Chapter Six

UNDERSTANDING YOUR ACCOUNTS

Drawing up your accounts is one thing, interpreting them is another. You can buy simple, cheap programmes for your computer which will churn out your accounts for you. Fine, provided you feed in the figures correctly.

If your accountant merely puts the accounts down in front of you, with his or her invoice on top, change your accountant. A good accountant will talk you right through the accounts, with advice and helpful suggestions.

What can Sally learn from her accounts? She made a profit. Great. Was it enough? If she could have earned twice that much as an employee, then the answer may be no. She has not forgotten she will now have to pay tax and the extra Class 4 National Insurance on her profit. On the other hand, Sally does not have to bother about the cost of running her car, because this comes out of the business.

The acid test is to take your profit and divide it by the number of hours you worked in the period. Be honest now. You might be horrified to find that you could have earned more addressing envelopes. The same is true of some employees.

Some women who claim to be self-employed are not really, although they work hard. They don't run a business, just a disguised hobby.  The Inland Revenue define a hobby as something you undertake for pleasure not profit. As soon as you achieve a profit (after deducting all expenses), your hobby ceases. It transforms itself into a business.

If your hobby offers a challenge, enjoy it. Recognise that it is not only not making money, it is gobbling up the time you could spend making money. Dabblers, whose 'hubby's' money cushions the bills and bails them out, reinforce women's reputation as mere amateurs in business.

Or you could look at life the other way and admit that women still relish the right to dabble, while men have lost it.

Sally made a profit. She is satisfied with the amount. But you will not find her preening or sitting smugly on her laurels. She will be studying her accounts to ask herself: Is my business well run? How can I increase the profit? Are any of my expenses too high?  How can I reduce them?

Her accountant should be able to help her because he will have prepared hundreds of accounts for similar businesses. Besides, after the first year, Sally can look back on last year's figures for a guide.

Sally enjoys one great advantage. She worked in the trade for many years before branching out on her own. Even as a trainee, then an improver, she kept her eyes open and watched how her employers ran their businesses.

You would be amazed how many couples sink their life savings into a shop without knowing the first thing about the trade.* In seaside resorts and other popular retirement spots, each season brings new traders as regularly as day trippers.

Husband and wife buy the shop, full of optimism, with their retirement nest-egg.  They have looked forward to their independence for years. 'Our own little shop' conjures up the second-favourite British dream after the cottage with roses around the porch. We really are a nation of shopkeepers.

But the husband has slouched for a lifetime over his desk as he pushed a pen or tapped at a keyboard in an office. Suddenly, he must lift, carry and restock all day long. The extra hours take their toll. He overdoes the heavy work and succumbs to a heart attack.

His widow cannot carry on alone and sells off the shop. It never achieved much profit because they did not know how. She receives next to nothing for it because of the poor results. The couple's dreams and savings have gone down the drain. Agents and solicitors cheerfully sign up the next hopeful pair, confident that the little shop will find itself back on the market again in a few years' time.

How can such sad waste be avoided? Every occupation guards its own rules of thumb and short cuts. Like Sally, you will need to master yours. It is always a good idea to spend at least a few months working in the sort of business you plan to buy.

Often the seller will offer to train you before you buy and take over. Make sure the period of training starts before you pay up, so the seller cannot leave you high and dry on day one. This initiation period also shows if you can physically tackle the task. Many trades that you think will not involve great muscle turn out to demand as much brawn as brains. Take cellar-work for instance - yet many men yearn to run a pub when they retire.  If you hint they are too old or weak, they think of pulling a pint and laugh.

Perhaps your results are middling and you are wondering whether they really reward the long hours and constant worry. But perhaps next year will turn out better. Why? To start with, you have more experience now, which helps. Look for other solid reasons on which to base your optimism.

A steady increase in takings month by month shows you are building up a faithful clientele. Perhaps a new employer is moving into your area and bringing their workers - potential clients for you. Perhaps you are now the only one in the district with a new and genuinely different product to sell or service to offer, and the manufacturers are launching a major advertising campaign. Perhaps your competition has shrunk. These are all genuine reasons to be optimistic, not gold-at-the-end-of-the-rainbow dreams.

Your results can look mediocre, not because your business lacks promise but because of your prices. Newcomers face the common difficulty of not knowing how much to charge. Again, each trade keeps its own rules. For instance, in catering you should reckon to charge £3 for every £1 of food you buy. Surprised? This is not just the rule for fancy restaurants with inflated prices.

