Interpreting Company Reports For Dummies

By Ken Langdon, Alan Bonham and Lita Epstein

Company financial reports are a key resource for investors, helping them uncover priceless information about a company’s profitability, or lack thereof, from the figures as well as through other non-monetary indicators. Details of lawsuits, changes in accounting methods, liquidations, and mergers and acquisitions can all be ways of detecting red flags if you know where to look.

However the jargon and financial footnotes in financial reports can be difficult to decipher, and this For Dummies guide on the subject will help readers to understand company reports and make sensible investment choices based on publicly held information.

Taking you step-by-step through the finer points of financial reports, this straightforward guide will help you get to grips with the most accurate way to wade through the numbers, judge a company’s performance, and make profitable investment decisions.

This UK Adaptation focuses on the UK financial market, with the FTSE index as the focus of the book.

• Language: English
• Publisher: Wiley
• Release date: Feb 15, 2011
• ISBN: 9781119997870

Book preview

Introduction

When you open an annual financial report today, one of the first things you ask yourself is, ‘Can I believe the numbers that I’m seeing?’ At one time no one doubted the numbers. Everyone believed that any corporate financial report, audited by a certified public accountant, was truly prepared with the public’s interests in mind.

However, the financial scandals of the late 1990s and early 2000s destroyed public confidence in those numbers, including millions of investors who lost billions in the stock market crash that followed after many of those scandals came to light. Sure, a stock market bubble (a period of rising stock prices that stems from a buying frenzy) had burst, but financial reports that hid companies’ financial problems fuelled the bubble and helped companies put on a bright, smiling face for the public. After these financial reporting scandals came to light, more than 400 public companies in the US alone had to restate their earnings.

Many people still wonder what government regulators and public accountants were thinking and doing during this entire fiasco. How did the system break down so dramatically and so quickly? Although a few voices raised the red flags, their pleas were drowned out by the euphoria of a building stock market bubble.

These financial scandals occurred partly because the City measures success based on a company’s periodic results. Many in the City are more concerned about whether or not a company meets its short-term expectations than they are about a company’s long-term prospects for future growth. Companies that fail to meet their expectations find their shares quickly beaten down on the market. To avoid the fall, companies ‘massage’ their numbers. And this short-sighted race to meet the numbers each period is a big reason why these scandals occurred in the first place.

Since the scandals broke, legislators and regulatory bodies have enacted new laws and regulations to attempt to correct the problems. In this book, we discuss these new regulations and show you how to read financial reports with an ounce of scepticism. We also give you a bunch of tools that can help you determine whether or not the numbers make sense. We help you see how companies can play games with their numbers and show you how to analyse the figures in a financial report so that you can determine the financial health of a company.

About This Book

In this book, you find detailed information about how to read the key financial statements – the balance sheet, the income statement, and the statement of cash flows – in a financial report as well as discover the other key parts of the report that you should scour. (Turn to Chapters 6, 7, and 8 to find out more about these important statements.)

Many people skim or skip over three crucial parts of annual reports – the auditor’s report, the notes to the financial statements, and management’s discussion and analysis. (See Chapters 5 and 9 for more info on these parts.) In fact, in these parts, you find most of the juiciest information. Unlike the fancy, glossy coloured pages that lead off the report and give only the information that a company wants you to know, these less graphically appealing black-and-white pages give the key data that you need to know.

Although we can’t promise that you’ll be able to detect every type of company problem or fraud, we can promise that your antennae will be up and you’ll be more aware of how to spot possible problems. When you finish reading this book, you’ll understand what makes up the parts of a financial statement and how to read between the lines, using the fine print to increase your understanding of a company’s financial position. You’ll find out about who regulates the companies and certifies the truth and fairness of financial reports and how the rules have changed since the corporate scandals broke.

Conventions Used in This Book

Our principle concern here is with public limited companies that you may choose to invest in. But we also include some information on different types of company, small as well as large. (To find out more about company types and structure, see Chapter 2.)

