Financial statements: knowing the basics
Financial reporting plays an essential role in explaining your business’s past or possible future performance. This is important to help you in planning and to attract new investments into your business.
Preparation of financial statements follows certain logical steps. Assets, liabilities, expenses, income and equity components are classified and presented in the financial statements under the terms of the applicable accounting standards. (The applicable accounting framework depends on the size of the business, its legal status, and other specific local regulations.)
With well-developed and -structured charts of accounts and correct posting of the respective accounts, financial statements can be prepared quickly based on standard accounting reports. Many accounting systems even provide reference financial statements as standard. This is achieved through specific tables that set and allocate account balances or account turnover to the respective positions in the financial statements or notes.
The table below shows the most common (standard) complete annual financial statements and what is reported in them:
Financial statements usually also include a statement of changes in the owners' equity, but this may be less relevant for smaller businesses.
1. Profit and loss (P&L)
A profit and loss or income statement shows the financial performance of the business for a defined period of time.
• A profit and loss statement should show how you have operated for the financial period (usually a year) and for a minimum of one comparative period (usually the previous year).
• The profit and loss statement shows how successful you were in managing your revenues and expenses; that is, how much profit you earned in the given period. This is usually valuable information for your investors as it shows whether you can provide a return on their investment, and if so, how much they can expect.
In general, your profit and loss statement will be split into two sections: revenues and expenses.
Revenues are income arising from your business activities.
• Revenues show increases in economic benefits during the accounting period in the form of cash or resource inflows, enhancement of assets, or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants.
• Your revenue sources may include revenue from:
— the sale of production goods, materials or non-current assets
— the rendering of services
— financing, interest or dividends
— foreign currency transactions.
• Your revenues should be compared on a year-on-year basis, but you can also compare sales revenues based on individual products or services to determine which are more profitable and which do not bring particular value to your business.
Expenses are what you spend or invest in your business.
• Expenses show decreases in economic benefits during an accounting period in the form of cash or resource outflows, depletions of assets, or increases of liabilities that result in decreases in equity, other than those relating to dividends.
• Your expenses may be either expenses by type, including:
— hired services
— salaries and social security expenses
or expenses by function, including:
— main, supporting, administrative and selling expenses
— interest expenses
— foreign currency transaction expenses.
• Your main groups of expenses will generally be the cost of goods sold (COGS) and operational expenses (OPEX). COGS is the cost of direct labour and any raw materials used to produce goods or services. OPEX is the cost of indirect labour and any other costs not directly linked to the production of good or services.
• In the same way as revenues, your expenses should be compared to what you incurred last year in order to determine whether you have improved your cost management or you need to find new ways to control possible inefficiencies.
Illustrative example of analysis of business cost of goods sold (COGS)
A chemical manufacturing business has the following cost structure:
From the table, you can conclude:
1. 38% + 14% = 52% of COGS is driven by oil prices, as the input materials are derived from oil.
The cost is dependent on the commodity price and supplier contracts (that is, they depend on external prices which cannot be influenced by and may cause risks to the business).
2. 60% + 7% = 67% of COGS (that is, the total materials costs and temporarily direct labour) are incurred in line with sales.
An increase in sales will increase these costs.
3. The 7% temporary labour should be regularly monitored.
This share of labour is variable as it is not under indefinite contracts and its rates and availability may change.
4. Full-time labour classified as overhead is considered indirect labour costs, meaning those labour costs which are not directly tied to production and manufacturing. In practice such costs are often related to maintenance and repair, administrative labour, capacity and so on.
If this 3% labour overhead is added to the 17% full-time direct labour, the result represents 20% of the total costs to which legal requirements related to wages may apply (such as minimum wage rates, overtime or other payments such as pension contributions) or contracted or negotiated terms.
Use this template to create your own profit and loss statement.
The numbers from your profit and loss statement can be used to calculate a wide range of profitability indicators that will help you analyse your performance.
Understanding the profitability of your business is key to making good commercial decisions when pricing work, reviewing engagement portfolios, looking at customer profitability or considering investments.
• Gross profit = sales revenue – cost of goods sold
This shows the difference between what you earned and spent when producing the goods or services you offer; that is, the efficiency and suitable fit of your sale prices and targets.
• Gross profit margin = (gross profit ÷ revenue) x 100
Gross profit when divided by revenue can show you how much of the profit you keep from each unit you sell. Use this template to calculate the gross profit margin of your key products and help you determine which ones are the most profitable for your business.
• Operating profit (EBIT) = gross profit – operating expenses
This is the profit generated from your core business activities (operations); that is, your earnings before interest and tax.
• Net profit = operating profit – (taxes + interest)
Net profit is your bottom line profitability indicator as it takes into account all the revenues and expenses.
• Other relevant ratios are available here.
2. Balance sheet
A balance sheet, or the statement of financial position, presents the assets, liabilities and equity of the business at the reporting date (usually at the end of the financial year) and at least another comparative period (usually the previous year).
