Accounting Statements: Profit and Loss

As I said in the introduction to accounting statements, the profit and loss (P&L) statement provides an historical picture of how our business has performed over a given time period. It is calculated annually, at the end of a financial year, but may also be calculated on a monthly basis if we wish to have more detailed knowledge of how we are doing.

The financial year is not necessarily the same as the calendar year (January to December), although in some countries, it is exactly that. In UK, a limited company may use any year end date they wish, although 31st March is the most common one since it co-incides with the tax year. Whichever year end we pick, we still have to fit in with the HMRC timetable for PAYE, National Insurance and tax returns, all of which operate on the year April to March. If we are self-employed, our year end will be 5th April, in line with the individual tax year which starts on 6th April each year.

If we do want monthly statements, then we are probably at the point where a computerised system is appropriate. It is not a necessary part of running a business to know how to construct financial statements, but it is essential that we know how to interpret these statements and understand what they are telling us. That’s the aspect from which I’m approaching these articles.

In previous articles, we’ve already looked at the P&L equation: I (total income) - E (total expenditure) = profit (if I is bigger than E) or loss (if E is bigger than I). This time, we’re going to look at this in a little more detail and cover five lines on the statement instead of the three quoted above.

Total Income

As the term suggests, this is the total amount of money that has been invoiced in the year. Note the use of the word ‘invoiced’. It’s more than likely that not all the money has been received yet, especially for any invoices raised in the last month, but everything earned in a financial year should be accounted for. Total income is also sometimes called Turnover, Revenue or Sales. It is a measure of the total amount of business we have done in the year.

Direct Expenses

This is the expenditure incurred directly in doing the business measured above. It is the cost of printing our book (but we can only include the cost of copies that have actually been sold); the postage for distribution of specific copies of our book; the travel costs incurred in presenting a training course or a paid-for appearance. We should ask ourselves the question: would those costs have been incurred if that piece of work had not been carried out. If the answer is ‘no’, then those are direct expenses. They are also sometimes called Variable Costs since they vary with the level of business or the Cost of Goods Sold.

Gross Profit

When direct expenses are deducted from total income, the resulting figure is called gross profit. In traditional businesses like manufacturing, it is a measure of how efficiently labour and materials are utilised. In our writing business, we don’t include labour costs unless we sub-contract out a specific piece of work, so it’s a measure of how efficiently we use the materials and other resources that go into generation of our income. There is no right answer to the question: what is a good percentage gross profit; it varies with circumstances and the type of business. However, I would suggest it should always be a positive number. In other words, we should always generate a gross profit, no matter how small, in our business. Otherwise, we might as well set fire to our money or (preferably) give it away. There may be times when we choose to sell our goods or services at cost (for example if we speak at an event for expenses only ) or even make a loss (for example by donating copies of our books for a raffle) but that’s not a sustainable business model in the long-term.

Indirect Expenses

There are all sorts of other expenses we incur running our business but which cannot be associated directly with any one income stream. For example, the cost of running our office, whether it is part of a serviced building or our back bedroom; marketing costs (business cards, book marks, adverts); Internet and phone charges; and most important of all, what we pay ourselves. We should ask ourselves the question: would those costs have been incurred even if no work had been carried out. If the answer to this question is ‘yes’, then we are looking at an indirect cost. They are sometimes called Fixed Costs or Overheads since they are independent of the level of business.

Net Profit

When the indirect expenses are subtracted from the gross profit, the resulting figure is called net profit.  Mathematically, the same figure is obtained by subtracting total costs (direct and indirect) from total income. So net profit, which is sometimes referred to as bottom line, is a measure of the overall success of the business in financial terms (I fully accept there are other ways of measuring success).  In formal company accounts, net profit is further sub-divided into net profit before tax and net profit after tax. I’m not going to go into tax, as it’s a highly complex area, apart from making the point that while not all income will be taxable, not all expenses will be tax-deductible. This is an area where I believe it pays to take expert advice.

Unlike gross profit, it is very likely that in the early years of a business, net profit will actually be a negative figure (more correctly called net loss) and so long as we have funding available to cover the short-fall, that’s perfectly acceptable. And that’s where cash-flow comes in. We’ll talk about that next time.

As always, note that I am not an accountant or a lawyer, just a long-term business owner, talking about my own experience. If you are unsure about anything, always take advice from an appropriate professional.

Accounting Statements: Introduction

In the past two articles, we’ve looked at what records we need to keep in our small business; records both of income and of expenditure. Now we’re going to start looking at why we need to keep those records and what we need to do with the data we collect.

