Most people start a business because they are good at what they do, not because they enjoy reading financial statements. Yet once you run a limited company, you will be handed a profit and loss account, a balance sheet and, if you are wise, a set of monthly management accounts, and you will be expected to make decisions based on them. Many new directors nod along at the year end meeting without being entirely sure what the numbers are telling them.
This guide is written for exactly that person. It explains, in plain English, how to read the two main financial statements, why your profit and your bank balance can tell very different stories, what retained earnings are and why they decide how much you can pay yourself in dividends, and which handful of numbers are worth checking every single month. One fictional company, Bluebell Design Ltd, runs through the whole guide, so you can see how every number connects to the others.
Disclaimer: This guide is for general information only. It explains accounting concepts in simplified terms for business owners and reflects UK accounting practice and tax rates current at the time of writing in October 2026. Your own accounts may be presented differently depending on the accounting standard, software and format used. Always speak to your accountant about your specific figures.
In This Guide
- How to read a profit and loss account
- How to read a balance sheet
- Profit versus cash: why they are not the same
- Retained earnings and distributable reserves
- Management accounts: the five numbers to check every month
- Frequently asked questions
Meet Bluebell Design Ltd
Bluebell Design Ltd is a small branding and design agency owned and run by its sole director and shareholder, Ellie. She set up the company on 1 April 2025 with £100 of share capital. The company's first financial year ended on 31 March 2026. During the year it employed one designer alongside Ellie, used freelance illustrators on larger projects, rented a small studio, bought £12,000 of computer and studio equipment, and took out a £15,000 bank loan to help with start up costs. Ellie paid herself a modest salary and took dividends from the profits.
Her accountant has just sent her the year end accounts. Let us read them together.
1. How to Read a Profit and Loss Account
The profit and loss account, sometimes called the income statement or simply the P&L, tells you whether the company made a profit or a loss over a period of time, usually a year for statutory accounts or a month for management accounts. Think of it as a video of the year's trading rather than a snapshot.
It always follows the same basic logic. It starts with the money the company earned, then subtracts the costs of earning it, in stages, until it arrives at the profit left over for the owners.
Bluebell Design Ltd: Profit and Loss Account for the year ended 31 March 2026
Turnover: £240,000
Cost of sales: £96,000
Gross profit: £144,000
Administrative expenses: £94,000
Operating profit: £50,000
Interest payable: £1,000
Profit before tax: £49,000
Corporation Tax: £7,790
Profit after tax: £41,210
Turnover
Turnover, also called revenue or sales, is the value of work the company did or goods it sold during the year, excluding VAT. It is not the same as the cash received. Under the accruals basis that limited companies use, Bluebell records turnover when the work is done and invoiced, even if the client has not paid yet. That point becomes very important when we look at cash later in this guide.
Cost of sales and gross profit
Cost of sales, sometimes called direct costs, are the costs that rise and fall directly with the work you deliver. For Bluebell, that means the freelance illustrators and printing costs for client projects, totalling £96,000. For a retailer it would be the cost of the stock sold, and for a construction business it would be materials and subcontractor labour.
Turnover minus cost of sales gives gross profit, here £144,000. Gross profit is often more useful as a percentage of turnover, known as the gross margin. Bluebell's gross margin is £144,000 divided by £240,000, which is 60%. In plain terms, for every £1 of work Bluebell sells, 60 pence is left after paying the direct costs of doing that work. This figure tells you a great deal about pricing. If the gross margin starts falling, you are either charging too little, spending too much on delivery, or both.
Administrative expenses and operating profit
Administrative expenses, also called overheads, are the costs of running the business that do not change much with each individual job. For Bluebell, the £94,000 is made up of salaries and employer National Insurance for Ellie and her designer of £48,000, studio rent of £18,000, marketing of £9,000, software subscriptions of £6,000, accountancy fees of £3,000, depreciation of £4,000 and other running costs of £6,000.
Two of those items often surprise new directors. The first is that Ellie's own salary appears here as a business expense, because she is an employee of her company as well as its owner. The second is depreciation, which is explained below.
Gross profit minus administrative expenses gives operating profit, here £50,000. This is the profit the business makes from its normal trading activities, before the cost of borrowing and before tax.
