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Worksheet: Understanding Financial Statements

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  • 1. Worksheet: Understanding Financial Statements Introduction There are three basic financial statements which, between them, describe the activities and financial state of any business:  The profit and loss (P&L) account shows how a business performed over a specific period, and reveals the total revenue and expenditure related to that period.  The balance sheet summarises the financial state of a business at a specific date. Balance sheets are linked by a P&L account, which covers the period between the two dates.  The cash flow statement summarises cash receipts to and cash payments from the business for a specific period. Understanding the uses of and differences between these financial statements, and how they are prepared and interact with each other, will enable you to review the performance of your client's business with greater confidence. It will also enable you to analyse the financial implications revealed by the statements so you can advise your client as to how this information might impact on the success of their enterprise. Advisory issues  Your clients will be aware of the different financial statements but may not be sure what they are and how they differ. They may approach you for an explanation of terminology they have heard, so it is important for you to understand the differences between the statements, and how they are calculated and applied in practical terms, so you can explain what they mean with confidence.  You need to be able to understand the meaning deriving from different financial statements so you can assess the potential value of a business and whether it is trading successfully.  It is important to be able to advise your client on the future implications revealed by the figures so they can plan ahead - for example, if cash flow problems are likely to result from their current actions.  You may have to take a 'hands on' approach to help your client prepare a cash flow forecast. You therefore need to know what should be included and how to set up a forecast in a practical way. Profit and loss account The P&L account shows how a business performed over a specific period and reveals the total revenue and expenditure related to that period. All businesses have to prepare a P&L statement as part of their annual accounts, either to comply with company law or the requirements of self-assessment tax returns.
  • 2. However, producing a P&L statement is also a valuable part of preparing monthly management accounts and, for many businesses, forecasting future profitability is an essential part of business planning. A P&L account shows:  The revenue (that is, the income) for a specific period, usually a year for formal accounts but typically a month for management accounts.  The expenditure for the period.  The profit.  Whether the profit has been retained by the business or distributed to its owners. Example of a simplified P&L statement Profit and loss statement Income Sales 40,000 less: cost of sales (12,000) Gross profit 28,000 Expenditure Overheads 22,000 Net profit 6,000 Explaining the terms The sales income figure reflects the revenue from actual sales of products Sales or services during the period, (excluding VAT if the business is VAT- income registered). It does not reflect the cash received from customers, since some payments may still be outstanding or have been paid in advance. (NB: For businesses registered for VAT, the output tax (i.e. VAT on sales) is exactly equal to the input tax (i.e. tax on purchases) plus the tax paid to the Government. In other words, VAT in plus VAT out exactly balances, with no benefit or deficit to the business.) Cost of Cost of sales, sometimes known as direct costs, are the costs that can be sales directly attributed to the production of a particular product or service. If a business manufactures tables, for example, the cost of sales will be the cost of the raw materials (wood, glue and so on) that go into the tables. For a retail business, the cost of sales will be the cost of the stock items being resold. It is important to note that the cost of sales equates to the cost of producing the goods that have actually been sold, not necessarily all the expenditure on raw materials. The value of unused raw materials, as well as the value of goods that have been made but not yet sold, will be shown on the balance sheet as stock. Gross This is the difference between sales income and direct cost of sales. It is profit often known as the contribution, because it contributes towards the overhead costs and, when they are all paid, contributes towards net profit.