There are two main reasons for keeping financial records. Firstly, it is a legal requirement. The law says if we earn money, we have to pay tax. I know that’s a very broad statement and there are all sorts of things to consider, such as whether a particular income type is tax-free; or whether our earnings exceed our tax allowance level; but in general terms, if we earn, we pay tax. And yes, before you ask, that does apply “even if it’s only a hobby”. Although why we would be thinking about hobbies when we are supposed to be running a business, I have no idea.

Incidentally, although I am writing about systems in the UK, I think I’m safe in saying the rule “if we earn, we pay tax” applies in most other countries as well.

But frankly, there is a much more important reason why we keep financial records: we need to know whether our business is successful or not. Remember the quote from Mr Micawber: “Annual income twenty pounds, annual expenditure nineteen nineteen six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.” (David Copperfield by Charles Dickens). Now, I’m not actually saying that profitability is the only measure of success; but we are running a business here. We need to know whether we’ve made a profit or not; whether our cash flow is going to be sufficient to pay the mortgage next month and so on. As always, we should try to keep the systems as simple as possible, so they are effective, tell us what we need to know, with as little effort as possible, so we can concentrate on what we really want to be doing: writing.

There are three main accounting statements. I’m going to introduce all three in this article, then go on to talk about the two key ones in the next couple of articles. The statements are: profit and loss; balance sheet; and cash flow.

Profit and Loss

The profit and loss statement is an historical picture of how the business has performed over a given time period. We’ve already talked about the profit and loss equation in earlier articles:

I (total income) - E (total expenditure) = profit (if I is bigger than E)
or loss (if E is bigger than I)

We’ll look at this in more detail next time. The P&L statement is usually calculated annually; it will certainly form part of our closing accounts. However, it may also be useful to monitor it on a monthly basis. If we are going to do that, it’s certainly easier to do with an accounts package (software).

Balance Sheet

The balance sheet provides a snapshot in time; what is the business worth today? It compares the total assets (what we own in terms of equipment; money in the bank; stock waiting to be sold; and money owed to us) with the total liabilities (what we owe in long-term or short-term debts) and also looks at how the business is funded. This statement is more appropriate to limited companies and is not a requirement for a sole trader in the UK. It can be calculated manually, but is much easier to prepare at the press of a button via a software package. I’m not going to cover balance sheets in nay more detail than this.

Cash Flow Statement

This is arguably the most important statement for any business; it is a forward-looking document, used to plan the flow of money over time. It is particularly important if we are going to incur high expenses (for example, if we are self-publishing a hard-copy book) or if there will be a delay before receiving payments.

In most businesses, there is a time-lag between incurring expenditure and bringing in income. Even cash businesses like shops often have to pay upfront for their stock, but only get income in return when the stock is sold. As writers, we may be lucky enough to have an advance against a commissioned book (although that’s becoming rarer these days) but even that will then to be a relatively small amount of income. If we have to wait for publication, for sales to grow and for the first royalty statement to be issued (which can be six or twelve months after publication), our investment (in time, in electricity, in printing costs etc) will occur quite a bit in advance of the expected income. We need to know if and when our cash flow is likely to be negative (more going out than coming in) so that we can plan our funding appropriately. This is particularly important in a start-up business and applies equally to sole traders or limited companies. We will look at cash flow in more detail in a couple of weeks’ time.

As always, note that I am not an accountant or a lawyer, just a long-term business owner, talking about my own experience. If you are unsure about anything, always take advice from an appropriate professional.
 

Keeping Financial Records: Expenditure

Last week, we looked at how to keep records of income; now we’re going to look at recording our expenditure. Then we’ve got the two sides of the equation: we need to know what money came in (our income) and what money went out (our expenditure). The difference between the two is our profit or loss. If our income is greater than our expenditure, we have made a profit. However, if our expenditure is greater than our income, we have made a loss.

So let’s think about how our expenditure is recorded.

As writers, our expenditure can go in lots of different directions. Here are a few I thought of and there will be others you can list too:

·       The cost of printing our books, if we publish independently; I’m not just thinking about the costs of the physical books, but the cover design, services of an editor or proofreader; the purchase of a block of ISBN numbers etc.;

·       The purchase of books or magazines relating to our business and bought for the purposes of research;

·       Competition entry fees;

·       Train fares or mileage for travelling to courses or workshops, whether as the teacher or as the student;

·       The money we pay ourselves (whether that’s a PAYE-managed salary within a limited company or personal drawings if we are self-employed);

·       Bank charges and accounting/book-keeping fees;

·       The costs of running an office (and as business people, we do have an office, whether it’s part of a serviced building; the back bedroom; or a corner of the kitchen table): paper for the printer; postage for sending out copies of our books, competition entries or submissions to agents; charges for our website; fee for renewing our antivirus software etc.;

·      Capital purchases such as our laptop, printer, desk and filing cabinet.