Depreciation: the expense that is not a payment
When Bluebell bought £12,000 of equipment, it did not treat the whole cost as an expense in the first year, because the equipment will be used for several years. Instead, the cost is spread over its expected useful life. Bluebell's accountant has assumed a three year life, so £4,000 is charged as depreciation each year. Depreciation is a real cost of using the equipment up, but no money leaves the bank account when it is charged. The cash left when the equipment was bought.
Interest, tax and profit after tax
Interest payable is the cost of the bank loan, here £1,000. Taking this off operating profit gives profit before tax of £49,000.
Corporation Tax is then charged on the company's taxable profit. A common surprise is that the tax charge of £7,790 is not simply 19% of £49,000, which would be £9,310. That is because taxable profit is calculated under tax rules rather than accounting rules. HMRC does not allow depreciation as a tax deduction. Instead, it gives capital allowances, and through the Annual Investment Allowance Bluebell can deduct the full £12,000 cost of its equipment in the year it was bought. So taxable profit is £49,000, plus the £4,000 of depreciation added back, minus the £12,000 capital allowance, giving £41,000. Corporation Tax at the 19% small profits rate on £41,000 is £7,790. Our guide to capital allowances explains this in more detail.
Profit after tax of £41,210 is what belongs to the shareholders. It is the pot from which dividends can be paid.
What is not on the profit and loss account
Three things new directors often look for on the P&L, and cannot find, are dividends, loan repayments and the purchase of equipment. Dividends are a distribution of profit to the owners, not a cost of running the business, so they appear in the reserves on the balance sheet instead. Repaying the capital on a loan is not an expense, only the interest is. And buying equipment is not an expense in the year of purchase, only the depreciation is. Each of these involves cash leaving the business without reducing profit, which is one of the main reasons profit and cash differ.
2. How to Read a Balance Sheet
If the profit and loss account is a video of the year, the balance sheet is a photograph taken on the last day of it. It shows what the company owns, what it owes, and what is left over for the shareholders at one specific moment, in Bluebell's case at close of business on 31 March 2026.
UK company balance sheets follow a standard layout, which can look intimidating at first but follows a simple idea. Everything the company owns, minus everything it owes, equals the value belonging to the shareholders. That is why it is called a balance sheet. The top half and the bottom half always come to the same figure.
Bluebell Design Ltd: Balance Sheet at 31 March 2026
Fixed assets: £8,000
Current assets
Debtors: £36,000
Cash at bank: £7,600
Total current assets: £43,600
Creditors: amounts falling due within one year: £31,290
Net current assets: £12,310
Total assets less current liabilities: £20,310
Creditors: amounts falling due after more than one year: £9,000
Net assets: £11,310
Capital and reserves
Called up share capital: £100
Profit and loss account (retained earnings): £11,210
Shareholders' funds: £11,310
Fixed assets
Fixed assets are things the company owns and expects to use for more than a year, such as equipment, vehicles, furniture or property. They are shown at cost less the depreciation charged so far. Bluebell's equipment cost £12,000 and has been depreciated by £4,000, so it appears at £8,000. This is a book value, not necessarily what the equipment would sell for.
Current assets
Current assets are things the company owns that are expected to turn into cash within a year. For Bluebell, they are debtors and cash. Many businesses will also show stock here.
Debtors, sometimes called trade receivables, are amounts customers owe for work already invoiced. Bluebell is owed £36,000. This is money the company has earned, and which is already counted in turnover and profit, but which has not yet arrived in the bank. Prepayments, which are costs paid in advance for a future period, such as annual insurance, are also usually included within debtors.
Cash at bank is exactly what it says, the balance across the company's bank accounts on the balance sheet date, here £7,600.
Creditors due within one year
This section shows everything the company owes that must be paid within the next twelve months. For Bluebell, the £31,290 is made up of £8,000 owed to suppliers and freelancers, £9,000 of VAT due to HMRC, £7,790 of Corporation Tax due to HMRC, £2,000 of PAYE and National Insurance due to HMRC, £1,500 of accruals for costs incurred but not yet invoiced, and £3,000 of the bank loan that is due for repayment in the coming year.
It is worth noticing how much of this figure is owed to HMRC. Tax liabilities are among the most common reasons small companies run short of cash, because the money to pay them is often sitting in the bank looking as though it belongs to the business.
