Business Coaching

Break Even Analysis - Cost Volume Profit Analysis

Today's Finance for Non Financial Managers training lesson concerns break even analysis and the calculation of the break even point. This is particularly suitable at the moment because another series of articles featuring in the blog concerns the issue of business turnaround where moving the business back above the break even point is such an important issue.

What Is The Break Even Point

The Break Even Point for a business is the sales volume or sales value where the business neither makes a profit or a loss but is said to break even.

While arithmetically, the break even point is very precise, in general if a business is trading at a small profit or loss is will be said to be breaking even.

In previous financial training lessons (e.g. Matching Costs To Time), I have tried to make you understand that financial performance is not precise since it depends on interpretations, judgements and estimates.

So one accountant may prepare a set of accounts for a business which shows a £4,000 profit for the year while another accountant will make a different set of decisions and report a £3,000 loss. In both situations, the business is operating at around the break even point and the differences will be evened out over time.

Cost Volume Profit Analysis

An understanding of break even analysis is based on the cost - volume - profit relationship within a business.

There are three fundamental relationships:

1. Revenue varies directly with the number of units sold and the price the sales units are sold at.
    
2. Some costs vary directly with the number of units sold
    
3. Some costs in the business are fixed for a period and do not vary directly with sales levels. These costs do not automatically increase if sales increase and do not reduce if sales are lower than expected.

This creates a cost volume profit relationship which can be seen by the graph below:

 

As you can see the blue Revenue line starts from zero (if you don't sell anything, you don't generate any revenue) while the red Cost line starts from a point on the £000 axis which represents the fixed costs of the business.

Where the Revenue line and the cost line meet, the business does not make a profit or loss and is said to be at the break even point.

To the left of the break even point, the business is making a loss because costs are greater than revenue. While the angle of the revenue line is steeper than the cost line, it takes single sales to pay for the fixed costs.

To the right of the break even point, the business is making a profit because revenue is greater than costs.

An alternative way to think about your break even analysis and cost volume profit relationship is to your sales as contributing to meeting and then exceeding your fixed costs. 

In this approach you don't look at total revenue and costs but instead focus on the contribution of every sale  which is the difference between your sales price and  the variable cost of that sale.

So for example, a book shop may have an average selling price per book of  £10 with an average cost price of £7.  This means that the contribution (margin) per book is on average £3.

This changes the break even graph to look like the one below:

This is the approach that I prefer since it helps focus on the three basic profit generating tactics more clearly:

1. Can you increase your sales volumes?
    
   
2. Can you increase the contribution per sales unit (either by having a higher selling price or a lower variable cost)?
    
   
3. Can you reduce your fixed costs?

These three questions are the very essence of working with the break even analysis / cost - volume - profit relationship to improve the results of a business.

Calculating The Break Even Point Of A Business

The standard calculatiion uses the simplifying logic of the second graph and therefore if you want to calculate the break even point for a business you need to know:

1. The value of fixed costs
    
   
2. The contribution margin either as per unit or as a percentage of sales.

The formula is simple

The Break Even Point = Fixed Costs / Contribution Margin

Let's work through a couple of examples starting with the book shop mentioned above.

If the fixed costs are £6,000 per month for the shop and wages for staff and the average contribution per book is £3 then the break even point is £6,000 divided by £3 per book which means that the shop needs to sell 2,000 books per month to break even.

If we assume that on average the shop is open on average five days per week and four weeks per month, that means that the break even target per day is 100 books and per week 500 books.

With this knowledge, the book owner has a general indication of how well the business is performing each day before any accounts are prepared.

If one day, they sell 200 books then the book shop owner knows that they have had a very good day and should make a profit but if only 50 books were sold, then the business is likely to have lost money.

This calculation assumes that the £3 contribution per book sold remains true but in practice the margin on books will vary significantly with a much lower profit on the latest paperback bestsellers and much higher prices and profit on the expensive hardback textbooks.

One way around this problem is to use a contribution margin as a percentage of sales in the break even point calculation and this is the method used where it is not practical to work with sales units.

Break even point in sales value equals fixed costs divided by the contribution margin as a percentage of sales value.

So in the book shop example, there were fixed costs of £6,000 per month and with a 30% contribution margin it means that the break even point in sales value equals 6000 divided by 30% which equals £20,000 sales per month.

So the book shop owner now has a slightly different daily measure as the minimum sales target becomes £1,000 per day.

Using The Break Even Analysis

The break even analysis or cost volume profit analysis can be used in many different ways:

1. Before you start a business, it is very difficult to know how much you are likely to sell but your fixed costs can often be estimated with reasonable accuracy and then it is up to you to live within the budget.
    
   So the break even point can be calculated based on your estimated margins and a "worst case margin" to give you a range of estimated break even points. This then acts as a sense check or feasibility check. Do you really think that your business can sell at above the break even point level and if so, how quickly?
    
2. If you are considering major changes in your business you can calculate what effect it will have on your business. For example, you may have a salesman who comes to you and says that your prices are not competitive but if you allow him to reduce prices by 10%, he can increase your sales by 50%.
     
