Accounting Glossary

The Cash Flow – is simply a forecast of your next 12 bank statements.  It records cash in and cash out as it happens.  Many good businesses run on a ‘cash accounting’ basis where they maintain cash in the business and take decisions based on the cash flow forecast.  They will delay buying assets or stock, for example, until such time as the business can generate cash from sales or raise finance.  The Cash Flow forecast is an important statement because you can predict when you will run out of cash and then take steps to avoid that happening. 

 

The Profit and Loss Account – is a record of your trading activity in any year.  It records your sales, direct and indirect costs, gross and net profit and level of corporation tax paid.  You can calculate a range of useful ratios to compare trends over say a 3 year period.  These include gross and net profit margins

 

The Balance Sheet – is a snapshot of the health of a business at a chosen time, usually at its accounting year end.  It records the assets and liabilities which sub-divide into fixed and current types.  The Balance Sheet always balances using the principle of double-entry bookkeeping.  The Capital Account (see note below) is the balancing figure and its sum is  the Net Worth of the business which is its book valuation and is what the shareholders would receive if the business was liquidated.  It is not the same as market value which is what a buyer will offer for a business and which the seller will agree to.  The section on Valuation below discusses how market value can be negotiated with, for example, an investor.

 

The range of accounting terms are set out in more detail below.

 

1.  Assets.  These are divided into fixed assets and current assets and are the resources a business owner uses to run their business.  Fixed assets are used over a longer period than current assets and include property, equipment, tools, computers.  Intangible assets include trademarks, intellectual property, patents.  Fixed assets are reduced in value each year based on standard depreciation rates, reflecting their useful life to the Company.  Intangible assets are amortised

 

Current assets will be used over a 12- month period and include trade debtors (cash due to you), cash in the bank, stock and work in progress.They can be turned into cash at short notice

 

The strength of your business can be assessed on the combined value of your fixed and current assets and by how much they exceed your short and long term liabilities

 

2.  Liabilities.  A sound business will aim to keep liabilities lower than their assets and by certain ratios, depending on the sector.  They divide into long and short term.  Long term liabilities include loans that extend beyond one year.  Current liabilities include loans to be paid back inside one year, trade creditors (people you owe money to) corporation tax and vat, directors loans, bank overdraft

 

3.  Working capital is the difference between your current assets and current liabilities.  You want your current assets to exceed your current liabilities to maintain liquidity in your business.

 

4.  Capital.  Capital is the money used to build, run, or grow a business. Capital is the money used to meet future expenses or to invest in new resources (assets) and projects.

 

5.  Capital Account on the Balance Sheet.  This is the balancing account on the balance sheet and typically holds:

     a) Opening capital

     b) New capital introduced in the current year, for example, from an investor

     c) Capital grants received

     d) Accumulated profit (loss) carried forward)

     e) Profit (and loss) added for this year

 

6.  Depreciation – this is where fixed assets are reduced in value on the balance sheet each year to reflect their useful life to the business.  The Depreciation sum is a cost on the profit and loss statement.  It does not effect cash flow

 

7.  Amortisation – this is the depreciation of intangible assets such as goodwill and intellectual property

 

8.  Direct costs.  These include payments for raw materials, wages, production costs and sub- contractors.  A rule of thumb is that direct costs go up and down roughly in line with your sales

 

9.  Indirect costs.  These are sometimes called overheads and, unlike direct costs, they do not follow increases in sales volume.  They include salaries, rent and rates, telephone, administration, legal costs and administration costs.    

​10.  Gross profit.  This is the difference between sales and direct costs. 

 

11.  Gross profit margin.  This is the percentage of income from sales remaining after paying for your direct costs.  Gross profit divided by revenue times 100 = gross profit margin.  It is expressed as a percentage.  It is a key performance indicator of the health of the business over a period of years.  

 

12.  Net profit is what is left after you have paid your direct and indirect costs.

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​13.  Net profit margin is expressed as a percentage.  Net profit divided by sales times 100 = net profit margin

 

14. Markup.  It is different to net profit margin.  It is the difference between your buying and selling price divided by your buying price times 100, expressed as a percentage

 

15.  Free cash flow represents the cash generated by a company each year after accounting for operational expenses, current assets, current liabilities and expenses incurred in maintaining capital assets. In other words, free cash flow is the cash left over after a company pays for its operating expenses and capital expenditure (CAPEX).  If your projections have good free cashflow then an investor see this as a positive.

 

          Free Cash Flow calculation:

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          Operating cash flow (from sales) – Operating expenses (to maintain the growth of the business= Free Cash                Flow

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​16.  Ratio Analyis – there are many common ratios and you can develop your own.  The beauty of ratios are that you can track your company’s performance and compare it with others in your sector.  They can be expressed as a factor such as your current assets exceed your current liabilities by a factor of 2:1 (often known as a ‘rule of thumb’).  Gross and net profit margins are expressed as a percentage

 

17. Valuation.  Valuing an early stage business is always tricky.  Your shares are not quoted on any market, and you are often simply negotiating with investors on the value for a percentage of your shares. Eg if you sell 20% of your shares for £100K then your value on that day is £500K.

 

One method is to use the EBITDA (Earnings Before Interest, Tax, Depreciation and Amortisation) figure with a multiplier for your sector. EBITDA you could say is a pure form of trading profit after all non-trading items are stripped out.  EBITDA demonstrates the ability of a business to generate cash from trading. You would not value your business with the EBITDA figure because that is your annual profit. You can however apply a multiplier using an industry list which will give you a multiplier figure for your sector. So if your EBITDA is £40K and your sector multiplier is a factor of 10, then your EBITDA valuation is £400K