The envelopes were ominously unopened. In them, meticulously organised, were my client’s management accounts. 'They're pointless,' he suggested when I asked him about them. 'My bank balance tells me all I need to know.’ I'm always amazed at the number of entrepreneurs who equate cash in the bank with profit. While there is usually a correlation, it’s vital that we have more solid financial information on which to base key business decisions.

Now for the good news. If we strip away the jargon, accounting is actually a fairly simple process. This is not a comprehensive guide, but the following basic concepts should help you decode some of the information your accountant might throw at you.

Double-Entry Book-keeping

This is the bedrock on which all accounting is based. In book-keeping every transaction has two equal and opposite entries. Suppose you buy an office computer for £500 with your debit card. Your bank balance will go down by £500 and your assets will go up by the same amount. It gets more complicated than that but, in essence, this principle works for every single business transaction.

The Profit and Loss Account

As you’d expect, this statement shows you how much profit you've made over a certain period. So why doesn’t this equate to cash in the bank? There are several key differences you need to be aware of:

Income and expenses are booked to the P&L when they are incurred (i.e. based on invoice date) regardless of when cash actually changes hands.

Both income and expenses are matched to the period to which they relate. If you sell a widget in January, the P&L will also reflect the associated cost of supplying that widget in that same month, regardless of whether you have received a bill for it or not.

The P&L always excludes VAT. If you’re VAT registered it may have a significant effect on your cash-flow, but VAT it is not an actual cost to your business because:

You reclaim VAT charged on your expenses.

You add VAT to your selling price and merely collect it on behalf of HMRC.

When you buy assets to use within your business such as fixtures and fittings or machinery (what we call ‘fixed assets’), their cost is not fully reflected in the P&L when you buy them because the business will benefit from using them over several years. The cost is therefore spread in the P&L over their ‘useful lives’ as ‘depreciation’.

With the exception of interest charges, financing transactions (such as cash received from investors or loan repayments) are never shown in the P&L as these are not connected to trading performance.

The Balance Sheet

This shows the financial position of your business at a given point in time (i.e. your assets less your liabilities). Going back to our double-entry concept, most trading transactions affect both the P&L and the balance sheet, since income, expenses (and therefore profits or losses) will inevitably make your business richer or poorer. The balance sheet is always presented in two halves that always balance (hence the name). One part summarises your ‘shareholder funds’ (i.e. the funds invested into the business plus the profits earned, after dividends). The other part shows how this investment has been used (i.e. it’s either sitting in the bank or it’s been spent on acquiring assets less any other debts).

Both your balance sheet and P&L reports are most meaningful when they include comparisons, such as to a budget or previous period. Now, with these concepts in mind, it’s time to open that envelope and look anew at your management accounts.