  • 3. Overheads All operating costs that are not directly linked to a product and which, generally speaking, are fixed costs (such as rent, utilities and insurance and staff costs not recorded under cost of sales), are classed as overheads. Net profit This is the gross profit of a business less all overheads. In business accounts, the word 'net' is often dropped, so you simply have 'Profit before tax' and 'Profit after tax'. Using a P&L account Regularly reviewing the P&L account, together with the balance sheet and cash book (preferably once a month), allows a business to keep an eye on how it is performing. It can be useful to produce a budget forecast P&L for each year, and ideally each month, to compare with the actual figures the business achieves. By analysing the differences between the planned and actual P&L accounts, the business can identify what has gone well, such as achieving higher sales, or what hasn't gone so well, such as coping with increased costs. This allows the business to identify changes it needs to make and to take corrective action as soon as possible. Comparing how the business has performed in the current year with the previous year also provides a useful benchmark, and can demonstrate that the business is making good progress. Limitations of P&L accounts The P&L account shows the profitability of a business but it does not show the cash position. Businesses need to ensure they are making a profit, but they also need to ensure they do not run out of cash, which is quite easy to do if sales are doing badly or if sales are doing much better than forecast but all being sold on credit. The P&L account does not show the solvency of a business - this can only be determined from the balance sheet. Balance sheet A balance sheet is a financial 'snapshot' that shows how a business is financed, how much capital is employed and how quickly assets can be turned into cash at a specific point in time. All businesses have to prepare a balance sheet at the end of their financial year as part of their annual accounts, but one can be prepared at any time. A balance sheet is a good indicator of whether or not a business is solvent and able to trade as a 'going concern'. The starting point for understanding balance sheets is to think about sources and applications of funds:  Sources show from where the money has come.  Applications show to where the money has gone. By definition, the total of the sources and the total of the applications will be equal.
  • 4. Imagine that the owner of a business provides start up capital of £10,000. That £10,000 is owed to the owner, but it is also used to finance the business. Initially it might be held as 'cash in bank', that is, an asset. If the business then spends £7,000 on equipment, it has fixed assets of £7,000 and cash in bank of £3,000, still totalling £10,000. Source of funds Application of funds Liabilities Assets Owner 10,000Cash in bank 3,000 Equipment 7,000 Total finance 10,000Total assets 10,000 The balance sheet also shows how much a business owes to suppliers and how much is due from customers. It reflects assets such as equipment and vehicles used in the business, the level of stock, and the amount of capital invested in the business. The more common way to display a balance sheet is given below. In this format, the fixed assets are shown first, then the current assets, and these together record the business' total assets. Current liabilities are then shown, and are deducted from the current assets to show the net current assets of the business. Net assets are calculated by adding fixed assets to net current assets and deducting any long-term liabilities. The value of net assets will always equal the net worth of the business. Example of a simplified balance sheet Balance sheet Fixed assets Equipment 80,000 Current assets Stock 3,000 Debtors (trade) - Cash in bank 26,150 Current liabilities Loan (80,000) Creditors (VAT) (3,150) Net current assets (54,000) Long-term liabilities - Net assets 26,000 Represented by Owner's capital 20,000 Retained profit 6,000 Net worth 26,000 Explaining the terms Fixed Fixed assets are generally assets with a lifespan of more than one year. For assets most businesses, all fixed assets will be tangible assets such as equipment and buildings. The cost of tangible fixed assets is 'depreciated', or written down, over the expected lives of the asset; it is quite common to see on a balance sheet the original cost of tangible assets together with their
  • 5. accumulated depreciation. This depreciation cost is charged to the P&L account and reduces the net profit of the business. Fixed assets may also include intangible assets such as goodwill or expenditure on research that has been capitalised. It is good practice to write off (or 'amortise') goodwill and other intangible assets as quickly as possible; ideally, they should be charged as expenditure immediately. It is, however, not always possible to write off goodwill in one go without making the balance sheet look sick. It should also be noted that lenders will generally ignore goodwill when assessing a business. Research and development (R&D) costs for contracts that are firm and will last more than one year may be capitalised and amortised over the term of the contract. Current Current assets include stock, work in progress, debtors, cash in bank and assets so on. Debtors represent the amount of money owed to the business by its customers and include VAT if the business is registered. Current Current liabilities include creditors, overdrafts, loans due within one year, liabilities money owed under hire purchase agreements, any amounts owed in VAT or tax and so on. Creditors, sometimes called trade