Understanding Key Financial Statements
If you don’t have regular and accurate financial statements, you’re driving your business 100 mph down a one way street the wrong way, at night, in the fog, without lights.
—Jim Blasingame
Understanding the key financial numbers associated with your business is critical and can make or break your venture. Having a strong grasp of what amount of money goes out and what comes in and the overall financial health of your business can be as daunting as it is necessary.
Ultimately, a business is started to make a profit and to make a living for the entrepreneur who started it. Any business needs to make more than it spends to sustain itself and to be successful. That means understanding and controlling the levels of spending and setting a fair and reasoned price point, making sure that you sell enough of a product or service at the right price to ensure enough income to cover your spending and support the business operations.
All of the various financial statements bring a business to life and give its performance some real context. This in turn will help make informed decisions about the running of a business and about what happens next. In terms of expanding a business, having solid and sustainable finances will provide an excellent foundation to build on.
The Key Stakeholders
The following stakeholders will (and should) take a keen and vested interest in your business’ financial statements:
• The business owner(s): As mentioned earlier, the business owner(s) need to have a full and comprehensive understanding of the relevant financial statements. This ensures a full understanding of business performance and makes it easier to make informed business decisions.
• Any investors: If external funding from an investor was sought in the early stages or to fund expansion, then the investor will take a keen and regular interest in business performance. This is to make sure that their investment is being used wisely and to judge their potential rate of return.
• Lenders: Similarly in the early stages or to fund expansion, a loan could have been used. As with investors, any lender will want to make sure that their money is safe and being used sensibly and that the business has the capability to repay it.
• Competitors: In any competitive marketplace, there will be mutual interest in each business’s financial health. Depending on circumstances, this could lead to opportunities for mergers or takeovers.
• Employees: Whether a business employs 1 person or 1,000 people or more, they have a responsibility to their employees. So, employees will take an interest in the financial health of their employers. If a business has strong and sustainable finances, that can increase employee confidence and may encourage them to stay long term. Similarly, if things start to look financially unsettled, there is a risk that employees may lose confidence and look for employment elsewhere.
• Customers: Will want clarity on the viability of the business before dealing with you and expect products or services to at least meet or exceed expectations.
• Suppliers: In many types of businesses, there is some degree of reliance on external suppliers. Each of those suppliers will need to be paid, so they will take an interest in the financial health of the businesses that they work with. Ultimately, if any of them hit financial turbulence, there is a risk that someone will not be paid on time.
• The government and tax authorities: Any business that generates funds will have to complete accounts and declare their income to government. This is to ensure that the correct level of tax can be paid.
Whether you are a “natural” or not, you need to have an understanding of the various financial figures and what they mean for you, your business, and you stakeholders. To begin with, let’s define two key terms.
Financial Accounting
This is where your financial statements are prepared for you and all your key stakeholders.
Other key stakeholders may include your accountant, your employees, your bank, any partner businesses and suppliers, the HMRC, and current and potential customers or clients.
The rules and regulations around this vary in different countries. Broadly speaking, if your business is a limited company, it is a legal obligation to submit regular updates of your financial statements, and if you are self-employed, you are likely to have to do some sort of tax self-assessment. The rules are important and have to be adhered to, if not there are likely to be penalties.
The areas of detail that are included in financial accounting are information on your business’s performance (i.e., profit or loss), it’s financial position (e.g., assets, liability, and equity), and any key changes to the financial position.
Management Information
This includes your financial metrics that will help you manage your business more efficiently and effectively.
This information will therefore facilitate your effective decision making and should underpin planning and ongoing business strategy.
Examples include the following:
• A purchase ledger to make payments to creditors and suppliers
• A sales ledger to invoice for the sales made to your customers or clients
Budgeting and Planning for Your Business
Budgeting is needed because all businesses have finite resources. Budgeting is therefore about making clear, measured, and informed choices for your business. Where you decide what you want to do with the resources that are available to you.
There are many types of budgets, each of which will contribute to your business strategies. Examples of budgets you may use include sales, cash flow, production, marketing, and project budgets.
