How to read financial statements
Posted on 23rd Mar 2022
Do you understand your financial statements? Do you know your Profit & Loss from your Balance Sheet & your Cashflow?
Don’t worry if you are unclear, you are not on your own……I’m always surprised to hear that a business owner who’s been in business for years doesn’t really know how to read their financial statements. Well in this article we will help you to understand why you need each one AND what it does.
It is a bit technical, and the article is meant to give you a better understanding but is not exhaustive.
Whether you are a brand-new business owner or established, getting your head around the basics of bookkeeping, accounting and good financial management may not come easily or naturally to a lot of business owners. Whether you like it or not, it’s going to set you in good stead the more understanding you can gain. By better understanding your numbers you’ll have more control over the business and decision making.
Money coming into the business or Revenue
Business owners are usually very ofay with the term revenue and understand that this is the income you generate through the sales of your product or service. So, your sales price multiplied by the number of sales you make gives you your revenue.
It’s a gross figure (i.e. before any deductions of what it costs to make or buy your product or service). It’s also shown in your bookkeeping software net of VAT.
Revenue can come from various sources, each source is known as a revenue stream and could be from products you sell, also if you sell maintenance contracts on those products that would be another stream.
It’s always good to have more than one stream of revenue in case it dries up…
Expenditure and money going out of the business
Expenditure is any payments you make (either cash or credit) in exchange for purchases of goods or services.
It’s always a good idea to keep a handle on your costs, so you are not throwing away profit margin unnecessarily!
Expenses could be payroll costs, marketing costs, overheads, and raw materials to produce your product.
This is a hugely important figure and one all business owners MUST know.
What is the point at which my sales income coming in covers my costs going out?
It might seem obvious, but a lot of business owners have no idea. You need to know this so that you know at what point you start to make profits and clearly, you need to get there very quickly so you don’t use up all the reserves of cash you have.
Profit & Loss (P & L)
The Profit & Loss Statement is usually referred to as the P & L.
It summarises the revenue, costs and expenses of the business.
It can be used as an internal or external document. If produced as part of your Annual Statutory reporting usually done by an Accountant on your behalf for various UK authorities, it would typically be for a 12 month period.
However, it can be produced for internal management accounts and in truth, this is where the real value is.
For external reporting to the authorities there are certain rules and regulations you have to follow when reporting (UK GAAP) but in truth, it is “Fictional” as you have a certain amount of flexibility “within the rules”.
You can decide to release provisions to affect your profit figure, adjust stock figures, all with the aim of increasing or reducing profit.
This all has to be done within the rules of UK GAAP!
You might want to show more profit in order: –
- To get a better credit worthiness score to win new contracts
- To gain funding to buy a business
- Or get a better price when selling
- To declare a larger dividend or salary because you want to move house in the following year.
There could be a whole myriad of reasons. It is really important to discuss your plans with your financial advisers so they understand your future plans.
It’s also worth pointing out that profit as shown in your Statutory P & L statement can be different to the profit for taxation purposes – this is because certain expenses are NOT allowable for taxation purposes.
For example (A few but not all): –
- Speeding/parking fines
For internal reporting – this is where the magic happens with a P & L report. Lots of larger businesses employ internal Management Accountants to assist the management team in reporting the true picture of where a business is and where it is going via a budgeting and forecasting process.
The real value here is being able to structure the report without the confines of UK GAAP, so you can split out information, report against last year, last month, budget, forecast and add in commentaries so it makes more sense to the user.
If you are too small an organisation to employ your own internal accountant, make sure your external accountant does this for you as it is really important you understand where your business is.
They can help you with: –
- What is happening to the business, is it essentially growing or shrinking.
- Pulling together a budget at the beginning of the year so you go through a process to define what your sales down to profit will be AND what you need to do to achieve that.
- They can report against this on a monthly basis and draw your attention to any one-off items so they don’t cloud your judgement when making decisions.
- They can make you aware of any major milestones or dates on the horizon – i.e. funding payments coming to an end, tax payments due which might affect cashflow etc.
- Produce a monthly Management Information pack that goes far further than just a P & L run from Xero or other Cloud Accounting software.
Cashflow Statements and Positive Cashflow
This is another vital tool to enable you to succeed in business. A cash flow statement is fact…
You either have the cash in the bank or you don’t.
A business can survive making a loss in the short term if it has enough cash and reserves. But, you do have to fix the underlying issues that cause the loss and quickly as no business can survive without profits indefinitely.
