Introduction to Financial Statements (part one)

This is the first blog post from Orben Accounts. Kicking off with the basics of how to interpret and analyse your financial performance using your financial statements. Many small businesses look at only a few figures on their profit and loss statement, tax paid & profit for example, but there is so much more that can be scrutinised and lessons that can be learned which could benefit your business.

 

Firstly there are many financial statements, most businesses will be familiar with names such as profit and loss, balance sheet and cash flow. Are you comfortable with what these are and what they represent? A balance sheet is a static report, it is fixed at a point in time usually at year end and states the value of the assets, liabilities and equity that relate to the business. A cash flow statement shows the changes in cash balances over a period of time, usually a year, so that you have a beginning cash balance, an end cash balance and an explanation of movements in between. The profit and loss, unlike the balance sheet is not fixed at a point in time, it is a statement describing the movement in income and expenditure throughout a reporting period, usually a financial year. We will focus on the profit and loss statement in this post.

 

Sales                                                                           £X

Cost of Goods Sold                                                  £(X)

Gross Profit                                                              £X/(X)                                               

Selling, General & Administration Costs                 £(X)

Profit before tax                                                      £X/(X)

Tax                                                                             £(X)

Net profit                                                                  £X/(X)

 

The above is the nuts and bolts of what a profit and loss looks like. Lines can be split out to add detail and inform readers better but what it boils down to is how much sales you make, less your direct costs such as wages and materials which give you your gross profit; then take off the indirect costs/overheads such as your management and back office costs to arrive at your profit before tax figure. Once tax has been paid on this figure (if its positive!) you end up with your net profit.

 

To a chartered management accountant this is not the end of the story. The statements can be further analysed. What is your gross or operating margin? This is your gross profit divided by your sales. How does this compare with your sector? Is it better or worse? How has this progressed over time, can you do a time series analysis where you compare your gross margin over the past few years and try and identify trends? Can you explain these trends, are they due to downward pressure on prices? Are they due to rising input prices (the price you pay for goods and services)? Can you mitigate these factors and gain control in this area?

You can do time series analysis on specific lines such as working out your sales growth, or your growth in overall costs. Is this in line with the sector, some industry analysis may be required to answer this question.

Another way you can look at this statement is to work out the percentage of your sales that is related to back office costs, are you as a business becoming too top-heavy? Should more be invested on the frontlines, at the coal face? Perhaps you could have a target of a maximum percentage your spend to be taken up by administrative costs.

This the profit and loss in a nutshell. In a future post we will explain how we decide if we expense financial transactions (they feature in the calculation of profit) or capitalise them (they remain on the balance sheet). Next week we will discuss the balance sheet and also we will begin to see how the financial statements interact, using ratios such as asset turnover and other metrics.