creditors, represent the amount of money owed by the business to suppliers. Loans Loans falling due in more than one year are usually shown separately from current liabilities as long term loans. It is quite common however, for small businesses to show all loans listed as current liabilities. Net Also known by accountants as 'working capital', this refers to the current difference between current assets and current liabilities. This should be assets positive or the business may not be able to meet debts as they fall due. In this example, it is negative and is known as 'net current liabilities', and could indicate that the business is short of working capital. The term 'working capital' can be confusing since the amount of working capital needed by a business will vary. Remember that the balance sheet is only a snapshot. Net assets This equates to the value of fixed assets added to net current assets and should always equal net worth. Net worth The bottom 'half' of the balance sheet shows the shareholders' or owners' capital and reserves - that is, the net worth, sometimes known as 'net finance' or the 'equity' of the business. This comprises the money introduced by the shareholders or owners and the retained earnings. Normally, for a small business, the reserves are simply the retained profits. The term 'reserves' is often misunderstood: remember that reserves show where the money came from, not how it has been used. They may exist as cash in the bank, but more likely they will have been used to buy more equipment or to add to working capital - that is, to finance stock and work in progress. To avoid misunderstanding, it may be preferable simply to use the term 'retained earnings'. Using a balance sheet
  • 6. A balance sheet can be useful in helping to analyse business performance and considering ways to improve it. It also enables the value or worth of a business to be assessed at a given point in time and it is a requirement that limited companies file a balance sheet as part of their annual accounts. Specifically, the balance sheet shows:  How much capital is employed in the business (how much is the business worth, where did the capital come from and how much of it is debt?).  How quickly assets can be turned into cash (how liquid is the business?).  How solvent the business is (what is the likelihood that the business might become insolvent?). Limitations of balance sheets A balance sheet can tell a lot about a business, but it cannot tell everything. That requires a P&L account and a cash flow statement as well. It is important to remember that a balance sheet:  Can show a different perspective from the P&L account of a business' financial position. For example, a business can be making good profits but have a weak balance sheet, and hence be financially vulnerable because of low net asset value. Conversely, a business can sustain a period of poor profitability when it has a strong balance sheet, shown by a high net asset value.  Does not show the profitability of a business. This is demonstrated by the P&L account. If your client has balance sheets from two consecutive years, you may be able to estimate the level of profit their business has achieved by comparing the change in value of retained earnings. This will understate the profit if the business pays dividends.  Does not reflect the true market value of the assets, which may be more or less than the figures given on the balance sheet.  Does not show the market value of a business. This depends on profitability and the current values (as opposed to costs) of assets. Cash flow statement The cash flow statement summarises cash receipts to, and cash payments from, a business for a specific period. Cash flow statements for historical periods usually show what happened for a year, though as with other statements, they can be prepared for any period. The cash flow statement shows how money flowed into and out of the business during the period, and relates the P&L statement to the balance sheet. In particular, it shows by how much the working capital in the business increased or decreased and highlights the reasons for the changes. It does not show the amount of working capital available -
  • 7. that is on the balance sheet - but it does provide a mechanism to estimate how much working capital is required. Example of a simplified cash flow statement Cash flow statement Receipts Debtors 47,000 Loan 80,000 Owner's capital 20,000 Cash inflow 147,000 Payments Creditors 17,625 Overheads 23,225 Capital expenditure 80,000 Cash outflow 120,850 Opening cash balance 0 Cash inflow (outflow) 26,150 Closing cash balance 26,150 Explaining the terms Receipts All the money coming into the business from debtors (that is, people who have bought goods or services previously and are now paying what they owe), cash sales, loans, and owners or shareholders funds. Payments All the money leaving the business to cover expenditure, all operating costs, loan repayments, and expenditure on capital items such as vehicles, computers, and manufacturing equipment. Balances The opening cash balance will either be the closing cash balance from the previous period or nil if it is a start up business. The cash flow for the period is calculated by subtracting the total payments from the receipts and this is added to the opening balance. The closing cash balance should match with the figure on the business' bank statement for the end of this period. Using a cash flow statement A cash flow comes into its own, however, when it is used as a forecast and is one of the most important management accounting tools. It provides an estimate of the business' cash requirements for the next trading period. There are two major reasons why your client should prepare a cash flow forecast. The first is so that the business can estimate its working capital needs and, if necessary, seek additional working capital funds. The second is to provide your client with a management tool that can help them to ensure proper financial control is exercised. Limitations of cash flow forecasting
