Whether you are running a huge multi-national company or a tiny micro-business, it is essential that someone in the organization is keeping a close eye on the figures – essentially, how much money is coming in and how much is going out. In a large business, it may be a whole team of accountants and accounts clerks who are responsible for keeping track of the figures, but in a small business, it will often be the person or people responsible for the day-to-day running of the business who have to make sure that the figures are in order.
Cash flow is quite possibly the single most important aspect of any business and can, when things go wrong, cause businesses to go under. Sometimes, even when a business is making plenty of sales, it can still go gust. However, making plenty of sales and having money in the bank is not the same thing. It’s quite possible that you are signing plenty of deals but until you collect the money you can’t, in many cases, afford to spend it. Consequently, if sufficient money isn’t flowing into the business to satisfy creditors and suppliers when it’s needed, then trouble is probably on the horizon. In such circumstances, even profitable businesses can go bust.
Here are a few reasons why poor cash flow can cause businesses to get into difficulty:
- Focusing on profit instead of cash flow (for example, a business whose fixed assets base is high and/or requires high working capital is likely to require more of the profits to be reinvested back into the business, thus reducing the cash available to service debts)
- Ignoring the relationship between receivables and payables
- Paying a supplier too quickly (always look at the terms of a contract and leave paying a bill for as is contractually acceptable)
- Carrying surplus stock (until you sell a piece of stock it hasn’r made any money for you, and may well be costing you money in storage costs)
- Being too slow to invoice (always get your invoices out as quickly as you can – the sooner you invoice, the sooner you will be paid)
- Giving credit to the wrong customers (not always easy to avoid, but don’t ever get caught twice)
Gross Profit is the difference between what an item costs and what it sells for. So, for example, if you pay £1 for an item, and you sell it for £5, the gross profit is £4.
If there are costs associated with, for example, the production of a product or service, these costs will play a part in the gross profit. For example, if a product costs £1 to buy and a further £1 to modify before it can be sold, and you sell it for £5, the gross profit will now be £3.
Gross Profit Margin
The gross profit margin is expressed as a percentage and is what remains from sales after a company pays out the costs of producing a product or service.
To obtain gross profit margin, divide gross profit by sales.
So, looking at the example above, if you receive £5 for the sale of an item, and it costs £1 to buy and a further £1 to modify, the gross profit margin will be:
Step 1: £5 – £1 -£1 = £3 (this is the gross profit)
Step 2: (£3 / £5) x 100% = 60% (this is the gross profit margin)
So, 60% gross profit margin means that for every £1 generated in sales, the company has 60 pence left over to cover operating costs (see below) and profit.
Here is a link to a Gross Profit Margin Calculator.
Net Profit is the difference between what an item sells for (£5 in our example above) and the costs associated with selling it. Here is an example:
Step 1: Add costs like rent, power, wages, advertising, delivery, and loan interest. These are the operating costs.
Step 2: Divide this figure by the number of items that you have (to sell). For example, £800 divided by 1700 (items) is 47 pence.
Step 3: Add this figure to the basic costs associated with the item (£2 + 47p = £2.47), giving you a net profit of £2.53 pence per item (£5 – £2.47).
Note that net profit is always smaller than gross profit.
Retained earnings refers to money that has not been paid out to shareholders in the form of dividends (see below for more information about dividends), but has instead been kept (retained) in the business. This money could then be re-invested in the business, for example, by training staff, buying new equipment, paying off debt, etc.
If the money is left in the company, it can be referred to as retained profit – money that has been kept in the company after all taxes, etc have been paid. It could then be used in future years, either to make dividend payments or to re-invest in the business.
If a business makes a loss, that loss is retained and called retained losses, accumulated losses or accumulated deficit.
Corporation Tax is a tax on the taxable profits of limited companies and other organisations including clubs, societies, associations and other unincorporated bodies. In the example given above, the taxable profits would be the net profit.
Taxable profits for Corporation Tax include:
- profits from taxable income, for example, trading profits and investment profits (except dividend income which is taxed differently – see below for more information about dividends)
- capital gains – known as ‘chargeable gains’ for Corporation Tax purposes
If a company or organisation is based in the UK, Corporation Tax will have to be paid on all the taxable profits of that company – irrespective of where in the world those profits are generated.
If a company is not based in the UK, but operates in the UK – for example through an office or branch (known to HMRC as a ‘permanent establishment’) – the company will only have to pay Corporation Tax on any taxable profits arising from its UK activities.
Corporation Tax – Financial Years
For Corporation Tax, the tax year is called the ‘financial year’ or ‘fiscal year’ and runs from 1 April to 31 March. This is different from the tax year for individual UK taxpayers, which runs from 6 April to 5 April.
Corporation Tax – Rates
There are currently two rates of Corporation Tax, depending on the size of a company or organisation’s taxable profits:
- the lower rate – known as the ‘small profits’ rate
- the upper rate – known as the ‘full’ rate or ‘main’ rate
There is also a sliding scale between the lower and upper rates known as ‘Marginal Relief’.
This means if a company or organisation’s profits fall between certain limits, it pays the full rate of Corporation Tax, which is then reduced by Marginal Relief.
Current rates of corporation tax for the financial year 2013-2014 are:
Small Profits Rate (up to £300,000 profit) = 20%
Marginal Relief Lower Limit = £300,000
Marginal Relief Upper Limit = £1,500,000
Main Rate of Corporation Tax = 23% (this will drop to 21% in 2014-2015)
Here is a link to a corporation tax calculator.
Dividends provide a tax-efficient way of extracting funds from a company to make payments to shareholders of that company. In order for a dividend payment to be made, a company must have made sufficient net profit (see above) in either the current year, or have sufficient retained earnings in the company to allow the dividend payment to be made. For example, if a company has a gross profit of £10,000, corporation tax will be £2000 (using 20% as the corporation tax rate), leaving £8000 that can be distributed to shareholders in the form of dividends.
Dividend Tax Vouchers
When a dividend payment is made, a tax voucher must be raised and issued to the shareholder. In days gone by, this would have been done by post, but these days it is common to issue tax vouchers electronically.
The dividend tax voucher shows the size of the dividend and the amount of tax credit. The tax credit shows the amount of tax paid by the company on behalf of the shareholder. Dividends are paid after tax (at the basic rate) has been deducted. If you are a higher rate tax payer, you will probably have additional tax to pay on the dividends you receive. This will often be worked out by HMRC at the time of completing your self assessment tax return.