   To see whether this is a good idea, you would do a quick calculation. For example suppose your business has fixed costs of £100,000 per month and you have a 35% margin. This gives you a current break even point of £286,000 (100,000/35%) which you comfortably exceed with average monthly sales of £350,000.
    
   With a 35% margin, sales are 100% and variable costs of sale are 65%. If sales prices reduce by 10%, this comes straight off the margin so sales are 90% of the old level, margins are 25% of the old level and the new margin as a percentage of sales is 27.8% (25/90).
    
   This will mean that the new break even level is £360,000 (100,000/27.8%) which is higher than the current sales level so the salesman must be right in his assertions that he can increase sales. If he can't the salesman has taken a profitable business and turned it into a business that is losing money and therefore you would see this sales price reduction as a very risky move.
    
   [It is not relevant to this discussion on break even points but the salesman's idea may work if he can increase sales by 50% because the contribution would be higher than the existing business generates.]
     
3. As a method to target business improvement and creative thinking. The cost volume profit analysis provides the framework to help you brainstorm ideas for increasing values, increasing contribution rates and for reduced fixed costs.

Conclusion

The break even analysis is a simple but powerful method for understanding the profitability of your business. In a future article I will look at some of the weaknesses and problems that exist in the simplifying assumptions but I am a stronger believer in businesses calculating their break even points and monitoring trends.

Fixed costs have a nasty habit of creeping up with time and margins often reduce as customers negotiate special discounts, purchase prices increase and the business is worried about increasing its own prices.

The trend of the break even point puts these changes into perspective and shows that the business must take action to improve its performance.

Your Profit Coach

Paul Simister

Business coaching for customer focused entrepreneurs

Understanding Finance: Calculating & Reporting Profit

The next instalment of my Understanding Finance articles based on my Finance For Non-Financial Managers training course looks at how profit is calculated and reported.

I have mentioned in passing that revenue (sales or income) and costs (expenses) are brought together in the Profit & Loss Account or Statement but I haven't really explained much about the breakdown of these items and how your profit should be reported.

Calculating Profit Is Not As Simple As Adding Up The Transactions

In Matching Costs To TimeI explained that certain transactions like the quarterly property rent need to be spread over the three months to calculate the right costs and that sometimes the business will account for the transaction in advance of the cost (a prepayment) or in arrears of incurring the cost (an accrual). I also explained that sometimes revenue has to be spread in the same way.

This means that to get a reasonably accurate measure of your profit, you need to have your accounts prepared by an accountant or an advanced book-keeper.

How Often Should You Measure Profit?

I am glad you asked. If you want to properly manage your business you can't afford to have your profit calculated a few months after your year end. That normally leads to surprises and often they are unpleasant.

You don't want to be in the situation of looking back on decisions and wishing that you could reverse them because you didn't know how bad things were.

Small businesses can get away with quarterly accounts (prepared within four weeks of the end of the quarter) provided the business is very stable but ideally I like to see:

1. A set of management accounts including a Profit & Loss Account or Statement prepared every month (and preferably within two weeks of the end of the month).
    
2. Weekly profit estimates based on revenue/sales achieved if the business is under pressure to hit agreed targets with owners or bankers.

I hope you noticed that I set targets for when the information is available to you because you don't want to be looking at your Profit & Loss Account for one period when the next one has already ended. The purpose and value in reporting your profit regularly is that it encourages you to take actions to correct problems and concentrate on any unexpected opportunities.

The Format Of Your Profit & Loss Account or Statement

A key phrase is "monthly management accounts" and this means information that is useful for you and your management team to know each month and which can be used to help you to manage your business.

You do not want a monthly version of your annual accounts which are prepared for the tax authorities and statutory reporting. Unfortunately that is what many firms of accountants will provide unless you specify your requirements in detail.

Analysis of Sales/Revenue

This can be by product category, by customer type (or even by customer), by region (or person) or a combination of them all.

Too often I see accounts with inadequate information provided about how sales are performing when this is the source of all your profit.

If you have too many categories to show on your main Profit & Loss Account, then these can be shown on a separate schedule.

Your Direct Variable Costs of Sale

Sorry about the jargon but I've said before, it is inevitable when we are talking about finance but I will try to make explain as I go along and please leave a comment if I miss anything.

Direct means that the cost allocation is without dispute.

• If you sell books, then the direct cost would be the cost of the books sold.
   
• If you sell steel components, then the direct cost includes the cost of the steel required to make the component including any scrap.
   
• If you sell cleaning services, this includes the cost of your cleaners' wages and national insurance/social costs.

Variable means that the value changes with the volume of sales you make.

So if you sell ten books, the cost is twice the cost of selling five books (assuming you don't cross a quantity discount threshold).

Your Gross Profit, Gross Margin or Contribution Margin

Sorry for the different terms but people use different terms for what could be the same measurement and I prefer contribution margin.

This contribution margin is your sales value minus your direct variable costs.

This is an absolutely vital measure to understand because contribution margin is effectively your real income and I like to see it analysed across the same categories as you look at your sales although it can be technically challenging.

Let me try to explain why this is so important.

You may have three different types of product, each selling £20,000 per month.

Product A has a 30% profit margin so generates £6,000 contribution.

Product B has a 15% profit margin so generates £3,000 contribution.

