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

to someone else to cover that loss? Even if major customers are high quality blue-chip

corporates or government bodies which are unlike to go broke, you still have to consider

the increased business risk arising from customer concentrations. What if 80% of all your sales

come from only two customers and one or both of them suddenly decided to take their business

elsewhere? Concentration risk can be an issue when you

are seeking financing because of the higher business risk as well as the potential financial

risk. It's something that financiers look at very closely. As business owner, you should

be pursuing strategies to diversify your customer base to minimise concentration risk in your

business.

Trade Creditors are an important source of working capital for a business. For example,

in February, if you didn't have credit terms from your suppliers, the cash flow impact

of the delays in debtor collections would have been magnified. Working capital requirements

would have chewed up $1,600 of cash flow. So, even though you made $800 profit, your

net cash flow from operations would have been MINUS $800. And the bank balance would be

much lower at $3700 at the end of February. It's important to manage your Trade Creditors

as tightly as your Trade Debtors.

Make sure you get an Aged Creditors Listing report with your Financial Statements every

month. This report is like the Aged Debtors listing except that it lists your creditors:

the businesses or people you owe money to for goods and services provided to your business.