Budgeting is usually done on a yearly cycle and will indicate:
• You have a clear understanding of the resources required for your key business activities.
• You can proceed with making key decisions knowing that the resources are available to carry out these activities.
The need to forecast is closely aligned with budgeting processes. Forecasting is where you predict/project how much resource will be required and when it will be required. Key resources will include finance, equipment, and people.
Therefore, budget planning should be an integral aspect of your business operations, where you look to:
• Start off by considering your intended activities for the designated planning period.
• Have a clear understanding of what you are looking to achieve and how you will achieve it.
• Work out resource availability, requirements, and capacity.
• Understand the total cost associated with the resources required.
Given the finiteness of your business’s capacity, robust budgetary control mechanisms must be in place. Having a budget means clear visibility of what resource has been allowed and used for a specific activity of your business. It also means you can readily and easily see what happens (e.g., actual resource requirements against budget). Clearly, any deviations need to be identified, investigated, and understood; then any appropriate adjustments can be made to the budget.
Control: A budget means you can have more control over how, where, and when you allocate the resources you have available. You can, for example, spread your expected resource requirements for the months or year ahead. It is important that your budget is regularly reviewed and updated to accommodate any unforeseen changes in internal and external circumstances.
Guidance: Your budget enables you to continually develop and inform your decision-making process. You can readily see how you have made decisions about resource allocation for the various activities of your business. As a result, you are then better equipped to understand the business’ resource priorities.
Capacity planning: Your business will have inevitable resource constraints, so your entrepreneurial skills must include the optimum allocation and use of the available capacity.
Understanding: Reality determines that nothing stays constant, so any of your budgetary predictions will soon be challenged in some way. It is therefore vital that your business has a robust and reliable process to track actual budget/resource activity against what was planned. There can be many reasons for a variance, including:
• Incorrect budget or resource allocation at the outset
• Unrealistic expectations as to what could be delivered from the initial set budget
• Unexpected or unplanned changes outside of your control
• Poor cost and resource management which leads to increased and unnecessary additional expense
Creating a Budget
When you create your budget, this will be an iterative process where you most likely begin with your principal budget factor. This term is also known as the limiting budget factor or key budget factor; by clear implication, however termed, this factor gives clear parameters for all activities of your business, for example, sales, material/stock, and people.
Clarification of Costs
• Fixed costs: These are the costs of your business that remain constant over a certain period, usually defined as 12 months or more. These costs remain constant irrespective of changes in your business’s activities or levels of production.
Therefore, whether your business has a zero output or record levels of output, the level of fixed costs will remain broadly constant. Over the longer term, fixed costs can change. Possibilities include increased overheads or an investment in your production capacity. Examples of fixed costs include mortgage payments, insurance, or rent.
• Variable costs: The costs that vary as your business activity levels change. So, these costs vary directly with the level of activity and production and are output-related inputs. Examples include wages, fuel, utilities, and other revenue-related costs like commission.
• Semivariable costs: Sometimes known as semifixed costs and are those costs that aren’t directly correlated to any level of business activity, yet can still change over time. Examples include maintenance costs and depreciation of machinery.
• Direct costs: Any costs that are readily identifiable and attributable to a specific product or service are direct costs, for example, material and labor costs. Direct costs are therefore any costs that clearly contribute to business activities (i.e., production of products or services). A direct cost can also be classified as a variable cost if it regularly fluctuates.
• Indirect costs: Any costs that cannot be directly allocated to business activities and will vary with output (i.e., production). These costs are more difficult to assign to a specific product or service. Examples may include quality control, maintenance, depreciation, and administration.
This account shows exactly what the name implies—How much cash comes into and goes out of your business. It therefore follows that to be sustainable, any business needs to have an overall positive cash flow. Meaning that over time, there will be more cash coming into your business than going out.
This account, when used in conjunction with other financial statements, can help you to understand and manage your business’s performance.
We also need to be clear that a positive cash flow is a significantly different financial indicator to profitability. Your profitability levels are calculated via your profit and loss account (this is outlined later in the chapter). That is, from day 1 it is essential to grasp that those levels of profit do not necessarily equate to or guarantee survival. Your business must have adequate cash to maintain liquidity.