Product C has a 50% profit margin so generates £10,000 contribution.

So if I ask you which is your most important product and the one you want your sales force to promote first, the answer is obviously Product C. It generates the highest profit and every extra £100 of sales generates the most profit.

But what if sales weren't equal?

What if product A has sales of £40,000 per month, product B had sales of £60,000 and product C has sales of £20,000 with the same margin percentages

Now which is your most important product which you should be concentrating on?

• Product B has the highest sales,
   
• Product A generates the highest contribution at £12k per month (Product B generates £10.5k and product C still generates £10k) and
   
• Product C has the highest margin %.

This is much closer to the real world where you are having to respond to opportunities by choosing between them but also balancing out how you are going to respond to threats.

There are only so many hours in the day and you and your team need to know where to focus their time for the maximum return.

Having your Gross Profit or Contribution reported by Product / Customer Type / Region means that you can understand what is happening in your business at a much deeper level than normal and you can take the appropriate actions.

Your Indirect Variable Costs

You may have other variable costs which vary with output and sales but which can't be directly allocated to particular products or customers.

Some businesses will find that Labour, Carriage, Power and Consumables fall into this category and for some businesses it is OK to bundle them up and apportion the costs to the product groups on some arbitrary basis.

Other businesses are better to recognise that they need two product margins. The first after direct costs and the second after the indirect variable costs to avoid deceiving themselves.

For example I used to work for a non ferrous metal supplier that identified a material margin (i.e. after only deducting direct material costs) and then a contribution (after allocating direct labour and variable production costs through a complicated calculation based on effort required at each stage of production).

This may seem unnecessarily technical because what you should do will depend on characteristics of your business and your ability to account at the different levels but back in the late eighties and early nineties, big businesses became aware of the damage incorrect cost allocations made to their management decisions.

I will be writing more about the issue of Activity Based Costing some time in the future but it is an advanced financial technique more suitable for bigger businesses.

If the indirect variable costs are comparatively small to sales and direct variable costs, either treatment will make little difference. If indirect costs are substantial, you will need to take advice from your accountants but please have your own thoughts on how they can be allocated and how the allocation may distort your numbers.

Your Overheads / Fixed Costs

These are your fixed costs which are broadly the same for each accounting period unless you take deliberate action.

It includes if appropriate:

1 - Your production overheads

2 - Your distribution overheads

3 - Your sales overheads

4 - Your marketing overheads

5 - Your administrative overheads

In the US, the final categories are often abbreviated to SG&A which stands for sales, general and administrative costs.

Your Operating Profit

The operating profit is the primary measure that you are trying to increase as this is the profit you generate from your business operations.

Other Income

You may also have other sources of income. For example you may have properties that you rent to other people or you may have sold a property in the year and made a profit on the sale.

To help explain performance from one period to another and from one year to another, I always like to see these unusual items which are not linked directly to the business activity shown separately.

Other Costs

You may also have one off other costs which need to be shown separately.

For example, costs of employee lay-offs and redundancies would distort relative performance comparisons if not they are not highlighted in a separate category.

Interest Payable or Receivable

Your interest will reflect your financing policy (do you borrow from the banks or provide the finance yourself as share capital). While interest is an important cost and should not be ignored, it is best to separate.

Profit Before Tax

A convenient sub-total to show how much economic gain you have generated before the government takes their slice from the company profits. However it is a little misleading since national insurance/social costs and property/local rates and taxes are usually included in overheads.

Company Taxation On Profit

If only death and taxes are inevitable, you should not ignore any opportunities for reducing your tax payable or delaying payment.

Check with your accountant. A big advantage of preparing monthly accounts for profitable businesses is that it means tax planning can be done from a position of knowledge.

Profit After Tax

The profit you keep within your business for the period before any dividends or distributions to shareholders.

Conclusion

This has been a gentle walk through the standard items in your Profit and Loss Account or Statement but if you have any questions (excluding local accounting policies), then please post a comment.

Many of the sets of Profit and Loss accounts I see prepared by professional accountants are:

1. Prepared too late.
    
2. Are glorified overhead analyses with no emphasis on the fundamental drivers of profit. It doesn't make sense to have three pages on overhead costs which are relatively easy to control and usually involve a positive decision to incur but only have six lines on the movement down from sales to contribution margin.

I hope that you are now in a position to tell your accountants what you expect to see and if they don't deliver. you may want to read up on my Guide To Finding An Accountant

To Your Success

Paul Simister

Your Profit Coach, business coaching for customer focused entrepreneurs

© Planning & Control Solutions Ltd 2008 All Rights Reserved

Financial Training: The Importance Of Cash & Cash Flow Forecasts

There is an old banking mantra which sums up the very essence of financial control:

"Turnover is vanity, profit is sanity but cash is reality"

Business owners and managers often make the mistake of focusing on sales growth thinking that it will automatically lead to profit, only to discover at the end of the year that price reductions have caused the margins to collapse.

Even more serious is that as a business grows it often consumes rather than generates cash.

More stock is needed if goods are sold. Debtors/accounts receivable increase much faster than creditors/accounts payable. Extra capital expenditure may be needed to provide the extra infrastructure and equipment for the growth.

It works the other way around as well.

