Download Understanding Financial Statements

UNDERSTANDING
FINANCIAL
STATEMENTS
Financial statements need to be demystified so that you can get
the most value out of them.
What are financial statements?
Financial statements are
a collection of reports
that quantitatively
describe the businesses
financial health or
condition
Financial statements are a collection of reports that
quantitatively describe the businesses financial health or
condition. The main reports are the Statement of Financial
Performance and Statement of Financial Position.
Financial statements are usually associated with your formal
year-end financial statements which you need to help prepare
your tax return. Equally important is the periodic management
reports that you should prepare and review regularly – ideally
monthly.
Statement of Financial Performance
The Statement of
Financial Performance is
an important means of
monitoring the progress
of your business
This is also known as your profit and loss statement or income
and expenditure statement.
The Statement of Financial Performance is usually
straightforward and relatively easy for non- financial people to
understand.
It provides a picture of your businesses trading performance
over a period of time. It’s a bit like a video … you can pause it
and look at one frame (e.g. a days trading), look at a section of it
(e.g. one month) or the whole video (e.g. 12 months). It’s an
important means of monitoring the progress of your business.
It is used to summarise the results of a business by matching
the revenue earned during a given period with the expenses
incurred in that same period, resulting in a net profit or loss.
Matching means preparing the statements on an accruals basis
where revenue and expense s are recognised when they are
incurred, as opposed to when they are paid - cash basis. This is
why profit does not equal cash in the bank.
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Revenue/ Sales /Income
Operating revenue is the income earned from activities directly
related to the core activity of the business e.g. sales, fees,
commission etc.
Cost of goods sold
This is the direct costs attributable to the production of the
goods sold by a company. This amount includes the cost of the
materials used in creating the goods along with the direct
labour costs, importation costs, freight and other direct costs of
getting the goods produced.
Gross Profit
This is the difference between revenue and the cost of goods
sold. This is a key number as it shows how much you have
made prior to deducting operating expenses, shareholder
remuneration and tax.
Expenses / Operating Costs
These are expenses incurred in carrying out the businesses dayto-day activities, but not directly associated with production.
Therefore, if you have not included it in cost of goods sold, it is
an operating expense.
It is important to note that capital expenditure is not an
expense – it is an asset. In addition, principal repayments of
loans are not expenses –they are a reduction of a liability. This
impacts on cashflow.
Net profit
This is often referred to as the bottom line. Net profit is
calculated by subtracting a company's total expenses from total
revenue, thus showing what the company has earned (or lost) in
a given period of time .
Statement of Financial Position / Balance
Sheet
Accountants, Financial
Analysts and Bankers pay
particular attention to
the Statement of
Financial Position
The Statement of Financial Position is more difficult to
understand.
It expresses the financial position or strength of the entity at a
point in time – a snapshot of the assets, liabilities and equity.
You may have heard the comment that a company has a “strong
or weak Balance Sheet”.
Accountants, Financial Analysts and Bankers pay particular
attention to the Statement of Financial Position.
The main components are:
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Assets
Assets are anything owned by the business, which has a
commercial or exchange value.
These assets are classified into current (resources held by the
business in cash or near cash form such as debtors and stock),
investments, fixed assets (eg plant and machinery) and
intangibles (e.g. goodwill).
Liabilities
Liabilities are owed by the business to an external source.
These liabilities are again classified into current (due for
payment in the next 12 months e.g. bank overdrafts, creditors,
tax) or non-current (amounts owing which are due beyond the
12 month mark e.g. bank loans).
Equity
Equity represents the company share capital plus the retained
earnings (or losses).
Most private companies have shareholder advances – loans by
the shareholders to the company. Whilst most owners consider
these advances to be equity, they are required to be shown as a
liability on the Statement of Financial Position. However banks
will often reclassify these as equity when they are trying to
determine the financial strength of a company when deciding
whether to lend money.
Analysis
The financial statements
represent the results of
business “game” played
Now we know what the “financial statements” are, what do we
do with them?
To provide a useful analogy, let’s liken these financial
statements to a sports game. The financial statements
represent the results of business “game” played!
How much time do you think coaches spend on analysing the
performance of their sports teams? How many dropped passes,
intercepts, shots on goal etc? Even at an amateur level there is
some form of analysis taken. From this, trainings are decided to
work on areas that need improving.