To help you practise the tools we show you in this book, we use the annual reports of two large retailers, Tesco and Marks and Spencer, and dissect their annual reports in various chapters throughout the book. We also include their financial statements in Appendix A so that you can practise with the actual reports. You can download a full copy of the reports by visiting the investor-relations section of the companies’ Web sites: www.tesco.com and www.marksandspencer.com.

What You’re Not to Read

Many of the topics discussed in this book are, by nature, technical. Dealing with finances can hardly be otherwise. But in some cases, we provide details that offer more than the basic stuff you need to know to understand the big picture. Because these explanations may not be up your alley, we mark them with a Technical Stuff icon (see the section ‘Icons Used in This Book’ later in this chapter) and invite you to skip them without even the slightest regret.

If you want, you can also skip over the sidebars (the grey shaded boxes) as these cover only example material or anecdotes. They’re interesting to read through, but you won’t miss the meat and veg by skipping them.

Even if you skip these items, you still get all the information you need. On the other hand, if you savour every financial detail or fancy yourself the bravest of all financial report readers, then dig in!

Foolish Assumptions

To write this book, we made some basic assumptions about who you are. We assume that you:

bullet Want to know more about the information in financial reports and how you can use it.

bullet Want to know the basics of financial reporting.

bullet Need to gather some analytical tools to more effectively use financial reports for your own investing or career goals.

bullet Need a better understanding of the financial reports that you receive from the company you work for to analyse the results of your department or division.

bullet Want to get a better handle on what goes into financial reports, how they’re developed, and how to use the information to measure the financial success of your own company.

Both investors and company insiders who aren’t familiar with the ins and outs of financial reports can benefit from the information and tools included in this book.

How This Book Is Organised

This book is organised into seven parts. After introducing the basics, we carefully dissect what goes into financial reports, giving you the tools you need to analyse those reports. We introduce you to the company outsiders who are involved in the financial reporting process and show you how to find red flags that might indicate deceptive or fraudulent reporting.

Part I: Getting Down to Financial Reporting Basics

Part I discusses the basics of accounting and financial reporting. If you need an introduction to these basics, or just a simple refresher course, you may want to begin here. In this part, you find information about the types of business structures, the differences between public and private companies, and the accounting basics necessary to understand financial reports.

Part II: Understanding Published Information: Annual Reports

This part introduces you to the key elements of an annual financial report. The first chapter in this part reviews the key sections of an annual report; the chapters that follow focus on each of these parts individually, explaining what you’ll find in a financial report and how to use that information. Another chapter explains in more detail what you can expect to find in the notes to the financial statements and what all that small print means. In the last chapter of this part, we discuss consolidated statements and the information that goes into them.

Part III: Analysing the Numbers

In this part, we give you the tools you need to analyse the numbers in financial statements. We show you how to test profitability, liquidity, and cash flow. These tools help you determine whether or not the company is a good investment.

Part IV: Understanding How Companies Optimise Operations

This part focuses on using financial statements to measure how efficiently management is using its resources. We review the basics of budgeting and how to use financial reports in the budgeting process. You also find tools for testing how efficiently companies manage their assets and keep cash flowing.

Part V: The Many Ways Companies Answer to Stakeholders

In this part, we focus on the outsiders involved in the financial reporting process. We review the role of auditors and the accounting rules and look at the role analysts play in the world of financial reporting. We also talk about shareholders and what they should expect from the companies that they invest in. In addition, we discuss how some companies ‘massage’ the numbers when they compile their financial reports.

Part VI: The Part of Tens

In the Part of Tens, we give you quick-reference lists pointing out the top-ten online resources you can use to do your financial research about companies and the top-ten signs that indicate that a company is in financial trouble. We also outline some of the juicier financial reporting scandals of the past several years.

