1.7 – UNDERSTANDING FINANCIAL STATEMENTS
Knowing how to manage your finances will help you make the right decisions for your business.
Financial statements that are produced regularly and correctly will give key information to continually improve your business. 41 per cent of failed companies in Australia say inadequate cash flow was to blame for their collapse.
There are three major financial statements to understand:
i) Profit and loss statement
ii) Cash flow statement
iii) Balance sheet
Profit and loss statement
The profit and loss statement (also called an income statement) is a summary of a business’ income and expenses over a period of time. It is prepared at regular intervals usually monthly and at financial year end.
Things to remember
Do a profit and loss statement in order to analyse all income and expense categories.
Try to do profit and loss statement monthly – you will get a better understanding of your income and costs.
Recognise areas that need more analysis, and take action before small problems become big problems (e.g. business expenses are increasing so you need to re-price your goods to keep making a profit).
Cash flow statement
A cash flow statement is a summary of money coming into and going out of the business for a set time period. It is prepared monthly and at the end of the financial year.
Types of cash flow
Cash flow is divided into three categories.
Operating activities are the day-to-day results of buying and selling of goods and services.
They usually include:
i) Receipts from income
ii) Payment for expenses and employees
iii) Funding of debtors
iv) Funding to and from suppliers
v) Stock movements.
Investing activities include investments in future business activities, e.g. buying and selling fixed assets. Can include items such as:
i) Payment for purchase of plant, equipment and property
ii) Proceeds from selling the above
iii) Payment for a new investment
iv) Proceeds from selling an investment.
Financing activities covers how a business finances itself. Examples include:
i) Extra money the owners inject into the business
ii) Money the business borrows
iii) Money others borrowed from the business they pay back
iv) Money the owners take out of the business.
Note: Net operating cash flow is the amount of cash that a business has after paying its bills. If a business has a number of overdue bills, these do not affect the cash flow statement until they are paid in cash. A cash flow forecast will help you measure and monitor how the business is operating.
Things to remember
The cash flow statement can provide helpful warning signals to avoid future financial troubles.
Potential warning signs are when:
i) Cash receipts are less than cash payments – you are running out of money
ii) Net operating cash flow is an outflow – cash flow is negative
iii) Net operating cash flow is less than profit after tax – you are spending more than you earn.
The balance sheet is a general snapshot of the financial health of a business on a given day. These are usually completed at the end of a month or financial year.
A profit and loss statement and cash flow statement is needed to do a balance sheet.
Your balance sheet includes the business:
iii) Net worth.
Your accountant is probably the best person to prepare a balance sheet. Accounting packages also offer balance sheet reports.
Assets are the items of value the business owns. They include:
i) Cash and stock on hand (inventory)
ii) Land and buildings
iii) Equipment and machinery
v) Patents and trade marks
vi) Money others owe the business (debtors or accounts receivable).
Liabilities are what the business owes others outside the business. They include:
i) Money owed to suppliers
ii) Money owed to taxation department (GST, PAYE, FBT etc.)
iii) Bank accounts that are in overdraft (i.e. you owe the bank money) and/or credit
iv) Card debt
v) Loans to buy capital assets, e.g. a new vehicle.
Ownership equity or net worth
This is the value of the business after deducting what the business owes. A negative figure means the business has debts it cannot pay.
Balance Sheet Classifications
‘Current’ and ‘non-current’ classifications are made to assist in monitoring the financial position of your business in regards to assets and liabilities.
Items that are likely to be turned into cash within a period of twelve months or less, such as cash in the bank, monies owed from customers (debtors) and stock.
Funds that must be repaid within twelve months, such as bank overdrafts, credit card debt and monies owed to suppliers.
Items that will continue to exist in their current form for more than twelve months. These can include furniture and fittings, office equipment, company vehicles etc.
Loans from external stakeholders that do not have to be repaid within the next twelve months.
Balance sheet equation
The balance sheet calculation is the value of all the assets of the business, less the value owed to those outside the business (liabilities). This figure equals what the business owner or owners can say the business is worth (equity).
Assets ($73,000) – Liabilities ($28,500) = Equity ($44,500)