  • 8.  The cash flow forecast is probably the most useful financial forecast, but it is important to remember that it is only as accurate as the accuracy of the individual elements. It is vital to take the time and effort to forecast each of these as accurately as possible.  Even if the figures are estimated accurately, it is always possible that sales might be lower than forecast or that costs may suddenly rise, so use the forecast to prepare 'what if' scenarios (usually referred to as a 'sensitivity analysis') to see what happens to the cash flow if sales are, say, 20% higher or lower than forecast, or if raw materials costs rise by 30% or energy costs rise by 60%. This is particularly easy to set up on a computerised spreadsheet.  The cash flow forecast makes allowance for the lag between invoicing a sale and actually receiving the payment into the business' account, but small businesses often struggle because they must meet their production costs before they receive payment, and do not have enough working capital in the bank to survive while waiting to be paid. Businesses need to think about ways in which they can speed up their receipts and possibly slow down their payments.  In general, it is easy to spot the peak borrowing requirement because it is the month in which there is the highest negative balance. However, for businesses with high levels of payment early in a month, and with receipts late in the month, note that the peak borrowing requirement may be much higher than shown on the cash flow forecast. In extreme cases, it may be necessary to prepare a forecast on a weekly basis to understand the worst position.  Be cautious, especially at start up, about the level of cash inflow anticipated - in the early stages, cash tends to go out from a business more quickly than it comes in.  A business looking for external investment, unless it is very simple, probably needs a three-year forecast, with the first year showing cash flow monthly, the second year quarterly and the third year as a single figure. Financial statements in practice To understand how the financial statements interact, you should follow through the seven steps in the simple example below. In this example, the transactions have been split into single transactions to demonstrate how each is treated. Figures in brackets denote a negative value. Cash flow Step 1 Step 1 Receipts Cat is starting a business to manufacture and sell Owner 20,000 baby cots. She introduces £20,000 of her own Payments - money. This is shown as a receipt to the business on Balance 20,000 the cash flow. Cumulative balance 20,000 Balance sheet It is not shown at all on the P&L account because it Current assets is not income. Cash in bank 20,000 Current liabilities It is shown on the balance sheet twice: firstly as cash Net current assets 20,000 in the bank, which is a current asset; secondly as Represented by owner's capital. In other words, the business owes Owner's capital 20,000 £20,000 to the owner. Net worth 20,000
  • 9. Step 1 Step 2 Step 2 Cash flow Cat then borrows £80,000 from the bank. This Receipts is shown as a receipt in the cash flow. Like Owner 20,000 - her own money, it does not appear at all in the Loan - 80,000 P&L account. Payments - - Balance 20,000 80,000 It does appear, though, in the balance sheet. Cumulative balance 20,000 100,000 Specifically, it adds to the cash in the bank, Balance sheet giving a total of £100,000. It is also shown as Current assets a current liability. The net current assets are Cash in bank 20,000 100,000 still £20,000 and this is still balanced by the Current liabilities capital introduced by the owner. Loan (80,000) Net current assets 20,000 20,000 Liabilities are often split to show 'current' Represented by liabilities - that is, liabilities that fall due Owner's capital 20,000 20,000 within a year - and long-term liabilities - that Net worth 20,000 20,000 is, liabilities that fall due in more than 12 months. For simplicity, in this example, all liabilities are shown as short-term liabilities. Step 2 Step 3 Step 3 Cash flow Cat spends £80,000 on capital equipment ('cap Receipts - ex'). This is shown as a payment in the cash Loan 80,000 - flow forecast. (Note that if Cat were registered Payments - - for VAT, this payment would include the Cap ex - 80,000 VAT. This has been ignored for simplicity.) Balance 80,000 (80,000) Cumulative balance 100,000 20,000 The cost of the equipment is shown on the Balance sheet balance sheet as a fixed asset. Fixed assets Equipment 80,000 Note that capital expenditure is not a P&L Current assets account item. Depreciation will be shown to Cash in bank 100,000 20,000 represent wear and tear, but has been omitted Current liabilities for simplicity. Loan (80,000) (80,000) Net current assets 20,000 (60,000) The cash in the bank has been reduced by Net assets 20,000 20,000 £80,000. And the balance sheet still balances. Represented by Owner's capital 20,000 20,000 Note that the net current assets figure is now severely negative. Normally this would be a warning bell that there is a problem, but the bank has lent the money on the basis of a forecast and looking at one transaction at a time gives a false impression of how the business might really be performing. Note that the balance sheet now has a line showing net assets as well as the one showing net current assets.