Your Cash Flow statement shows:-
A summary of the amount of cash or cash equivalents entering and leaving your business.
- Cash from operating activities – Cash Inflows & Cash outflow – money coming in or going out from trading activities. It could be receipts from sales of goods or services, interest payments, income tax payments made, payments to suppliers for goods or services, salary & wage payments, rent payments and other operating expenses paid
- Cash from Investing Activities – Sources and uses of cash from a company’s investments. A purchase or sale of an asset, loans made to vendors or received from customers. Payments made as a result of a merger or acquisitions. In short, changes in equipment, assets, or investments.
- Cash from Financing Activities – This includes sources of cash from investors or banks, as well as the uses of cash paid to shareholders. Payments of dividends, repayment of debt (loans) are included.
The real value of a Cash flow statement is to get a picture of, is the business receiving a cash Inflow each month or a net cash outflow.
Clearly, for a business to survive and thrive you need to build up a net cash surplus in the business. Whilst most businesses have enough reserves to survive in the short term, a business that is spending more than it earns will run out of cash at some point.
The danger point comes when a business is growing and expanding as it needs enough working capital to fund growth and this is very often when a business fails due to running out of cash and can’t pay and falls foul of wrongful trading.
A balance sheet is a snapshot of your business at a particular time usually at your year-end.
It shows all the balances at that point in time of all the assets (what your business owns) and liabilities (what your business owes) and Shareholders equity (The money put into and generated (retained earnings) by your business).
Balance sheets are often used by banks and other lending institutions to assess the health of your business and whether you are suitable to lend money to.
Is it stable enough to be able to pay the money back, when it becomes due?
As the name implies a balance sheet should balance – the theory is that what your business owes, as well as the money it has available, are what’s funding its assets.
Therefore Assets + Liabilities + Shareholder Equity
Assets should be divided into Fixed, current and non-current assets.
- Current Asset is if it can reasonably be converted into cash within one year. So, for example, Debtors, stock and work in progress not yet sold etc. This is important as it offers flexibility and solvency!
- Clearly, the best current asset is CASH in the bank account– although some companies are able to generate lots of cash easily. Some companies don’t have huge stocks of cash as they are constantly re-investing it back into the business to enhance their future profit potential.
- Fixed Assets can be tangible or intangible. Intangible, items could include intellectual property and customer goodwill (intangible as these can depreciate in value and are difficult to quantify. Tangible on the other hand could be property & equipment like buildings, land and equipment used in running the business, like computers
Like Assets, liabilities are either current or non-current.
- Current liabilities are obligations due within one year like your creditors (raw material or service providers), HMRC for tax liabilities like VAT, PAYE and Corporation Tax.
- Non–current could be a loan not due to be repaid within 1 year. It could also be a mortgage or other labilities that don’t need to be paid back for at least 12 months.
This part of the balance sheet goes below the liabilities section. It refers to the amount of money generated by a business – your net assets.
You have the capital stock – the shares that a company has and can sell (essentially this is a liability as it would owe it to the owners if the business was sold).
Retained earnings – this is income that has been kept by the business rather than by being distributed to owners
Clearly, a company that has more assets than liabilities is in a healthier position and a positive cash flow statement would also aid this.
Why is a balance sheet useful?
It’s useful because you can see: –
- How easily you can access money, by looking at your current assets
- How much financial risk you can take on, by comparing equity against your liabilities
- How efficiently your business can generate revenue using its assets, comparing Balance sheet to your P & L
Some useful terms
Turnover = the total sales revenue made in a period. It’s also sometimes called “Gross Revenue”, as it’s the number prior to any deductions being made
Assets = the things you own in the business, like equipment, property, or cash etc
Liabilities = the things you owe to other people, like bills, debts and loan repayments.
Balance Sheet = a snapshot of your assets and liabilities on a given date
Working Capital = your current assets minus your liabilities. In common usage, it’s the capital (money) You have in the business to keep the company operating and trading.
Funding = bringing additional capital into the business, usually in the form of business finance products like loans, or through private investment from outside sources.
Credit Score = a rating given to the financial health and risk level of the business. The bigger the score, the lower the risk – and the better your access to funding.
EBITDA = Earnings before Interest, Taxes, Depreciation, and Amortization. It’s a financial metric that can be used to understand how profitable a business is, without taking into account daily operating expenses
Here at Krystal Clear Accounting we are here to support. If you’d like some help when it comes to understanding your financial statements then drop us an email at email@example.com or give us a call on 0161 410 0020.