It is very important for every entrepreneur to understand basic accounting rules in order to predict the success of the business. Knight (2017) presents words of Richard Ruback, a professor at Harvard Business School ‘If you can speak the language of money, you will be more successful.’ The success lies in understanding, even though many of us don’t feel comfortable with numbers. ‘’Joe Knight, a partner and senior consultant at the Business Literacy Institute and the co-author of Financial Intelligence, says that an absence of financial savvy is “career-limiting.’ (Knight, 2017).
To overcome limitations and achieve success, I took a workshop with Simon Hulme Programme Director & Senior Teaching Fellow MSc Entrepreneurship at UCL School of Management, who presented in a very interactive way the key financial statements, explaining that accounting is important for us to understand what is happening underneath the surface of the business.
The key financial statements Profit & Loss, Balance Sheet and Cash Flow explained by Mr. Hulme
P&L is like a video, it records what happened in the company in terms of revenue and expenses in a period of time (a month, quarter or a year).
Balance sheet is like a photo. It shows a still image of the assets & liabilities on a particular date.
e.g. ‘As at 31 March 2018’
Cash Flow shows ‘movements’ of money that come in and out of the business.
To understand P&L better, let’s review the exercise for Love Taste Company created by Simon Hulme.
In order to complete that exercise, it is essential to understand levels of profit. There are five levels of profit included in the P&L.
- Gross profit – profit made specifically on the product or service, before any other service (excluding tax).
- EBITDA – Earnings Before Interest, Tax, Depreciation & Amortisation. ‘This is a very early profit figure. It is looking at the profit after operating costs, but before Depreciation or Amortisation, Interest and Corporation Tax.’ (Hulme, 2015).
What is operating costs, depreciation and amortisation?
Operating costs is also called a ‘fixed costs’, basically our monthly costs as wages, bills, cleaning fees, advertising, fuel etc.
Depreciation it’s ‘an accounting method of allocating the cost of an asset over an appropriate period of time.’ (Hulme,2015). If a company buys an asset e.g. a laptop and assumes that it will work for 5 years, it will divide the cost of it by five, therefore only 1/5 of the price will be charged to the P&L each year.
Amortisation follows the same pattern as depreciation, however in this case the asset is intangible e.g. patent, goodwill, copyright or a trademark.
- EBIT- Earnings Before Interest, Tax also called and ‘operating profit’. It’s a good measure of profitability, it takes into account depreciation, but eliminates the cost of interest.
- Net Profit – the most common profit definition, it includes all operating costs, depreciation and interest costs.
- Net profit after tax it’s the final profit level, this is what is left for reinvestment, in the company after paying corporation tax.
After revising all five levels, I was ready to help Love Taste Company to calculate the P&L?
However, there is one more thing I need to consider – ‘The matching principal’.
The matching principal says that we need to […] ‘match’ the cost to the period in which they are incurred.’ (Hulme,2015). Firstly, Carl paid £6000 of rent in January, however it was a prepayment for the next three months. In this case, the whole cost needs to be divided by three. Therefore, £2000 goes to P&L. Secondly, £5000 worth of orders were out of stock and they will be delivered next month. Hence, they are not included in this month P&L, because ‘The matching principle’ indicates that sales counts on the moment of delivery.
**Loan repayment and Meal Cost do not count to the P&L.
This is just a very first step to understand one of the key accounting statements. I have never been good with numbers, however learning new languages has always been something exciting. Getting to know the ‘language of money’, will surely open new doors for me. How about you? Are you willing to learn a new language?
Hulme, S. (2015) ‘The Profit & Loss Made Easy’. London: UCL School of Management
Knight,R.(2017) How to improve your financial skill (even if you hate numbers). Business Harvard Review. Available at https://hbr.org/2017/03/how-to-improve-your-finance-skills-even-if-you-hate-numbers. [accessed: 05/12/2018]