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  • Hi, I'm Siu Ling Hui with Part 2 of a video series about how your financials can help

  • you manage and drive business success. In this video, we'll focus on trading activities

  • and working capital.

  • Let's take it from the start of a new business so we have a clean balance sheet to build

  • on. You put in $5,000 cash to get the business

  • off the ground. That cash is contributed as capital. That means you took up shares in

  • the business. You could have put the cash in by way of a loan from you personally to

  • the business but let's say it's capital for the time being. The business in involved in

  • selling widgets.

  • Let's say you start the business on the 1st of January. Your balance Sheet at the end

  • of that very first day of business would show Cash of $5,000 as Assets and Paid up Capital

  • of $5,000 as Equity. And if you looked at the Cash Flow Statement

  • at the end of that very first day of business, it would show that $5,000 came in as Proceeds

  • from Equity Raising. That's the capital your put in.

  • That's the only transaction that happened this day. So the Net Cash Flow would be $5,000.

  • At the start of the day, your opening bank balance was zero and at the end of the day

  • it's $5,000. So that change in bank balance is exactly equal to the Net Cash Flow for

  • the day. Which is how it should be.

  • So you start trading! In your first month, you sell of $1,000 worth of widgets. $800

  • of these sales were on credit terms. You gave your customers 30 days to pay. $200 of the

  • sales was done on cash terms. The widgets cost you $500. Because you're

  • a new business, your widget supplier insisted on being paid in cash up front. Let's assume

  • that you sell all the widgets you bought during the month. In other words, you don't have

  • any inventory left at the end of the month. You also hired an assistant and paid wages

  • of $200. Now let's look what your accounts show you

  • about this first month of trading.

  • Let's start with the Profit and Loss. You made sales of $1,000. The widgets cost $500.

  • That's your Cost of Sales or Cost of Goods Sold. So you have a Gross Profit of $500.

  • Then you had to pay wages. So that leaves you with a Profit Before Tax of $300. I'm

  • going to ignore the impact of taxes for the time being. Let's assume that Income Tax is

  • zero - so Profit Before Tax is equal to Net Profit After Tax.

  • So, what did this month's trading do to your business' financial position? Your balance

  • sheet as at 31st of January has grown as a result of the profit you made. You put in

  • equity of $5,000 on the 1st of January and that's grown to $5,300. Assets have also increased

  • to $5,300. But even though you made a profit, your cash went DOWN by $500 to $4,500. And

  • you've now got an asset called Debtors on your balance sheet.

  • To understand what happened with Cash, you need to look at your Cash Flow Statement for

  • the month of January. This Statement shows you that your operating activities used up

  • $500 of Cash because of working capital requirements. Specifically, because your business had $800

  • of cash being tied up in debtors. The Financing Activities section shows the

  • proceeds of $5,000 from equity raising earlier in the month when you set up the business.

  • So your Net Cash Flow for the month is $4,500. And that is exactly with the amount that your

  • bank balance changed by from the time you set up the business - just before you put

  • in equity - and at the close of business on 31st of January.

  • Now let's see what happens when we have credit terms from suppliers. In February, your business

  • doubles its sales to $2,000. $1,600 on 30 day terms and $400 on cash terms.

  • It cost you $1,000 to buy those all those widgets in February. When you were ordering

  • your widgets at the beginning of the month, your supplier was happy to give you credit

  • terms of 30 days from the date of invoice. So let's say you were invoiced sometime during

  • the 1st week of February That means you don't have to pay for the widgets until sometime

  • during the 1st week of March. Let's assume you had a complete sell-out again. In other

  • words, you don't have any stock left at the end of the month.

  • Your wages bill stays at $200. Now let's see what your financials show you

  • about your business at the end of February.

  • Your Profit & Loss for February shows sales of $2,000, double that of January. And better

  • still, Profit before tax of $800 is more than double that of last month. In other words

  • the business is more profitable now than it was in January. We'll discuss profits vs profitability

  • shortly.

  • The fact that you got credit terms from your supplier has no impact on your profit and

  • loss. The use of credit terms - or for that matter, the extension of credit terms by you

  • to your customers - only has implications for your balance sheet and cash flow.

  • Your balance sheet now shows total assets of $7,100. That's a $1,800 increase since

  • the 31st of Jan. That increase is made up of a $1,000 increase in cash and a $800 increase

  • in Debtors. This business expansion has been funded by

  • using your own money -the $800 profit which increased Retained Earnings to $1,100 - and

  • from using "other people's money" - that's the Trade Creditors of $1,000. Now, if you

  • didn't have the credit terms from your supplier, you wouldn't have this $1,000 liability but

  • you would have reduced assets because you would have less cash.

  • But how did your bank account increase by $1,000 when you only had $800 in profits?

  • Look at your Cash Flow Statement. It shows you a $800 increase in Trade Debtors. Increases

  • in Debtors tie up cash - that's why it shows as negative in the Cash Flow Statement. Now,

  • you know that a pretty high proportion of your sales are on credit terms. So the increase

  • in debtors from February's sales should be much higher than $800. In fact, new debtors

  • from credit sales in February was $1600. The fact that the increase in debtors is only

  • $800 means you have received debtor payments during February and presumably it's all of

  • your January debtors. I say "presumably" because you don't actually know who paid or didn't

  • pay you until you review the report called the Aged Debtors Listing. I'll get to what

  • an Aged Debtors Listing is in a moment. The $1,000 increase in Trade Creditors means

  • your supplier effectively provided you with "funding" during February. You got widgets

  • to sell without having to pay for them first. The net effect of the timing differences in

  • receipts and payments of your operating transactions ended up generating positive cash flow of

  • $200. This Cash Flow generated by Working Capital movements, together with your Net

  • Profit figure, gives you Net Cash Flow from Operations in February of $1,000. There are

  • no Investment and Financing Activities in February. So $1,000 from Operations is your

  • Net Cash Flow for the business for the month. And that reconciles exactly with the change

  • in your bank balance between the 31st of January and the 28th of February.