Part VII: Appendixes

Appendix A includes two actual financial reports from the retailers Tesco and Marks and Spencer. We refer to these reports throughout the text. Appendix A also contains the results of the analysis carried out in the chapters. And, because much of the language of financial reporting may be new to you, we include a glossary in Appendix B.

Icons Used in This Book

Throughout the book, we use icons to flag parts of the text that you’ll want to notice. Here’s a list of the icons and what they mean.

Tip

This icon points out ideas for improving your financial report reading skills. In these paragraphs, you find useful financial resources, too.

Remember

This icon highlights information you definitely want to remember.

Warning(bomb)

This icon points out a critical piece of information that can help you identify the dangers and perils in financial reports. We also use this icon to emphasise information you definitely don’t want to skip or skim when reading a financial report.

TechnicalStuff

This icon highlights information that may explain the numbers in more detail than you care to know. Don’t worry – you can skip these points without missing the big picture!

RealWorldExample

Throughout the book, we give examples from financial reports of real companies, particularly Tesco and Marks and Spencer, whose reports are featured in Appendix A of this book. We highlight these examples with the icon you see here.

SmallCompany

From time-to-time we use this icon to show you differences in nomenclature or systems that apply to small companies after text in which we have discussed their equivalent big brother companies. In this context, when we use the term small company, we are referring to companies that are not listed on the stock market.

Where to Go from Here

You can start reading anywhere in this book, but if you’re totally new to financial reports, start with Part I so you can get a good handle on the basics before delving into the financial information. If you already know the basics, turn to Part II to start dissecting the parts of a financial report. If you’re ready to get started on the road to analysing the numbers, turn to Part III. If your priority is tools for optimising company operation, you might want to start in Part IV. Those of you who want to know more about company outsiders involved in the financial reporting process may want to start at Part V.

Part I

Getting Down to Financial Reporting Basics

In this part . . .

If you’re a complete novice to the world of financial reports, this part gives you the background you need to understand this complex world, which has a language and rules of its own. In this part, we discuss the key types of financial reports, both internal and external, as well as what you should expect to find in those reports. We also explore different types of business structures and talk about the differences between a public and a private company. Finally, we review the accounting basics you need to understand in order to read financial reports.

Chapter 1

Discovering What Reports Reveal

In This Chapter

bullet Reviewing the importance of financial reports

bullet Exploring the different types of financial reporting

bullet Discovering the key financial statements

F inancial reports give a snapshot of a company’s worth at the end of a particular period, as well as a view of the company’s operations and whether it made a profit. In the modern business world it’s unthinkable that public, and some would say private, limited companies do not give the public some way to gauge their financial performance. Many stakeholders depend on this information.

Right now, nothing could possibly replace financial reports. Nothing could be substituted that’d give investors, financial institutions, and government agencies the information they need to make decisions about a company. And without financial reports, the people who work for a company wouldn’t know how to make the company more efficient and profitable because they wouldn’t have a summary of its financial activities during previous business periods. These financial summaries help companies look at their successes and failures, and help them make plans for future improvements.

This chapter introduces you to the many facets of financial reports and how internal and external stakeholders use them to evaluate a company’s financial health.

Finding Out What Financial Reporting Is For

Financial reporting gives readers a summary of what happened in a company based purely on the numbers. The numbers that tell the tale include the following:

bullet Assets: The cash, amounts receivable from customers, stock awaiting sale, investments, buildings, land, tools, equipment, vehicles, copyrights, patents, and any other items needed to run a business that the company owns or has the use of.

bullet Liabilities: Money a company owes to outsiders, such as loans and unpaid bills.

bullet Equity: Shareholders’ money invested in the company.

bullet Sales: Products or services sold to customers.

bullet Costs and expenses: Money spent to operate the business, such as money used for production, employee remuneration, and costs of operating the buildings and factories and supplies to run the offices.

bullet Profit or loss: The amount by which the revenue from sales exceeds (or is less than) the costs and expenses.

bullet Cash flow: The amount of money that flowed into and out of the business during the time period being reported.

