Financial Statements

Understanding Financial Statements

  • Financial statements are reports prepared by sole traders to present their financial performance and position at a given time.
  • They include the Balance Sheet, Income Statement, and sometimes the Cash Flow Statement.
  • These statements are crucial for decision making, planning, and controlling activities within the business.

The Role of Financial Statements

  • Provide valuable information about a business’s financial health.
  • Help in making economic decisions/strategies, such as where to invest money.
  • Assist regulatory bodies in monitoring a business’s activities.

Anatomy of a Balance Sheet

  • A balance sheet shows a snapshot of a business’s total assets, liabilities, and owner’s equity at a certain date.
  • Assets are economic resources a business owns that can be converted into cash.
  • Liabilities are obligations a business must pay to others.
  • Owner’s Equity, also known as Capital, represents the owner’s claim on the assets of the business after all liabilities have been paid.

Break Down of an Income Statement

  • The income statement, also known as the Profit and Loss Account, summarises the revenues, costs, and expenses over a period, showing the net profit or loss made.
  • Revenue is the income that a business earns from its normal operating activities.
  • Cost of sales refers to the cost of producing the goods sold by the business.
  • Gross profit is calculated by subtracting the cost of sales from the revenue.
  • Expenses refer to costs incurred in the process of running the business. This could include rent, salaries, utilities, etc.
  • The bottom line of the income statement shows the net profit or loss, which is calculated by subtracting total expenses from gross profit.

Understanding the Cash Flow Statement

  • Although not always prepared by sole traders, the cash flow statement provides a record of cash and cash equivalents entering and leaving the business.
  • It is divided into three sections: Cash Flow from Operating Activities, Cash Flow from Investing Activities, and Cash Flow from Financing Activities.
  • It portrays how a business is generating cash and how that cash is being spent.

Using Financial Statements for Decision Making

  • By examining a company’s financial statements, decisions about the level of risk involved, the ability to generate profits, pay debts, and whether the business is growing, can be made.
  • They can also highlight areas where performance might be improved.

Limitations of Financial Statements

  • Financial statements are based on historical data hence they do not provide information about a company’s future.
  • They do not factor in non-quantifiable items such as a business’s reputation or employee morale.
  • Since different companies may use different accounting methods, it can be challenging to directly compare them based on their financial statements.