As a business contracts and sales get smaller, the business can incur losses but generate cash.

Financial Control - Turnover, Profit & Cash

You can't use your turnover as a reliable guide to your financial health and that's why the banking mantra tells you to look at profit and cash.

For information about profit, you look at the Profit & Loss Account. For more information, read Understanding Financial Statements although I will be looking at the Profit & Loss Account in more detail in future articles.

Today you will learn to understand, monitor and control the cash aspects of your business.

As with Profit, you should look at historical cash flows and also try to predict the future with a cash flow forecast.

There are two main formats:

1. Receipts & Payments
    
2. Reconciliation from the Profit (this will be covered in a separate article)

The receipts and payments format is the easiest to understand and the best for day to day control of cash although the other format explains the common question "We made a profit but where has all the cash gone?"

Receipts & Payments

The format is simple.

Receipts minus Payments equals Cash Flow.

Cash Flow plus the Bank Balance at the start of the period equals the Bank Balance at the end of the period.

Sources Of Receipts

1. Receipts from cash sales which may also include debit card and credit card sales
    
2. Receipts from credit sales which you will collect from your trade debtors/accounts receivable after a credit period
    
3. New bank loans
    
4. New cash introduced from the business owners, either as equity or loans
    
5. Sundry receipts

The credit sales are the items which cause the timing of cash flow to differ from sales by a period which is often between 30 and 90 days and sometimes even longer.

Credit control is a subject of a different article but the amount of credit you give to your customers is a critical factor and must be tightly managed. Sales people should not have the authority to agree delayed terms because they are not in a position to understand the consequences.

In general I have a dislike of bank loans since they can be used to cover up symptoms of poor profitability and bad cash management. Banks also expect security for their money and this puts the business owner's personal assets at risk. If you need a bank loan, I recommend an ebook "The Secrets of Getting Your Bank Manager To Say Yes"

Sources of Payments

In many ways payments are the opposite of receipts but payments are made to a wide variety of stakeholders like suppliers, employees and the government.

1. Cash payments including debit and credit card payments
    
2. Periodic payments, standing orders and direct debits
    
3. Payments to creditors/accounts payable which will reflect the credit you take from your suppliers/vendors
    
4. Net wages and salaries paid to employees
    
5. Payment of employee taxes, social security and benefits
    
6. Business tax payments on the profit of the business
    
7. Value added tax / sales tax
    
8. Capital expenditure
    
9. Interest payments on bank loans and overdrafts
    
10. Repayments of bank loans
     
11. Dividends payable to the business owners
     
12. Other payments

Credit will be available from suppliers but extended terms often require careful negotiation as it may be seen as a sign of financial weakness.

Payments for employees in the UK are split between the net payment made to employees in the month and the associated PAYE tax and national insurance/social security which is paid by the 19th of the following month.

Value added tax is an issue if your company is over the VAT limit and will have to be added to your sales but the VAT charged and paid on your purchases can be reclaimed.

Unless much of your sales are outside of the scope of VAT (eg insurance), zero rated (e.g. basic food) or you export, your VAT on sales (known as output VAT) will be more than your input VAT (on purchases) and this has to be paid to the taxman. There are a number of different schemes so you need to talk to your accountant or HM Customs & Excise to make sure that you use the scheme which best suits your business.

Corporation tax or business tax is easily forgotten about in the rush to make a profit. Again talk to your accountant about arranging your tax affairs in the most beneficial way whilst staying on the right side of the law.

Forecasting Cash Flows

Cash needs to be managed and it is best done by using a cash flow forecast to make sure that you have cash available throughout the year.

It is far better to talk to the bank about an increase in overdraft or an extra loan well in advance of the need for the money. Going to your bank manager at the last minute when you have found out you can't make the payroll payment this month sends out a clear message "You are not in control of your cash." This is not something you want to be telling your bank manager and you will have a very difficult meeting.

Long Term Cash Forecasting

I like a long term cash forecast which is linked to a forecast Profit & Loss Account for the next twelve months. It is also best to have a Forecast Balance Sheet to complete the picture and check for errors and inconsistencies.

The long term cash flow forecast will be for 12 months and you should prepare it before the year starts and then update it periodically if the underlying forecasts prove to be inaccurate.

The long term cash forecast is particularly important if you have a business where sales fluctuate sharply across the seasons or where you have very "lumpy" payments and/or receipts.

It is less important if your transactions are small and regular and one month is very much like another and if you have plenty of cash, you may be able to use simpler controls.

Short Term Cash Forecasting

I like the discipline of short term cash forecasting to cover the next one to three months where you can take the information from your sales ledger/accounts receivable and purchase ledger/accounts payable together with current payroll expectations and other known payments.

The level of detail required will depend on the level of cash crisis. I like to see a forecast by week but if your business is in a cash crunch, the forecast will have to be daily to make sure you don't commit yourself to non-priority payments on the assumption that receipts may come to allow you to meet the payroll.

The next step is to monitor how the actual receipts and payments compare with your forecasts for the month. Building up a monthly record of actual payments and receipts together with notes on unusual items, helps you to prpeare your long term forecast the following year.

The short term cash flow gives you the ability to manage your cash on a day to day basis and if customers are paying slower than expected, you can decide to hold back your payments to your suppliers.

