Management of Finance: Financial Statements

Understanding Financial Statements

Financial statements provide a clear and organised overview of a business’s financial activity during a specific period.
These documents are crucial for managers, investors, and creditors to understand the business’s performance and health.
There are three key financial statements: the balance sheet, the income statement (profit and loss account), and the statement of cash flows.

The Balance Sheet

The balance sheet provides a snapshot of a business’s financial position at a particular moment in time.
It is divided into three parts: assets, liabilities, and equity.
Assets represent everything that a business owns, such as property, inventory, or cash.
Liabilities are what the business owes to other entities, like loans or accounts payable.
Equity represents the net worth of the business, calculated by subtracting total liabilities from total assets.

The Income Statement (Profit and Loss Account)

The income statement shows how much profit or loss a business made over a specific accounting period.
It is split into revenues, cost of goods sold (COGS), gross profit, operating expenses, and net profit.
Revenues refer to the sales income generated by the business.
The cost of goods sold (COGS) represents the direct costs associated with producing the goods sold.
The gross profit is calculated by subtracting COGS from revenues, showing a raw profitability figure before other costs.
Operating expenses are the indirect costs of running the business, such as salaries and marketing costs.
The net profit is what’s left after subtracting operating expenses from gross profit, showing the ‘bottom-line’ profitability of the firm.

The Cash Flow Statement

The cash flow statement details the inflow and outflow of cash within the business over an accounting period.
It is segmented into cash flows from operating activities, investing activities, and financing activities.
Operating activities include cash flows related to the business’s core operations, such as selling products or paying salaries.
Cash flows from investing activities involve buying or selling long-term assets like property or equipment.
Financing activities involve the raising of funds or repayment of funds, such as taking out loans or issuing shares.

Importance of Analysing Financial Statements

Analysing financial statements helps stakeholders to make informed decisions about the future of the business.
Profitability ratios derived from the income statement can highlight trends in the business’s revenues and expenses, indicating overall profitability.
The liquidity ratios derived from the balance sheet can help assess the business’s ability to meet short-term debts.
The cash flow statement can provide insights into a business’s cash management and liquidity, showing how effectively the business generates cash to pay its debts and fund its operations.