Whilst an important indicator, just looking at your business profit and cash at bank doesn’t give a true reflection of your performance. When it comes to the world of business, navigating the path to success requires taking a holistic view and understanding your business’s financial statements.
Financial statements show how your business is doing financially at a particular point in time. Usually compiled around 30 June in Australia, they provide an overview of your business’s overall financial health - indicating where your money is going, and where it's coming from.
Understanding these documents is essential for making strategic business decisions – for future planning, securing loans, attracting investments or possible valuation for sale.
The 3 components of financial statements are as follows:
1. Balance sheet
A balance sheet is a comprehensive summary that reflects the value of an entity, including its assets, liabilities, and equity. It summarises what the entity owns and owes, as well as the investment made by owners at a specific point in time. It is divided into 3 main parts:
- Assets: These are items owned by your business that can be converted into cash. Assets are further classified into current assets (cash, trade debtors and inventory) and non-current assets (property, plant and equipment).
- Liabilities: These are your business’s debts or obligations and are also classified into current liabilities (debts due within 1 year, e.g., trade creditors) and long-term liabilities (debts due over a longer period, e.g., business loan).
- Equity: Also known as net assets, it represents the residual value that would be returned to shareholders if all the company assets were liquidated, and all debts repaid. If operating in a trust structure, equity generated from current year profits is distributed to the beneficiaries at year end with the unpaid amount becoming a liability (beneficiary entitlement). The equity account in a trust will simply be reduced to the initial settlement sum, compared to a company that may have retained earnings.
The balance sheet follows the equation Assets = Liabilities + Equity. This means the resources of the entity (assets) are financed by either what the entity owes (liabilities) or the owners’ personal investment in the entity (equity). By analysing a balance sheet, your investors can assess the business’s financial stability, liquidity, and solvency, which can help them make informed investment decisions.
2. Profit and loss statement
The profit and loss statement is a financial report that defines the business’s profitability over a specific period of time (normally 1 July to 30 June in Australia if annual). It provides a detailed breakdown of the business’s revenues, costs, and expenses, and ultimately calculates the final net profit or net loss for the period. It typically includes the following:
- Revenue (sales): This is the income source generated from the business’s main operation such as sales of goods or services.
- Cost of sales: These are the direct costs associated with producing the goods sold by your business. This can include direct labour costs and any materials used in producing or manufacturing the entity’s products.
- Gross profit: This is calculated as revenues less cost of sales. It represents the profit an entity makes after deducting the costs associated with producing and selling its products or providing its services. By looking at gross profit relative to sales across several time periods, an owner can identify situations in which cost increases outpace revenue gains. This allows owners to take prompt action to correct this financial imbalance through activities such as re-negotiating processes with suppliers or eliminating inefficiencies in production.
- Other income: This is revenues outside the entity’s main revenue sources.
- Expenses: This includes other costs not included in cost of sales, such as selling, administration expenses and depreciation. These mostly consist of overhead items that would not vary too much if sales were to increase or decrease.
- Net profit: This is the final profit or loss figure after all revenue and expenses.
By analysing a profit and loss statement, investors can assess an entity’s profitability, operational efficiency, and compare its performance with that of other entities within the same industry.
It’s also a helpful budgeting tool, enabling you to compare current year figures with prior year performance, which allows for informed investment decisions.
3. Cash Flow statement
This statement provides information about a business’s cash receipts and cash payments during an accounting period (normally 1 July to 30 June in Australia if annual). It outlines how changes in both balance sheet and income accounts affect cash and cash equivalents. A cash flow statement tells us "here is the opening cash balance", "here is the closing cash balance", and where funds were spent during this period.
Conclusion
Financial statements are more than figures on a page, they are narratives telling stories of past performance and predictors of future success.
Understanding your financial statements is essential to running a successful business and making informed strategic and investment decisions.
By analysing these statements, you can assess an entity’s profitability, liquidity, solvency, and investment. However, it is important to note that financial statements should be analysed in the context of the business’ industry, size, and market conditions for a comprehensive understanding.
Connect with a Nexia Advisor for help understanding your financial statements. Our team of experts can provide the right insights and advice to ensure you are unlocking your business’s true potential.