Cash Is King

I am writing about business turnaround in other articles around this one so it is always important to remember that a business is bankrupt when it runs out of cash and can no longer make the payroll or pay suppliers.

Cash is also black and white and not the shades of grey which Profit can be.

Profit depends on estimates and the accounting policies which are used so talk to five accountants and they may give you five different profit numbers.

Cash is reality and you can see it in the receipts and payments.

To Your Success

Paul Simister

Your Profit Coach, business coaching for customer focused entrepreneurs

© Planning & Control Solutions Ltd 2008 All Rights Reserved

Understanding Finance: Matching Costs To Time

Two weeks ago I explained why every transaction has two sides to it in Understanding Finance: Two Sides To Every Transaction using a market trader as a simple example. Did you notice how I introduced the concept of spread costs over time?

I wrote about agreeing to rent the market stall the day before and that created an obligation to pay for the stall (a creditor) and an asset in the form of the rights to use the market stall the next day.

By the end of the day, the rights to use the market stall had expired so it was no longer an asset included in the Balance Sheet but a cost to be included in the Profit & Loss Account.

The Profit & Loss Account Is For A Period Of Time

Because the Profit & Loss account is for a particular period, a week, a month, three months or a year, it is essential that revenue and costs are properly allocated to the right periods.

If the matching isn't right, your Profit & Loss Account isn't right.

Items Are Held In The Balance Sheet

Costs that have been incurred but where there is not yet a transaction to process create an obligation to pay. For example a business will use electricity every day but will only be invoiced every month or three months.

To show the right costs, we recognise that we have used the electricity which is a cost in the Profit and Loss account, and the other side creates a creditor in the balance sheet.

Accruals

These costs are called accrued charges and the creditors are called accruals.

Each time a Profit & Loss account is required, the accountant or bookkeeper will estimate the accrued costs. Large costs, for example electricity for a factory would be based on meter readings but most of the time the costs are assumed to be incurred at the same rate as the previous invoice.

Eg Invoice for electricity for the three months to 31 March 2008 = £6,000

So the sensible accrual for April would be around £2,000 (i.e. £6,000 / 3) although you may want to calculate it on days or working days.

£2,000 will be charged to the electricity cost in the Profit & loss Account and creditors will include the obligation to pay the electricity company £2,000.

At the end of the three months, you will have accrued £6,000 and when the electricity invoice comes in for £5,857.42, you have a small adjustment to make which will reduce the electricity charge in the next period.

It is not an exact science but you can see that it makes much more sense that having a big cost for electricity for one month, then nothing for two months and then a big cost again.

Prepayments

Accruals you incur the cost first and then pay for it afterwards.

Prepayments work the other way around. You pay first (or at least accept an invoice to pay) and then you benefit going forward in the future.

In the UK it is common to have to pay building rent 3 months in advance so at the end of March you have to pay for April, May and June. Let's say the payment is £10,500 to keep the numbers easy on 31 March.

In the March accounts, you have a prepayment of £10,500

In the April accounts, you have now used one third so you have a Rent cost of $3,500 and a prepayment of £7,000 (which represents the rights to stay in the property until the end of June - this is an asset).

In May, we have another £3,500 rent cost and the prepayment is now reduced to £3,500 which is then used up in June but we have to pay for the next quarter's rent so the prepayment at the end of June jumps back to £10,500.

Capital Expenditure, Fixed Assets and Depreciation

More accounting jargon but unfortunately if you are going to master accounts and understand finance, it is impossible to avoid some of this jargon.

A fixed asset is an item with an enduring value which is expected to last for longer than a year. A big computer system is a fixed asset. An automatic lathe is a fixed asset. If you have bought a business property, that is a fixed asset.

When you buy a fixed asset, the process is called capital expenditure and in a later article we will look at how you can decide whether it is a good idea to buy and whether the capital expenditure can be justified.

While the value is long lasting, fixed assets do wear out over time.

The pick up truck may last four years but by the end, it is unreliable and you need to buy another.

Accountants reflect this use of the value of the fixed asset through a cost called depreciation.

So if the truck costs £21,000 and is estimated to have a useful life of 4 years and only be worth £1,000 at the end of year 4, we have a cost of £20,000 to recognise over the four years.

If we decide that this cost should be incurred on a straight line basis, we charge depreciation of £5,000 to the Profit & Loss account every year. This is called a 25% depreciation rate because the estimated useful life is 4 years.

There are other depreciation policies which say that a great proportion of the value is used up in the early years.

After the first year of owning the truck, we have an original cost of £21,000 in the balance sheet, a £5,000 depreciation charge in the Profit & Loss account, and because every transaction has a second side, we have £5,000 accumulated depreciation in the balance sheet.

Original cost minus accumulated depreciation equals the current value of the fixed asset in the balance sheet and is known as net book value or NBV. For the truck this is £21,000 minus £5,000 = £16,000.

Revenue Matching

If buying companies have accruals and prepayments, selling companies have the opposite entries.

Just as a company paying property rent would spread the cost over the period of the rent, the owner of the building who is receiving the rent will have to spread the revenue over the future period.

