How to understand what a financial statement is REALLY telling you
Finance expert Ted Wainman explains what the differences are between profit & loss, balance sheets, and cash flow statements
There are three primary financial statements of a business; each statement provides different information, which will allow you to build up an overall picture of the business:
The Income Statement (also known as the Profit & Loss Account)
Your profit and loss shows the overall profitability of a business over a particular time frame. It will show the total sales of the business compared with the costs of generating those sales. If the costs are less than the sales, the company will make a profit!
The company can do one of two things with that profit – it may choose to re-invest or return to the shareholders by way of a dividend. Any profit that is reinvested will appear in the Balance Sheet as an (additional) amount that is owed to the shareholders (equity).
The Balance Sheet
The Balance Sheet shows the assets and liabilities of the business. It shows how a company is funded and what the company has done with that funding.
Companies are funded through a mixture of debt and equity. The debt of the company can be found in the Long Term (or Non Current) Liabilities; and the equity in the Shareholders’ Funds (sometimes called Capital & Reserves). The debt plus the equity represents the total capital employed in the business.
Companies use the capital to invest in plant and machinery and other Fixed (or Non Current) Assets – assets that are used to run the business.
Companies also need Working Capital – a combination of assets which either are cash or are due to become cash soon (known as Current Assets) and Current Liabilities – which are obligations that must be paid soon.
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The Working Capital of a business is the equivalent of the oil in the engine of a car – it is essential to the smooth running of a company. If the company runs out of working capital (in effect, runs out of cash) the effect is similar to a car running out of oil – it will cease to trade.
So in summary, the Balance Sheet summarises the financial health of a company, showing how it is funded and what it has done with that funding.
Cash Flow Statement
The final statement is the Cash Flow Statement. Due to accounting rules, companies must recognise sales when they are earned and costs when they are incurred – not when the cash is physically paid.
It is therefore possible for a company to make a profit, but to loose cash. The aim of the Cash Flow statement is to reconcile the profit generated (found in the Profit & Loss Account) with the movement in the cash balance over the same period (found by comparing the cash on the Balance Sheet at the beginning of the period with that at the end).
Rather than re-running every transaction on a cash basis, the Cash Flow Statement will first take the Accounting Profit and made adjustments for non-cash items (such as depreciation) to turn it into a Cash Profit (i.e. the equivalent profit figure as if sales and costs were recognised on a cash basis).
The cash flow then examines what was done with that cash in terms of investment in the business – in effect Capex (or Capital Expenditure); because if a company buys Fixed Assets that purchase will have no immediate effect on profit (it merely turns one form of asset – cash – into another form of asset).
The Cash Flow Statement also examines the effect of financing on the cash balances of the business. Perhaps the company took out a loan during the period (in which case cash would have increased) or perhaps it paid off a loan (decrease in cash). It may have issued new shares (increase in cash) or bought back some shares (decrease in cash). The company may also have paid interest (cost of debt) and paid dividends (cost of equity).
By examining all three financial statements – and ensuring that you can identify how they link to one another – a user of the accounts is able to build up an overall picture of the company.
However, one word of caution – remember that the numbers merely tell you what has happened in the past; the financial statements of a business can be used as a guide as to what might happen in the future.
Ted Wainman is a professional business trainer and author of How to Talk Finance: Getting to grips with the numbers in business (Pearson, 2015). www.wainman.net