understanding financial statements - accounting...

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UNDERSTANDING FINANCIAL

STATEMENTSFinancial statements need to be demystified so that you can get the most value out of them.

What are financial statements?

Financial statements are a collection of reports that quantitatively describe the businesses financial health or condition

Financial statements are a collection of reports that quantitatively describe the businesses financial health or condition. The main reports are the Statement of Financial Performance and Statement of Financial Position.

Financial statements are usually associated with your formal year-end financial statements which you need to help prepare your tax return. Equally important is the periodic management reports that you should prepare and review regularly – ideally monthly.

Statement of Financial Performance

The Statement of Financial Performance is an important means of monitoring the progress of your business

This is also known as your profit and loss statement or income and expenditure statement.

The Statement of Financial Performance is usually straightforward and relatively easy for non- financial people to understand.

It provides a picture of your businesses trading performance over a period of time. It’s a bit like a video … you can pause it and look at one frame (e.g. a days trading), look at a section of it (e.g. one month) or the whole video (e.g. 12 months). It’s an important means of monitoring the progress of your business.

It is used to summarise the results of a business by matching the revenue earned during a given period with the expenses incurred in that same period, resulting in a net profit or loss.

Matching means preparing the statements on an accruals basiswhere revenue and expense s are recognised when they areincurred, as opposed to when they are paid - cash basis. This is why profit does not equal cash in the bank.


Revenue/ Sales /IncomeOperating revenue is the income earned from activities directly related to the core activity of the business e.g. sales, fees, commission etc.

Cost of goods soldThis is the direct costs attributable to the production of the goods sold by a company. This amount includes the cost of the materials used in creating the goods along with the direct labour costs, importation costs, freight and other direct costs of getting the goods produced.

Gross ProfitThis is the difference between revenue and the cost of goods sold. This is a key number as it shows how much you have made prior to deducting operating expenses, shareholder remuneration and tax.

Expenses / Operating CostsThese are expenses incurred in carrying out the businesses day-to-day activities, but not directly associated with production. Therefore, if you have not included it in cost of goods sold, it is an operating expense.

It is important to note that capital expenditure is not an expense – it is an asset. In addition, principal repayments of loans are not expenses –they are a reduction of a liability. This impacts on cashflow.

Net profit This is often referred to as the bottom line. Net profit is calculated by subtracting a company's total expenses from total revenue, thus showing what the company has earned (or lost) in a given period of time .

Statement of Financial Position / Balance Sheet

Accountants, Financial Analysts and Bankers pay particular attention to the Statement of Financial Position

The Statement of Financial Position is more difficult to understand. It expresses the financial position or strength of the entity at a point in time – a snapshot of the assets, liabilities and equity. You may have heard the comment that a company has a “strong or weak Balance Sheet”.Accountants, Financial Analysts and Bankers pay particular attention to the Statement of Financial Position.

The main components are:


AssetsAssets are anything owned by the business, which has a commercial or exchange value. These assets are classified into current (resources held by the business in cash or near cash form such as debtors and stock), investments, fixed assets (eg plant and machinery) and intangibles (e.g. goodwill).

LiabilitiesLiabilities are owed by the business to an external source. These liabilities are again classified into current (due for payment in the next 12 months e.g. bank overdrafts, creditors, tax) or non-current (amounts owing which are due beyond the 12 month mark e.g. bank loans).

EquityEquity represents the company share capital plus the retained earnings (or losses). Most private companies have shareholder advances – loans by the shareholders to the company. Whilst most owners consider these advances to be equity, they are required to be shown as a liability on the Statement of Financial Position. However banks will often reclassify these as equity when they are trying to determine the financial strength of a company when deciding whether to lend money.

Analysis

The financial statements represent the results of business “game” played

Now we know what the “financial statements” are, what do we do with them?

To provide a useful analogy, let’s liken these financial statements to a sports game. The financial statementsrepresent the results of business “game” played!

How much time do you think coaches spend on analysing the performance of their sports teams? How many dropped passes, intercepts, shots on goal etc? Even at an amateur level there is some form of analysis taken. From this, trainings are decided to work on areas that need improving.