If a director owes money to the company, or the company owes money to a director, this will also appear on the balance sheet, within debtors or creditors. That is the director's loan account, and an overdrawn balance can carry significant tax consequences, as explained in our guide to director's loan accounts.
Net current assets
Net current assets, sometimes called working capital, is current assets minus creditors due within one year. For Bluebell, £43,600 minus £31,290 gives £12,310. A positive figure suggests the company should be able to meet its short term obligations as they fall due, provided debtors pay on time. A negative figure, shown as net current liabilities, is a warning sign worth discussing with your accountant.
Creditors due after more than one year
This shows debts that are not due for at least twelve months. For Bluebell, this is the remaining £9,000 of the bank loan. The loan balance of £12,000 has been split, with £3,000 due within a year shown above and £9,000 shown here.
Net assets and capital and reserves
Net assets is everything the company owns, minus everything it owes. For Bluebell, that is £11,310. The bottom half of the balance sheet, capital and reserves, explains who that value belongs to and where it came from. Ellie put in £100 as share capital when she formed the company, and £11,210 is profit the company has made and kept, known as retained earnings. Together they make £11,310, matching the net assets exactly. If they ever do not match, something has gone wrong.
3. Profit Versus Cash: Why They Are Not the Same
This is the single most important concept in this guide, and the one that causes the most stress for new business owners. Bluebell made a profit before tax of £49,000 in its first year, yet it ended the year with only £7,600 in the bank, and owed HMRC £18,790 in VAT, PAYE and Corporation Tax. How can a profitable company be short of cash?
The answer is that profit measures whether the business is earning more than it costs to run, while cash measures what has actually moved in and out of the bank. The two are linked, but timing differences and certain types of payment pull them apart.
Bluebell's profit to cash bridge
Here is how Bluebell's operating profit of £50,000 turned into a bank balance of £7,600.
Start with the operating profit of £50,000. Add back the £4,000 of depreciation, because it reduced profit but did not use any cash. That gives £54,000.
Next, subtract the £36,000 still owed by customers. That turnover is included in profit, but the cash has not arrived. That leaves £18,000.
Then add back £20,500 owed to suppliers, HMRC for VAT and PAYE, and accruals. These costs have been counted against profit, or the VAT collected has been banked, but the money has not yet been paid out. That brings the figure to £38,500.
Subtract the £1,000 of loan interest paid, giving £37,500.
Subtract the £12,000 spent on equipment. This was a large cash payment that only affected profit through £4,000 of depreciation. That leaves £25,500.
Add the £15,000 bank loan received and subtract the £3,000 of loan capital repaid, giving £37,500.
Subtract the £30,000 of dividends paid to Ellie, which do not appear on the profit and loss account at all. That leaves £7,500.
Finally, add the £100 Ellie paid for her shares, giving the closing bank balance of £7,600.
Corporation Tax has not been paid yet, because for a company of Bluebell's size it is not due until nine months and one day after the year end, on 1 January 2027.
What this tells Ellie
The bridge shows that Bluebell is genuinely profitable, but three things are squeezing its cash. Customers are slow to pay, with £36,000 outstanding. A large share of the profit has already been taken out as dividends. And significant tax bills, £18,790 in total, are owed to HMRC and will need to be paid from a bank balance of just £7,600, before any new customer payments come in.
None of this means the business is failing. It means Ellie needs to chase her debtors, set money aside for tax as she goes, and think carefully about the timing of future dividends. A rolling cash flow forecast, which we explain step by step in our guide to building a cash flow forecast, is the best tool for seeing these pressures coming. Businesses that invoice at project milestones face an additional timing gap from unbilled work in progress, covered in our separate article on that subject.
The most common reasons profit and cash differ
Customers paying on credit means profit is recognised before cash arrives. Buying stock means cash leaves before the cost hits the profit and loss account. Buying equipment means a large cash outflow but only a small annual depreciation charge. Loan repayments reduce cash but not profit. Dividends reduce cash but not profit. VAT collected sits in your bank account but belongs to HMRC. And Corporation Tax is charged against profit in one year but paid in the next.
4. Retained Earnings and Distributable Reserves
Retained earnings, shown on the balance sheet as the profit and loss reserve or profit and loss account, are the total profits after tax that the company has made since it was formed, minus all the dividends it has ever paid. It is a running total that carries forward from one year to the next.
