Understanding Financial Statements
If you have problems understanding financial statements and finance in general then I recommend that you sign up to the RSS feed because I am planning to take you through my finance for non financial managers course on a week by week basis.
See Why Measuring Performance Is Essential
I hope this week is straight forward because it will get more complicated but i want you to understand the basics. Remember my purpose is not to turn you into a book-keeper or an accountant but to give you enough knowledge that you can understand the way money flows through your business.
Terminology & Accounting Jargon
One of the big problems in the world of finance and accounting is that the jargon can be very confusing. One finance term can have different definitions in different companies and countries and there are hundreds of different terms.
Don't be intimidated. Try to fix the terminology you want to use and stick with it. Look to your professional accountant for guidance. While you may understand what you mean, you don't want to be calling apples oranges as it won't give a good impression to any banker or investor.
The Core Financial Concepts
In business finance and personal wealth you have two basic concepts that you must be clear on:
- Income, profit or cash flows - the critical factor is "per period". You can't say "My profit is £10,000." It doesn't mean anything. It has to be "My profit is £10,000 per year" or some other time period. This the same with payroll costs for employees - it is per period.
- Balance - here the critical factor is that it is a snapshot a particular point in time and at any other time, the number could be significantly different. "I have $23,000 in my bank account today but if I pay my overdue suppliers I will only have $7,000 tomorrow." On a personal level wealth is a balance, income is a flow.
On this basis it won't surprise you that the profit is shown in the Profit & Loss account per period and the balances are shown in the balance sheet at a set date.
Here's the problem with the jargon. It intimidates anyone who doesn't understand this flows and balances concept.
People understand on a personal basis the difference between income and wealth but I've lost count of the number of people who say something like "If you want to know my sales, I'll have to look in my balance sheet."
Wrong - people do get confused between periodic flows and set date balances even though it seems obvious to you as you read this article.
The difference between balances and flows is all about momentum.
People can be wealthy but have little income or can have a high income but no wealth (because whatever comes in they then spend).
So can businesses. The Balance Sheet shows the position at the particular date but the Profit & Loss Account shows the momentum, which way the business is heading.
Two Things You Need To Know About Flows Per Period
Flows can be good - revenue, sales, income, fees
or
Flows can be bad - costs, expenditure, expenses, overheads
That's it.
If sales are greater than costs, the business makes a profit.
If sales are less than costs, the business makes a loss.
As Mr Micawber from Charles Dickens book David Copperfield said "Annual income twenty pounds, annual expenditure nineteen pounds nineteen and six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery."
If sales and costs are similar value, the business is referred to as "breaking even" although there may be a small profit or loss for the period.
Three Things You Need To Know About Balances
There are only three broad categories of balances that are shown in your balance sheet:
Assets - items that the business owns
Liabilities - money that the business owes to other people
Equity or Capital or Shareholders Funds - money invested by the owner and profit reserves that can be paid back to the owner
What Must A Balance Sheet Do?
A balance sheet must balance so there is a simple equation
Assets = Liabilities + Equity e.g. 400 = 250 + 150
or another version is
Assets - Liabilities = Equity e.g. 400-250 = 150
Do you remember that I gave you the simple Sales good, Costs bad guide on the profit and loss account flows but I can't do that so clearly with the balance sheet.
Even the owners equity in the business doesn't give a clear guide although it is a very bad sign if it is negative which happens when liabilities are greater than assets.
While you want the business to make a profit and that will mean that equity increases, if you take money out of the business as a dividend (to buy the yacht or the villa in Spain), equity will reduce.
Next Lesson
No exercises to do this week except that you need to get the idea of flows and balances clear in your mind.
Next week we will look at the Understanding Finance the two sides to every transaction.
Feedback
I hope you found this first financial training article helpful and I would appreciate your feedback. By all means post finance questions that you would like me to cover although I won't be answering questions about the different accounting standards across the world.
That's far too technical and boring and to be honest, beyond my knowledge or interest level.
Your Profit Coach
Paul Simister
Business coaching for customer focused entrepreneurs
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