A guide to reading and understanding financial statements

We hope this concise guide to financial statements helps you to read and understand the information contained in them, so you can make better informed decisions about your own business.

Contents:

1. How important is understanding your business’ financial health?

2. Gaining financial clarity from financial statements.

3. What are the key different types of UK financial statements?

• Balance sheet (statement of a business’ current financial position).
• Profit and loss statement (income statement).
• Cash flow statement.

4. Critical skills that your business can benefit from.

How important is understanding your business’ financial health?

Developing the ability to read and understand financial statements cannot be underestimated and is highly relevant to business owners, senior managers, entrepreneurs, and to aspiring investors.

The skill of understanding a business’ finances can help business owners and managers make well-informed strategic decisions, identify potential opportunities, and help avoid undue risks.

Who is required to publish financial statements?

It is a legal requirement of Limited companies to produce financial statements, both a balance sheet and a profit and loss account, when they are filing their annual accounts. These reports are typically compiled and presented in a structured format by the business’ accountants finance team.

Sole traders are not legally obliged to file financial statements, but as they themselves are running a business, it is still recommended that they keep accurate financial records. Sole traders can gain as much benefit from learning the ins and outs of financial statements, just as Limited company owners can.

Also, some sole traders make the switch to Limited companies as their businesses grow and they look to take on staff. This is mainly due to the limited liabilities protection offered by the Limited company structure, which theoretically helps to protect the business owner’s personal assets.

Gaining clarity from financial statements

Financial statements provide a window into the financial health of a business. Accountants and financial professionals are trained to read and understand financial statements, and with experience they can make informed decisions based on them.

Many other professionals do not have this type of training and as such they do not have the means to gain insight into a business and thus cannot make the same informed decisions.

What are the key different types of UK financial statements?

There are many types of financial statements, but arguably the three that are most relevant to small business owners are:

• The balance sheet (statement of a business’ current financial position).
• The profit and loss statement (income statement).
• The cash flow statement.

Understanding the balance sheet

The balance sheet provides a clear statement of a company’s assets, its liabilities, and the equity of a business at that point in time.

The figures in the balance sheet can be used to calculate your equity (also known as ‘net assets’, ‘net worth’, or ‘capital’) using the following equation:

Assets – Liabilities = Equity

Company assets are the items owned or controlled by the business that help to generate income. Types of assets include current, non-current, physical, intangible, operating, and non-operating. These can include: property, IT Hardware, machinery, vehicles, furniture, inventory, investments, and patents.

Correctly identifying and classifying the types of assets in a business is vital to the survival of a business, its solvency and its associated risks.

Accounting standards require companies to separate long-term or non-current assets (also known as ‘fixed assets’) from short-term or current assets.

Separating asserts can look something like the table below:

For more information about company assets, read our blog on the classification of business assets.

Liabilities are the company’s obligation to transfer money or services because of a transaction or prior event. This can be an invoice, the delivery of paid for goods or services to a customer, or to honour a warranty. Money that is owed to suppliers is known as payables.

As with assets, the liabilities should be separated into non-current and current liabilities.

• Non-current liabilities refer to amounts that are not due within 12 months, such as loans.

• Current liabilities refer to amounts due within one year such as business debts and other monetary obligations including supplier invoices, paid for goods that are yet to be delivered to customers, and bank overdrafts.

Separating liabilities can look something like the table below:

Understanding the profit and loss (P&L) account

A profit and loss account is compiled to indicate the gross and net profit or loss during an accounting period e.g. a quarter or a year.

The following simple equation calculates the profit:

Total income – Total expenses = Profit

Income is mainly derived from monies received from sales of goods and services. This can be supplemented by income from other sources such as savings interest or discount though bulk buying or paying early.

Expenses are the daily running costs of the business e.g. purchase of goods and services, salaries, and buying consumables.

Profit is calculated over a period of time and works to what’s called the ‘accrual concept’. The accrual concept is one of three basic accounting concepts, others are going concern and consistency.

A profit and loss account helps business owners to calculate:
• Sales revenue.
• Cost of sales.
• Operating expenses.
• New profit.
• Gross margin.
• Net profit margin.

Understanding a cash flow statement

Cash flow statements are used by many businesses to monitor and forecast incomings and outgoings. A cash flow statement will indicate:

• What a business expects to spend in costs.
• What a business expects to make in sales.
• What the current cash position of the business is.

Cash flow forecasting is a vital component of business management. Especially for those organisations who experience fluctuation in income and expenditure from seasonal influences, such as a restaurant or café that are situated in a tourist area that experiences a steep rise in income during the summer, but then sees a fall during the winter months.

Critical skills that your business can benefit from

Knowing your numbers and being able to review and understand financial documents can provide you with valuable insights about your own business (and another business if you are looking to make an acquisition), including:

• The business’ ability to pay its debts.
• The business’ profits and losses for any given quarter or year.
• Whether the business is growing e.g. the profit has either increased or decreased when compared to similar previous accounting periods.
• What investment is required to maintain or grow the business.
• What the business’ operational expenses are in relation to the revenue generated.

Accounting teams, investors, shareholders, and company leaders need to be aware of the financial health of their business, but it can also be beneficial for employees to understand balance sheets, income statements, cash flow statements, and annual reports, especially those who work in sales and in marketing.