Getting a grip on the finances of your startup may seem to be a daunting task. The aim of this blog is to demystify some of the main accounting phrases and concepts and try and help you to apply them when running your business.
I am not trying to turn you into an accountant; I still recommend you purchase accounting software and hire an accountant. What this blog will do is help you become more financially literate and will enable you to implement good financial management into your business.
Ok, let’s get straight into it.
The P&L statement is also known as a “statement of profit and loss,” and “income statement” or an “income and expense statement.” The P&L is measured over a particular period (typically a year, quarter or month).
One of the most important items of this P&L is the sales line. To calculate profit you need to subtract the costs, and in all financial statements, this happens in a consistent, well-defined way.
The term ‘cogs’ is a much-used term meaning the Cost of Goods Sold. These are the costs directly related to producing the goods or services to be sold. So for manufacturing, you’ll see the cost of the raw materials and the man hours spent in production.
Attached to the cogs, but separately mentioned, you’ll find DSC or Direct Sales Cost. This is the costs directly related to sales, not being the COGS. Costs such as logistics, customs, commissions and discounts are booked in here.
Opex the next big group of costs a company occurs. It is short for ‘operational expenditure’ and consists mainly of salary costs (for as far as they do not belong to man hours in the manufacturing plants, they belong to COGS).
These costs mentioned above are all that we call ‘Operational costs.’ Other, more minor costs could resort under here, but I believe we captured the main ones.
These are other accounting transactions that occur on the P&L
The main ones are:
Depreciation – This is the usage and devaluation of your fixed assets. Assets are held in your Balance Sheet and cost value. Depreciation is charged to the P&L and netted off against the book value.
Amortisation – Very similar accounting treatment to depreciation, however, the charge does not relate to fixed assets.
Interest: The interest for loans and hire purchases are charged to the P&L.
Taxation: This is usually corporation tax, on a company’s profits.
Profit is one of those words everybody knows, yet the clear definition of it is only possible after we have gone through the items above. But… we are not fully there yet. There are many different kinds of profit, the main ones I’ll touch upon here.
The revenue minus the COGS will give you gross profit: the most basic kind of profit, the one that will pay your salary costs and all the rest.
Is Earnings Before Interest, Tax, Depreciation and Amortisation. Often EBITDA is interesting because it is a better indication of the current performance, filtering out depreciation is often the leftover of decisions made a while ago.
Also called net income. This is the result of all of the above. When subtracting interest and, if appropriate, tax from the EBIT we end up with the net earnings. This is the money in our pocket. In most cases, the earnings will be divided among the shareholders. It also can be added back into the company; then it is called ‘retained earnings’ in the Balance Sheet.
A balance sheet shows the value of the business on a particular date. A balance sheet shows what the business owns and owes (its assets and its liabilities). Fixed assets show the current value of major purchases that help in the running of the business, like delivery vans or PCs.
Current assets show the cash or near-cash available to the firm. This includes stock ready to sell, money owed to them by debtors and cash in the bank. Deducting all the current liabilities from the total amount of fixed and current assets gives the value of the business on the day the balance sheet was drawn up.
Cash Flow is the movement of money into or out of business. It is usually measured during a specified, limited period. Positive cash flow is the lifeblood of any business. You can be profitable but if you do not have the money to pay your staff and suppliers you will go out of business. As a business owner, you will have to ensure your business maintains positive working capital.
The formula to work out working capital is:
working capital = current assets – current liabilities
A business is a solvent if it can meet its short-term debts when they are due for payment. To do this, it needs adequate working capital. There are three main reasons why a business needs adequate working capital. It must: Wages paid to employees are part of a company’s variable costs
Managing your business cash flow is probably the most important aspect of running a business. It is very surprising to see how so many small businesses fail to implement a robust cash management process.
Managing cash flow is more than just knowing how much money is in your bank account. It is about managing your customer relationships, having strong procurement processes, understanding how to leverage your purchasing power and having the ability to plan ahead
Relationships with Customers
Increasing the number of new clients is a top priority for small businesses, especially startups. However, there is little to be gained if your new client does not pay you. Before you start a working for a new client, take the time to credit check them first.
The next stage you need to define how and when your customer pays, getting this right is extremely important for the relationship. Offer your customers discounts for early payment and give them several options on how to pay you.