  • 10. Step 3 Step 4 Step 4 Cash flow Cat is now ready to buy some raw materials. Receipts - - She spends £15,000 on raw materials, though this time Payments VAT has been included. She has paid immediately for Raw these materials, so the payment of £17,625 (inclusive materials - 17,625 of VAT) is shown on the cash flow. The raw materials Overheads - - are shown as stock under current assets, at the value Cap ex 80,000 - net of VAT. The input tax - that is, the VAT owed to Balance (80,000)(17,625) the business by the Government - is shown as a debtor. Cumulative balance 20,000 2,375 Note that the cash in the bank has changed again, but Balance the net assets figure is still the same. sheet Fixed assets Equipment 80,000 80,000 Current assets Stock - 15,000 Debtors (VAT) - 2,625 Cash in bank 20,000 2,375 Current liabilities Loan (80,000)(80,000) Net current assets (60,000)(60,000) Net assets 20,000 20,000 Represented by Owner's capital 20,000 20,000 Net worth 20,000 20,000 Step 4 Step 5 Step 5 Cash flow Cat and her team now start to manufacture the cots Receipts - - from the raw materials. She incurs staff costs Payments (£15,000), premises costs (£5,000) and marketing costs Raw (£2,000). There is no VAT on the staff costs, but it is materials 17,625 - assumed that all the premises and marketing costs Overheads - 23,225 attract VAT. She has total payments, including the Capital VAT, of £23,225. This is shown on the cash flow. expenditure - - Balance (17,625)(23,225) These overheads are the first entry that appears on the Cumulative P&L account, net of VAT. balance 2,375(20,850) Profit and There is no sales income yet, so effectively there is a loss loss equal to the expenditure figure. Income Expenditure The cash in the bank is reduced by the amount paid Overheads 22,000 out.
  • 11. Net profit (22,000) The retained profit, or in this case, the retained loss, is Balance carried on to the balance sheet and added to the sheet owner's capital. Fixed assets Equipment 80,000 80,000 The net worth has become negative. If this was the Current final month end position, it would be worrying as a assets negative net worth means the business is insolvent. Stock 15,000 15,000 Debtors (trade) - - Debtors (VAT) 2,625 3,850 Cash in bank 2,375(20,850) Current liabilities Loan (80,000)(80,000) Creditors (VAT) Net current assets (60,000)(82,000) Net assets 20,000 (2,000) Represented by Owner's capital 20,000 20,000 Retained profit (22,000) Net worth 20,000 (2,000) Step 5 Step 6 Step 6 Cash flow Cat has made her first products and is in a position to Receipts - - start selling them. She sells products worth £40,000 (+ Payments VAT), but does not receive any money as she has Raw offered her customers 30 days' credit so there is materials - - nothing to show on the cash flow. Sales of £40,000 are Overheads 23,225 - shown on the P&L account. Capital expenditure - - The cost of the sales can now be shown. It may be Balance (23,225) - possible to show the exact cost of sales; it may be Cumulative necessary to calculate the figure, allowing for waste balance (20,850)(20,850) and so on. Profit and loss Cat has opted for this approach and estimates that the Income cost of sales is 30% of the sales price. For this month, Sales - 40,000 then, it is £12,000. The gross profit is £28,000. We less: cost of have already considered the expenses, so the net profit sales -(12,000) equals the gross profit. Gross profit -28,000 Expenditure Note that the stock value has gone down by the same Overheads 22,000 - amount as the cost of sales.
