How to Read Your Own Financial Statements

Three statements, three questions

Profit and loss. Did the business make money over the period?

Balance sheet. What does it own and owe at one moment?

Cash flow statement. Where did the cash actually go?

The confusion that costs owners most is between the first and the third. Profit is an accounting measure of a period. Cash is what is in the account. They diverge, and both are correct.

Reading the profit and loss

Start at the top and work down, comparing to last year.

Revenue. Did it move, and do you know why?

Gross profit. Revenue less direct costs. Look at the percentage, not the amount. If it moved more than a point or two, something changed in pricing, costs or mix.

Overheads. Look for lines that grew faster than revenue.

Net profit. The result, but not the point. The percentage lines above tell you more, because they explain it.

Reading the balance sheet

Four things.

Receivables. Growing faster than revenue means you are collecting more slowly.

Payables. Growing faster than costs means you are paying more slowly, which may be deliberate or may be a cash problem.

Stock, if you hold it. Growing faster than revenue means cash is sitting on shelves.

The director's account. The line most owners skip and auditors always look at. It should be explainable in one sentence.

Reading the cash flow statement

One question. Did operating activities generate cash?

A business with profit and negative operating cash flow is funding itself from somewhere else. Borrowing, owner money, or stretching suppliers. That works until it does not.

The three checks that reveal most problems

Profit up, cash down. Almost always receivables, stock, or profit that is not real because costs were not accrued.

Receivables growing faster than revenue. Your collection is slipping, or a bad debt is being carried at full value.

Gross margin moving with no explanation. Pricing, input costs or mix has changed and nobody noticed.

The vocabulary worth knowing

Accrual. A cost incurred but not yet invoiced. It belongs in the period it was incurred.

Prepayment. Paid in advance for a later period. Not this period's cost.

Depreciation. Spreading an asset's cost over its life. A real cost, no cash movement.

Provision. An estimated liability, recorded because it is likely.

Net realisable value. What you could actually sell something for. Stock is carried at the lower of this and cost.

The questions to ask whoever prepares your accounts

Why did gross margin move?
What is in the director's account?
Which receivables will not be collected?
What did we accrue for, and what did we decide not to accrue?
Which accounting policies did we choose, and would a different choice change the result?

An accountant who can answer these clearly is doing the job. One who cannot is producing a document.

Where we fit

We walk clients through their own numbers monthly. If you receive accounts you do not read, that conversation is worth more than the report.