Understanding Financial Statements
Just as a picture tells a thousand words, so do financial statements. At first, they look like quite a challenge, but understanding them takes some explanation. In our blog series on ‘why managing cash flow shouldn’t be an extreme sport’, let’s take a look at what financial statements are used for.
The purpose of financial statements is to present an accurate account of a business’ trading operations and its assets and liabilities position. Having a handle in this should not come as a surprise (your business management style should give you an adrenaline response like an extreme sport!). A financial report will include:
- A profit and loss statement for the year
- A balance sheet as at the end of the year
- A statement of cash flows for the year
- Notes to the financial statements
- Directors’ declaration about the statement and notes
The financial report is used by the business owners to manage and make decisions about the business, but also by financiers, investors or shareholders and creditors. They are also used in matters that involved analysis of your business’ financial information for:
- Compliance under the Corporations Act and Income Assessment Act
- Business sale
- Mergers, acquisitions and takeovers
- Assessment of damages / economic loss in a claim
- Family court proceedings
- Partnership disputes
- Issues relating to insolvency
…among other things.
The information in financial reports is drawn from the records that a business is required to keep. This may include your cash book; sales, debtors and creditors ledger; payroll records, general ledger, plant and equipment register; stock records; orders; receipts and invoices. Fortunately, online business accounting systems, like Xero, make these requirements far easier than they used to be!
Now that we have all the financial information in order, it’s time to talk about two of the main financial statements; the Profit & Loss Statement and the Balance Sheet.
Profit & Loss Statement
A Profit & Loss Statement sets out the trading position of a business and indicates whether it is trading at a profit or loss. It has three, main sections. For a manufacturing company, it may look something like this:
So the report sets out your revenues (Sales) and then deducts how much it has cost to produce those products to be ready for sale (cost of sales). From this figure, you then take away the value of the stock you have remaining (because you still are able to sell this in the future), to be left with a figure that tells you how much it has cost to produce the goods that you have sold. This is deducted from the revenues and you are left with your gross profit.
Gross profit is a reflection of the profit that remains after all of the direct costs associated with generating income or sales have been deducted. Gross profit expressed as a percentage of sales (Gross profit %) is an important benchmark for looking at the performance of a business – this can be compared with previous years or industry averages to see how you are performing.
You can then go on to deduct any other expenses in your business to obtain your final profit or loss.
A Balance Sheet sets out the financial position of your business at a particular point in time. It does so by listing all of your assets and liabilities, and your equity. The difference between them represents the equity which owners have in the business.
A Balance Sheet will list your assets (what you own) and liabilities (that you owe). They are categorised as follows:
- Fixed (Non-Current) Assets – These represent the more permanent assets such as property, plant & equipment and investments. The rule of thumb is that an asset will be considered fixed if it is unlikely to be realised within 12 months.
- Intangible Assets (a non-current asset) – These are assets which are not of a tangible nature such as goodwill, patents, trademarks and copyright.
- Current Assets – These are the most liquid assets such as cash, debtors, stock and work in progress. There is an expectation that these assets will be turned over within 12 months.
- Current Liabilities – These constitute liabilities of the company which are payable within a 12 month period. They include trade creditors, short term loans and bank overdrafts.
- Non-Current Liabilities – These are liabilities that are not payable until 12 months or longer after the balance sheet date. They include long term loans and leases. However, loans and leases may be included in both current and non-current liabilities with the component due in the next twelve months being shown under current liabilities.
Doesn’t the thought of getting a handle in this make you start to sweat? Running your business shouldn’t be like an extreme sport. Get in touch and make a free consultation with us today.