However, your cash flow account is important because you can readily see how much cash you have available to meet various ongoing financial obligations. Potentially your business may be able to survive for the short term without sales or profit. However, there will be an ongoing requirement for cash.
An unfortunate reality is that many start-ups will fail because of poor cash flow scrutiny and monitoring. This can also be a risk when going through expansion.
Calculating Your Cash Flow
Your cash flow is basically a calculation:
• The money which flows into your business on a given day, less the money which flows out.
• The ongoing balance is what was left from the day before (either a credit or debit cash flow balance).
• Your aim is to ensure you have enough cash (ideally plus a margin) to honor your day-to-day financial commitments.
• Your cash flow document is ideally sectioned into meaningful blocks and subtotals. This clarity of structure is vital, so you can readily obtain clear information on the cash movements in your business.
Later, we will consider a range of methods to be adopted which will speed up your cash inflows and minimize your cash outflows.
Components of Your Cash Flow
Overall, in this context, cash embraces a range of components all of which are normal trading activities:
• Cash (notes and coins)
• Credit card payments
• Electronic money transfers, for example, via PayPal
• Mobile technology payments
• Checks (though these aren’t common these days)
Income
The primary source of cash coming into your business is most likely to be from sales of products or services. Therefore, if you purchase on credit, you should aim to sell your product or service before payment is due. Clearly if you offer credit terms on your sales, make sure your business can cover this delay until payment is received. Ideally, you will be paid in cash and buy on credit (though this is not always reality).
Another potential source of income for your business could be new finance: for example, an investment from your business partner or a bank loan. Either of these circumstances will provide a one-off boost to your cash flow.
Outgoings
The main outflow of cash will be the costs that are necessary to run and sustain your business: for example, office overheads and colleague salaries.
There may be occasional larger outgoings, when, for example, you need to purchase more stock, raw materials, or new machinery.
Perhaps, the purpose of your business will mean that for the short term, any work-in progress will need to be funded. For example, a designer may spend several months on a project before it’s ready to sell. So, in the meantime, the materials, labor, and other fundamental activities will need to be funded prior to payment.
Cash Flow Forecasting
A cash flow is primarily historic, representing aspects of your business’s performance in the recent past. It is always useful and probably essential to develop, say, monthly cash flow forecasts.
Benefits of cash flow forecasting include the following:
• Indicating to your key stakeholders that you are managing your business responsibly.
• Giving you a clearer understanding of your business’s financial performance—Knowing and understanding your numbers is so important!
• You can see when you may need additional funding, most likely for the short term. For example, when cash out exceeds cash in, an overdraft facility may be a viable short-term option to maintain liquidity. Other possible scenarios include making greater profits, reducing stock levels, improving your debtor management, or increasing your creditors.
• Inconsistencies in your business’s performance can be more easily identified.
• Your actual cash flow can be compared to your forecasts so that deviances can be identified, and you can then take the appropriate course of action to remedy the situation. Once you have an established and reliable cash flow process, it must be regularly reviewed and updated. The information contained in your cash flow needs to be accurate and inclusive.
Understanding and managing your cash flow can ultimately be your critical success (or failure) factor. This aspect needs to be constantly reviewed so that you realize very early on if your business’s funding strategies need to be changed.
A break-even analysis expressly reveals the levels of product or service that you need to sell to cover your costs.
So, this is where your revenue generated from sales covers your fixed and variable costs, where you make neither profit or loss.
Examples of fixed costs, which are not related directly to the volume of production, could be administration costs, research and development, and rental costs and rates.
Examples of variable costs, which change when production output changes, could be costs of raw materials, labor, fuel, and revenue-related costs such as commission.
Profit and Loss Accounts
As an entrepreneur or business leader, it is essential that you understand your continuing profit or loss situation. This is usually done on a monthly, quarterly, or annual basis.
Effectively your profit and loss account looks at your business’s income and expenditure. Your net financial position will be in either profit or loss for the given period.
Therefore, this financial statement shows where your business’s incomes and gains are credited and expenses and losses debited. It is a list of all the ins and outs from your business. So, sales less costs.