People often create insurmountable difficulties for themselves by not charging enough. They doom themselves to fail. It is not always the cheapest who makes the most profit. Especially in a prestige business  where you provide a personal service, people genuinely want to pay more. They value your product in proportion to what you charge for it.

Generally, in a new business, the crunch comes after about eighteen months. This is the make-or-break time. If you have not sorted out your teething troubles by then, you never will. You also receive your first tax bills around this time.

Had you forgotten about tax? It can eat into your hard-earned profit, leaving you with crumbs. Did you spend your taking as they came into the till on new stock to sell?

Your accountant should have advised you roughly how much to set aside to provide for tax. This reserve of cash should go straight into a bank or building society, earning interest. If, instead, you now need to borrow to get ready money to pay your tax, you are saddling your struggling business with yet another outgoing - worse still, with one that is not even an accepted business expense.

Sometimes, depending on the business, accountants only have to glance at the accounts they have prepared to see that something is wrong, although the figures balance and both accountant and proprietor have acted honestly.

If for example, a pub bought £10,000 worth of beer in a year, it should have sold it for far more than £12,000. So if  £12,000 is the total of sales in the year, an ocean of booze or money, or both has disappeared. There is a hole in the profits. Was it the barmaid with her fingers in the till? Or mother-in-law who lives in? Has the landlady salted the missing money into a villa in Spain or lost it on a racehorse? Is the landlord so blind drunk by nine O'clock each night that he has no notion what he or his staff are charging? Did the takings plummet when he employed a manager so he could enjoy a week's well-earned rest in the sun? I have known all these things to happen.

In her trade too, Sally must get to know what figures to expect and to hunt for the reason if they fall short. That leads us on to evasion.

TAX EVASION AND TAX AVOIDANCE

Both tax evasion and tax avoidance have the same aim: to pay less tax. Evaders break the law and risk prison doing so. As with many crimes, there are almost as many different ways to evade tax as there are evaders. Broadly, they either hide part of what they have received (the greedier ones hide it all) or invent imaginary or unacceptable expenses to claim. Or both.

For instance, one restaurant honestly recorded every meal it served in the evenings but 'forgot' that it opened its doors at lunchtime too. A carpenter's accounts included every job he did during the week but skipped those he did at weekends. On the expenses side, all sorts of things are wrongly included as 'purchases of stock' - even the family grocery bills from the supermarket or Dad's account with his bookmaker.

In practice, few people go to prison for tax evasion. The Inland Revenue normally agree not to prosecute, without involving the police at all, if you pay penalties plus interest on the tax lost. This usually doubles the sum you would otherwise have paid in tax. It also costs you thousands of pounds in extra accountant's fees, plus the misery of sleepless nights during an enquiry which may drag on for years. Of course, your affairs will always be closely reviewed ever afterwards.

A reputable accountant will never help you to evade. He or she risks joining you in the next cell. But accountants do use all their expertise in legal avoidance. They may suggest legitimate deductions that would not have occurred to you.

For example: a small wage to Mother for answering the phone and helping out in the shop occasionally. You don't actually pay any money over. Mother is included as a creditor of the business. When you tell her, she says, 'It was nothing. I was glad to help. Forget it.' This means, in accounting terms, that the debt is forgiven and the money is yours to keep.

A good accountant will use his detailed knowledge of tax law. From the dozens of options the rules permit, he will choose the one that means you pay the least tax.

Let us jokingly imagine that I receive £100,000 from sales of this book. This sum might all be taxed in one year. But if my accountant knows his stuff, he will choose to pay as though I had earned the money over three years, at £33,333 a year. This option will save me a staggering £9,000 in tax - just for a letter and totally legal. This is tax avoidance.

SOLE TRADERS, PARTNERSHIPS AND LIMITED COMPANIES

Sally runs her business on her own. She is a sole trader. There are two other ways she could run it if she chose: as a partnership or as a limited company.

If she joined forces with Jenny, another talented sole trader in the next town, the two of them could form a partnership. Each of them would be a partner.

PARTNERSHIPS

Partners can enjoy great advantages. If Sally falls sick or wants a holiday, Jenny can take over; or vice versa. They can pool ideas and skills. The two of them together can probably borrow more money if they want to expand than either could on her own.

The drawback is that partners have 'joint and several liability', a fancy term but a simple idea. On her own, Sally is only responsible for her own debts, just as you are. In partnership, she stands responsible for Jenny's too and Jenny is responsible for hers. So, obviously, Sally would not dream of going into partnership unless it was with someone she knew she could trust. Even then, she would keep a close, friendly check, and expect Jenny to do the same.