Build a relationship with your customer; they should feel like they can tell you they will be one week late with a payment or cannot pay you in full on-time. If they feel they cannot, it will increase the chance, they will not pay you at all.
If payment issues persist, consider ending your relationship with your customer.
You can manage the relationship with your suppliers by choosing whom you do business with very carefully. Keep your suppliers to a minimum; there is the little value in having multiple suppliers for the same product or service. Tell your suppliers just how much money you are planning to spend with them and try to negotiate a discount.
Pay your suppliers when you have to, take advantage of early payment discounts where possible but do not pay suppliers before you need to, it is always better to have your money in the bank.
Many managers and employees spend money without understanding the impact this has on the cash flow. The starting point should be a robust budget for profit and loss (daily expenditure) and capital expenditure (assets). Before an expense is authorised it should be confirmed that is within the allocated budget. Any costs that are not budgeted should be signed off by senior management who should check that there is enough cash in the bank to pay for it.
Large or aged debts should be chased as soon as possible. An aged debtors report should be run each week and analysed. It is also important that senior management relieves the pressure on the credit control department by helping chase large or aged debts by discussing the money owed with their peers at the relevant company.
Cash flow should be forecasted at least weekly; you should review income and expenditure in the bank statement against what was expected. Any large variances should be reported back to senior management who should investigate.
Starting a cost reduction program can at times seem daunting, there are a few key areas that you should be able to find efficiencies that will yield results within weeks of implementation and bring a long-lasting change.
1. Look to the cloud for process improvement & cost savings
Review your current IT infrastructure and software strategy, moving your business to the cloud could reduce your IT spend significantly.
Infrastructure & Platform as a Service (IaaS/PaaS) can save businesses thousands on hardware and software costs. Flexible and scalable payment options ensure you do not waste valuable capital on expensive software and equipment.
Replacing physical servers with virtual services can also help you reduce energy costs and lessen your carbon footprint.
Infrastructure as a Service (IaaS) companies provides support to their customers who could give you the opportunity to reduce IT support staff costs.
Software as a Service (SaaS) provides small businesses with enterprise level solutions at a fraction of the price.
2. Redefine how and where your business operates
Premises and staff costs are the largest costs in most businesses, to achieve substantial cost reduction with your business you need to redefine where, how and with whom your business operates.
Many business owners believe they should locate their offices in a central, well-known location as it adds prestige to their business. For some businesses such as retail, location is crucial for business success. However, for most businesses, a central location is not essential because what drives sales is the product or service, not the location.
Conduct an assessment on what drive sales to your business, if the location is only a minor factor consider moving offices to a cheaper location.
There are lots of serviced office options to choose from; this will give you an opportunity to reduce utilities, repairs, and maintenance. Many serviced offices come with shared IT resources, which will allow you to reduce your IT spend.
The popularity of mobile phones, laptops and tablet computers is driving businesses to implement Bring Your Device (BYOD) programmes. Instead of buying expensive hardware for your employees you invest in the IT infrastructure to enable them to use their work on their own devices. Even if you contribute to the hardware costs for employees, a well planned and marketed BYOD programme can save money and improve employee satisfaction.
If your employees can work remotely, assess whether they all have to work at the same location at the same time to be productive. Allowing employees to work flexibly from home could give you the opportunity to downsize your premises and implement a hot-desking policy in the workplace.
This not only reduces potential cost to your business but can also increase employee satisfaction which could increase employee retention rates which could consequently save you money on recruiting and training new staff.
Once you can get your employees to work from home, think about whether your staff needs to be UK based. Labour can be much cheaper abroad especially in Asia. Alternatively, think about getting some of your costs outsourced – by a company or managed through freelancer web or by crowdsourcing
Review your current business processes, can you do things differently? Can you improve your processes, so you perform the staff tasks with less staff?
People are put off of outsourcing because they feel that they are losing control, but they are forgetting that they are gaining more time to focus on what is truly important to their business.
Energy prices are increasing, but this does not mean that savings cannot be made, not enough businesses challenge and interrogate their utility bills it simply isn’t good enough to just accept that prices will increase. Many multi-site businesses are on different tariff and have inconsistent billing based on estimates and often find it difficult to recover money from utility companies.
Better overhead cost management comes from understanding consumption in each unit and monthly trends, try to gather this information for at least a year.
Get control of your utility bills by analysing how much energy you have consumed over the past year and how much money you have spent.
