The 30 Day MBA (6 page)

Example

A company had sales of $/£/€5 million this year and $/£/€4 million last year and these figures appeared in the profit and loss accounts of those years. Debtors at the end of this year were $/£/€1 million and at the end of the previous year were $/£/€0.8 million. The cash inflow arising from sales this year is $/£/€4.8 million ($/£/€0.8 million + $/£/€5 million – $/£/€1 million) whereas the sales figure in the profit and loss account is $/£/€5 million.

For these reasons it is not possible to look at just this year's profit and loss account and balance sheet to find all the cash flows; you need the previous year's accounts too. The balance sheet will show the cash balance at the period end but will not easily disclose all the ways in which it was achieved. Compiling a cash-flow statement is quite a technical job and some training plus inside information is needed to complete the task. Nevertheless, the bulk of the items can be identified from an examination of the other two accounting statements for both the current and previous years.

From an MBA perspective it is understanding the requirement for a cash-flow statement as well as the other two accounts that is important, as well as being able to interpret the significance of the cash movements themselves.

XYZ plc

The un-audited condensed cash-flow statement for XYZ plc, established as a supplier of container solutions for source-separated waste, is shown in
Table 1.5
. Initially one man and a desk, the company grew to become a leading supplier of kerbside recycling boxes as well as a key supplier of other types of waste and recycling container solutions. Turnover by 2010 was running at over £30/$47/€34 million a year, with operating profit in excess of £1/$1.6/€1.13 million.

TABLE 1.5
  
Un-audited condensed cash-flow statement for XYZ plc (for the 6 months ended
30
June
2011
)

The three columns represent the cash activities for two equivalent six-month periods and for the whole of the preceding year. The cash of £2,126 ($3,336/€2,395) thousand generated to 31 December 2010 (bottom of the right-hand column) is carried over to the start of the June 2011 six-month period (second figure from bottom of left-hand column). By adding the net increase (or decrease) in cash generated in this period we arrive at the closing cash position.

The cash-flow statement then gives us a complete picture of how cash movements came about: from normal sales activities; the purchase or disposal of assets; or from financing activities. This is an expansion of the sparse single figure in the company's closing balance sheet stating that cash in current assets is £3,751 ($5,886/€4,226) thousand.

The income statement/profit and loss account

If you look back to the financial situation in the High Note example you will see a good example of the difference between cash and profit. After all, the business has sold $/£/€60,000 worth of goods that it paid only $/£/€30,000 for, so it has a substantial profit margin to play with. While $/£/€39,108 has been paid to suppliers, only $/£/€30,000 of goods at cost have been sold,
meaning that $/£/€9,108 worth of instruments, sheet music and CDs are still in stock. A similar situation exists with sales. We have billed for $/£/€60,000 but been paid for only $/£/€48,000; the balance is owed by debtors. The bald figure at the end of the cash-flow projection showing High Note to be in the red to the tune of $/£/€4,908 seems to be missing some important facts.

The difference between profit and cash

Cash is immediate and takes account of nothing else. Profit, however, is a measurement of economic activity that considers other factors that can be assigned a value or cost. The accounting principle that governs profit is known as the ‘matching principle', which means that income and expenditure are matched to the time period in which they occur. (Look back to earlier in the chapter where realization and accruals are explained.)

So for High Note the profit and loss account for the first six months would be as shown in
Table 1.6
.

TABLE 1.6
  
Income statemen
t
/profit and loss account for High Note for the six months Apr–Sept

The structure of the income statemen
t
/profit and loss statement

This account is set out in more detail for a business in order to make it more useful when it comes to understanding how a business is performing. For example, although the profit shown in our worked example is $/£/€8,700, in fact it would be rather lower. As money has been borrowed to finance cash flow there would be interest due, as there would be on the longer-term loan of $/£/€10,000.

In practice we have four levels of profit:

• Gross profit is the profit left after all costs related to making what you sell are deducted from income.
  
• Operating profit is what's left after you take away the operating expenses from the gross profit.
  
• Profit before tax is what is left after deducting any financing costs.
  
• Profit after tax is what is left for the owners to spend or reinvest in the business.
  

For High Note this could look much as set out in
Table 1.7
.

TABLE 1.7
  
High Note extended profit and loss account

A more substantial business than High Note will have taken on a wide range of commitments. For example, as well as the owner's money, there may be a long-term loan to be serviced (interest and capital repayments); parts of the workshop or offices may be sublet, generating ‘non-operating income'; and there will certainly be some depreciation expense to deduct. Like any accounting report, it should be prepared in the best form for the user, bearing in mind the requirements of the regulatory authorities. The elements to be included are:

1. sales (and any other revenues from operations);
   
2. cost of sales (or cost of goods sold);
   
3. gross profit – the difference between sales and cost of sales;
   
4. operating expenses – selling, administration, depreciation and other general costs;
   
5. operating profit – the difference between gross profit and operating expenses;
   
6. non-operating revenues – other revenues, including interest, rent, etc;
   
7. non-operating expenses – financial costs and other expenses not directly related to the running of the business;
   
8. profit before income tax;
   
9. provision for income tax;
   
10. net income (or profit or loss).
    

Income statement/profit and loss spreadsheet

There is an online spreadsheet at SCORE's website (
www.score.org/resources/1-year-profit-loss-projection.xls
). Download in Excel format and you have a profit and loss account with 30 lines of expenses, the headings of which you can change or delete to meet your particular needs.

The balance sheet

A balance sheet is a snapshot picture at a moment in time. On the one hand it shows the value of assets (possessions) owned by the business and, on the other, it shows who provided the funds with which to finance those assets and to whom the business is ultimately liable.

Assets are of two main types and are classified under the headings of either fixed assets or current assets. Fixed assets come in three forms. First, there are the hardware or physical things used by the business itself and which are not for sale to customers. Examples of fixed assets include buildings, plant, machinery, vehicles, furniture and fittings. Next come intangible fixed assets, such as goodwill, intellectual property etc, and these are also shown under the general heading ‘fixed assets'. Finally there are investments in other businesses. Other assets in the process of eventually being turned into cash from customers are called current assets, and include stocks, work in progress, money owed by customers and cash itself.

Total assets = Fixed assets + Current assets

Assets can only be bought with funds provided by the owners or borrowed from someone else, for example bankers or creditors. Owners provide funds by directly investing in the business (say, when they buy shares issued by the company) or indirectly by allowing the company to retain some of the profits in reserves. These sources of money are known collectively as liabilities.

Total liabilities = Share capital and reserves + Borrowings and other creditors

Borrowed capital can take the form of a long-term loan at a fixed rate of interest or a short-term loan, such as a bank overdraft, usually at a variable rate of interest. All short-term liabilities owed by a business and due for
payment within 12 months are referred to as creditors falling due within one year, and long-term indebtedness is called creditors falling due after one year.

So far in our High Note example, the money spent on ‘capital' items such as the $/£/€12,500 spent on a computer and fixtures and fittings have been ignored, as has the $/£/€9,108 worth of sheet music etc remaining in stock waiting to be sold and the $/£/€12,000 of money owed by customers who have yet to pay up. An assumption has to be made about where the cash deficit will be made up, and the most logical short-term source is a bank overdraft.

For High Note at the end of September the balance sheet is set out in
Table 1.8
.

TABLE 1.8
  
High Note balance sheet at
30
September