capital we mean the cashinvested in the business by the owner orpartners.

For most small businesses, this is the onlysource of capital available, particularly inthe first few years of operations.

Owner’s capital has a number oflimitations as an on-going source offinance to the business, particularly inregard to the following:

✧ The initial cash investment is oftenquickly turned into long-term assets –for example, premises, equipment,etc., which cannot be readilyconverted into cash to support the on-going trading operations of thebusiness.

✧ In most cases, the owner will alreadyhave invested all of his/her availablemoney and may not be willing to riskfurther investment.

Although the owner’s capital may belimited, particularly in the start-up phase,it is a vital source of finance that is oftenrequired before any other source willbecome involved in the business – forexample, an investor, bank or grantagency.

Outside Equity Outside equity refers to investments in thebusiness by people or organisations otherthan the owners. Outside equity isdifferent from a loan or other source ofdebt finance because of the following:

✧ It does not include any form ofinterest and does not requirerepayment in the short-term.

✧ If the business fails, so does theequity. In other words, all other debts,including debt finance such as loans,are repaid before the equity isreturned to the investor.

Due to the level of risk involved inproviding equity to businesses, theinvestment needs to provide a certain levelof return to the investor that cannot beacquired through other investments.

The most common of these include thefollowing:

✧ The contract negotiated between theinvestors and the business mayinclude

5 Sources of Finance

10 In the case of limited companies,owner’s capital is often calledshareholders’ capital, becauseshareholders are the owners oflimited companies.

a certain percentage of profits to beprovided to the investor on an annualbasis.

✧ Some investors will provide equity tothe business in return for a percentageof shares in the business. This meansthat the investors will have someelement of control over the business,depending on the number of sharesthey hold. If the business is sold, theywill be entitled to a share of the profitfrom the sale.

✧ The investor can benefit from a numberof tax breaks in return for providingequity to certain types of smallbusiness. The most popular form of taxbreak in this regard is the BusinessExpansion Scheme, details of which canbe accessed on www.revenue.ie.

Debt Finance Debt finance refers to the main bank andlender products that incorporate someform of interest and short- to long-termrepayment schedule. The most popularforms of debt finance include thefollowing:

✧ Bank overdrafts.

✧ Term loans.

✧ Leasing.

✧ Hire Purchase.

✧ Commercial mortgage.

Bank overdrafts An overdraft is a form of bank loanwhereby the business is allowed towithdraw more money from its account

than is currently available, thereby leaving

a negative balance.

The main features of a bank overdraftinclude the following:

✧ You pay interest on the amount youare overdrawn each day.

✧ You repay the overdraft simply bylodging money to your account.

✧ The overdraft is normally agreed withthe bank for a period of 6 to 12months. This can be reviewed withthe bank if necessary.

✧ Once arranged, the overdraft can becalled upon at various times, withouthaving to inform the bank.

✧ It is very costly to exceed your creditlimit, due to high interest rates andsurcharges for exceeding the limitwithout prior authorisation from thebank.

A bank overdraft can be the cheapestsource of finance for a business, as long asit is repaid promptly. Otherwise it canbecome the most expensive, due to thehigh interest rate being charged.

Term loans Term loans are suitable for your business ifyou need a fixed amount of finance for ayear or more. The main features of termloans include the following:

✧ Most loans are for a fixed period of 1to 8 years.

✧ Repayments are agreed in advance.

✧ Loans are much more suitable thanoverdrafts for long-term finance.

✧ Loans are unsuitable for solving short-term cash flow problems.

Leasing Leasing is used to finance equipment orvehicles you do not need to own. The mainfeatures of leasing include the following:

✧ You rent the item instead of buying it.

✧ Payments are spread out over therental period.

✧ You get full tax relief on leasepayments, both interest and capitalrepayments.

✧ Capital allowances are not allowedbecause you do not own the itemleased.

30

Term loans, leases and Hire Purchase agreements areoften seen as similar alternatives to financing the sametypes of expenses – the purchase of equipment, vehicles,etc. These similarities have increased over the past fewyears, with the introduction of new financial products by thebanks and lending institutions. For example, most leasingarrangements contain a term whereby the ownership of theequipment or vehicle will pass to the lessee uponcompletion of the lease and the payment of an appropriatefee.

