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Introduction to financial statements

This chapter will introduce you to three key documents:

• The balance sheet
• The profit and loss account
• The cash flow statement

Introduction

To have a coherent view of how a business performs, it is necessary, first, to have an understanding of its component parts. This job is not as formidable as it appears at first sight, because:

• much of the subject is already known to managers, who will have come in contact with many aspects of it in their work;
• while there are, in all, hundreds of components, there are a relatively small number of vital ones;
• even though the subject is complicated, it is based on common sense and can, therefore, be reasoned out once the ground rules have been established.

This last factor is often obscured by the language used. A lot of jargon is spoken and, while jargon has the advantage of providing a useful shorthand way of expressing ideas, it also has the effect of building an almost impenetrable wall around the subject that excludes or puts off the non-specialist. One of the main aims of this book is to show the common sense and logic that underlies all the apparent complexity.

Fundamental to this level of understanding is the recognition that, in finance, there are just three key documents from which we can obtain the vast majority of raw data for our analysis. These are:

• the balance sheet
• the profit and loss account
• the cash flow statement.

A description of each of these, together with their underlying logic, follows.

The balance sheet (B/S)

The balance sheet can be looked on as an engine with a certain mass/weight that generates power output in the form of profit. It is a useful analogy that demonstrates how a balance sheet of a given mass of assets must produce a minimum level of profit to be efficient.

But what is a balance sheet? It is simply an instant ‘snapshot’ of the assets used by the company and of the funds that are related to those assets. It is a static document relating to one point in time. We therefore take repeated ‘snapshots’ at fixed intervals – months, quarters, years – to see how the assets and funds change with the passage of time.

The balance sheet is the basic document of account. Traditionally it was always laid out as shown in Figure 1.1, i.e. it consisted of two columns that were headed, respectively, ‘Assets’ and ‘Liabilities’. (Note that the word ‘Funds’ was often used together with or in place of ‘Liabilities’.)

Figure 1.1 The balance sheet – traditional layout

Assets and liabilities

The ‘Assets’ column contains, simply, a list of items of value owned by the business.

Assets are mainly shown in the accounts at their cost. Therefore the ‘Assets’ column is a list of items of value at their present cost to the company. It can be looked on as a list of items of continuing value on which money has been used or spent.

The ‘Liabilities’ column simply lists the various sources of this same sum of money.

These sources are essentially amounts due to third parties, including the owners.

The company is a legal entity separate from its owners, therefore, the term ‘liability’ can be used in respect of amounts due from the company to its owners.

The amounts in these columns of course add up to the same total, because the company must identify exactly where funds were obtained from to acquire the assets.

All cash brought into the business is a source of funds, while all cash paid out is a use of funds. A balance sheet can, therefore, be looked on from this angle – as a statement of sources and uses of funds (see Figure 1.2).

Figure 1.2 The balance sheet – sources and uses of funds approach

The style now used is a single-column layout (see Figure 4.2). This new layout has some advantages, but it does not help the newcomer to understand the logic or structure of the document. For this reason, the two-column layout is mainly used in this publication.

A snapshot

The balance sheet gives a snapshot of the company assets at an instant in time, e.g. 12 o’clock midnight on 31 December 2014.

Further snapshots will be taken at fixed intervals. After each interval the sums recorded against the various components of the balance sheet will have changed.

An analysis of these changes gives crucial information about the company’s activities over the period in question.

The profit and loss (P/L) account

The profit and loss account measures the gains or losses from operations over a period of time. It measures total income and deducts total cost.

Both income and cost are calculated according to strict accounting rules. The majority of these rules are obvious and indisputable, but a small number are less so. Even though founded on solid theory, they can sometimes, in practice, produce results that appear nonsensical. These accounting rules are subject to regular review as they attempt to reflect changes in the global economy and business practice.

The profit and loss account quantifies and explains the gains or losses of the company over the period of time bounded by the two balance sheets.

It derives some values from both balance sheets. Therefore it is not independent of them.

It is not possible to alter a value in the profit and loss account without some corresponding adjustment to the balance sheet. In this way the profit and loss account and balance sheet support one another.

The cash flow (C/F) statement

The statement of cash flow is a very powerful document. Cash flows into the company from actual receipts and it flows out when actual payments are made. An understanding of the factors that cause these flows is fundamental.

Figure 1.3 Three basic financial statements

The cash flow statement depends on the two balance sheets and the profit and loss account.

It links together the significant elements of all three, so that even though its inclusion in the set of accounts is the most recent in time, it is now regarded in some quarters as the most important.

Summary

These three statements are not independent of each other, but are linked in the system, as shown in Figure 1.3. Together they give a full picture of the financial affairs of a business. We will look at each of these in greater detail.