• The total amount of assets should equal the total liabilities plus equity. This is a basic rule derived from the principle of double entry accounting and it is an important control for proper preparation of the statement of financial position.
To properly understand the financial statements you need to know the definition of current and non-current assets and liabilities.
An asset is a resource controlled by the business as a result of past events and from which future economic benefits are expected to flow into the business.
Assets may be current or non-current, and within those classifications, they may be tangible, intangible or financial. Current assets are typically those which a business can or will sell or trade within the next 12 months, whereas non-current assets are those required to do business and turn current assets into revenue, but held long-term and not readily convertible to cash themselves.
• Current assets (short-term or non-fixed assets) are:
— expected to be realised or are held for sale or use in the normal course of operating of the business, or
— held mainly for trading, or
— expected to be realised or used within 12 months of the reporting date, or
— cash or cash equivalent unless restricted from being exchanged or used to settle a liability for at least 12 months from the reporting date.
• Non-current assets are all assets that are not current. These are also known as long-term or fixed assets.
Inventories, cash and cash equivalents, and trade receivables are typical current assets, whereas the property, plant and equipment (PPE), intangible assets, and investment properties are typically non-current assets.
• Tangible assets include:
— raw materials and supplies
— production facilities and land
— machinery and equipment.
• Intangible assets include:
— program and database assets
— trademarks and patents
• Financial assets include:
— cash and cash equivalents
— trade and other receivables
— investments in equity securities
— investments held to maturity (debt instruments).
Liabilities are defined as present obligations of the business arising from past events, the settlement of which is expected to result in an outflow of the business’s resources – that is, assets.
• Your liabilities may include:
— liabilities to personnel
— social security, duties and tax liabilities
— trade payables
— loans (debentures)
Liabilities consist of current (short-term) and non-current (long-term) liabilities. Current liabilities are generally incurred as a result of regular trading or fall within 12 months, whereas non-current liabilities are longer-term.
• Current liabilities are liabilities that are:
— expected to be settled within the common operating cycle of the business
— held mainly for trading
— to be settled within 12 months from the reporting date or, if there is no unconditional right of the business to defer settlement of the liability, for a period longer than 12 months from the reporting date.
• Non-current liabilities are all liabilities that are not current.
• Typical examples for the distinction between current and non-current liabilities are loans and credits of the business. These can be both current and non-current depending on their maturity. In the case of a simple loan, the part with maturity within the next year is presented as current, and the rest as non-current. Typical current liabilities are trade payables and bank overdrafts.
Equity (owner's equity) is the residual interest in assets, after all liabilities are deducted.
• Your equity may include:
— registered capital
— share premium
— retained profits and losses.
• The intercorrelation between three elements of the balance sheet can be illustrated with the following formula: equity = assets – liabilities. The difference between assets and liabilities shows the amount of capital; that is, the amount of assets left after all the liabilities have been settled, as well as the owner's equity.
Use this template to create your own balance sheet.
3. Cash flow statement
The cash flow statement reflects the ability of the entity to generate and use cash and cash equivalents.
• In technical terms, the cash flow statement represents a financial snapshot of the total amount of cash inflows and outflows for a particular period aggregated and analysed based on business activity. The snapshot presents the actual movements in cash and cash equivalents during the period regardless of the time of finalising a transaction and recognising revenue and expenses.
The cash flow statement is also a critical planning tool for any business’s long-term success and it portrays a comprehensive view of the sources through which cash flowed into the entity and how cash was utilised. The statement serves as a source for a number of key performance indicators which are often overlooked and is a key tool in making future projections and identifying any future funding needs. Even the most profitable businesses at times face liquidity issues which become most apparent to stakeholders through the statement of cash flows.
• When used in conjunction with the rest of the financial statements, the cash flow statement provides information that enables users to evaluate the changes in net assets of a business, its financial structure (including its liquidity and solvency) and its ability to adjust the amounts and timing of cash flows in order to adapt to changing circumstances and new opportunities.
• The cash flow statement enables users to develop models to assess the net present value of future cash flows of the entity.
To derive some relevant meaning from your cash flow, the statement should be compared to your last year’s statement. An increase in your net cash flow (the difference between cash inflows and outflows) suggests that you are operating a healthy business.
There are two methods of compiling and presenting the information in the cash flow statement: direct and indirect. Businesses may freely choose (if not specifically regulated in the local market) which method to apply in presentation of the financial statement and the difference affects only the cash flows from operating activities. The cash flows from investing and financing activities are presented in the same way.
Cash transactions come from many different business operations that can be broken down into separate categories. These categories include: operating activities, investing activities and financing activities.
Cash flows from operating activities are generally those that arise primarily from the principal income-generating activities of a business. Typically, these cash flows originate from transactions that enter into the determination of the profit or loss of a business. The increase or decrease in working capital requirements of the business is also included in this classification.