As a result, when choosing between a term loan, lease andHire Purchase agreement, the choice can often be basedsolely on the cost of the financial product – interest rates,fees and repayment schedules. The cost of debt finance(described in greater detail later in the section) can varysignificantly, depending on the bank or lending institutionyou approach.

Finance

31

Hire Purchase Hire Purchase is used to finance thepurchase of equipment or vehicles. Themain features of a Hire Purchaseagreement include the following:

✧ You buy the equipment or vehicle, butpayments are spread out over a fixedperiod.

✧ You can claim capital allowances onthe equipment or vehicle, and interestpayments receive full tax relief.

✧ Depending on the agreement,ownership of the equipment orvehicle may not pass to the businessuntil the final payment is made.

Commercial mortgage This is a long-term source of finance forthe purchase, development orrefurbishment of business property. Themain features of a commercial mortgageinclude the following:

✧ Security is likely to be required on theproperty.

✧ You can arrange the repaymentschedule to suit your needs.

✧ It may be possible to secure amoratorium (explained in a latersection) on the interest and/or capitalrepayments.

Cost of Debt Finance

The cost to the business of using each ofthe debt finance products listed above isbased upon a number of factors, primarilythe interest rate, bank fees/costs and therepayment schedule.

Interest rate The rate of interest charged on each of theproducts tends to decrease in line with thelength of the finance available.

For example, a 12% interest rate may becharged on a short-term product such asan overdraft facility, while a 4.5% interestrate may be charged on a long-termproduct such as a 15-year commercialmortgage.

However, the cost of the product shouldnot be based solely on the interest rate. The

level of interest is calculated over the lifeof the debt and for very short-termrequirements a short-term loan or bankoverdraft can be cheaper than arranging amedium-term loan, despite the lowerinterest rate for the latter option. Forexample, using a bank overdraft to financea shortfall of €1,000 over a few weeks canresult in minimal interest repayments ifmanaged properly – it is repaid within ashort period of time.

Use the Annual Percentage Rate (APR) tocompare interest rates between productsfor different banks. This is a standard formof interest calculation used by the mainbanks and is provided on all advertisingand literature relating to the product.

Costs and fees Some costs of debt finance are less obviousthan interest rates and tend to be “hidden”within the product package. For example,the bank or lending institution may chargethe following for some of its products:

✧ General bank fees and costs.

✧ Commitment fee.

✧ Arrangement fee.

✧ Legal & professional fee.

✧ Negotiation fee.

✧ Management fee.

Always ask the bank or lender what feesand costs, apart from interest payments,are involved in obtaining and repaying thefinancial product. For example, most HirePurchase agreements include a final fee, tobe paid in conjunction with the lastrepayment on the contract.

Repayment schedule –Interest and capitalrepayment moratoriums

Moratoriums are a suspension of interestand/or capital repayments, usually for 6months or 1 to 2 years.

Be prepared to shop around for the best deal on anyfinancial product. The interest rates, fees/costs andrepayment schedules for each of the products canvary significantly, depending on the bank or lendinginstitution you approach. Remember, you arepurchasing their financial product and they shouldadapt their own costs to attract your custom.

32

Although they do not significantly affectthe actual cost of a financial product,repayment moratoriums can be verybeneficial to a business. This is particularlytrue during the start-up period when theycan provide a breathing space for thebusiness, during which it can generate theincome necessary to meet the on-goingrepayments.

Grant Funding

The term “grants” is used to describemoney given by State agencies tobusinesses for a specific purpose – forexample, purchase machinery, developpremises, carry out a feasibility study,employ extra personnel, etc.

In general, grants do not have to be repaid,nor do they include any form ofownership or management in the businessby the funding agency. This is not alwaysthe case, however, for example:

✧ A number of grants provided byCounty Enterprise Boards (CEBs) willinclude a loan element, which isrequired to be repaid over a numberof years. For example, an allocation of€ 4,000 by a CEB may include acapital grant of € 3,000 and a loan of€ 1,000, to be repaid over 3 to 4 years.

✧ In return for a large capital grant,Enterprise Ireland may require anequity stake in the company for afixed period of time.

Apart from grants, a significant level ofsupport in the form of advice andassistance is available from a number ofagencies for business at any stage ofdevelopment.

The main forms of grant and other supportfrom State agencies are listed in Figure 14.

Other funding Other funding is available to specificindustry or service sectors – for example:

✧ Childcare funding available from theDepartment of Justice,

✧ Equality & Law Reform.

✧ Tourism funding from Fáilte Ireland.

