Lenders often ask a business to submit its management accounts to analyse its current financial performance and financial position because audited annual financial statements are either not available or not current. While these have their uses they are often prepared internally by the company and arrive in a variety of formats which make the information difficult to understand and to analyse.
What you need to do
- Check the period of time covered by the income statement – you may need to annualise some of the numbers for ratio calculation and comparison purposes
- Determine whether the business is seasonal. If so, be careful when annualising the figures without making a seasonal adjustment depending on the date of the management accounts and whether that time is high or low season for the business
- Income statements often don’t show annual or monthly depreciation as an expense because the accountant calculates that figure at financial year end. This will result in net profit being overstated
- There may be some expenses included of a personal nature which may be removed by the accountant when finalising the annual financial statements
- Directors’ or members’ remuneration may look significantly different (either larger or smaller) when the accountant adjusts it to take advantage of corporate and personal tax allowances
- Have the director(s) sign the management accounts with a confirmation that the figures are accurate and a true reflection of the business’ financial performance and financial position
- Check the revenue shown on the income statement against the turnover through the bank account to see if they are similar. This will give some confidence in the accuracy of the management accounts although remember that turnover through the bank account may include Value Added Tax so you will need to adjust for that
- Check the key ratios and large amounts in the management accounts with those contained in the annual financial statements to see if there is any major disparity
If you have to make some of these adjustments there are some points to keep in mind. If you adjust the expenses in the trial balance by adding an expense because it is missing or by removing an expense because it does not belong in the trial balance, you will affect the net profit for the period and, consequently, the net profit carried forward to the balance sheet will have to be adjusted. This means that you will have to change another balance sheet figure to keep the trial balance in balance.
- If you deduct an expense item the net profit carried forward to the balance sheet will have to be increased and you will have to add the same amount to a debit balance (left-hand side) or reduce a credit balance (right-hand side) by that amount so that the trial balance remains in balance. The simplest adjustment would be to the shareholders’ or members’ loan account.
- If you add an expense item you will reduce the net profit carried forward to the balance sheet. If the additional expense is depreciation, you will reduce the net profit carried forward to the balance sheet and add the amount of depreciation to the existing accumulated depreciation figure on the balance sheet (which has the effect of reducing the value of the fixed assets).
- If you calculate an amount of taxation and add it to the income statement you will, again, reduce the net profit carried forward to the balance sheet and you will add that amount of taxation to the balance sheet (on the right-hand side) in the form of a new current liability called “Taxation Payable” (that is assuming that there is no taxation payable in the trial balance already in which case you would simply add the new amount of taxation to the existing figure).
Calculating ratios from management accounts
Once the amounts in the trial balance have been adjusted you can calculate some ratios and margins. If you do bear in mind that, with management accounts, there are two types of ratios; dynamic and static.
This occurs because the management accounts may not cover a full 12-month accounting period and therefore, without some adjustment, some of the ratios will be incorrect.
- Dynamic ratios
These are the ratios that use a figure from the income statement as one of the variables. For example, revenue to assets or accounts receivable days, both of which use the revenue figure. To achieve a more accurate comparative ratio you would first have to annualise the income statement and then calculate the ratio. Be careful, however, to ensure that the business is not seasonal as, if it is, a straightforward annualising of the figures may not be a true representation of the turnover over a 12-month accounting period.
- Static ratios
These are the ratios that only use balance sheet figures as the variables. For example, gearing which uses only debt and equity figures would not require any annualising since there are no income statement figures involved.