The data found in a company’s financial statements is vital. Without accurate and up-to-date financial statements, neither the performance nor the financial health of a business can be fully understood.
This understanding, however, is not just driven by the content of the financial statements. It is equally important to ensure the financial statements are interpreted properly. In this article, we will look at the main components, what they represent, and how they can be interpreted.
What are financial statements?
Financial data is important for business management, shareholders, investors, and creditors. As well as the financial health of a business, financial statements help determine the potential for future earnings.
There are three main types of financial statements:
- Profit and Loss Account
- Balance sheet
- Cashflow Forecast
It is important to understand what the purpose of each of these financial statements is, what information they include, and how that information is useful.
What is a Profit and Loss Account?
The Profit and Loss account for a business provides a periodic overview of:
- Revenue
- Cost of Sales
- Overheads/Expenses
Revenue includes sales and operating revenue.
Cost of sales includes costs directly associated with a sale. E.g. Materials or delivery costs for an item that you have sold or costs related to a service provided e.g. direct wages.
Overheads/Expenses – are costs indirectly related to sales e.g. Marketing, Professional Fees, repairs, and utilities.
Interpreting the Profit and Loss Account
Profit and Loss reports are used to determine whether a company has made a profit or a loss. It is a short-term report – looking at performance over a given period.
It includes all the revenue and costs associated with the trade within a set period. The result at the end of the report is then a profit or loss (revenue/other income less all costs).
To provide insight, the report may include several formulas, including:
- Gross Profit: This shows the net sales income minus cost of goods sold. This allows you to view how much contribution the sale of goods/services provides. This can be viewed as a % instead (Gross Profit Margin).
- Operating Profit (or EBIT): This is the gross profit less the overheads/expenses, excluding Interest and Taxes. It can be viewed as a total or percentage (Operating Profit Margin).
- Net Profit Margin: This is a company’s net profit as a percentage of revenue.
The Profit & Loss report is useful for various reasons. Firstly, it gives essential insight into the profitability of individual business activities, allowing strategic decisions on areas like where to increase margins, reduce costs increase investment, or diversify.
It also allows management, shareholders, or investors to see how the profitability compares with other businesses in a similar industry to benchmark performance against.
What is the balance sheet?
The Balance Sheet presents a top-level snapshot summary of the assets and liabilities of a business at a given time, as well as shareholder equity.
It is a long-term report, cumulative totals from day one of the business existing to date.
It is particularly important if a business is trying to raise capital. A would-be lender will need to see the balance sheets in order to determine the risk of lending to a business.
A Balance Sheet is comprised of the following:
Assets
Assets are something of value that an entity owns/part owns and may include fixed assets e.g. property/computers/tools etc, investments, stock, cash, and unpaid sales invoices.
Liabilities
Liabilities are something that the entity owes and can include unpaid purchase invoices, unpaid taxes, and loan obligations.
Equity
Equity is the value retained in the entity from the very beginning of it being started. It is essentially Total Assets – Total Liabilities.
What is a Cashflow Forecast?
Cashflow forecasts look ahead, instead of historically, and add planning and forethought to finances.
The Cashflow Forecast reports on the impact of cash throughout the business and predicts a cashflow position at the end of a period. This makes it a really useful tool to identify periods where there is a potential deficit of cash – giving time to do something about it.
This is especially useful for a business that is spending a lot of cash in order to achieve growth.
Interpreting cashflow Forecasts
The report depicts the inflow and outflow of cash for specific time periods. Cashflows will generally include three different cash types:
- Cash to/from operations. This will usually be generated by the main operating trade that a business does, such as selling goods and services.
- Cash to/from financing: This is cash that enters the company’s balance sheet as a result of borrowing, such as a bank loan, and then the repayments of these loans reducing cash.
- Cash to/from investing: This is generated when an asset owned by the business is disposed of (or sold) for cash or shows as an outflow of cash if an investment is made.
A cashflow forecast allows you to understand the effects that spending decisions have on operating performance. It helps the business understand its liquidity and can also help with scenario planning.
Can we help?
Financial reporting is not just about profit and loss, accounts, or a balance sheet. It is what you do with this information that matters most.
Once you have your numbers, the Genus team can collaborate with you to interpret these results, looking at underlying trends and KPIs to identify areas of success and those that need more attention.
We can also monitor the cashflow forecast and budget with you to help identify areas of improvement and discuss ways to do this to keep your business on track.
Alicia Williams
Alicia is Director of the Genus team at Shorts, a chartered certified accountant and Xero specialist.
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