Your profit and loss account can also be known as your P&L, income and expense statement, or income statement.
This account will include your incomes and credits, including sales turnover and debits, including allowances, cost of sales, and other overheads.
As a result, you can see how your business is performing in terms of sales and expenses.
Your profit and loss account has particular significance as it used to calculate your income and corporation taxes. These calculations need to be accurate because if they are submitted incorrectly there can be severe consequences (which can include added interest and financial penalties).
The completion of your profit and loss account means your key stakeholders have an awareness of your business’s profitability over that specific accounting period.
For example, potential investors will want to see how well your business is performing and will heavily scrutinize all your financial statements prior to a lending decision.
Key Terms
Net income: Means your income/revenue after the cost of goods/services sold, other expenses and taxes have been deducted.
Gross profit: Refers to your income/revenue less the direct cost of goods/services sold. This is a crucial metric which indicates the financial well-being of your business.
Operating profit: This is your profit after all operational expenses (e.g., rent) are taken off gross profit. Nota Bene (NB): This calculation excludes tax liabilities and interest.
Net profit: This is your final figure, what is left after everything else has been deducted. That is, after all remaining expenses have been deducted from gross profit (e.g., tax liabilities)
Understanding the Cost of Sales
• The first entry is your sales figure, sometimes called turnover or income. This figure is the total amount of all the sales invoices over the last accounting period.
• Then, the costs of sales need to be deducted, also referred to as the cost of goods sold. These costs could typically embrace materials, machinery costs, and the people resource, that is, factory/production costs.
You can calculate a useful percentage of sales figure by dividing cost of sales by sales. This means comparisons can be made to businesses like your own, so you can have an idea of what could realistically be expected.
• Other costs are then deducted so that you can calculate your operating profit. These costs cover any expenses not considered as a cost of sale. These costs are more general and may include personnel costs, office costs, and marketing and advertising costs,
• So far then you would have been able to calculate your business’s operating profit.
• Over time you may need to consider loans and other borrowing to support your ambition for business growth. This will mean interest will become payable. Interest payments will need to be honored, so affordability needs to be considered. To take a simple example, if your operating profit was £1,000 and interest £200, the interest could be paid five times over. You could say your “interest cover” was 5. In any circumstances where your business borrows, there must be positive interest cover as you arrive at your profit before tax (PBT) metric.
• Finally, you need to deduct your estimated or actual tax liabilities. Income must be available to meet your business’s tax obligations as the tax authorities are primary creditors. Once tax is deducted, you have your profit after tax (PAT) metric.
• What you are left with is your retained profit, or perhaps in some future years your retained loss. Your retained profit is then available to support your plans for growth.
The Balance Sheet
Your balance sheet is a snapshot of all your business’s assets and liabilities at that moment in time. It is a snapshot of your entire business at the close of business on a specific day. This means the figures are correct at only that precise moment time.
In most cases, your balance sheet will be produced concurrently with your profit and loss account.
The assets are everything that has a financial value that is owned by your business or is owed to it. Assets may include machinery, premises, stock/inventory, equipment, cash, and debtors.
The liabilities are everything that is owed by your business to one of your key stakeholders. Liabilities may include creditors, tax, overdrafts, and loans.
The difference between your business’s assets and liabilities is its value to you, the owner. So, if you were to sell off all the assets and pay of all the liabilities, what is left is known as the “net worth” of your business.
All the assets and liabilities are shown at their historic cost, that is, their original cost to your business. Remember that a balance sheet includes only costs and as a result cannot represent the value of your business.
Current Assets
Current assets are cash or near to cash that is owed to your business, usually within a period of 12 months.
The main categories of current assets include the following:
• Cash: Which means cash in hand (on your business premises) or held with your financial services provider. This normally includes cash deposits with a notice period of less than 12 months. Cash is the most liquid of your current assets.
• Debtors: These are your customers or clients who have been invoiced and are yet to make payment. In most cases (ideally all), your business will agree terms of payment, often being integrated into the contract. Your business could expect to agree terms of debtor payment between 30 and 90 days. You will probably find your debtors are your business’s largest current asset, so they need to be closely monitored and controlled. The emphasis is for your customers/debtors to pay you on time to facilitate liquidity.