  • Let's look at Profit vs Profitability. Gross Profit is the profit you make after deducting

  • the cost of the goods sold from your sales. You've still got to cover overheads and other

  • expenses. Profit before tax is the profit your business makes after deducting overheads

  • and other expenses but before paying income tax. In this example, we've only got wages

  • as an expense. All these profit numbers are absolute numbers.

  • You do need to know whether your business is making a profit or not. But these numbers

  • don't show you how profitable your business is. Profitability is about how efficient your

  • business is in turning your sales into profits. That's where ratios come in.

  • Gross Profit margins gives you insights into how your business is pricing its products.

  • The Gross Profit Margin is the ratio of Gross Profit to Sales, expressed as a percentage.

  • A 50% margin - as it is in this case - means that you marking up your products by 100%.

  • The Net Profit Before Tax Margin tells you how efficient your business is at turning

  • your sales into profit before paying income taxes. It is the ratio of Net Profit before

  • Tax to Sales, expressed as a percentage. In this example, you achieved increased profitability

  • in February: your Profit Before Tax margin is higher because even though you doubled

  • sales, you haven't had to pay out more in wages. So your business is now converting

  • more of each sales dollar into profit.

  • Using margins enable you to benchmark your business' performance in a far more meaningful

  • way than just comparing absolute numbers. You might be making more sales but are you

  • making more money out of each dollar of sales than you used to? If you don't achieve the

  • absolute sales dollars that you targeted in your budget but you achieve a higher than

  • budgeted profit margin, is that necessarily a bad thing?

  • Margins also let you benchmark your business against your competitors, regardless of size,

  • and against industry standards. Are you getting comparable gross profit margins as your competitors

  • or is the rest of the industry achieving higher gross margins? Is that because of you have

  • chosen to discount your prices or because you are paying higher prices for your stock?

  • Are you achieving better or worse net profit margins than others? You do need to be very

  • careful about jumping to conclusions when doing external benchmarking. Your competitors

  • may have a different product mix. Their business or financial structures could be very different.

  • For example, some may own their warehouses instead of renting; some may be using debt

  • in their financing structure and others may not. However, external benchmarking is still

  • very useful as it gives you a feel for what your business should be achieving.

  • Now let's consider a different scenario for February. What if none of your January Debtors

  • paid you during February? Your Profit and Loss doesn't change but there's a big impact

  • on your Balance Sheet and your Cash Flow. First, the Balance Sheet. You still have $7,100

  • in Total Assets but the composition of the Total Assets is quite different. You cash

  • is now down to $4,700 instead of being $5,500 in the previous example. Total Debtors are

  • now up at $2,400, instead of the previous $1,600.

  • So, although you made $800 in profit AND you got credit terms from your supplier, your

  • cash only increased by $200. Your Cash Flow Statement tells you exactly what happened.

  • Your business now has an additional $1,600 tied up in trade debtors, instead of $800

  • in the previous example. Instead of working capital throwing off cash, it now chews up

  • cash of $600. So you end up with Net Cash Flow from Operations of only $200. And that's

  • your Net Cash Flow for the month. Which is why you only have a $200 increase in cash

  • despite the good trading month.

  • Let's see what's going on with your Trade Debtors by looking at your Aged Debtors Listing.

  • The Aged Debtors listing is a report that can be generated from any accounting system.

  • Make sure you look at this report every month as part of your business review. This report

  • gives you insights into the quality of your debtors, a key asset in any business. You

  • should have processes in place to manage debtors very tightly. A sale is not a sale until you

  • get the cash in. This is an example of an Aged Debtors Listing.

  • The aging periods - Current, 30 days and so on - are common "age" periods but it's not

  • cast in stone. If you sold on 14 day terms, it might be useful to have a column after

  • Current to show Debtors that are older than 14 days but less than say, 30 days. Current

  • means that they are still within terms. In this example, you can see that none of

  • your Debtors from January have paid you and still owe you money at the end of February.

  • Now, your terms of trade is 30 days so these customers are now way overdue with their payments.

  • Someone should have been calling these customers to follow up payment of overdue amounts within

  • days of payment due date. Sometimes customers may not have paid because of some issue with

  • your invoicing that didn't meet their internal processes or there is some issue with the

  • product. The earlier you find out and fix any problems, the sooner you'll get paid.

  • You can also see that two customers who are haven't paid you from January bought more

  • from you in February on credit terms. Should you still be extending credit terms to customers

  • who don't pay their bills?

  • In the Aged Debtors listing, you can see that Customer Number 1 is now your largest debtor,

  • representing 25% of your Total Debtors. This raises the issue of Concentration Risk. You

  • have potentially higher financial risk in your business because if a major Debtor like

  • Customer Number 1 went broke, you will have a bad debt of $600. Losing 25% of a major

  • business asset - $600 out of $2,400 - has huge implications for profits, your balance

  • sheet and cash flow going forward. You have to pay your supplier for those widgets. But

  • what are your chances of getting your widgets back from Customer Number 1 to sell them again