Firstly, you should use this information to decide how you can reduce consumption. Think about how and when you consume energy, challenge any assumptions that have been made and focus on reducing consumption.
Secondly, you should try and broker a new deal with a new supplier. Knowing just how much you have consumed in the past year, and how much will consume in the future will help you get the best deal possible from a new supplier.
If you are using separate suppliers for gas, and electricity tries to consolidate this into one and use increased bargaining for leverage to negotiate a better deal. The same methodology can be used for telephony and broadband.
4. Renegotiate Contracts
Assess all of your contracts and try and shop around. For instance, business insurance cannot be avoided, but ensure you review your policy annually and make sure you are getting the best possible price.
Shopping around with other suppliers may take time, but it could save your business thousands every year.
5. Use Time & Space More Wisely
Travel should be restricted to sales meetings and critical business meetings. There are many great web conferencing and video conferencing solutions out there that will save you money.
6. Think Outside the Box
Every business is different, keep thinking of ways to improve processes and reduce costs. Have a monthly meeting with employees to think of new ways to save money and improve productivity. Offer employees’ incentives to come up with ideas; it will save you money in the long term.
Times are tough and to pull out of things businesses should look to reduce costs, this is often deemed negative, but you should see this as a positive action as you are making your business more efficient.
Redefining how your business operates forces you to access your value proposition and makes you more competitive and hopefully more able to provide your customer’s value.
Budgeting & Forecasting
It is a basic tenet of business – before you can make money you have to figure out how to spend it. Drafting a budget is a key way to help you turn your dreams for business success into reality. Using this vital tool, you can track cash on hand, business expenses, and now much revenue you need to keep your business growing — or at least afloat. By committing these numbers to paper, your chances of succeeding with your business are helped by anticipating future needs, spending, profits and cash flow. It also may let you spot problems before they mushroom, so that you can switch gears.
The following sections explain why your business needs a budget, what components you should include in a budget, and how to get started drafting a budget, and how to use your budget to improve your business performance.
Why Your Business Needs a Budget
Budgets can also help you minimise risk to your business. A budget should be created before you sign a new lease or invest in new machinery or equipment. It is better to find out that you cannot afford new office space before you commit to spending a certain amount of money every month.
Components of a Budget
A budget should include your revenues, your costs, and — most importantly – your profits or cash flow so that you can figure out whether you have any money left over for capital improvements or capital expenses. A budget should be tabulated at least yearly. Most yearly budgets are also divided up into 12 months.
Sales and other revenues – These figures are a budget’s “cornerstone.” Try to make these estimates as accurate as possible, but err on the side of being conservative if you have to. The best basis for your projected sales revenues is last year’s actual sales figures.
Total costs and expenses – Now that you have your sales estimates done, you can come up with figures for how much it will cost your business to earn those revenues. These can be tricky because sometimes they will vary because of inflation, price increases, and other factors. Costs can be divided into categories: fixed, variable, and semi-variable.
• Fixed costs are those expenses that remain the same, whether or not your sales rise or fall. Some examples include rent, leased furniture, and insurance.
• Variable costs correlate with sales volumes. These include the cost of raw materials you need to make products, inventory, and freight.
• Semi-variable costs are fixed costs that can be variable when influenced by the volume of business. These can include salaries, telecommunications, and advertising.
Profits – Let’s face it: you are in business to make a profit on your investment and work. You estimate this figure by subtracting your costs from your revenues. Check with trade associations, accountants, or bankers to make sure that you are getting an appropriate profit from your business. Once you have profit estimates, you can also start to plan for whether you can purchase new equipment, move to a bigger location, add staff, or give your employees bonuses or raises.
You can also troubleshoot your projected costs and see where you can cut if your profit projections are not up to standard.
The budget should operate according to basic mathematical equations — either “sales = total cost + profit” or “sales – total cost = profit.”
How to Draft Budget
Drafting a budget is easiest if you wrote one the previous year. Those projections, coupled with the actual income and expense figures you realised, would form the basis of your estimates for the coming year. However, if you are reading this article, the odds are that you’ve never written a budget for your business before. In that case, read on.