• Stock/inventory: This is your business’s work-in progress. This could be goods held, perhaps as raw materials, incomplete goods, or finished goods ready for sale. Finished goods are safer assets as they have a higher value and are more liquid. However, overall, stock is the least liquid current asset as it is further away from cash.
• Prepayments: These are any payments that are made in advance of receipt of goods or services, so technically belong in the next accounting period. An example could be if your business makes an advanced payment of 24 months’ rent. This is a prepayment on your balance sheet because it is an amount owed to your business.
• Refunds not yet received: At one time your business may be due a refund, for example, value-added tax (VAT), tax, or other monies.
Current Liabilities
Current liabilities are those payments due to be made by your business in the next 12 months.
The main categories of current liabilities include the following:
• Creditors: This means what is owed to your suppliers, usually under the terms of trade or formal contractual arrangements.
• Accruals: These are the value of goods and services received by your business though yet to be paid for (i.e., the invoice from your supplier is yet to be received).
• Tax: The taxation system and legislation varies from country to country. Your business may charge VAT to your clients and pay corporation tax to the authorities.
• Short-term debt: For example, a bank overdraft facility. This is a current liability and legally it is repayable on demand. Also, any repayment toward a long-term debt that is due in the next 12 months is also a current liability.
Fixed or Noncurrent Assets
Your business’s fixed or noncurrent assets:
• Belong to your business
• Have an expected usage for at least 12 months
The features of these fixed or noncurrent assets include the following:
• They are for regular use: for example, premises, machinery, vehicles, leases.
• Tangibility, which means they can be seen, touched, and felt. Premises and vehicles are again included here.
• Intangibility, meaning they exist on paper or electronically. This aspect includes goodwill, trademarks, copyrights, patents, and licenses.
• Appreciation, where these assets hold, possibly increase in value. Freehold property may fall into this category. NB: Appreciation value cannot be considered until the time of sale and for the interim period will be balanced out via a notional liability (i.e., a revaluation reserve).
• Depreciation, where the value of assets decreases over time. So, depreciation writes off the cost of an asset over time, over its effective useful life. Possibilities here include computer equipment, vehicles, and machinery. NB: Your business accounts will need to show the original costs of your fixed assets, along with their cumulative depreciation.
So, your business’s fixed assets will be shown at cost less depreciation. This is often called the net book value.
For example, if you acquired a new computer at £5,000 with a useful life of three years. The annual depreciation will be £1,000. The computers valuation will therefore be written down to £4,000 after one year, £3,000 after two years, and £2,000 after three years.
Depreciation spreads the cost of a fixed asset over its lifetime. There is no residual value and neither is it an approach to provide funding for a replacement.
Goodwill
This means the value attached to your business’s reputation, good name, and customers or clients. Goodwill can be calculated by taking the value of your business’s assets from the potential sale price. It is effectively a premium added to the value of your business if it were to be sold.
This category will include amounts payable by your business more than 12 months from the balance sheet date:
• Loans: Any loan repayment due in the next 12 months is included as a current liability. The residual amount (i.e., what is due after a 12-month period) will be categorized as a non-current liability.
• NB: Any overdraft can be called up (i.e., repayment demanded anytime) and therefore is included as a current liability.
• Debenture: It is a loan that is formally documented and refers to a loan specifically taken out by your business. A debenture or loan can be unsecured or can be secured against a specific asset of your business.
• Director’s loan: This could be where you loan money to your business in its early days to facilitate liquidity. Once your business is established and is sustainably solvent, the director’s loan can be repaid.
• The purpose of splitting your business’s liabilities into current and long-term categories is so you can see how readily immediate and short-term debts can be accommodated.
Interpreting Your Business’s Financial Data
In this chapter, we have explored how to build your key financial statements. In a lot of ways, this is only the beginning because of greater significance is the need to understand what they all mean—illustrating and evaluating their importance for your business. It is essential to bring these figures to life.
There are a series of ratios which can be used that will facilitate your business planning and control.
