Understanding My Numbers

Turnover, also called revenue or sales, is the total income generated by your business before any costs are deducted. It is the top line of your profit and loss account.

Turnover does not tell you whether a business is profitable. A business can have very high turnover and still make a loss if its costs are higher than its income. Turnover is a measure of scale, not of success.

Gross profit is what remains after the direct costs of producing your goods or services, known as cost of sales, are deducted from turnover.

The formula is: Turnover minus Cost of Sales equals Gross Profit.

For a product business, cost of sales typically includes materials, components and direct labour. For a service business, it may include subcontractors, direct staff costs or materials consumed in delivery.

Gross profit shows you whether your core trading activity is financially viable before the overheads of running the business are considered.

Gross margin is gross profit expressed as a percentage of turnover.

The formula is: Gross Profit divided by Turnover, multiplied by 100.

If your turnover is £200,000 and your gross profit is £80,000, your gross margin is 40%.

Gross margin is useful for tracking whether your pricing and cost structure are holding up over time. If your margin is declining, it means either your prices have not kept pace with your costs, or your cost of sales is increasing. It also allows you to benchmark your performance against industry norms.

Net profit is what remains after all costs, both direct costs and overheads, have been deducted from turnover. It is the bottom line.

The formula is: Gross Profit minus Overheads equals Net Profit.

Net profit is the clearest single measure of whether a business is making money. However, the accounting net profit and the cash the owner can take out of the business are not always the same thing. Tax, loan repayments and reinvestment reduce the cash available even when net profit is positive.

Working capital is the money available to fund the day-to-day operations of the business. It is calculated as current assets minus current liabilities.

Current assets include cash, amounts owed by customers (debtors) and stock. Current liabilities include amounts owed to suppliers (creditors), short-term loans and tax liabilities due within twelve months.

Positive working capital means the business has more short-term assets than short-term liabilities, it can meet its obligations as they fall due. Negative working capital means the reverse, which can indicate financial stress even in a profitable business.

Managing working capital, collecting debts promptly, controlling stock levels and timing payments sensibly, is as important as managing profit.

Break-even is the point at which your revenue exactly covers your total costs. Below break-even you are making a loss; above it you are making a profit.

Break-even analysis is a straightforward but valuable planning tool. It tells you the minimum level of sales you need to cover your costs, which helps you assess whether a business, product or project is viable before you commit resources to it.

It is particularly useful when you are considering a significant new cost, hiring an employee, moving to larger premises, or launching a new service. Ask: how much additional revenue do I need to cover this cost? Is that realistic?

Overheads are the costs of running the business that are not directly tied to the production of individual goods or services. They are sometimes called fixed costs, although not all overheads are truly fixed.

Typical overheads include rent, rates, utilities, insurance, telephone, marketing, accountancy fees, bank charges and management salaries.

Unlike cost of sales, overheads continue whether or not the business is generating revenue. This is why understanding your overhead base matters: it sets the minimum level of gross profit the business needs to generate before any net profit can be made.

Overhead recovery is the process of allocating overhead costs to individual products, services or projects to ensure they are fully covered by the prices you charge.

If a business has £120,000 of overheads per year and plans to work 2,000 billable hours, the overhead recovery rate is £60 per hour. Each hour of work charged to a client needs to recover at least £60 of overhead before any profit is generated.

Businesses that do not understand their overhead recovery rate often underprice their work. They cover direct costs and assume they are making money, without realising that the overheads are quietly consuming the margin.

Debtor days is a measure of how long, on average, it takes your customers to pay you. It is calculated by dividing trade debtors by turnover and multiplying by 365.

If your annual turnover is £300,000 and your debtors at any given point are £50,000, your debtor days are approximately 61.

The lower your debtor days, the faster you are converting sales into cash. High debtor days are one of the most common causes of cash flow problems in otherwise profitable businesses.

Cash flow is the movement of money into and out of your business. Positive cash flow means more money is coming in than going out. Negative cash flow means the reverse.

Cash flow is distinct from profit. A business can be highly profitable and still experience negative cash flow if its customers pay slowly, if it has invested heavily in assets, or if it has significant loan repayments.

Managing cash flow means understanding the timing of receipts and payments, not just the amounts. A cash flow forecast projects these movements forward, typically over 12 months, so that gaps can be anticipated and addressed before they become crises.

Profit is an accounting measure. It records income when earned and expenses when incurred, regardless of when cash moves.

Cash flow is a liquidity measure. It records money when it physically arrives or leaves the bank account.

The two diverge because of timing: invoices not yet paid, expenses paid in advance, loan repayments that reduce cash but not profit, depreciation that reduces profit but involves no cash, and VAT that passes through the bank account but is not income.

Both matter. Profit tells you whether the business model is working. Cash flow tells you whether the business can survive in the short term. Many businesses have failed not because they were unprofitable, but because they ran out of cash before the profit arrived.

A balance sheet is a snapshot of your company’s financial position at a specific point in time. It shows what the company owns (assets), what it owes (liabilities) and the net difference (equity or net assets).

The balance sheet balances because equity is defined as assets minus liabilities. It is called a balance sheet precisely because the two sides must always be equal.

A balance sheet tells you, among other things, whether the company has positive net assets (worth more than it owes), how much cash it holds, how much it is owed by customers and how much it owes to suppliers and lenders. It is a key tool for understanding the financial health of the business.

A profit and loss account (also called an income statement) records a company’s income and expenditure over a period, typically a financial year. It shows whether the business made a profit or a loss during that period.

It begins with turnover, deducts cost of sales to give gross profit, and then deducts overheads to give operating profit. Interest and tax are then deducted to give the final net profit figure.

Unlike the balance sheet (which is a snapshot), the profit and loss account covers a period. Together, the two documents give a complete picture of business performance and financial position.

Retained earnings are the cumulative profits that the company has generated since it was incorporated, less any dividends paid to shareholders.

They appear on the balance sheet as part of equity. A business with significant retained earnings has built up a reserve of past profits that can fund future investment or provide a buffer against difficult periods.

Retained earnings are not the same as cash. The profits may have been reinvested in assets, used to reduce debt or simply tied up in debtors and stock. A high retained earnings figure does not mean there is cash sitting in the bank.