✧ Arts funding from the Arts Council.

✧ Mentoring and training programmesfor the food industry from Bord Bia.

Matching Sources offinance to BusinessExpenses

To effectively manage your sources offinance, you will need to understand eachof the main sources of finance and to beable to match these sources with theexpenses of your business.

Most business expenses can be classifiedas Capital or Operational Expenses.

Capital expenses

This is usually described as expenditureincurred in the purchase or lease of assets– for example, premises, equipment,vehicles, fixtures & fittings, etc. – that aregoing to be used in the business for aperiod greater than 1 year. These are alsosometimes called the development costs ofthe business.

Capital expenses can be further sub-divided into the following:

• Medium term expenses – Assets that aregoing to be used in the business for one tofive years – for example, equipment,vehicles, etc. In other words, the benefit tothe business from the expenditure will beover a period of 1 to 5 years.

• Long-term expenses – Assets that aregoing to be used in the business for greaterthan 5 years – for example, buying a newbusiness, premises, etc. In other words, thebenefit to the business from theexpenditure will be over a period of 5 to 20years or even greater. Operationalexpenses Operational expenses refer to thenormal day-to-day expenses involved inrunning a business – for example,insurance, rent, travel, wages, etc. In otherwords, the benefit to the business from theexpenditure will be over a period less than12 months. These expenses will always belisted in the Profit & Loss Account of thebusiness.

Carlow County Enterprise House, www.carlow-ceb.comEnterprise Board O’Brien Rd., reception@carlow-ceb.com

Carlow. Tel: 059 9130880

Kilkenny County 42 Parliament St., www.kceb.ieEnterprise Board Kilkenny. enquiries@kceb.ie

Tel: 056 7752662

Tipperary South 1 Gladstone St., www.southtippceb.ieEnterprise Board Clonmel, ceb@southtippcoco.ie

Co. Tipperary. Tel: 052 29466

Waterford City Enterprise House, www.waterfordceb.comEnterprise Board New St. Court, info@waterfordceb.com

Waterford. Tel: 051 852883

Waterford County The Courthouse, www.enterpriseboard.ieEnterprise Board Dungarvan, waterfordceb@cablesurf.com

Co. Waterford. Tel: 058 44811

Wexford County 16/17 Mallin St., www.wexfordceb.ieEnterprise Board Cornmarket, info@wexfordceb.ie

Wexford. Tel: 053 22965

Wicklow County 1 Main St, www.wicklowceb.ieEnterprise Board Wicklow. enterprise@wicklowceb.ie

Tel: 0404 67100

Finance

33

Figure 14: Sources of Grant Finance

Source Address Website/Email/Telephone Services/Grants/Advice

Enterprise Ireland Waterford www.enterprise-ireland.comIndustrial Park, 051 333500Cork Road,Waterford.

Having identified the 3 main classes ofexpenses in your business, you mustmatch these expenses to appropriatesources of finance. The general rule is touse sources of finance that are repaid overa similar period of time during which theexpense provides a benefit to the business.

For example, consider a business that isbuying a car. The car is going to be used inthe business for 4 to 5 years, therebyassisting in the generation of tradingincome during this period – the benefit ofpurchasing the car is going to last 4 to 5

years. Therefore, the source of financebeing used to purchase the car shouldmatch this benefit period.

The most appropriate source of finance forthis period is a term loan, lease or hirepurchase for 4 to 5 years. The choicebetween each of these options should bebased on the cost of each product andwhether the business needs to own thevehicle at the end of the period.

Financing the car through an overdraft isinappropriate in this case, because an

Range of services to existingand start-up businesses:

• Business planning &information.

• Research, development &design.

• Production & operations.

• Marketing & businessdevelopment.

• Human resourcedevelopment.

• Finance for growth.

Range of services to existingand start-up businesses:

• Information.

• Advice.

• Financial Incentives.

• Business skills Training.

• ManagementDevelopment.

• Mentoring.

• Networking.

• eBusiness Supports.

34

overdraft should only be used to financeexpenses, the benefit of which shouldaccrue to the business within, for example,3 months. In other words, the expenseshould repay itself within the 3-monthperiod. Otherwise, the business is going tobe paying high interest rates on theoverdraft over a period of time that mightbe better served through a term loanoffering lower interest rates.