These ratios can be allocated to three main areas:
• Profitability
• Liquidity
• Efficiency
These are known as the control ratios for your business and quantify the long-term investment in your business. In other words, considering:
• The return on capital employed (ROCE)
• How far your sales contribute to the fixed costs of your business, subsequently revealing what remains as profit
Return on Capital Employed (ROCE)
• Firstly, calculate your net capital employed (total assets—current liabilities)
• You can then calculate your gross profit as a percentage of your net capital employed as follows:
This ratio, especially when available over several years (as your business gets established), is a key indication of your level of control over your business’s operations.
You are also able to calculate your net profit as a percentage of your net capital employed (also known as the primary ratio) as follows:
This ratio is of particular interest as it indicates the overall return on the long-term investment in your business. Should you wish, while the correlation will never be linear, you can compare your primary ratio percent with the returns you would achieve from investing your money in a different way (e.g., with a financial services organization such as a bank or investment firm).
• When you consider your gross profit as a percentage of sales, you have a measure of the difference between the buying price and selling price of your goods or services.
This ratio is calculated as below:
As with all of your financial metrics, they have greater context when considered as a trend, over a number of years. This ratio confirms your business’s markup—the amount added to the cost price to obtain the selling price of your product or service. This markup must be appropriate to cover all your running costs and profit.
• If you then consider net profit as a percentage of sales, you quantify what is left for profit after all other expenses have been covered.
We can calculate as follows:
It is therefore critical that this ratio is monitored carefully, to see whether it is improving or reducing over time.
Liquidity Ratios
In this range of ratios, you gain an understanding of your business’s ability to meet its short- and long-term obligations—in a nutshell, its ability to pay its way.
As with all your other ratios and financial metrics, in isolation, they add minimal value. Nevertheless, by considering trends and realistic comparisons, you can then gain a more realistic understanding of your business’s liquidity.
The current ratio is where you compare your current assets (cash or near to cash coming into your business) against your current liabilities (cash or near to cash going out of your business), expressed as a ratio to 1.
This ratio is of vital importance as it demonstrates your business’s ability to meet its day-to-day (i.e., very short term/immediate) financial obligations.
This ratio is calculated by:
For example, if this ratio is 1:1, then current assets equal current liabilities, so your business can pay its way at that moment in time.
If this ratio is less than 1, then cash or near to cash coming into your business is less than cash or near to cash going out: A position which is nonsustainable over the longer term.
The acid test, sometimes known as the quick ratio, gives a truer indication of your business’s short-term liquidity. This is because the current assets are adjusted to include only those that are readily turned into cash. This means that stock and inventory are excluded as you look to gain a more accurate measure of your business’s ability to meet its short or more immediate financial obligations.
This ratio is calculated by:
The importance of excluding stock will be relative to the type of business you run. The key aspect is being how quickly your stock can be converted into cash.
For example, if you sell fruit, salad, and vegetables, your stock must be converted (i.e., sold) quickly; otherwise, it will be worthless (being perishable). Alternatively, if you sell cars or vans, it is more likely sales may not be so immediate (i.e., conversion to cash taking much longer).
The long-term solvency of your business will evolve as you become more established. You will then need to consider your gearing ratio. This is when you compare the level of borrowing as a proportion of long-term finance. Most would say the higher the proportion of the former to the latter, the greater the risk of your business failing.
The primary reason for this is that any borrowing needs to be paid for, by interest and possibly charges. So, funds need to be generated via your business’s cash flow to facilitate timely payment of these interest payments.
Efficiency Ratios
These ratios are also of vital importance as they indicate how effectively your business manages its stock/inventory, creditors, and debtors. These three financial metrics, as we have seen, are part of your working capital (current assets – current liabilities), measuring your business’s liquidity. Therefore, is it critical that they are closely managed and understood.
Stock Turnover
This figure indicates how many times per year your stock is converted into cash. Clearly, the higher the level of stock turnover, the greater benefit to your business’s liquidity.
Depending on what your business does, the ideal scenario is to keep stock levels as low as possible. Essentially, any money tied up on stock is idle money and could be put to better use in other areas of your business.