Conclusion

The purpose of this matching is to make sure that the Profit & Loss Account reflects what is really happening in the business rather than the commercial arrangements.

This means that profit and cash flow can be very different and we will look at cash flow as a concept in the next understanding finance briefing.

I hope that this is helping you to understand, The Finance For Non-Financial Manager courses I used to run were very successful and gave business owners and managers a chance to understand their accounts in a way that they never could before.

Feedback

I hope you found this third financial training article helpful and I would appreciate your feedback. By all means post finance questions that you would like me to cover although I won't be answering questions about the different accounting standards across the world.

To Your Success

Paul Simister

Your Profit Coach, business coaching for customer focused entrepreneurs

© Planning & Control Solutions Ltd 2008 All Rights Reserved

Previous articles in this series

Understanding Financial Statements

Understanding Finance: Two Sides To Every Transaction

Understanding Finance: The Two Sides To Every Transaction

Last week in Understanding Financial Statements I explained the basic components of the Profit & Loss Account and Balance Sheet and this week I am going to look at how there are two sides to every transaction.

You will have heard of double entry bookkeeping and I'm not going to even attempt to teach you about debits and credits because to understand finance you don't need to know.

But you do need to understand that there are two sides to every financial transaction and it is this logic which is picked up and recorded by double entry bookkeeping.

Many people find finance complicated because they don't see both sides to the transaction or understand the consequences of what it is they do.

Quick Summary of the Five Essential Components of Finance

If you read last week's posting I hope that you remember that:

• Your Profit & Loss has two components - what I am calling revenue and costs, and provided total revenue is greater than total costs, you have made a profit for a period of time.
   
• Your Balance Sheet has three components - assets (items owned by the business), liabilities (obligations to pay) and equity (the money you have invested in the business).

You need to be clear about these five components of finance - revenue, costs, assets, liabilities and equity for the next stage.

Your Business - A Fruit and Vegetable Market Stall

I have used this market stall example in Finance For Non Financial Managers training and it seems to be easily understood by all.

Transaction 1 - Hiring Your Market Stall

You start by visiting the market organiser and you check whether there are any fruit and vegetable stalls available. You find that there are and you agree to hire one market stall in the best position for tomorrow at a cost of $20 which you agree to pay at the end of the day.

You now have:

An increase in assets - the rights to use the market stall worth $20

An increase in liabilities - an obligation to pay $20

Transaction 2 - Buying Fruits & Vegetables To Sell

You get out of bed really early and go to the wholesale market where you buy all the fruit and vegetables you need for $200 but because they don't know you, your supplier forces you to pay cash.

After transaction 2 you have:

An increase in assets - $200 of inventory/stock

A reduction in assets - your cash has reduced by $200

Transaction 3 - Selling Your Inventory

You decide that you will mark up your costs by 100% so the apple which costs 20 cents will be sold for 40 cents.

During the day you sell $300 of fruit and vegetables.

After transaction 3 you have:

An increase in assets - $300 extra cash

An increase in revenue - your sales are $300

A reduction in assets - you have reduced your inventory by $150

An increase in costs - your costs of sales are $150

An increase in equity - you have made a profit of $150 on the fruit and vegetables that you have sold

Transaction 4 - The Expense Of Your Market Stall

Yesterday when you agreed to hire your market stall you created an asset and a liability.

Today as you have been selling on the stall, your asset has been reducing minute by minute and it becomes a cost so that by the end of the day you have used up all your rights to the market stall and if you want it next week, you will have to do another deal.

After transaction 4 you have:

A reduction in assets - you no longer have any rights to the stall which had cost $20

An increase in costs - you have incurred market costs of $20

A reduction in equity - the costs reduce the profits you have made from the day by $20

Transaction 5 - You Pay The Market Organiser

As expected the market organiser comes to see you as you are packing away the unsold fruit and vegetables and you have to pay him the $20 you promised.

After transaction 5 you have

A reduction in assets - your cash has reduced by the $20 you paid

A reduction in liabilities - you no longer have an obligation to pay the $20

Transaction 6 - You Sell Your Surplus Inventory

You have some fruit and vegetables left over at the end of the day but you won't be back for another week so you have to sell your surplus inventory to another trader who visits another market tomorrow.

You have inventory of $50 left (you bought $200 and sold $150) but the other trader won't pay you what you paid. He is a regular and gets a better deal from the wholesalers and he also knows that you don't have many alternatives.

The trader offers you $20 for your inventory which cost $50 and you reluctantly accept.

After transaction 6 you have

An increase in revenue - you have sold your final inventory for $20

An increase in assets - you have an extra $20 in cash

A reduction in assets - you have sold your $50 of inventory

An increase in costs - you have cost of sales of $50

A reduction in equity - you lost $30 on the day by selling the $50 inventory for $20

To help you to see the difference between Balance Sheet and Profit & Loss Account, I have printed the Balance Sheet items in blue so that you can see that at each stage, the balance sheet balances.

Reckoning Up At The End Of The Day

After the flurry of activity during the day, has it all been worthwhile? You started working at 6:00 am and you haven't got back home until 6:00 pm.