Financing the car by adding it to thecommercial mortgage is inappropriate inthis case also, because the commercialmortgage is going to be paid back over aperiod of approximately 15 years. As aresult, although the car may be disposed ofwithin 5 years, the business will repay thecost of the car for another 10 years, despitethe fact that the car is providing no furtherbenefit to the business whatsoever withinthose 10 years – it has been replaced.Obviously, this would not be a goodfinancial management decision.

The scenario above may seem a bitextreme, but it is a valid example of thesituations faced by many businesses anddemonstrates how a business can easilyrun into financial difficulties by matchingthe wrong source of finance to the wrongbusiness expense.

Examples of other financing decisionsinclude the following:

✧ Some businesses will use an overdraftto pay for the purchase of equipment,merely because it is readily available tothem and, as a result, they do not haveto approach the bank to arrange furtherfinance. While they may do this withthe intention of quickly paying back theoverdraft from the income to begenerated from the new equipment, inmost cases the increase in income willnot arrive as quickly as envisaged. As aresult, they will be faced with anincrease in high interest repayments onthe overdraft facilities, which theycannot meet through their tradingincome, putting increasing pressure

and stress on the business and, moreimportantly, the owner/manager. Thisis called “chasing your own tail” – thebusiness is generating income merely tomeet the cost of repaying its debts. Inthis example, it may be beneficial forthe business to convert the overdraftinto a term loan (it is never too late todo this) thereby reducing the monthlyinterest repayments and ensuring therepayment period is matchedappropriately to the expense.

✧ Businesses may find themselvessomewhat cash-rich at a particularpoint in time – for example, at the endof a busy trading period. Thetemptation at this time is to use theavailable cash to purchase newequipment, thereby avoiding the needto use debt finance such as a term loan.While this may be of benefit to thebusiness, the owner/manager shouldconsider the options available tohim/her in this case. Debt finance isnot necessarily a bad thing and, as longas it is matched to the appropriateexpense, it can be financed adequatelyby the business, without putting anyundue strain on the cash resources. Asa result, the cash-rich business may bein a position to use the cash to bettereffect elsewhere or hold it in reserve fora later period – for example, the lullthat can often follow the busy tradingperiod!

✧ Businesses experiencing tradingdifficulties may look to a term loan as asource of finance to meet their day-to-day expenses. Although this provides aquick injection of cash to the business,it tends to mask the real difficulty in thebusiness – its trading income is notenough to meet its trading expenses. Asa result, putting the repayment ofanother term loan onto the businesscould be a recipe for disaster. A short-term overdraft, re-negotiation of creditterms with suppliers, or calling in cashfrom debtors may be the better answer– for example, re-negotiating creditterms to ensure that income from salesarrives in sufficient time for paymentsto suppliers. Remember, while youmay see your suppliers as a source ofcredit, many of your own customerswill look upon you in the same way.

Trading expenses should only be met by tradingincome, trade credit from suppliers or short-termsources of finance, such as a bank overdraft that canbe repaid within a few weeks. If the business cannotmeet its trading expenses from trading income,then it is not financially viable.

Finance

35

Approaching Banks &Funders –The Business Plan

Banks and funders often make theirdecision to finance a business based uponthe viability of the business proposal andthe ability of the owner/manager tomanage the business. They base thedecision upon the information available tothem regarding both the business and theowner/manager, most of which will besupplied by the owner/managerthemselves. As a result, in order to dealsuccessfully with your bank and/orfunders, you must be able to present yourbest possible case in as clear and concise aformat as possible.

The most effective means of achieving thisis, without doubt, the preparation andpresentation of a Business Plan to the bankand/or funding agency.

The business plan will provide thefollowing information:

Main document

✧ Introduction to the owner/manager.

✧ Introduction to the business.

✧ Description of the product/service.

✧ Market analysis.

✧ List of competitors.

✧ Marketing plan.

✧ Capital expenditure.

✧ Sources of finance for capitalexpenditure. Appendices

✧ Financial projections.

✧ Business details – for example, bank,solicitor, accountant, architect, etc.

✧ Short CV of owner/manager.

The business plan should be prepared bythe owner/manager, unless the level ofdetail is such that he/she will need theassistance of a mentor/consultant.