Remember

Without financial reporting, nobody would have any idea where a company stands financially. Sure, the managers of the company would know how much money the company had in its bank accounts but even they wouldn’t know how much is still due to come in from customers, how much inventory is being held in the warehouse and on the shelf, how much the company owes, or what the company owns. As an investor, if you don’t know those details, you can’t make an objective decision about whether the company is making money and whether it’s worth investing in the future of the company.

Many people rely on the information companies present in financial reports. Here are some key groups of readers and why they need accurate information:

bullet Executives and managers: They need information to know how well the company is doing financially and to get information about problem areas so they can make changes to improve the company’s performance.

bullet Employees: Employees need to know how well they’re meeting or exceeding their goals and to know where they need to improve. For example, if a salesperson has to make £30,000 in sales every month, they need a financial report at the end of each month to gauge how well they did in meeting that goal. If they believe that they met their goal, but the financial report doesn’t show that they did, they’d have to provide details to defend their level of productivity. Most salespeople are paid according to the level of their sales. Without financial reports, there would be nothing to base their bonuses on.

Employees also make career and pension decisions based on financial reports released by the company. If a company’s financial reports are misleading or false, employees could lose most, if not all, of their pensions and their long-term financial futures could be at risk.

bullet Creditors: Suppliers need to understand a company’s financial results to determine whether they should supply goods and services to the company. Banks and other lenders need to decide whether to risk lending more money to the company and to find out whether the company is meeting the minimum requirements of any existing loans. To find out how companies meet creditors’ requirements, see Chapters 9 and 12.

If a company’s financial reports are false or misleading, banks might lend money at an interest rate that doesn’t truly reflect the risks being taken. They could miss out on a better opportunity because they trusted the information released in the financial reports.

bullet Investors: Investors need information to judge whether or not the company is a good investment. If investors think that a company is on a growth path because of the financial information it reports, but those reports turn out to be false, investors can make large losses. They may buy shares at inflated prices, risking the loss of capital as the truth comes out or missing out on better investment opportunities.

bullet Government agencies: These agencies need to be sure that the company is complying with regulations. They also need to be satisfied that the company is accurately informing the public about its financial position.

bullet Analysts: Analysts need information to develop analytical reviews for clients who are considering the company for investment or additional loans.

bullet Financial reporters: Financial reporters need to provide accurate coverage about a company’s operations to the general public. Their commentaries help investors to be aware of the critical financial issues facing a company and any changes the company makes in its operations.

bullet Competitors: Every company’s top people read the financial reports of their competitors. If these reports are based on false numbers, it distorts the financial playing field. A well-run company could make a bad decision to keep up with the false numbers of a competitor and end up reducing its own profitability.

Looking at Different Types of Reporting

Under UK company law, every company must prepare accounts for shareholders and file information on the public record at Companies House.

Small private companies will usually prepare one set of accounts for their shareholders but will file a simplified set of accounts known as abbreviated accounts at Companies House. In most cases, neither of these sets of accounts will need to be audited.

Medium-sized private companies require to have their accounts audited. Some minor concessions, to make things simpler, are available for the set of accounts which are filed.

Larger private companies receive no concessions.

Public limited companies, or PLCs, are not necessarily listed on the stock market. A PLC has the right to issue shares to the public but does not necessarily have to exercise that right. All PLCs are subject to more detailed reporting requirements than private companies but, except for listed entities, the extra requirements are minor.

There are three markets for trading shares in the UK. The full market is subject to very detailed listing rules which are considered briefly below and in more detail in Chapter 3. AIM (Alternative Investment Market) provides a lighter touch for companies seeking a listing for the first time. As AIM companies grow, they may progress to the full market. The third market is known as the Plus market (formerly OFEX) which exists to permit arranged (matched) deals between buyers and sellers as distinct from the open market dealings in shares for companies on the AIM or full markets.