Take the history of Avril, who was once a colleague of mine. She and her cousin Siobhan jointly inherited a large house from their grandfather. They decided to run it as an old people's home.

To Siobhan, with no job and no home, but a small child to keep, the legacy came as a godsend. She moved in and worked in the house during the week.

Avril was not long married. She enjoyed her well-paid job and her own home and decided to stay put. She kept the books in the evenings and travelled down every weekend to help out. The two were good friends, had known each other all their lives and been to school together. Ideal partners, you would think.

Avril was a little surprised to find Siobhan's toddler swamped by expensive toys, but imagine her horror when she discovered where the money had come from. Siobhan had simply helped herself to most of the takings. Worse,  she had ordered grandiose improvements they could never afford, even signing binding contracts without her partner's knowledge.

Siobhan was caught out but she refused to stop. 'There's plenty more where that came from,' she would shrug, reaching for the business chequebook. The only thing left for Avril to do was sell up and split up before Siobhan ran her into debt. Moral: you can never be too careful in your choice of partners. At least Avril's checking paid off.

I once watched a weedy tax inspector sort out a dozen toughies from a building site who all claimed to be partners. He simply pointed a finger at the biggest of them and asked, 'If everyone in this room disappeared, would you be prepared to pay their tax for them?' The labourer muttered a four-letter word and then hitched his donkey jacket over his muscled shoulder. They all stomped out, with their accountant following sheepishly behind.

Coming back to Sally's Salon, if it proved a real winner, either on its own or after partnership with Jenny, Sally might consider it worthwhile to run the business through a limited company.

LIMITED COMPANIES

Name me any business you like - any shop in the high street (from Sainsbury to Habitat, Boots to Mothercare, Tesco to Harrods) or any brand of goods you buy (Heinz, Nestle, Coca-Cola) - and I can guarantee that the business will be run through a limited company. Virtually all really big businesses these days are. What does this mean?

First of all, let's clear the ground. Many people talk about a 'company' when they only mean a business. J.Smith & Company or J.Smith & Co, only means J. Smith himself and his dog, or his dogsbody wife.

Throughout this book I talk about a limited company, because this is something different. A limited company is a legal person, set up by shareholders, to run a business.

A 'legal person' means that the law treats it as much like a human being as possible. A limited company must be born (set up). Then it lives until it dies (is wound up). The company continues to live even though the shareholders and directors change and the trade finishes or a new one starts. Some have existed for centuries, running businesses that started hundreds of years before that.

Think of the company as a bus. The shareholders provide the money to buy the bus. Each owns a share in the bus, hence shareholders. They own it, so they decide who should drive it. The drivers are called directors. In small limited companies, the shareholders usually choose themselves, in other words, they appoint themselves directors. The shareholders, as owners, receive the profits from the passengers. The directors, as drivers, just collect the profits for them.

Why are limited companies 'limited' ?  If the trade fails and the company owes more money than it can find, the shareholders' loss is limited to their original stake - that is, to the money they put up to buy the shares in the beginning. They can wave goodbye to that, but this is the worst they have to fear. All their other assets, like the family home, remain safe. This is the big advantage that limited companies enjoy over partnerships and sole-trader businesses.

Directors are employees of the limited company. They usually receive a wage on which PAYE is operated, just like the rest of the company's employees. The company itself pays a sort of income tax on its profits called corporation tax. Then it can pay out the rest of its profits to the shareholders. The cash shareholders receive is called a dividend.

So, shareholder-directors can earn dividends as well as a wage, and of course, they can vote themselves a bonus or tax-free expenses if they wish.

Two vital questions will probably have occurred to you by now:

Why should someone who went to a lot of trouble to become self-employed to avoid PAYE now turn himself into a director and return to being an employee again? Also, if company profits suffer corporation tax, and then shareholders' dividends suffer income tax, this makes two bites of tax out of the same income, so won't you be worse off as a result?

So anyone might expect. Reality is more complicated. It is still your business and you control the cash. You can still employ whom you like and run your company car on the business. There are all sorts of legal ways, known to any good accountant, which allow you to delay or choose which tax (corporation or income) you pay. This all makes a limited company highly attractive - but not for a beginner.

