Financial statements guide
(the four main financial statements)
The four main financial statements are:
- Balance sheet
- Profit and loss statement
- Cash flow statement
- Statement of changes in equity
None of them can provide the complete picture, but combined, they are very powerful tools for understanding and managing your company´s finances. Some of these statements are legally required (e.g., balance sheet and profit and loss), while others are highly recommended.
A balance sheet (also known as statement of financial position) shows what your company owns and what it owes on any specific date, or in other words, it provides information about your company´s assets, liabilities and shareholders´ equity:
- Assets (buildings, vehicles, machinery, equipment, furniture, inventory, cash, trademarks, patents, etc.)
- Liabilities (bank loans, supplier invoices, payroll, taxes, lease agreements, etc.)
- Shareholders’ equity (shows what the owners would have left if they sold all of the assets and paid off all of the liabilities).
In the balance sheet formula, the assets must equal (balance) the sum of the liabilities and shareholders’ equity: ASSETS = LIABILITIES + SHAREHOLDERS’ EQUITY
The assets are classified as:
- Current assets (convert to cash within one year, e.g., cash, inventory) and
- Fixed assets (used for longer than one year, e.g., buildings, vehicles)
The liabilities are classified as:
- Current liabilities (due in less than one year, e.g., supplier invoices, taxes) and
- Long-term liabilities (due in more than one year, e.g., bank loans).
The shareholders’ equity can be calculated as:
- total assets – total liabilities, or
- owners´ investment + retained earnings (retained earnings = profits – losses – paid out dividends) since inception.
Companies must prepare a balance sheet at the end of each accounting year as part of the annual accounts.
PROFIT AND LOSS STATEMENT
A profit and loss statement (also known as income statement) shows your company´s:
- Revenues over a period of time (e.g. year)
- Expenses associated with earning that revenue, and
- Profit or loss at the end of the period.
The purpose of the profit and loss statement is to determine whether a company has made a profit or loss, and how much corporation tax its owners have to pay.
Revenue is recorded as:
- Operating revenue (generated from sales of products and services), or
- Other revenue (generated from activities other than sales of products and services, e.g., interest income, sale of fixed assets, etc.)
Expenses are recorded as:
- Cost of goods sold (incurred in making of products and services, e.g., direct materials, direct labour, depreciation, etc.)
- Operating expenses (incurred by supporting activities, which can´t be linked directly to the production process, e.g., salaries of administrative personnel, office supplies, marketing expenses, rent, depreciation of buildings, amortisation of trademark, etc.)
- Other expenses (interest expenses, capital expenditures such as purchase of fixed assets, etc.)
Depreciation and amortisation refer to spreading the cost of fixed assets over multiple periods. Depreciation is associated with tangible assets (e.g., buildings, machinery), while amortisation is associated with intangible assets (e.g., trademarks, patents, licences). For example, if you buy a machine that costs £10,000 and is expected to be used for 10 years, every year you´ll allocate £1,000 to your company´s expenses.
To analyse your company´s financial results, you can use:
- Gross profit/loss = sales revenue – cost of goods sold
- Operating profit/loss = sales revenue – cost of goods sold – operating expenses
- Net profit/loss = operating profit/loss + other revenue – other expenses – corporation tax.
Companies must prepare a profit and loss statement at the end of each accounting year as part of the annual accounts.
CASH FLOW STATEMENT
A cash flow statement shows your company’s cash inflows and outflows over a period of time. While a profit and loss statement tells you whether your company has made a profit, a cash flow statement tells you whether it has generated cash.
A cash flow statement is normally divided into three sections:
- Cash inflows/outflows from operating activities (product/service sales, direct costs, operating expenses)
- Cash inflows/outflows from investing activities (purchase/sale of buildings or machinery, purchase/sale of shares of other companies, etc.)
- Cash inflows/outflows from financing activities (sale/repurchase of your company´s shares, dividend payments, bank loans, etc.)
Although it´s not a legal requirement, preparing periodic cash flow statements and cash flow forecasts is highly recommended, to ensure you always have enough cash to meet your short-term financial obligations.
STATEMENT OF CHANGES IN EQUITY
A statement of changes in equity shows whether the shareholder´s equity in your company has increased or decreased. For example:
- The issue of new shares will increase the shareholders´ equity (for it will increase the paid-in investment capital)
- Payments of cash dividends will decrease the shareholders´ equity (for they will decrease the retained earnings)
- Profit will increase the shareholders´ equity, while loss will decrease it
The shareholders´ equity can be increased or decreased for other reasons such as:
- Changes in accounting rules that require reissue of financial statements, and affect the retained earnings
- Fixed assets revaluation can increase the revaluation surplus, or a reversal of the revaluation can decrease the revaluation surplus.
Small companies are not required to prepare a statement of changes in equity as part of the annual accounts. However, they are strongly encouraged to submit it with their annual accounts.