Businesses should be no different – you would want to know
what areas you need to work on to help improve the
performance of your business!!
So how do we do this?
We need to analyse and interpret the financial statements, get
to know what these numbers mean and how we use them.
Financial analysts often assess the businesses for:
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Although financial
statements/management
accounts are based on
historical information,
they provide important
indicators of how the
business will perform in
the future
1. Profitability -its ability to earn income and sustain
growth in both the short-term and long-term. A
company's degree of profitability is usually based on the
Statement of Financial Performance which reports on
the company's results of operations;
2. Solvency and Liquidity - its ability to pay its obligation
to creditors and other third parties;
This is based on the Statement of Financial Position
which indicates the financial condition of a business as
of a given point in time.
3. Stability- the firm's ability to remain in business in the
long term, without having to sustain significant losses in
the conduct of its business. Assessing a company's
stability requires the use of both the Statement of
Financial Performance e and Financial Position.
Although financial statements/management accounts are based
on historical information, they provide important indicators of
how the business will perform in the future, its weaknesses and
strengths and trends. The key is to have timely financial
information which is why you need regular up to date
management reports.
There are a few forms of analytical tools that are used in
analysing financial statements.
Horizontal Analysis – comparison of two or more years periods
financial data – year to year, quarter to quarter etc. It
illustrates the changes between periods and aids in determining
how each item has changed.
Vertical Analysis – this concentrates on the relationships
between various financial items on a financial statement eg
advertising costs to sales. This analysis gives insight into the
relative importance of items on the statement.
Trend Analysis – comparing information for 3 or more years.
The first year is the base year and each year is then compared
to this.
Ratio analysis – this involves the comparison of ratios to
previous results or known standards.
We have attached an appendix of ratios.
Key Question
What would the financial impact be on your business if you
improved 5 key financial indicators?
Talk to us to find out more.
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Appendix – Ratios
There are a number of ratios that can be utilised to assist
business owners to monitor performance in business. Below
are some of the more useful ones.
Profitability Ratios
Gross Profit Margin – this measures the businesses overall
efficiency as reflected in sales generated and cost control.
GPM = Gross Profit / Sales
Gross profit = sales less cost of sales (opening stock + purchases
– closing stock)
Net Profit Margin – this measures the overall operating
efficiency of the business/entity
NPM = net profit / sales
Net profit = Gross profit less other expenses
Return on Investment – this is a measure of the earning power
of the shareholders’ investment.
ROI = net profit / (shareholders equity + current accounts)
Net Profit to Total Assets – this measures a business’s
performance in generating profits from its asset base.
NP/TA = Net profit / total assets
Working Capital Ratios – Solvency and Liquidity
Working capital = Current Assets – Current Liabilities
Current Ratio – used to measure a business’s liquidity. It
quantifies the relationship between current assets and current
liabilities and measures how many dollars of current assets are
available to pay each dollar of current liabilities – paying debts
as they fall due.
CR = Current Assets / Current Liabilities
Quick Ratio – more rigorous test for short term liquidity
QR = (Current assets – stock – prepaid expenses) / (current
liabilities – bank overdraft)
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Financial Structure Ratios
Debt to Equity – measures the relationship between debt and
equity, the measure of risk in a business’s capital structure in
terms of the amount of capital contributed by creditors and that
of owners.
DE = Total Liabilities / Total Equity
Investment in the Business – measure of total funds of the
business represented by risk capital. It can be broken into 3
categories (together they should add to 100%):
Your investment = (shareholders equity + current assets) / Total
Assets
Banks investment = bank od + bank loans / Total Assets
Other lenders investment = all other lenders (including
creditors) / Total Assets
Activity Ratios
Stock Days – measure of the effectiveness of the business stock
policy.
SD = Average Stock (being opening stock + closing stock / 2) /
cost of goods sold / 365
Stock Turn – the number of times a business turns over its stock
during the year.
ST = 365 / Stock Days
Debtor Days – measures how quickly your debtors are paying
you, or the average collection time.
DD = Average Debtors (ex GST) / (credit sales / 365)
Asset Turnover – how well a business is putting its assets to
work.
AT = Sales / Total Assets
Disclaimer
This publication has been carefully prepared, but has been
written in general terms only. The publication should not be
relied upon to provide specific information without also
obtaining appropriate professional advice after a detailed
examination of your particular situation.
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