Beginner’s guide to financial statements (2024)

Learn how to check that your numbers add up with AAT’s guide to financial statements, balance sheets, and profit and loss accounts.

When running a business there are few things more fundamental than being able to understand and keep on top of your business finances. Financial statements are a crucial part of this – providing you with key information to help you monitor and analyse your overall performance.This guide will provide you with a quick summary of the main types of financial statements andwhat they’re used for.

What are financial statements?

Financial statements play an important role in helping you to understand the financial position of your business. These statements – or reports as they’re sometimes referred to –showcaseamixtureof financial information, including:

• Balance sheet (statement of financial position)
• Profit and loss account (income statement)
• Cash flow statement

Limited companies are legally required to produce financial statements(both abalance sheet and profit and loss account) when they file their company accounts at the end of the financial year.Presented in a structured format, these reportsare usually prepared by your accountant or finance team.

Asole traderhas no legal obligation to file financial statementswith a public body,however,it is strongly recommended that theymaintainreportsin some capacity.

It’s not just a compliance exercise, though. If you’re looking for investment, lenders and investors will usually want to see your financial statements before committing funds.Staff, particularly budget holders, should be familiar with financial statementstoo –to ensure financial responsibility is maintained across the business.

Understanding the balance sheet

Let’s start with a quick summary of one ofthemainfinancial statements. Thebalance sheetprovides a statement of the assets, liabilities, and equity of a business at a particular point in time.

Using the ‘accounting equation’,the figures in your assets and liabilities columns can be used to calculateyour equity (also known as ‘net assets’, ‘net worth’, or ‘capital’)– in other words:

Equity = assets – liabilities

To explain in more detail,assetsare items owned or controlled by the business which have the potential to produce income or other benefits. For example, buildings, machinery, oreven other companies. Money owed toyou, known as receivables, is included in this category.

Accounting standards requireyouto separate long term, or non-current assets(sometimes referred to as ‘fixed’)from short term or current assets, for example:

Liabilitiesarean obligation to transfer cash or servicesas a result ofpast events. This may be to pay an invoice, deliver goods or services that have been paid for, or tohonora warranty. Money owed to suppliers is known as payables.

Again, liabilities should be separated intonon-current and current liabilities. Non-current refers toamounts not due in the next 12 months such as mortgages and long-term loans. Current liabilities are a business’ debts or obligations that must be paid within one year. These include invoices due to suppliers (payables), goods that have been paid for but not delivered to customers, short term loans like bank overdrafts.

Profit and loss account

Aprofit and loss accountisan account compiled to show gross and net profit or loss during a specifictime period– for example, a month, a quarter, or a year.Thesimplestprofit formula is:

totalincome– totalexpenses = profit.

Income(sometimes called revenue) is mainly the operating income received from sales of goods and services. Other income can come from interest received on savings or discounts received for paying quickly.

Expensesare the day to day running costs of the organisation, for example, buying goods for manufacturing or for resale, paying wages, or buying general items or services that are consumable.

It is important to understand that profit is calculated overa period of time.This is a fundamental concept, called the accruals concept,which states that income for a period must be matched against the expenditure for the period.

A profit and loss account will help you calculate the following:

• Sales revenue
• Cost of sales
• Operating expenses
• Net profit
• Gross margin
• Net profit margin.

Cash flow statement

Although not a legal requirement, cash flow statementsare used by many businesses to monitor theircash inflows and outflows, including:

• how much you expect to spend incosts
• how much you expect to make insales 
• your cash position each month.

Forecastinglike this is crucial – especially for those businesses that seesignificantseasonal changes in income and expenditure.

If you’re a small restaurant business in Cornwall, for example, you’d expect tohave busy summer months and quieter winters.Your cash flow statement detailsthose movements – for example, increased staff costsnext toincreased sales income in July and August. Based on these figures, you’re able tocalculate thecashshortfalls and surplus for each month.Thishelps you to know when, for example, you’ll have cash to invest in the business.

Know yournumbers

It’s important that you’re able to make sense of financial statements and not just relying on your accountant to deliver news at the end of the financial year – by which point, it may be too late totake action. Accounting software plays an important role in getting you closer to real-time data on your business, but you also need to know what to look for.Educating yourself on basic finances will help you to spot the danger signs as well as identify growth opportunities.