• Under the cash flow from operating activities you may find items including:
— the sale of goods and rendering of services
— payments to suppliers for goods and services
— payments on behalf of and to personnel
— payments or recovery of income taxes
— proceeds or payments of fees and commissions.
Cash flows from investing activities pertain to cash flows arising from the acquisition or sale of either fixed assets, or equity or debt instruments of other entities. In general, these are expenditures for resources intended to generate future income and cash flows.
• The cash flows related to sales and purchases of assets expected to generate future profits, and cash flows are included in the investing activities section, as are purchases and sales of fixed assets, intangible assets, stocks, bonds and other financial assets. Interest and dividends received from investments are also included in this section.
The financing activities section refers to cash flows related to loans from financial institutions or providers of capital to the entity.
• The financing activity section includes cash flows associated with people and institutions who have provided capital to the entity – banks, shareholders and bondholders, for example – received and repaid loans, proceeds from issuance of share capital, and so on.
Use this template to create your own cash flow statement.
Free cash flow
Free cash flow is an important measure of the financial wellbeing or value of a business.
• The free cash flow indicator is used by investors as a measure to assess the business’s net cash from operating activities after deduction of cash outflows for investments in intangible assets (excluding goodwill) and property, plant and equipment, and the repayment of liabilities.
Free cash flow (FCF) is calculated by extracting capital expenditures (CAPEX) from operating cash flow.
• FCF = operating cash flow − capital expenditures
4. Financial forecasting
Businesses use forecasts to predict and manage future performance. Through accurate forecasting, businesses are able to predict the future performance of the business and make better business decisions in areas such as investments, recruitment and redeploying staff.
The most common type of financial forecasting is the cash flow forecast.
A robust cash flow forecast:
— identifies the key drivers of a business’s cash flow and highlights the controls needed to deliver the forecast result
— helps enable management to proactively manage the cash flow as they have visibility of potential issues in advance
— identifies trends in the business and possible opportunities to improve headroom
— is a key element of embedding a cash culture within a business.
The key elements in establishing a successful cash flow forecasting process include:
— proper set-up (templates, instructions and so on)
— obtaining a clear understanding of historical cash performance before you consider the forecasts
— inputs to the cash flow forecast received from the owners of the actual flows within the business
— anchoring the forecast to an opening balance sheet
— assumptions that are documented with proper local and senior management oversight
— undertaking variance analysis of forecast versus actual and forecast versus reforecast
— a commentary covering key items and assumptions.
There are two bases for cash forecasting: a receipts and payments cash flow forecast and a funds flow forecast, and they are used for two different purposes. However, both approaches take into consideration the flow of cash and funds, the profit and loss statement and the balance sheet.
— The receipts and payments cash flow forecast approach is where cash flows are forecast by major inflow and outflow type.
— Funds flow cash flow forecasts use the forecast balance sheet to drive the profit and loss items into the funds flow (coupled with other non-profit-and-loss items).
Cash should ideally be forecast as an account separate from loans and other borrowings. Where possible, it should not be rolled up into a net debt number. Restricted and trapped cash should not be included in the analysis as available cash (cash readily available to the business) and this refers to items such as deposits, cash collateral, cash in geographies which have access limitations, cash buffers and similar. Also, the level of undrawn and available facilities needs to be determined and added to the level of available cash.
When reviewing the forecast outcome, measure the anticipated profit to cash conversion ratio and compare it to prior performance. This will serve as a check to see if the forecast outcome is in line with expectations and that any improvement or deterioration in the profit to cash conversion ratio can be readily explained.
• The profit to cash conversion ratio represents the proportion of earnings before interest, taxes, depreciation, and amortisation (EBITDA) before exceptional items are converted into a measure of adjusted cash flow. This is usually defined as cash generated from operations before exceptional items less cash related to the acquisition of fixed and intangible assets.
Here is a template to help you create your own cash flow forecast.
How to plan and make good financial decisions
Use tools and templates to help you make key decisions relating to the financial management of your business in a challenging environment. Having a business plan is vital for the success of your business and to securing sufficient finance and business liquidity.
• You should complement your business plan with a more detailed financial plan to determine whether or not your business idea is viable and to see whether you can interest any potential investors.
Establish a long-term integrated cash flow forecast, balance sheet and profit and loss statement, as well as an annual cash budget. See how potential short-term disruptions can impact your longer-term financial behaviour. Always use updated and reliable information sources.
The net present value (NPV) method can help you in capital budgeting and investment planning, to analyse the profitability of a business, project or solution.
• This method can provide insight into the current value of all expected future cash flows (known as discounted cash flows) generated by a business, project or solution, including the initial capital investment.
• A positive net present value indicates that the earnings will exceed the anticipated or estimated costs and therefore the enterprise can be considered profitable, while investments with a negative NPV will result in a net loss.
You can also use forecasting to conduct exercises and test your business’s resilience. For example, forecast the P&L, balance sheet and cash flow effect of hibernating then re-awakening all or part of your business should this be necessary in times of crisis.