Businesses should be no different – you would want to know what areas you need to work on to help improve the performance of your business!!

So how do we do this?

We need to analyse and interpret the financial statements, get to know what these numbers mean and how we use them.Financial analysts often assess the businesses for:


Although financial statements/management accounts are based on historical information, they provide important indicators of how the business will perform in the future

1. Profitability -its ability to earn income and sustain growth in both the short-term and long-term. A company's degree of profitability is usually based on the Statement of Financial Performance which reports on the company's results of operations;

2. Solvency and Liquidity - its ability to pay its obligation to creditors and other third parties; This is based on the Statement of Financial Position which indicates the financial condition of a business as of a given point in time.

3. Stability- the firm's ability to remain in business in the long term, without having to sustain significant losses in the conduct of its business. Assessing a company's stability requires the use of both the Statement of Financial Performance e and Financial Position.

Although financial statements/management accounts are based on historical information, they provide important indicators of how the business will perform in the future, its weaknesses and strengths and trends. The key is to have timely financial information which is why you need regular up to date management reports.

There are a few forms of analytical tools that are used in analysing financial statements.

Horizontal Analysis – comparison of two or more years periods financial data – year to year, quarter to quarter etc. It illustrates the changes between periods and aids in determining how each item has changed.

Vertical Analysis – this concentrates on the relationships between various financial items on a financial statement eg advertising costs to sales. This analysis gives insight into the relative importance of items on the statement.

Trend Analysis – comparing information for 3 or more years. The first year is the base year and each year is then compared to this.

Ratio analysis – this involves the comparison of ratios to previous results or known standards. We have attached an appendix of ratios.

Key QuestionWhat would the financial impact be on your business if you improved 5 key financial indicators?

Talk to us to find out more.


Appendix – Ratios

There are a number of ratios that can be utilised to assist business owners to monitor performance in business. Below are some of the more useful ones.

Profitability Ratios

Gross Profit Margin – this measures the businesses overall efficiency as reflected in sales generated and cost control.

GPM = Gross Profit / Sales

Gross profit = sales less cost of sales (opening stock + purchases – closing stock)

Net Profit Margin – this measures the overall operating efficiency of the business/entity

NPM = net profit / sales

Net profit = Gross profit less other expenses

Return on Investment – this is a measure of the earning power of the shareholders’ investment.

ROI = net profit / (shareholders equity + current accounts)

Net Profit to Total Assets – this measures a business’s performance in generating profits from its asset base.

NP/TA = Net profit / total assets

Working Capital Ratios – Solvency and Liquidity

Working capital = Current Assets – Current Liabilities

Current Ratio – used to measure a business’s liquidity. It quantifies the relationship between current assets and current liabilities and measures how many dollars of current assets are available to pay each dollar of current liabilities – paying debts as they fall due.

CR = Current Assets / Current Liabilities

Quick Ratio – more rigorous test for short term liquidity

QR = (Current assets – stock – prepaid expenses) / (current liabilities – bank overdraft)


Financial Structure Ratios

Debt to Equity – measures the relationship between debt and equity, the measure of risk in a business’s capital structure in terms of the amount of capital contributed by creditors and that of owners.

DE = Total Liabilities / Total Equity

Investment in the Business – measure of total funds of the business represented by risk capital. It can be broken into 3 categories (together they should add to 100%):

Your investment = (shareholders equity + current assets) / Total Assets

Banks investment = bank od + bank loans / Total Assets

Other lenders investment = all other lenders (including creditors) / Total Assets

Activity Ratios

Stock Days – measure of the effectiveness of the business stock policy.

SD = Average Stock (being opening stock + closing stock / 2) / cost of goods sold / 365

Stock Turn – the number of times a business turns over its stock during the year.

ST = 365 / Stock Days

Debtor Days – measures how quickly your debtors are paying you, or the average collection time.

DD = Average Debtors (ex GST) / (credit sales / 365)

Asset Turnover – how well a business is putting its assets to work.

AT = Sales / Total Assets

DisclaimerThis publication has been carefully prepared, but has been written in general terms only. The publication should not be relied upon to provide specific information without also obtaining appropriate professional advice after a detailed examination of your particular situation.

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