The calculation each year is simple. Take the retained earnings at the start of the year, add the profit after tax for the year, or subtract the loss, and subtract any dividends paid during the year. The result is the retained earnings at the end of the year.
For Bluebell's first year, opening retained earnings were nil, profit after tax was £41,210 and dividends paid were £30,000, so closing retained earnings were £11,210.
Why this number matters so much to directors
Under company law, a company can only pay dividends out of profits available for the purpose, usually called distributable reserves. For most small private companies, distributable reserves are essentially accumulated realised profits less accumulated realised losses, which in practice usually means the retained earnings figure, adjusted for any unrealised items such as certain revaluation gains.
This is a legal limit, not a guideline. A dividend paid without sufficient distributable reserves is an unlawful dividend. It can be reclaimed from the shareholder, and HMRC may treat it as a loan to the director, bringing the Section 455 tax charge into play. Our guide to calculating dividends correctly covers the paperwork and checks in detail.
Worked Example: Checking Whether a Dividend Is Allowed
In its second year, Bluebell has a quieter period and expects profit after tax of around £30,000. Ellie would like to take dividends of £50,000 over the year, as she has larger personal commitments.
Starting with retained earnings of £11,210 and adding the expected £30,000 of profit after tax gives £41,210 available. A dividend of £50,000 would leave retained earnings at minus £8,790, which means at least £8,790 of the dividend would be unlawful. The maximum Ellie can safely take, if the profit forecast proves accurate, is around £41,210, and in practice she should leave a margin for error and for the cash the business needs.
Crucially, the test is applied when each dividend is paid, using up to date figures, usually interim management accounts, not just at the year end. If Ellie takes a large dividend in month three, the company must have enough distributable reserves at that point, based on the profits actually made by then. This is one of the strongest reasons for keeping your bookkeeping up to date.
A loss can wipe out reserves
If a company makes a loss, retained earnings fall, and if losses exceed past profits, the figure becomes negative. A company with negative retained earnings cannot pay any dividends until it has made enough profit to bring the figure back above zero. Directors who are used to taking regular dividends need to watch this closely in a difficult year, which is another reason why salary and dividend planning, covered in our guide to paying yourself as a director, should be reviewed every year rather than set once and forgotten.
5. Management Accounts: The Five Numbers to Check Every Month
Statutory accounts are prepared once a year, usually several months after the year end, and their main purpose is to meet legal obligations to Companies House and HMRC. By the time they arrive, the information is history. Management accounts are different. They are internal reports, usually prepared monthly or quarterly, that show how the business is performing now, so you can act while there is still time.
There is no legal requirement to prepare management accounts, and no fixed format. Typically they include a profit and loss account for the month and the year to date, often compared with a budget or the same period last year, a balance sheet, and a short summary of cash and key figures. With cloud accounting software such as Xero or QuickBooks, and bookkeeping kept up to date, producing them is far easier than it used to be.
A full set of management accounts can run to many pages. In our experience, these five numbers tell most owner managed businesses the majority of what they need to know.
Number one: turnover against target
Are sales where you expected them to be? Comparing actual turnover with your budget or forecast for the month, and for the year to date, gives an early warning of a slowdown, or a sign that the business is growing faster than its resources can cope with.
Number two: gross margin percentage
Gross margin, explained in section 1, shows whether you are pricing and delivering work profitably. A falling gross margin is often the first sign that costs are creeping up, a supplier has increased prices, or work is being quoted too cheaply. It is a percentage, so it can be compared from month to month even when sales vary.
Number three: overheads against budget
Overheads tend to rise gradually, through new subscriptions, extra staff or higher rent, and are easy to miss until they have become a permanent part of the cost base. A monthly check against budget keeps them under control.
Number four: cash position and cash forecast
How much cash does the business have today, and how much will it have at its lowest point over the next three months, once known bills including VAT, PAYE and Corporation Tax have been paid? This forward looking view is far more useful than the current bank balance alone.
Number five: debtor days
Debtor days measures how long, on average, customers take to pay. It is calculated by dividing trade debtors by turnover and multiplying by the number of days in the period. For Bluebell at the year end, £36,000 divided by annual turnover of £240,000, multiplied by 365 days, gives around 55 days. If Bluebell's payment terms are 30 days, customers are paying almost four weeks late on average, which explains much of the cash squeeze shown in section 3.