Many of these payments will be made by cheque, internet payment or credit card and will be accompanied by an invoice or a receipt from the seller, so there is an immediate paper trail. Others will tend to be cash payments, especially if it’s for a small amount. All businesses should be able to provide a receipt on request; we need to get into the habit of always asking for one, even when it’s just a short taxi ride from the station to a conference location, or a quick sandwich grabbed during the lunch break on a course.

We looked at invoices and receipts in last week’s article. The only difference between income and expenditure is that in the first, we issue the documents, whereas in the second, the documents are issued to us. The documents themselves will be the same. And remember they will range from a formal invoice from a printer to a scrappy till receipt from a coffee bar. So once again, when it comes to sorting out our total expenditure for the business, we will be faced with a complete mix of different types of record.

As with income, all the bits of paper need to be collated in order to calculate total expenditure. It is also useful at this stage to group expenses together under different headings: direct expenses; wages; office expenses; professional fees etc. Our options were spelled out last time, but bear repeating: we can give the job to the accountant to do for us at the end of the year, which is effective but costly. We can give it to a book-keeper, either monthly or at the end of the year; again, this is effective and less costly than an accountant, but still means paying out money. Or we can do it ourselves, either monthly or at the end of the year. This option may be effective, depending on our abilities with numbers, and is the least costly in terms of actual expenditure, but it is costly in terms of our time.

Once again, I’m going to assume we decide to do it ourselves on a monthly basis, while the task is smaller and our memory is fresher. We will be listing all items of expenditure in one place. Let’s look at what that might look like for our three types of financial system:

·       Paper-based: a simple cash book with appropriate layout can be bought from any stationers. An A4 hard backed notebook will do the job just as well, but the columns will have to be drawn in. Start each month on a new page. List the expense items in date order (which helps when reconciling the bank statement) and put a total at the bottom. If you are grouping expenses as this stage, have a separate column for each category of expense and total each column separately as well In theory, you can use the same page as the income record, but it’s probably simpler and neater to use a different book, or a different section of the same book.

·       Spreadsheet: Use one spreadsheet for all the accounts, but use a separate worksheet for each type of transaction (income, expenditure etc). List the expenses in date order and use the software to calculate a total at the bottom. As above, use separate columns for different categories of expense.

·       Commercial software: Each transaction will need to be converted to an expense payment to enter it into the system. If the supplier has issued an invoice, this needs to be entered and then the payment is accounted against it. If there are a lot of small cash transactions, it can be time-consuming and unnecessary to enter each one separately. My solution is to pull these all together on a monthly basis as a single invoice, itemised line by line within the document. The software has the provision for allocating a category to each expense and the facility for producing reports on each category as required.

Using any of the above systems on a monthly basis means that at the end of the year, there will be just twelve figures per category of expenditure to collate in order to identify total expenditure.

For non-receipted expenses, such as mileage, it is important to keep a written record. Every year I promise myself I will put a book in the glove-compartment and record every journey at the time it occurs; and every year the system collaspes quickly or never gets started. Luckily, I keep a detailed appointment diary and have a reasonably good memory. At the end of each year, I list all my journeys and calcualte the mileage using Bing Maps, but it takes me ages. Doing it on a monthly basis (or better still, journey by journey) would be a much more effective approach.

Closing notes: This article is about recording expenditure. Some of that expenditure will be tax-deductable, some may not be. No distinction is made here between the two. At this point, we are only looking at what records we need to keep. What we do with them later is a whole different subject.

As always, note that I am not an accountant or a lawyer, just a long-term business owner, talking about my own experience. If you are unsure about anything, always take advice from an appropriate professional.

 

Keeping Financial Records: Income

Back in January, we looked at the common types of financial system used by small businesses, whether paper-based; a simple spreadsheet; or commercial software. Now we are moving on to think about the data we will keep within those systems. Let’s start by asking the question: what records do we need to keep?

Well, at its simplest, we need to know what money came in (our income) and what money went out (our expenditure). The difference between the two is our profit or loss. If our income is greater than our expenditure, we have made a profit. However, if our expenditure is greater than our income, we have made a loss.