All public companies and private companies (other than small private companies) require an audit by a firm of registered auditors which are firms of accountants regulated by the various professional bodies. More details about auditors and the audit are included in Chapter 18.

Keeping everyone informed

One big change to a company’s operations after it decides to sell shares to the public is that the company must report publicly on a regular basis to its shareholders and the major financial institutions that help fund their operations through loans or bonds. As well as an annual report, listed companies in the UK currently need to produce the following:

bullet Interim reports (currently at the 6 month stage).

bullet Preliminary announcements (these are advance notices of the profit and other key information which will appear in the annual accounts).

bullet Notification of material events such as indications that the profit is going to fall significantly short of the previously announced expectations. These notifications would also include other matters such as proposed take overs, mergers, and so on.

bullet Notification of major changes in shareholdings.

Remember

Most major companies put a lot of money into producing glossy reports filled with information and pictures to make a good impression on the public. The marketing or public relations department, rather than the financial or accounting departments, writes much of the summary information. Too often, annual reports are puff pieces that carefully hide any negative information in the notes to the financial statements, which is the section that offers additional detail about the figures provided in those statements (see Chapter 9). Find out how to read between the lines – especially the tiny print at the back of the report – to get some critical information about the accounting methods used, any pending lawsuits, or other information that could negatively impact results in the future.

Tip

You can access reports filed with Companies House online at the Companies House Web site www.companieshouse.gov.uk.

Staying within the walls of the company: Internal reporting

Not all the finance department’s reporting is done for public consumption. In fact, companies usually produce many more internal reports than external ones to keep management informed. Companies can design their internal reports in whatever way makes sense to their operations.

These internal reports help managers to:

bullet Find out which of the business’s operations are producing a profit and which are operating at a loss.

bullet Determine which departments or divisions should receive additional resources to encourage growth.

bullet Identify unsuccessful departments or divisions and make needed changes to turn the troubled section around or, for example, kill a project.

bullet Determine the staff and inventory level they need to respond to customer demand.

bullet Review customer accounts to identify slow-paying or non-paying customers in order to devise the best collection methods and to develop guidelines for when a customer should be cut off from future orders.

bullet Prepare production schedules and review production levels.

Each department head usually receives a report from the top managers showing the department’s expenses and revenues, sometimes called sales or turnover, and whether it’s meeting its budget. If the department’s numbers vary significantly from budget, the report indicates red flags. The department head usually needs to investigate the differences, or variations on budget, and report what the department is doing to correct any problems. Even if the difference is increased revenue (which can be good news), the manager still needs to know why the difference exists because an error in the data input may have occurred. We talk more about reports and budgeting in Chapter 14.

Reports on inventory are critical not only for managing the products in hand, but also for knowing when to order more inventory. We talk more about inventory controls and financial reporting in Chapter 15.

Tracking cash is vital to the day-to-day operations of any company. Some large companies actually provide cash reporting to their managers daily. The frequency of a company’s reporting depends on the volatility of its cash status. The more volatile the cash, the more the company needs frequent reporting to make sure that it has cash in hand to pay its bills. We talk more about cash reporting in Chapters 16 and 17; Chapter 16 focuses on incoming cash, and Chapter 17 deals with outgoing cash.

These are just a few of the many uses companies have for their internal financial reports. The list is endless and is limited only by the imaginations of the executives and managers who want to find ways to use the numbers to make better business decisions. We talk more about using internal reports to optimise results in Chapters 14, 15, and 16.

Preparing the reports

The finance department is the key source of financial reports. This department is responsible for monitoring the numbers and putting together the reports. The numbers are the products of a process called double-entry bookkeeping, which requires a company to record resources and the assets it used to get those resources. For example, if you buy a chair you must spend another asset probably cash. An entry in the double-entry system would show both sides of that transaction. The cash account would be reduced by the cost of the chair and the furniture account value would be increased by the cost of that chair.