Worked Example: Bluebell's Management Accounts in Month Four of Year Two
In July 2026, Ellie's accountant sends her the management accounts for the month. Turnover is £22,000 against a budget of £25,000. Gross margin has fallen from 60% to 52%, because Ellie has relied more heavily on freelance illustrators to cover a staff absence. Overheads are on budget. Debtor days have improved to 42 days after she introduced automatic payment reminders. Cash is £14,000, but the forecast shows it falling to £3,000 in late August, once the VAT quarter is paid.
From those five figures, Ellie can see that she needs to review her freelance costs and the prices on two current projects, that her debtor chasing is working and should continue, and that she should hold back the dividend she had planned for August until the cash position recovers. None of that would be visible from the previous year's statutory accounts.
Frequently Asked Questions
What is the difference between a profit and loss account and a balance sheet?
The profit and loss account shows how much profit or loss the company made over a period, usually a year or a month. The balance sheet shows what the company owns, what it owes and what belongs to the shareholders at a single point in time, usually the last day of that period.
Why does my company show a profit when there is no money in the bank?
Profit and cash differ for several reasons, including customers who have not yet paid, money spent on equipment or stock, loan repayments, dividends taken out, and VAT and tax being held for HMRC. A profit to cash bridge, like the one in section 3, shows exactly where the money has gone.
Is my salary as a director a business expense?
Yes. A director's salary is an employment cost of the company, shown in administrative expenses on the profit and loss account and deductible for Corporation Tax. Dividends are different. They are a distribution of profit after tax and are not an expense.
Why doesn't my Corporation Tax equal 19% or 25% of my profit?
Because Corporation Tax is charged on taxable profit, which is calculated under tax rules rather than accounting rules. Common differences include depreciation being replaced by capital allowances, and some costs, such as client entertaining, not being deductible for tax. Profits between £50,000 and £250,000 are also subject to marginal relief, which creates an effective rate between 19% and 25%.
What are retained earnings?
Retained earnings are the total profits after tax a company has made since it started, minus all the dividends it has paid. They appear in the capital and reserves section of the balance sheet, and for most small private companies they are the starting point for working out how much can legally be paid out as dividends.
Can I pay a dividend if my company made a loss this year?
Possibly, if the company has enough retained profits from earlier years to cover both this year's loss and the dividend. If accumulated losses exceed accumulated profits, no dividend can be paid until the position is restored.
What does negative net current assets mean?
It means the company owes more in the next twelve months than it has in cash and short term assets. It does not automatically mean the company is insolvent, but it is a warning sign that the business may struggle to pay its bills on time, and it should be discussed with your accountant promptly.
Do I need management accounts if my accountant prepares annual accounts?
They are not a legal requirement, but they are the only way to see how the business is performing during the year, rather than months after it has ended. They also provide the up to date figures needed to check that dividends are lawful before they are paid.
How often should I look at my numbers?
Monthly is a sensible rhythm for most small businesses, with a quick weekly look at cash and debtors if cash is tight. The key is consistency, and keeping bookkeeping up to date so the figures are reliable.
What CoreAcc Accountants Can Help You With
CoreAcc Accountants prepares statutory accounts for limited companies, but we also make sure our clients understand what those accounts are telling them. For clients who want to stay on top of their numbers throughout the year, we provide monthly or quarterly management accounts built around the figures that matter most to their business, cash flow forecasting, and dividend checks before payments are made, all using cloud accounting software such as Xero and QuickBooks. When a new client joins us, we walk through their first set of accounts line by line, in plain English, so the numbers become a tool for running the business rather than a document to file away.
If you are setting up or running your first company, our companion guide to limited company filing requirements explains what you need to file with Companies House and HMRC, and when.
Get in Touch
If you have been handed a set of accounts and are not sure what they are telling you, or you would like monthly figures you can actually use to run your business, contact CoreAcc Accountants. We will go through your numbers with you and explain what they mean for your decisions, from pricing and hiring through to how much you can safely pay yourself.
CoreAcc Accountants is an ACCA accredited firm of Chartered Certified Accountants based in Borehamwood, Hertfordshire. This guide was last updated in October 2026. It explains accounting concepts in simplified terms and reflects tax rates current at the time of writing. It does not constitute professional or legal advice. Always seek specific advice tailored to your individual circumstances.