After transactions 1 to 6 your accounts show:

Profit & Loss Account

Revenue = $300 + $20 = $320

Costs of Sales  = $150 + $50 = $200

Market Hire Costs = $20

Profit = $320 - $200 - $20 = $100

Balance Sheet

You started with some cash because you paid out $200 to buy your inventory so let's assume that at the start of the day you had a balance sheet which looked like this:

Assets = Cash = $250
Assets = Rights To Use Market Stall = $20
Total Assets = $270

Liabilities = Obligation to Pay For Market Stall = $20

Equity = $250 (from the cash you put in)

And as we learnt from the last lesson Assets minus Liabilities = Equity

So $270 - $20 = $250

At the end of the day we have

Assets = Cash = 250-200+300-20+20 = $350

Liabilities = 20-20 = $0

Equity = 250 +100 (your profit) = $350

and your balance sheet still balances.

Debits & Credits & Double Entry Bookkeeping

If you found this helpful and you really want to know the debits and credits of the two sides for every transaction:

Debits are increases in assets and costs

Credits are increases in revenue, liabilities and equity

Debits and credits are opposite so a reduction in an asset is a credit.

Conclusion

I have tried to keep things simple but if you have become confused by the example, just go back and work through it. Real life businesses are much more complicated but the five essential components of finance stay the same.

Take transactions that you have made and try to work out how they flow through your business accounts.

If you buy something does one side of the transaction:

a) create an asset

b) create an asset which will reduce over time

c) create a cost

and does the other side of the transaction

d) create a liability

e) immediately reduce another asset

Good luck and please ask me questions by leaving a comment if you don't understand.

Next Lesson

Next week we will look at some more complicated transactions which are affected by time - Understanding Finance Matching Costs To Time

Feedback

I hope you found this second financial training article helpful and I would appreciate your feedback. By all means post finance questions that you would like me to cover although I won't be answering questions about the different accounting standards across the world.

To Your Success

Paul Simister

Your Profit Coach, business coaching for customer focused entrepreneurs

© Planning & Control Solutions Ltd 2008 All Rights Reserved

Business Book Reviews 1

My new Business Books blog has been active in the first week with a combination of book reviews and book summary reviews.

Book Reviews

The Ultimate Sales Letter Dan Kennedy - 4.5 Stars

I review my well thumbed guide to copywriting by non nonsense copywriter Dan Kennedy.

Instant Team Building Bradley Sugars - 3 Stars

I plucked up courage to read another of Brad's Sugars books and this time it does have some good points but not enough to recommend it as a buy.

Ebooks

The Secrets Of Getting Your Bank Manager To Say Yes by Rob Warlow - 4.5 Stars

Excellent guide to convincing your bank manager to give you a loan.

Book Summaries

Success In Small Business Is A Laughing Matter Phil Johnson

Business advice with humour.

Creative Marketing Communications

Compendium of articles from the big creative agencies ran into my scepticism of brand advertising.

How To Close Every Sale Joe Girard

Hard nosed sales book from the Guinness Book of Records top salesman. Not for the squeamish who prefer consultative selling but ideal for those people tired of being walked over by prospects.

New Leaders Wanted Now Hiring Leandro Herrero

Thought-provoking and unusual book about leadership

Built To Last Jim Collins & Jerry Porras

Other people love it but I can't see what the fuss is about.

Articles

Michael Porter Five Forces Update

Latest Harvard Business Review article updates the classic with recent examples but the basic theory stays untouched.

Free Ebooks

Download these free ebooks while you have the chance as I intend to refresh the contents regularly.

Internet Marketers Guide To FREE Traffic, Sales and Profit by Raam Anand

Making A Living Off Your Blog by Terry Jett

AdSense Income Blueprint by Kurt Chrisler

To Your Success

Paul Simister

Your Profit Coach, business coaching for customer focused entrepreneurs

© Planning & Control Solutions Ltd 2007-2008 All Rights Reserved

How To Get A Small Business Loan: CAMPARI

Another day and even more headlines about the global credit crisis which must affect the availability of loans for small businesses. Banks are becoming much more risk sensitive so if you need extra funding, it is essential that you know how to get a small business loan.

Basically the more you see the loan application from the bank's perspective, the more you make it easy for the bank to say yes rather than no.

You Need A Business Plan

The banks have the upper hand and you will be expected to prepare a business plan to support your loan application.

Follow their rules or don't expect to get the money.

See business plans for guidance.

But what happens after you have prepared your business plan?

How Do Banks Look At Loan Applications

The bank makes money by making loans but as the credit crisis is showing, there are major problems if they don't get the money back and repayment is always their first concern.

There are various acronyms for the way a bank manager and the bank' lending committee will assess an application for a loan. The one I find easiest to remember is the banker's acronym CAMPARI.

CAMPARI stands for:

• Character
   
• Ability
   
• Margin
   
• Purpose
   
• Amount
   
• Repayment
   
• Insurance

CAMPARI - Character

The bank knows that the success of your small business depends on you as the owner and senior manager so it will look very carefully at how good a risk you are:

• How old are you and how is your health?
   
• What are your personal assets? Have you been a saver or a spender?
   
• What is your banking and credit history? Do you have a record of defaulting on loans or have you always paid back on time?
   
• How committed are you to the business?
   
• Do they believe that you are honest and with high integrity?