This crucial method of accounting gives companies the ability to record and track business activity in a standardised way. The principles of double-entry bookkeeping have stood the test of time, remaining unchanged for centuries but accounting standards are constantly updated to reflect the business environment as financial transactions become more complex. To find out more about double-entry bookkeeping, turn to Chapter 4.

Dissecting the Annual Report for Shareholders

The annual report gives more detail about the company’s business and financial activities than any other report. This report is primarily for shareholders, although any member of the general public can request a copy or look at it online. Glossy pictures and graphics fill the front of the report, highlighting what the company wants you to know. After that, you find the full details about the company’s business and financial operations.

The annual report is broken into the following parts (We summarise the key points of each of these parts in Chapter 5):

bullet Mission statement: Many companies put their statement of intent, or their mission statement, on the front cover, or in a key position on the first page. This succinct statement explains the company’s key vision and strategy.

bullet Financial highlights: The inside cover and first page normally contain the company’s view of their financial performance last year compared to the year before. This comparison is interesting, but carefully selected, information.

bullet The chairman’s statement: This is always a key description of the intentions of the company. Whilst predicting what will be in any particular statement is impossible, in this section the chairman is expected to pick out the critical issues in the recent past and in the future.

bullet Reports of the chief executive and directors: These reports contain a number of matters required by law as well as describing the principal activities of the company.

A recent development in the directors’ report now requires the directors to state that they are not aware of any information of which the auditors are unaware (Yes! That is exactly what it says). A review of the business, including financial and non-financial key performance indicators, is also required to be included in the directors’ report as a substitute for the information which would have been required in the OFR (see below).

bullet Review of operations – also known as the operating and financial review (OFR): This section has always been an important voluntary statement from which we can derive the company’s strategy. The detection of the overall strategy should not be too difficult.

Recently, the government got in a right pickle when it decided to make the OFR compulsory but then changed its mind soon after in order to cut red tape. In the meantime the Accounting Standards Board had written rules for the OFR and many companies had done so much work in gathering the necessary information that they went ahead and published their OFR’s on a voluntary basis!

bullet Directors’ responsibilities: This section covers a number of issues including the responsibilities of the directors in relation to the publishing of financial information.

bullet Auditors report: This statement is also nearly a standard with few particular variations. It’s here to record the fact that the auditors have done their job, how they did the job, and what their considered opinion is of the prepared accounts.

bullet The financial statement: For those who want to know how well the company has done financially, the financial statement is the most critical part of the annual report as it includes the balance sheet, the income statement (also known as the profit and loss account), and the cash-flow statement.

• The balance sheet gives a snapshot of a company’s financial condition. On a balance sheet, you find assets, liabilities, and equity. The balance sheet got its name because the total assets must equal the total liabilities plus total equity (which in itself is a liability of the company). For more on the balance sheet, see Chapter 6.

• The income statement, also known as the profit and loss account (P&L), gets the most attention from investors. This statement shows a summary of the financial activities of an entire year or any other period. Many companies prepare income statements on a monthly basis for internal use. Investors always focus on the exciting parts of the statement: sales revenue, net income, and earnings per share. To find out more about the information you can find in an income statement, go to Chapter 7.

• The cash-flow statement is relatively new to the financial reporting game. The Accounting Standards Board didn’t require companies to publish it with the other financial reports until 1991 – previous to that there was a requirement for a rather convoluted document known as the ‘Source and Application of Funds’. Basically, the cash-flow statement is similar to the income statement in that it reports a company’s performance over time. But instead of focusing on profit or loss, it focuses on how cash flowed through the business. This statement has three sections: cash from operations, cash from investing, and cash from financing. We talk more about the statement of cash flows in Chapter 8.

Understanding How the Number Crunchers Are Kept in Line

Every public company’s internal accounting team, as well as its external auditors, must answer to government. The primary government entity responsible for overseeing corporate reporting and making sure that reporting is accurate is the Financial Reporting Council (FRC). Reports filed with Companies House may be reviewed by the Financial Reporting Review Panel which is a subsidiary body of the FRC. The Review Panel will also investigate complaints from members of the public concerning financial reports.