To calculate stock turnover, you need to:
• Calculate your average stock:
• Then calculate:
• Finally divide this figure into 52 (weeks in the year). Alternatively divide this figure into 365 to give the number of days taken to convert stock to cash.
Creditor Turnover
This figure indicates the speed with which your business adheres to its short-term financial obligations: that is, the number of weeks which your creditors wait for payment.
As your creditors will include your suppliers and the tax authorities, their payments must be thoughtfully monitored and managed.
Late payment to suppliers, for example, may lead to less beneficial terms next time. Perhaps, worse as your suppliers may demand payment on delivery.
We can calculate this metric by:
• Then divide this figure into 52 (weeks in the year). Or, as above, divide this figure into 365 to give the number of days your business takes to pay its creditors.
Debtor Turnover
This figure shows the average rate with which you receive payment for products or services provided: that is, how long your clients take to may payment to you.
This figure is calculated by:
• Then divide this figure into 52 (weeks in the year). Or alternatively, divide this figure into 365 to reveal the number of days it takes for you to receive payment.
These efficiency ratios are therefore key indicators to enable you to understand your business’s propensity to survive and thrive by meeting its financial commitments.
Example of financial statements:
Income statement for the periods ending 1-31-21 and 3-31-22
| 2021 | 2022 |
| £000 | £000 |
Sales revenue | 5,500 | 7,500 |
Cost of sales | (1,450) | (1,770) |
Gross profit | 4,050 | 5,730 |
Overheads | (1,280) | (1,400) |
Depreciation | (300) | (300) |
Operating profit | 2,470 | 4,030 |
Interest on bank loan | (100) | (100) |
Net profit for the period | 2,370 | 3,930 |
Breakdown of overheads
| £000 | £000 |
Salaries and wages | 1,000 | 1,200 |
Rates, utility bills, etc. | 40 | 40 |
Advertising | 90 | 175 |
Logistics | 100 | 120 |
Other | 50 | 65 |
| 1,480 | 1,600 |
Statement of financial position at 1-31-21 and 3-31-22
| 2021 | 2022 |
| £000 | £000 |
Assets |
|
|
Fixed Assets |
|
|
Buildings | 830 | 830 |
Machines | 500 | 420 |
Motor vehicles | 220 | 200 |
| 1,550 | 1,450 |
Current assets |
|
|
100 | 240 | |
Trade receivables | 260 | 260 |
Cash in the bank | 150 | 180 |
| 510 | 680 |
Equity and liability |
|
|
Equity |
|
|
Shareholder funds | 1,000 | 2,080 |
Retained profit | 280 | 240 |
| 1,280 | 2,320 |
Noncurrent liabilities |
|
|
Bank loan | 300 | 300 |
Current liabilities |
|
|
Trade payables | 150 | 150 |
Tax | 180 | 160 |
Dividends | 240 | 200 |
| 570 | 510 |
Total equity and liabilities | 2,150 | 3,030 |
Example Ratios
Gross profit as a percent of sales
(Calculated by Gross profit/Sales × 100)
2021:
2022:
These figures indicate that gross profit as a percent of sales is increasing.
Working capital ratio
(Calculated by Current assets/Current liabilities:1)
2022:
We can see from these figures that in both years, there is evidence of the ability to meet ongoing financial obligations. In addition, the working capital ratio is improving from 2018 to 2019.
Acid test/liquidity ratio
(Calculated by Current assets – Inventory/Current liabilities:1)
2021:
2022:
This indicates that the levels of liquidity are improving. This ratio, as inventory is excluded, gives a more accurate indication of the business’s ability to meet its ongoing financial commitments.
Stock turnover
This indicates the frequency in which inventory and stock are converted into cash. The higher the frequency, the greater increase in liquidity.
Calculated by Cost of sales/Inventory. Then, work out average days taken to convert stock into sales.
2022:
We can see from these figures the conversion of inventory/stock to sales increases between 2021 and 2022.
Don’t ever let your business get ahead of the financial side of your business. Accounting, accounting, accounting. Know your numbers.
—Tilman J. Fertitta