Even in that case, however, theowner/manager should be heavilyinvolved in the research and preparationof the plan. This involvement will enablethe owner/manager to update the plan,particularly the projections, on a regularbasis, thereby putting him/her in theposition of being able to approach thebanks/funders to provide accurateinformation regarding the progress of thebusiness. This is extremely beneficial whenapproaching the banks for the annualmeeting or at any other time when the

The above are examples of real financialdecisions taken by businesses every day ofthe year and illustrate the importance ofmatching the right source of finance withthe right expense. Mismatching thesources to the expenses will cause

unnecessary pressure and strain on thebusiness and owner/manager.

The main expenses and appropriatesources of finances are summarised inFigure 15.

Figure 15: Matching Expenses & Sources of Finance

Source of finance

Short-term Medium-term Long-termLong-term capital expenses • Owner’s capitalBuy a new business • Outside equityBuy new property • MortgageDevelop your premises • Grants

Medium-term capital • Term loanexpenses • LeasingBuy new machinery • Hire PurchaseBuy new equipment • Grants

Operating expenses • Trading income Buy stock • OverdraftDay-to-day costs • Trade credit

36

business needs to access debt finance – theowner/manager has a very accurate ideaof the level of finance needed by thebusiness over the next 6 to 12 months andcan convey this to the bank.

Capital expenditure, both medium- andlong-term expenditure, is shown in themain body of the Business Plan. Thesources of finance for these expensesshould be shown alongside the costs, as inFigure 16.

Capital Costs Description €

Premises Equipment Vehicles Fixtures & Fittings Total

The totals for the capital expenditure andsources of finance should be equal.Operational expenditure is not shown in themain document of the Business Plan. This isusually shown in the Appendices by a 3-yearProfit & Loss Account and Cash Flowprojections. The aim of these projections

should be to show that the trading income ofthe business is sufficient to meet the tradingexpenses. In general, no other sources offinance other than trading income, tradecredit or short-term bank overdraft should beused to meet the expenses, otherwise thebusiness is not financially viable.

Figure 16: Capital costs & Sources of Finance in a Business Plan

Sources of Finance Description €

Own Funds Bank Loan Grants Other Total

Finance

37

Balance Sheet: The Balance Sheet is astatement that shows the assets andliabilities of a business – what thebusiness owns and what it owes.

Bookkeeping: A system of recording all of abusiness’ transactions. The records canbe kept on a manual or computerisedbasis. A bookkeeping system consists of“books of account”, which is a termused to describe documents that containinformation about transactions withinyour business.

Break-Even Point: The Break-Even Point isdescribed as the minimum level of salesat which the business is covering all ofits costs, including Cost of Sales andexpenses – making neither a profit nor aloss.

Capital Employed: This refers to thesources of finance that fund thebusiness’ operations. One of the firstsources of capital is money invested inthe business by the owner(s) and/orother people. Another common source ismoney that has been reinvested in thebusiness from profits – retained profitsfrom previous years and this year’sprofit.

Capital Expenditure: This is usuallydescribed as expenditure incurred in thepurchase or lease of assets – forexample, premises, equipment, vehicles,fixtures & fittings, etc. – which are goingto be used in the business for a periodgreater than one year. These are alsosometimes called the development costsof the business.

Cash Book: This is a record of all cashreceipts and payments within thebusiness. You should remember that theterm “cash” includes cheques as well asordinary cash receipts. The book isdivided into two sections: Money In andMoney Out.

Cheque Journal: The Cheque Journalrecords all amounts of money paid outof your bank account. These are alsocalled “debits” to your bank account.Remember, the Cheque Journal onlyrecords money going out of your bankaccount.

Commercial Mortgage: This is a long-termsource of finance for the purchase,development or refurbishment ofbusiness property.

Computerised Accounts: These are

accounts that are recorded on computerby specifically designed accountingpackages that update all of the booksonce one entry is made. The choice ofwhether to use manual or computerisedaccounts is entirely up to theowner/manager.

Cost of Sales: Cost of Sales refers to coststhat can be allocated directly to eachproduct manufactured and/or sold bythe business. These costs are often calleddirect costs.

Current Assets: This refers to short-termassets that are owned by the businessand can be readily turned into cash.Examples include stocks, debtors, cashat bank, VAT refundable, etc. Current

Liabilities: Current liabilities are liabilitiesthat, by their nature, must be paid in thenear future – generally within 30 days or1 year of the Balance Sheet date. Theseinclude trade creditors, overdraft,expenses due, VAT payable, etc.

Debt Finance: Debt finance refers to themain bank and lender products thatincorporate some form of interest andshort- to long-term repayment schedule.

