How much has my business made this year? The big question for all business owners. It feels like it should be very simple – sales less expenses surely equals profit. Yet somehow when you get your accounts back there are so many different figures, drawings, dividends, directors account, profit, taxable profit and all different. Not only that, but none of them add up to money that you’ve actually taken out of the business. How can you tell how much money you have really made?
The big question should really be, “why you want to know?” Is it tax credits annual return time, are you tax planning, working on your household budget, trying to get a business loan or personal mortgage? Each of these questions would be answered with a slightly different figures from the accounts or tax return. Is it the business profit you are interested in or your own personal earnings?
When you are a small business, even as a limited company, your business is very much linked with your personal life and the decisions you make in one can affect the other. Understanding the various answers and options can help with better planning upfront for choices that may affect both business and personal finances. If you know in advance what you are trying to achieve, there are often business decisions that can be made with your accountant, to present your figures more favorably for a particular purpose.
- Business profit – why does my accountant come up with a different figure from me?
The profit from a business is income less expenses. However, the total you calculate from your invoices and receipts may not always agree with the figure your accountant provides. Your accountant is trying to follow accepted accounting conventions in terms of what to include and what is allowed or not allowed for tax and so might end up adding some extra items in or disallowing items you had included.
You might be just counting what you have actually spent or earned whereas accounts need to be based on what belongs in the period whether or not the cash has been received – see accruals and prepayments article for more on this.
Items that your accountant might add in include: depreciation (spreading the cost of large items of equipment over a number of years instead of just in the year you buy them), salaries, use of home as an office and business mileage.
Items that might get taken out include: personal spending, fines and penalties, payment of personal tax, national insurance and personal tax payment for sole traders.
You might even find that you have taken more money out of the business than the final profit figure because some of the expenses have been added, such as use of home and mileage, are assumed to have been paid for personally.
- Taxable profit – why is it different to my accounts?
For added confusion, the amount of profit used to calculate your tax often ends up as a different figure from the profit shown in your accounts. This is mainly due to capital allowances and depreciation.
In your accounts depreciation is used to spread the cost of assets (large items of equipment) across a number of years. There are some standard methods to do this, but the decision of which to chose and how many years to spread the cost is down to your and your accountant.
For tax purposes HMRC needs everyone to be consistent and use the same method. Capital allowances are the tax system of dealing with asset purchases. The depreciation expense is removed from your tax return and replaced with a capital allowances deduction which may not be the same amount. The capital allowances generally spread the cost in a different way to the depreciation, so the taxable profit figure for the year will look different to the profit in your accounts.
Other things that may get taken out at this stage include: entertaining (meals that are not allowable), and percentage for personal use (if not already included in the accounts).
- Drawings and directors loan account – how much money have I earned?
So now you have two different numbers for profit and taxable profit, but neither shows how much money you have actually taken out of the company. Sometimes it is this figure that you need to know rather than the profit e.g. for tax credit returns as a limited company, mortgages or budget planning. There are two ways to represent this depending on whether you are a sole trader or limited company.
Drawings – For a sole trader drawings are money taken out of the business and capital introduced is the money put in. The balance of the two should give an indication of how much money you have had from the business, or if things are tricky, how much you have had to put in. As a sole trader, you and your business are the same legal entity, so the amount of drawings that you can take out of the business is not limited. You are allowed to borrow from the business because you are really just borrowing from yourself – but hopefully not more than the cash flow can support. For sole traders it is generally profit rather than drawings that is required for tax credits, mortgages etc.
Directors loan account – The directors loan is similar to drawings in that it is a way for you, as a director, to take money out of your limited company or put money in. In a limited company the director and the company are separate legal entities. The business profit belongs to the company and director takes it out in the form of wages and / or dividends. As a director you can borrow against some of this profit on a short term basis via the directors account. The directors account is like a virtual bank account that exists to keep a record of the flow of money between you as a director and the limited company. Unlike sole traders directors are not allowed to borrow off the business, so at the year end any money borrowed must have been repaid either with cash or through declaring dividends. For tax credits it is the combination of salary and dividends that you need and mortgages will probably be interested in both profit and dividends.
As with drawings, the amount of dividends declared will have a relationship with the business profit but will not equal the profit. Again it will depend on what expenses are included, accruals, prepayments and also for directors, how much salary has been paid. Dividends are paid after tax so the amount that can be taken will also depend on how much tax is due.
- Why is this important?
Business and personal finance are strongly intertwined for a small business and you should not be thinking about one without the other. It is really worthwhile to give wider life decisions some thought before your accounts are prepared and at the start of the HMRC financial year as it may affect some of the choices you make.
The profit shown in your year end account isn’t necessarily a true reflection of how much you, or the business can really afford. For tax purposes, it pays to include all allowable expenses to reduce the business profit and therefore reduce the tax due; this is how accounts and returns are normally done. However this can be a conflict later on if you want to apply for a personal mortgage or business loan and need to show high earnings or profit. You might chose to pay a bit more tax now to improve your chances of getting a mortgage later.
In limited companies directors often take a small salary to reduce National Insurance contributions and they make up the rest of their income via dividends. This can be complicated to explain to finance providers (particularly if the account year end and dividends issue date is out of sync with payroll year end) and dividends may not fit easily into some standard lender calculations. It may also have an impact on your tax credit calculations depending on when dividends are declared. You might chose to take a higher salary and cover the employer’s national insurance contributions to improve the chance of getting a mortgage. You might decide to delay dividends until just after the tax year end.
Asking “how much money has my business made”, at the point of applying for finance is often too late make any changes to the situation, as accounts may have already been filed. Loans, mortgages, tax credits, budgets etc are all issues that need to be considered and discussed as early as possible so that you and your accountant can make the best business decisions for your overall life plans.
There are different ways to present the success of the business and they money you have earned from it
Your accountant may add in extra income and expenses such as accruals, prepayments and depreciation
Your accountant may take out expenses such as entertaining
The accounts profit and taxable profit are different due to capital allowances
Drawings are how a sole trader takes money out of the business
Directors loan and wages are how directors take profit out of a limited company
You need to consider wider life decisions in your business and tax planning as business and personal finances are strongly linked for a small company
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