We’re going to start by looking at keeping records of income.

As writers, our income can come from lots of different source. Here are a few I thought of and there will be others you can think of too:

·       Sales of our books, either to bookshops or direct to readers;

·       Sales of articles or short stories to magazines, journals or websites;

·       Prizes from writing competitions;

·       Fees for running workshops or courses on writing;

·       Advance payments and royalties from publishers;

·       Payments through PLR (Public Lending Rights, relating to books borrowed from libraries);

·       Payments through ALCS (Authors’ Licensing and Collecting Society, relating to photocopying).

Most of these payments will come in as cheques or direct payments into the bank, so there is an immediate paper trail. Others will tend to come as cash, especially the direct sales of books. Some, particularly the bottom three on the list, will come with full statements.

The two classic ways to document income are by issuing an invoice, which is a demand for payment; or by issuing a receipt, which is a record of payment made. Some companies issue both for the same transaction, although this is not necessary.

There is no standard format for an invoice, but some pieces of information must be present:

·       Date of the transaction;

·       Invoice number;

·       The Sellers’s name, contact details and VAT number (if applicable);

·       The Customer’s name and contact details;

·       Description of the goods or services being sold;

·       The net price, any discounts applied, rate of VAT and amount of VAT (if applicable), and the final gross amount to be paid.

Some invoices also carry details of: customer account numbers; order number; payment terms and instructions on how to pay (who to make the cheque out to; bank details for direct transfers). The back of the invoice can be a useful space for advertising or getting other messages directly to our customers; for example, these days our utility bills and credit card statements come stuffed with additional information. 

If we have a system for issuing invoices, we also need a way of recording when those invoices are paid. However, from the point of view of the buyer, the invoice is sufficient record, so there is no need to issue a receipt against payment of an invoice unless we want to.

Receipts are generally issued against smaller payments, received by cash or cheque. Once again, there is no standard format. Think of a simple receipt issued when we buy something at a craft fair; or the till receipts issued by a larger retailer or petrol station. There is a world of difference between the levels of detail in the two. However, as a minimum, they need to show the date, customer’s name, description of the goods or services; and amount paid. If the seller is VAT registered, the VAT number should also be shown.

Invoices and receipts are ways of issuing documents to our customers; as mentioned earlier, some customers will issue documentation to us, in the form of payment statements. So it is likely we will end up with a complete mix of different types of income record.

At some point, all the documentation needs to be collated in order to calculate total income. We can give this to the accountant to do for us at the end of the year, which is effective but costly. We can give this to a book-keeper to do, either monthly or at the end of the year; again, this is effective and less costly than an accountant, but still means paying out money. Or we can do it ourselves, either monthly or at the end of the year. This option may be effective, depending on our abilities with numbers, and is the least costly in terms of actual expenditure, but it is costly in terms of our time.

There really is no right answer on this one. It depends on individual circumstances, resources and preferences. However, let’s assume we decide to do it ourselves on a monthly basis. The benefits are that the task is smaller and our memory will be fresher. Basically, all we are doing is listing all the sources of income in one place. Let’s look at what that might look like for our three types of financial system:

·       Paper-based: a simple cash book with appropriate layout can be bought from any stationers. An A4 hard backed notebook will do the job just as well, but the columns will have to be drawn in. Start each month on a new page. List the income-generating transactions in date order (which helps when reconciling the bank statement) and put a total at the bottom.

·       Spreadsheet: Use one spreadsheet for all the accounts, but use a separate worksheet for each type of transaction (income, expenditure etc). List the income-generating transactions in date order and use the software to calculate a total at the bottom.

·       Commercial software: Each transaction will need to be converted to an invoice to enter it into the system. However, these invoices do not necessarily have to be issued to the customer. For example, PLR and ALCS do not need an invoice as they generate the appropriate documentation themselves. If there are a lot of small cash transactions, it can be time-consuming and unnecessary to issue an invoice for each one. My solution is to list all the books sold, and the prices on a single invoice issued to myself, then accounted against the cash receipts.

Using any of the above systems on a monthly basis means that at the end of the year, there will be just twelve figures to collate in order to identify total income. Next time, we will look at recording business expenditure.

Closing notes: This article is about recording income. Some of that income will be taxable, some may not be. No distinction is made here between the two. At this point, we are only looking at what records we need to keep. What we do with them later is a whole different subject.

As always, note that I am not an accountant or a lawyer, just a long-term business owner, talking about my own experience. If you are unsure about anything, always take advice from an appropriate professional.