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  • Dec 15, 2021
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Understanding Financial Statements

Your finances are an essential part of managing your business. It is vital that you understand the various financial statements. They provide you with key information to help you monitor and analyse your business’ overall performance.

They are a necessity if you are looking to raise funding whether this is a loan or raising equity. If you want people or companies to invest in your company, you need to present a professional front and having and understanding these statements form a vital part of this.

Here is a simple explanation of these key financial statements.

What are financial statements?

Financial statements or reports display a mixture of financial information. The key three are:

  1. Profit and loss account (statement of income and outgoings)
  2. Balance sheet (statement of financial position)
  3. Cash flow statement

Limited companies are legally required to produce both a balance sheet and a profit and loss account when they file their company accounts. These structured reports are usually prepared by your accountant or finance team.

Sole traders do not have to file financial statements. However, they should have some basic reports to help them manage their business.

Any business looking for funding must have these financial statements prepared. Many businesses fail in their search for loans or equity finance simply because they lack these key statements.

Successful businesses use management accounts in which they review these statements on a monthly or quarterly basis. They are fundamental to controlling your business.

Profit and loss account

A profit and loss account is an account compiled to show gross and net profit or loss during a specific time period typically over a month, a quarter or a year.

Simply put:

Total Income – Total Expenses = Profit

Income mainly consists of your turnover generated from the sale of goods and/ or services. Other income can come from interest received on savings, R&D tax credits, sale of equipment you have used etc.

Expenses are the day to day running costs of the organisation, for example, paying wages, buying goods or services etc.

Profit must be calculated over a period of time. This is a fundamental concept, called the accruals concept, which states that income for a period must be matched against the expenditure for that same period. This could be over a month, a quarter or a year.

A profit and loss account will help you to calculate the following:

Turnover generated by sales- it can be helpful to break this down by product or service so you can see what is selling and what is not.

Cost of sales- this is a breakdown of all the costs directly related to the sales you’ve made. It includes the cost of raw materials and stock or, if you are delivering services, employee time spent solely on delivery. For example, solicitors would include their billable hours. No other costs are included in this section.

Gross profit- your net sales minus the cost of the goods or services sold

Operating expenses- this is where you include all your other costs and expenses, such as rent, marketing, insurance, accountancy fees etc.

Net profit- the actual profit after working expenses not included in the calculation of gross profit have been paid.

It is important to keep on top of your profit and loss account. It gives a snapshot into your business and is very powerful when used with the other financial statements.

Balance Sheet

Your balance sheet provides a statement of the assets, liabilities and equity in your business at a particular point in time.

It is called a balance sheet as it is divided into sides which must balance. On one side is the company’s assets and on the other side are your liabilities and shareholder equity.

The balance sheet equation is:

Assets = Liabilities + Shareholders' Equity

This can sound confusing to business owners, mainly because of the accounting terminology. If we break it down, it is fairly straightforward.

An asset is either cash or anything that can be converted into cash. This includes outstanding invoices, stock, equipment, buildings etc.

Accounting standards require you to separate long term, or non-current assets (sometimes referred to as ‘fixed’) from short term or current assets. Current assets include cash in the bank and things that can be quickly converted into cash. This includes:

  • Cash in the bank
  • Inventory- e.g. stock and raw materials
  • Accounts receivable (i.e. you have invoiced someone and are waiting for them to pay you)

Non-current assets typically include long-term investments that aren’t expected to be converted into cash in the short term, such as:

  • Buildings
  • Equipment and machinery used to produce goods or perform services

Liabilities should be separated into non-current and current liabilities. Current liabilities are those amounts that are expected to be paid off within a year. They're typically listed before long-term liabilities on a balance sheet, and include:

  • Invoices
  • Expenses
  • Salaries
  • PAYE and National Insurance
  • VAT
  • The part of long-term loans and mortgages due in one year
  • Bank overdrafts

Long term or non-current debts are expected to continue for more than one year. These include:

  • Leases and loan payments due after one year
  • Mortgage payments due after one year

Shareholder’s equity is the amount of money the owners have invested in the business. It includes:

* Retained earnings: the amount of a company's profits that are reinvested in the business

* Share capital: the amount of money a company receives from its shareholders for business purposes

The easiest way to work out the equity in your business is to re-arrange the balance sheet equation:

Equity = assets – liabilities

Your balance sheet shows you and your directors what the company owns and what it owes. It is primarily used to track earnings and spending. However, it does show the profitability of a business to those who are interested in investing. If you apply for a loan or funding, you will need someone to prepare a balance sheet for you.

Cash Flow Statement

Cash flow statements are used by many businesses to monitor their cash inflows and outflows.

They are important as you need to be aware of your cash position. If you don’t control your cash flow, it can have a significant effect on your business’ financial health. For example, your business could be profitable but late payers may cause you major problems in meeting your financial obligations.

A cash flow statement covers three key aspects of your business activities:

1. Operating activities –This is your regular business activities. Inflows include turnover from the sale of products or services, dividends received by the business, interest, and other cash receipts. Outflows include taxes, payroll, overheads and payments to suppliers and vendors.

2. Investing activities –This refers to gains and losses from investments in your business. Inflows include sales from business assets and payments from loans made by your business, Outflows include purchases of assets and loans made by your business.

3. Financial activities – This refers to capital that is raised externally. Inflows include any money that has been borrowed, as well as sales of your company’s securities. Outflows include dividend payments and paying back debt.

Cash flow statements show the detail of your ingoing and outgoing cash, including loan payments. Profit and loss statements don’t go into this type of detail but give you more insight into the long term financial standing of the company.

Naylor Accounting Services can prepare these documents for you and help you understand them and take action so you can grow your business and achieve your goals.

You are invited to contact us at accounts@nayloraccountancy.com or call us at 44 (0) 1892 807 001.