Build yourself a thriving business first. Remember, your accountant will charge more than twice as much to prepare accounts for the tiniest limited company, because there will be far more work to do. Get a few years' good profits under your belt. Then consider buying an off-the-shelf (brand new)  limited company and transferring your business to it. You become shareholder and director of course.

PRIVATE AND PUBLIC LIMITED COMPANIES

You recognise a private limited company because it has 'Ltd' (short for Limited) after the name. It has a small number of shareholders, usually a family.

A public limited company has P.L.C., plc or Plc after its name, like Barclays Bank Plc. Barclays counts its shareholders in tens of thousands. You or I can join them if we buy its shares through the stock market.

Once a private limited company achieves a certain size, it will almost certainly change over to become a public limited company**. This is called 'going public'. The company issues a lot more shares to the family. They then sell them on the stock market and can grow very rich overnight.

On the other hand, there are now hundreds of new shareholders in the new P.L.C. Each has a say in how the company should be run. They can attend the annual general meeting and vote. The previous shareholders, the family, may well lose control of their company to outsiders with quite different ideas.

This is a long way from Sally and her salon. She is unlikely ever to grow this big. Most hairdressers stay sole traders. Empire-building is normally a masculine dream. The few hairdressers who really hit the big time, like Vidal Sassoon, establish a chain of salons and then branch out into their own range of hair-care products, expensive styling conferences for hairdressers world-wide etc.

LIMITED LIABILITY

Limited liability is only the name for the advantage I mentioned above. If the trade fails, your losses as a shareholder (your liability) are limited to what you paid for the shares. The rest of your assets remain safe.

In practice, limited companies go bust every day of the week. There is a special City newspaper, The Gazette, which lists them. (www.gazette.co.uk/)

Over the years, many banks that have lent money to these limited companies have often lost it. They cannot persuade the courts to seize the shareholders' personal property to sell it off, as they can with sole traders and partnerships.

So, to protect themselves, banks insist on personal guarantees from directors or shareholders before they make a loan. Even accountants ensure that they will get their fees by insisting on such written guarantees. If you sign one, your home and all  your other possessions are no safer than if you were a sole trader.

In Chapter 4 I said never buy an existing limited company just to obtain its trade. Why not?

Remember, a company is a legal person. It had a life before you bought it. Anything can come to light later on. It is like taking in a stray dog and finding out later that its previous sufferings mean you dare not trust it near your children, or that it is infected with distemper.

With a limited company, you are responsible for anything the company did in the past, even for things that happened before you ever came on the scene. Just a few examples:

- Some previous work was shoddily done and the customers claim recompense. You will have to do all the work again - for nothing.

- The accounts did not show all the debts that the limited company had incurred.     Now the creditors are pressing for their money, and you have to pay - not personally, of course, but out of the company's money.

- The accounts show that various customers have not paid up, so you expect to receive their money. It may never come, even though when you bought the company you paid extra because of the value of those debts.

- Earlier years' tax affairs may not be settled or may be reviewed. Perhaps the old directors were on the fiddle for years. It is the company you now own that will have to pay to sort everything out, and fork out the extra tax at the end.

(Maybe you will have a case to sue the old directors or the accountants who misled you. In practice, you can forget it if they have no assets or have left the country. Besides, all  the professions are adept at covering their tracks.)

Luckily, there is an easy alternative if the business you yearn to buy is run by a limited company. Make an offer for the trade - the company's assets, lease, etc. The sellers may insist on you buying the debtors and stock, perhaps even the goodwill, otherwise don't bother with these things. We have already warned that money owing from customers (debtors) may not come. The stock too may include old or unsellable items. You have nothing to show for buying goodwill, as explained below. Avoid buying all three if you can.

Goodwill is another of those vague, invisible assets. It covers those vital, immeasurable things like having a faithful clientele ready-made rather than having to work hard to build one up from scratch. Goodwill may be hard to value but is still important.

When you bought its trade, the old company became an empty shell. It still belongs to the old shareholders, and they, not you, must pay to allow it to die (wind it up).

Even though you bought it from a limited company, run your new business as a sole trader or partnership until you get established.  Allow yourself at least two years. Then buy your own off-the-shelf company and transfer your business into it. An accountant will do this for you. It is quick, easy and not particularly costly.

We have spent three chapters looking at money you have to work for - income. In the next, we consider the other sort - capital.

* An unplanned business venture is also the normal reason why so many people who have won fortunes on pools and lotteries end up bankrupt!

** There is a halfway house for companies called the Unlisted Securities Market.

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