Another subsidiary body of the FRC is the Accounting Standards Board (ASB) which, as its name suggests, is responsible for setting accounting standards in the UK. The ASB’s power has been reduced in recent years since UK listed companies are now required to prepare their consolidated accounts in accordance with International Accounting Standards as adopted by the European Community. There is much more about this regulatory hiatus in Chapter 18.

Finally, auditors of listed companies are visited by the Audit Inspection Unit – yet another public body answerable to the FRC. We now have the answer to the question ‘Who audits the auditors?’

Remember

Financial statements filed at Companies House must adhere to Generally Accepted Accounting Principles (GAAP). To meet the demands of these rules, financial reporting must be understandable, relevant, reliable, and comparable with the financial reports of other similar entities. To find out more about GAAP, turn to Chapter 18.

You may wonder why so many accounting scandals have hit the front pages of newspapers around the country for the past few years with GAAP in place. Filing statements according to GAAP rules has become a game for many companies. Unfortunately, investors and regulators find that companies don’t always engage in transactions for the economic benefit of the shareholders but to make their reports look better and to meet the expectations of the City. Many times, companies look financially stronger than they actually are. For example, as scandals have come to light, companies have been found to overstate income, equity, and cash flows while understating debt. We talk more about reporting problems in Chapter 21.

Chapter 2

Recognising Different Business Types

In This Chapter

bullet Exploring sole traders

bullet Taking a look at partnerships

bullet Figuring out the advantages of limited liability partnerships

bullet Discovering the differences between types of limited companies

All businesses need to prepare key financial statements, but some businesses can make less formal statements than others can. The way in which a business is legally organised greatly impacts on the way it must report to the public and the depth of that reporting. For a small business, financial reporting is needed only to monitor the success or failure of operations. But as the business grows, and more and more outsiders such as investors and creditors become involved, financial reporting becomes more formalised until the company reaches the point where audited financial statements are required.

Each business structure also follows a specific set of rules about what financial information the business must file with government agencies. In this chapter, we review the basics about how each type of business structure is organised, how taxation differs, what must be filed, and what types of financial reports are required.

Flying Solo: Sole Traders

The simplest business structure is the sole trader – a business owned and run by an individual. Most new businesses with only one owner start out as sole traders. Some never grow into anything larger. Others start adding partners and staff and may realise that incorporating is a wise decision for legal purposes. (Check out ‘Seeking Protection with Limited Liability Partnerships’ and ‘Shielding Your Assets: Public and Private Limited Companies’ later in this chapter to find out more about incorporating.)

Anyone who wants to start a business as a sole trader must inform Her Majesty’s Revenue and Customs (HMRC) within three months. Weekly National Insurance Contributions (NICs) will need to be paid and, at the end of the tax year, the sole trader completes a self-assessment tax return. If turnover is expected to exceed the threshold for Value Added Tax (VAT) (currently £64,000 per annum), then VAT registration is also required.

Warning(bomb)

The biggest risk for a sole trader is that the business isn’t a separate legal entity. All debts or claims against the business are filed against the sole trader’s personal property. If you are the owner of a sole tradership and are sued, then insurance is the only form of protection against losing everything you own.

Keeping taxes personal

Sole traders aren’t taxable entities, and sole traders don’t have to fill out separate tax forms for their businesses. Instead, sole traders simply add the self-employment forms about the business entity to their personal tax returns, and this is the only financial reporting they must do.

TechnicalStuff

Sole traders will pay weekly National Insurance Contributions (NICs). NICs are fixed in amount (currently £2.20 per week) and are known as Class 2 National Insurance Contributions. If the trader’s annual profits exceed a set amount (currently £5,225), then additional contributions known as Class 4 Contributions will be payable. These are calculated from the