CAMPARI - Ability

The focus now moves a little beyond you to include your senior management.

• Is the bank manager impressed with your business acumen? Do you show that you understand the numbers and your business?
   
• What has been your record in business?
   
• Are you giving the impression that you are in control of your business? A sudden but urgent request for an increase in overdraft suggests that you are not.
   
• How strong is the management structure or does the business just rely on you? Do you or someone in your business have the necessary finance skills?
   
• Is there are succession plan if anything happened to you?

CAMPARI - Margin

• How much money is the bank going to make from the business loan?
   
• Is the risk and return ratio right?

CAMPARI - Purpose

• Why do you want the small business loan? Is it to finance expansion or is it needed to fund business problems? Are any problems resolved and if not, is there an achievable action plan?
   
• Can you prove your reason is true? Banks have been caught by people saying one thing and doing another.
   
• Is the reason sensible for the business?
   
• How do you want the extra finance provided?

CAMPARI - Amount

• How much are you asking for?
   
• How much do the cash flow forecasts indicate that you need?
   
• Do the forecasts look realistic?

CAMPARI - Repayment

• How long do you need the money for?
   
• Is the repayment profile suggested acceptable?
   
• Have you repaid similar loans in the past?
   
• If the business can't pay back the loan, can you?

CAMPARI - Insurance

• What security are you offering? What extra could you offer?
   
• How well does the offered security fit with the bank's criteria?
   
• Does the security available comfortably cover the amount of the loan?

Think Of Getting A Small Business Loan Like Selling To A Customer

When you see a customer you work hard to persuade them that you offer a good deal which is good for them.

When you are working out how to get a small business loan, you are effectively selling your idea of the loan to the bank manager. It is your job to persuade the bank that it is in the bank's best interests to lend you the money.

There is an old making question that you have to remember.

People always ask in their minds "What's in it for me?"

If you go to the bank with a badly prepared proposal with no security, you are failing the "what's in it for me" test.

Learn More About How To Get A Small Business Loan

I have just reviewed Rob Warlow's excellent ebook "The Secrets Of Getting Your Bank Manager To Say Yes" (link to sales letter for this 240 plus page book).

Nearly a quarter of the book is about CAMPARI and how your small business loan application is reviewed. The more you understand what the bank wants, and the more you give the bank what it wants, the more likely you are to succeed with your small business loan.

You can see my review How to apply for a small business loan

Your Profit Coach

Paul Simister

Business coaching for customer focused entrepreneurs

© Planning & Control Solutions Ltd 2007-2008 All Rights Reserved

Understanding Financial Statements

If you have problems understanding financial statements and finance in general then I recommend that you sign up to the RSS feed because I am planning to take you through my finance for non financial managers course on a week by week basis.

See Why Measuring Performance Is Essential

I hope this week is straight forward because it will get more complicated but i want you to understand the basics. Remember my purpose is not to turn you into a book-keeper or an accountant but to give you enough knowledge that you can understand the way money flows through your business.

Terminology & Accounting Jargon

One of the big problems in the world of finance and accounting is that the jargon can be very confusing. One finance term can have different definitions in different companies and countries and there are hundreds of different terms.

Don't be intimidated. Try to fix the terminology you want to use and stick with it. Look to your professional accountant for guidance. While you may understand what you mean, you don't want to be calling apples oranges as it won't give a good impression to any banker or investor.

The Core Financial Concepts

In business finance and personal wealth you have two basic concepts that you must be clear on:

1. Income, profit or cash flows - the critical factor is "per period". You can't say "My profit is £10,000." It doesn't mean anything. It has to be "My profit is £10,000 per year" or some other time period. This the same with payroll costs for employees - it is per period.
    
2. Balance - here the critical factor is that it is a snapshot a particular point in time and at any other time, the number could be significantly different. "I have $23,000 in my bank account today but if I pay my overdue suppliers I will only have $7,000 tomorrow." On a personal level wealth is a balance, income is a flow.

On this basis it won't surprise you that the profit is shown in the Profit & Loss account per period and the balances are shown in the balance sheet at a set date.

Here's the problem with the jargon. It intimidates anyone who doesn't understand this flows and balances concept.

People understand on a personal basis the difference between income and wealth but I've lost count of the number of people who say something like "If you want to know my sales, I'll have to look in my balance sheet."

Wrong - people do get confused between periodic flows and set date balances even though it seems obvious to you as you read this article.

The difference between balances and flows is all about momentum.

People can be wealthy but have little income or can have a high income but no wealth (because whatever comes in they then spend).

So can businesses. The Balance Sheet shows the position at the particular date but the Profit & Loss Account shows the momentum, which way the business is heading.

Two Things You Need To Know About Flows Per Period

Flows can be good - revenue, sales, income, fees

or

Flows can be bad - costs, expenditure, expenses, overheads

That's it.

If sales are greater than costs, the business makes a profit.

If sales are less than costs, the business makes a loss.

As Mr Micawber from Charles Dickens book David Copperfield said "Annual income twenty pounds, annual expenditure nineteen pounds nineteen and six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery."

If sales and costs are similar value, the business is referred to as "breaking even" although there may be a small profit or loss for the period.