  • 12. Net profit (22,000) 28,000 Note that trade debtors includes the VAT owed to the Balance business (the output tax). sheet Fixed assets Note that the VAT, previously shown as owing from Equipment 80,000 80,000 the Government to the business, is now shown as Current being owed by the business to the Government. Note, assets however, that it is the difference of the output tax Stock 15,000 3,000 (£7,000) and the input tax (£3,850) giving a balance Debtors owing of £3,150. (trade) - 47,000 Debtors The net profit is added to the bottom of the balance (VAT) 3,850 - sheet in retained profit and the net worth of the Cash in business is now positive. bank (20,850)(20,850) Current liabilities Loan (80,000)(80,000) Creditors (VAT) - (3,150) Net current assets (82,000)(54,000) Net assets (2,000) 26,000 Represented by Owner's capital 20,000 20,000 Retained profit (22,000) 6,000 Net worth (2,000) 26,000 Step 6 Step 7 Step 7 Cash flow Eventually, Cat collects the money owing Receipts to her. This is shown as a receipt in the Debtors - 47,000 cash flow. There is nothing to show in the Payments P&L account. Balance - 47,000 Cumulative balance (20,850) 26,150 The debtors drop out of the balance sheet, Profit and loss though, as the money has been paid. As a Income result, the cash in bank once again looks Sales 40,000 - quite healthy. less: cost of sales (12,000) - Gross profit 28,000 - Note, though, that neither the net assets Expenditure nor the net worth has changed. Overheads - - Net profit 28,000 - Normally, of course, the financial Balance sheet statements would not be recalculated after Fixed assets every individual transaction, but rather Equipment 80,000 80,000 should be reviewed at the end of every Current assets month. If a business is going through a Stock 3,000 3,000 difficult period, however, it may be Debtors (trade) 47,000 - necessary to review them more
  • 13. Debtors (VAT) - frequently. Cash in bank (20,850) 26,150 Current liabilities Loan (80,000) (80,000) Creditors (VAT) (3,150) (3,150) Net current assets (54,000) (54,000) Net assets 26,000 26,000 Represented by Owner's capital 20,000 20,000 Retained profit 6,000 6,000 Net worth 26,000 26,000 Cash flow Summary Receipts The figures for the first month can now all Debtors 47,000 be pulled together into a single summary Owner 20,000 showing the complete picture for the Loan 80,000 business. Have another look and remind Payments yourself where each of the figures came Raw materials 17,625 from. Overheads 23,225 Capital expenditure 80,000 Balance 26,150 Profit and loss Income Sales 40,000 less: cost of sales (12,000) Gross profit 28,000 Expenditure Overheads 22,000 Net profit 6,000 Balance sheet Fixed assets Equipment 80,000 Current assets Stock 3,000 Debtors (trade) - Debtors (VAT) - Cash in bank 26,150 Current liabilities Loan (80,000) Creditors (VAT) (3,150) Net current assets (54,000) Net assets 26,000 Represented by Owner's capital 20,000 Retained profit 6,000 Net worth 26,000
  • 14. Understanding financial statements - a checklist for advisers  It can sometimes be difficult to gather all the figures from your client to put together a balance sheet, but doing so will help you understand their business proposition much better. At least preparing a balance sheet is partially self- checking in that it must balance or else you know you have an error. Usually the best place to start is with your client's capital and reserves, since that figure is usually fairly simple to calculate. Then work down through fixed assets, current assets and liabilities.  A business is solvent if it has sufficient assets (cash, stock, debtors and fixed assets) to cover its liabilities (loans, creditors and so on). However, a business also has to be able to meet its debts as they fall due. If it doesn't have sufficient cash, or sufficient assets that can quickly be turned into cash (often known as liquid assets), it may be regarded as insolvent. Trading when knowingly insolvent is an offence, so care must be taken.  The cash flow forecast should be set out as a table, with receipts and payments placed in the months in which they occur. If the business is not yet trading, the figures should be shown from the month in which it is going to start.  The cash flow forecast will never be totally accurate, so don't worry about making the individual figures totally accurate. Depending on the size of the business, round to the nearest ten, hundred or even thousand so it is easier to see the overall picture. This information is meant as a starting point only. Whilst all reasonable efforts have been made, the publisher makes no warranties that the information is accurate and up- to-date and will not be responsible for any errors or omissions in the information nor any consequences of any errors or omissions. Professional advice should be sought where appropriate. Published by Cobweb Information Ltd © 2007 If you have any feedback or queries please contact us: Tel: +44 (0)191 461 8000 E-mail: bootcamp@cobwebinfo.com