Finance: Why you really need to know where your money is coming from and going.

The definition of what finance is can be quite broad and sometimes confusing. In the sense of business, it is the way in which a business or individual manages the flow of money coming into and out of their accounts. If we take the definition as explained by the merriam-webster dictionary we get the below:

money or other liquid resources of a government, business, group, or individual

I feel that this definition explains what finance means to a business as it describes not just the money but also the other things (liquid resources) which a company has in its possession that has a value which can be traded.

In the first session with Simon Hulme, we started looking at what finance means in a business sense starting with a few of the core concepts of finance for businesses. Some of the basic things we needed to understand were Profit & Loss statements, Product Pricing, Break-Even Analysis and the Balance Sheet. 

The Profit & Loss statement (P&L)

The profit and loss statement is a look at a company’s finances over a period of time. For example, I could look at a P&L for the last 30 days of my company’s running and this would help me to understand how my business is performing for that period of time.

The law requires companies to provide annual accounts, which lets the government know what the company has been up to and if it has been paying the correct amount of tax. In one example taken from Simon’s Profit & Loss Made Easy PDF, we can see the different measures used to understand where a company’s profits are, and apply a few different calculations to work out how we are doing.

Profit & Loss Made Easy PDF by Simon Hulme

Gross Profit: how much has the company made before taking into account any spending except for cost of sales.

EBITDA: ‘Earnings before Interest, Tax, Depreciation & Amortisation.’ This level tells us how much a company has made before accounting for depreciation of assets in the company’s possession, but after taking into account the day to day operating costs of the business.

EBIT: This figure takes into account the profit after accounting for depreciation of assets.

Net Profit: This is the first measure which shows what the company has earned after all costs have been taken into consideration, although tax is a cost in itself, it is a cost that cannot really be controlled as it is set in stone what you pay, whilst other things such as interest on a loan could be renegotiated for better terms.

Net Profit after Tax: This is the final figure after taking into consideration all costs and is the number that can be used to tell if a company is doing well or needs to improve.

Why is it important for me?

The Profit and Loss statement is a document I was aware of before but didn’t really understand how to use. I had previously tried to set one up to use as part of my calculations for when my web design business would become profitable but I didn’t understand all of the elements I needed to take account of. Now that I understand the P&L, I’ll be able to see at a glance how well my company is doing in a month. However, I still haven’t shown how to work out what the future might look like for me. To do this, we would use Break Even Analysis to find out if the company is making a profit or a loss based on the revenue over the costs of the company.

Break Even Points

The break-even point is the point in time when a company is not making a loss nor making a profit from trading. Many companies would start trading at a loss, and eventually reach this point through their daily activities. After this point any revenue counted can be seen as profit, and below this point is loss. The break even point can be used to work out how long you would need to trade for in order to turn a profit, there are a few things which need to be calculated before plotting a break even analysis chart.

Fixed Costs:  the costs associated with running the business that do not change. In the case of a web design business, I would say my fixed costs are around website hosting, internet package, domain name(s) and utilities for my home as I work from home as well as paying myself a wage.

Variable costs: these are a little bit harder to work out for a web design firm, however these are costs which are associated with the sale of goods and services. One example for web design might be a specific piece of software purchased on behalf of the client for a particular project or hiring a freelancer to help with something that my skills do not cover.

Sales / Revenue: This is a theoretical line to show how many sales I would have to make in order to turn a profit. The line is usually drawn from 0 and goes up steadily. The break even point is when the total costs  and the sales meet. Below is an example of what this might look like taken from the break even analysis made easy document from Simon Hulme.

Break Even chart from "Break Even Analysis made easy" by Simon Hulme

Depending on the type of business, the break even point will vary quite a lot. For example, a business which has large fixed and variable costs will need to sell more or at a higher price to break even, when compared to a company with lower total costs. In my case as a web designer, my fixed costs are quite low as I am ‘working from home’ as a freelancer, however as the business scales this will grow based on things like renting office space and buying my own web hosting servers. My variable costs are very low as the sales I’m making are based on services I offer. Any products I offer are paid for as part of the fixed costs (for example, hosting space which is pre-paid per month). The ability to generate revenue is very high, as the service is design skills which is technically ‘free’ for me, however the price I charge is based on an hourly rate which is then estimated and charged upfront.

Without taking into account ‘real world’ issues such as client acquisition and projects which might run over into the next month causing me to be unable to take on more work, the break even point should be quite low and I should break even much earlier than many traditional businesses. The last part of the finance lectures we had looked more deeply into the balance sheet.

Balance Sheets

The balance sheet is a statement of what a business owns or owes and it’s ownership equity (shareholders’ equity) at a particular point of time. The balance sheet can only be correct up to the day it was made, as the business operating day to day would change what the balance sheet shows. It can show if a business has been making profits or losses historically, and can help business owners to work out if the company is in a vulnerable place in the short term. By understanding this, we can decide what we can do in order to make sure the company stays ‘healthy’.

The balance sheet has a particular formula, and should always balance on both sides of the equation.

Assets - Liabilities = Shareholders' equity

The balance sheet should include everything a company owns or owes and can give a clearer idea of a company’s finances at a certain point in time. It can then be used to compare with previous balance sheets and understand the performance of a company. Ideally, a company should have more assets than liabilities, to get the best return for themselves and their investors.

Using the balance sheet, we can work out a few liquidity ratios which can give us this information at a glance. For example, the Current Ratio is used to evaluate how large current assets are vs the current liabilities.

Another useful ratio is the Quick Ratio, which removes stock from the Current Ratio. Stock is not always a good indication of if a company is doing well. If for example a company has lots of stock in inventory but is making a loss, it’s likely that the business is not going as well as expected. If the business were to fail, then the stock may not be worth as much as it was purchased for hence it does not give a good indication of what the business is actually worth.

To conclude this post, it is important for me to consider everything that I own in order to create websites, many of my physical assets have fully depreciated but can still be used, for example, my desktop computer and the monitors I use when I am designing are still in fully working order and do not need replacement, but are over 7 years old and would not have a very good resale value.

This does however bring up the question of what other assets I could have, would I include design work I’ve created and sell through third parties to multiple users as an asset or ‘stock’ for example? A question for another time.

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