For a startup business, begin by estimating what type of realistic profit you’d like to see in the coming year. If you have been in business for a while, take your company’s most recent financial statements — be they generated by a ledger or a computer software program — and use those as the basis for developing your sales and profit targets. The reason you start with sales and profits is because this information will drive the rest of your estimates for costs, expenses, and capital expenditures. Take into considering factors that might affect your sales numbers — such as the economy or the loss of a major customer – but don’t worry too much because the basic tenet of budgeting is that the figures will never turn out to be exactly right.
Calculate operating expenses. A good place to start, once again, is those financial statements. These statements should include an itemised list of the fixed and variable expenses you incurred during the year, including salaries and wages, rent, postage, research, travel, utilities, taxes, etc. If you are just starting out, you are going to have to brainstorm to make sure you factor in all the costs you will incur.
Sticking To Your Budget
Setting a budget is easy, sticking to it is the hard part. There is no point in going through the budgeting process if you do not follow it A budget is a roadmap to your business goals, to ignore it means your business is at risk of going off course.
Many business owners do not realise that budgets can be flexible, you do not have to follow them rigidly if circumstances change.
The key to adding flexibility to your budget is adding a level of business analysis and performance metrics to your budget.
Key metrics to add your budget:
Staff Costs %
How much are your staff costs compared to your revenue? Alternatively, relation to your total expenditure?
Revenue Formula: [Staff Costs / Revenue] Expenditure Formula: [Staff Costs / Total Expenditure]
Cost Per Unit/Sale
How much does it cost you for every unit you sell?
Formula: [Total Expenditure / Unit or Sales]
Marketing Cost Per New Customer
Every business needs new customers. Therefore, you need to budget how much you spend to get new business.
Formula: [Marketing Expenditure / New Customers]
How much are your overheads (running costs) compared to your expenditure?
Formula: [overheads / total expenditure]
Gross Margin %
To calculate your Gross Margin you need to understand how much of your expenditure is directly related to making, delivering or selling your product/service
Formula: [(Sales-Cost of Sales)/Sales]
Net Margin %
This is similar to Gross Margin %, but you should replace the cost of the sales with total expenditure.
Formula: [(Sales-Total Expenditure)/Sales]
Using Budget Metrics to Control Your Business
By budgeting for these metrics helps you to rationalise the changes within your budget. For instance, if you win a new contract that was not included in the budget, and you require additional staff to fulfil the contract you should proceed to recruit the additional staff but you should ensure that your actual staff costs % remain at the budgeted level.
Your budget will also allow you to find and rectify problems in your business. By analysing the P&L against the budget, you can analyse variances and rectify and overspend. Variance analysis should also pick up underspends that can be used to cover overspending thus allowing you to stay within your gross margin % or net margin %.
This technique can work for revenue also, for instance, if revenue is down on a particular product you can check your marketing activity is at the required level by analysing the marketing cost per new customer,
Use variance analysis against the budget metrics to investigate potential problems in your business. For example, if your overhead spends % varies significantly than budgeted it should be investigated.
You should review actual performance against budget every month. Any changes in your budget should be recorded separately as your forecast.
Each time you update your forecast, you should note down the reasons for the variance to the budget. This will not only improve your budgeting process next year but will ensure you keep good control over your business.
You are a small business owner, not an accountant. You would rather spend your time running your business than stressing out about manually updating ledgers, tracking expenses, creating reports and performing other time-consuming tasks to manage your company’s finances.
This is where accounting software can help. If you use it correctly and choose the right one for your business, accounting software can make your life easier by doing all the number crunching and inputting all the data, so you do not have to.investing in an accounting software is one of the best decisions a small business owner can make. However, is using one right for your business? For some businesses, using spreadsheets and even hand-written ledgers will do. For most, however, the ease and efficiency of an accounting software make it the better choice.
If any of the following applies to your business, investing in an accounting software is the way to go:
Do you need accounting software?
Investing in an accounting software is one of the best decisions a small business owner can make. However, is using one right for your business? For some businesses, using spreadsheets and even hand-written ledgers will do. For most, however, the ease and efficiency of an accounting software make it the better choice.
If any of the following applies to your business, investing in an accounting software is the way to go:
You are just starting out. Using accounting software right from the start sets your business up for success down the line. It is far more beneficial to begin using an accounting software from the first day than to implement one after months or even years of using spreadsheets or hand-written ledgers.
Your business is growing. If you plan on expanding or if your business is quickly growing, a manual accounting system becomes inefficient and complicated. Using an accounting software can save your growing business lots of time and money by automating processes and being highly scalable to your business’ size.