Depreciation: A method by which theportion of a total cost of a capitalexpenditure is included as a cost in theProfit & Loss Account.

Fixed Assets: These are permanent assets,whose value can only be realised bytheir sale. Examples of fixed assetsinclude vehicles, equipment, officeequipment, computers, furniture andfittings, premises, etc.

Gearing: Gearing, sometimes called theDebt/ Equity ratio, is a measurement ofthe degree to which a business is fundedby outside loans rather thanshareholders’ equity. A business withlow Gearing is one that is funded(financed) in the main by share capital(equity, the owner’s investment) andreserves, whilst one with high Gearingis funded in the main by borrowings.

General Expenses: General Expensesrepresent the general costs of running abusiness which cannot be allocateddirectly to the products or services – forexample, insurance, electricity,telephone, marketing, accountancyexpenses, etc. They are sometimes calledoverheads.

6 Glossary of Terms

38

Grant Funding: The term “grants” is used todescribe money given by State agenciesto businesses for a specific purpose – forexample, purchase machinery, developpremises, carry out feasibility study,employ extra personnel, etc.

Gross Profit: Gross Profit is Sales less Cost ofSales. Hire Purchase: Hire Purchase isused to finance the purchase ofequipment or vehicles – you buy it, butthe repayments are spread out over aperiod of time.

Income: This refers to the income receivedfrom the sale of goods/services normallytraded by the business. It includes cashsales made and credit sales invoicedduring the business period. The termsincome, sales, revenue and turnover arevirtually interchangeable.

Leasing: Leasing is used to financeequipment or vehicles you do not need toown – you rent it rather than buying.

Ledgers: Ledgers keep a detailed account ofthe running totals of transactionsinvolving individual debtors, creditors,expenses, assets and liabilities. All of theinformation is taken from the business’books – for example, Sales Book,Purchases Book, etc.

Long-term Liabilities: Long-term liabilitiesgenerally refer to debts that are repayablein a period greater than one year of thedate of the Balance Sheet – for example,commercial loans.

Manual Accounts: Manual accounts refer tobookkeeping systems that are “written”in a book such as an analysis book. Thechoice of whether to use manual orcomputerised accounts is entirely up tothe owner/manager.

Net Assets: The figure for Net Assets isarrived at by adding Working Capital toFixed Assets. Net Profit: This is thedifference between the Sales revenue andall costs, including Cost of Sales, andgeneral expenses/overheads.

Operational Expenditure: Operationalexpenses refer to the normal day-to-dayexpenses involved in running a business– for example, insurance, rent, travel,wages, etc. In other words, the benefit tothe business from the expenditure will beover a period less than 12 months. Theseexpenses will always be listed in theProfit & Loss Account of the business.

Outside Equity: Outside equity refers toinvestments in the business by people ororganisations other than the owners.

Overdraft: An overdraft is a form of bank loanwhereby the business is allowed towithdraw more money from its accountthan is currently available, thereby leavinga negative balance.

Owner’s Capital: By owner’s capital, wemean the cash invested in the business bythe owner or partners. For most smallbusinesses, this is the only source ofcapital available, particularly in the firstfew years of operations.

Profit and Loss Account: A Profit and LossAccount is a document that tells youwhether your business made a profit or aloss during a particular period of time.The difference between the total sales andthe total costs gives you the business’profit or loss for that period of time.

Purchases Book: This book records all thepurchases made by the business. Theseinclude stock, electricity, services,equipment, insurance, etc. The normalsource of information is suppliers'invoices.

Ratio Analysis: Ratio analysis is a techniquefor analysing financial accounts. The ratioscan be compared on a yearly basis to trackthe financial performance of the companyor they can be compared to ratios in othercompanies or against the industry/servicesector.

Records: Records are the basic evidence ofbusiness transactions. They include copiesof sales invoices, supplier invoices, bankstatements, cheque stubs and counterfoilsof lodgements. You need to record everytransaction made through your business.

Sales Book: A Sales Book records all the salesthat have been made by the business. Theinformation in the book is taken from yoursales invoices/receipts and it can beupdated each week or month.

Term Loans: Term loans are repayable over aperiod of between 1 to 8 years. Term loansare suitable for your business if you needa fixed amount of finance for a year ormore.

Working Capital: This is the differencebetween Current Assets and CurrentLiabilities. Working capital represents thebusiness’ ability to meet its short-termdebts with its Current Assets.