What is a financial statement that measures an enterprises performance in terms of revenue and expenses over a certain period?

By Eshna VermaLast updated on Mar 22, 2022167223

2. How is the Financial Performance of the firm over a given period of time?

These questions can be answered with the help of a financial analysis of a firm. Financial analysis involves the use of financial statements. A financial statement is a collection of data that is organized according to logical and consistent accounting procedures. Its purpose is to convey an understanding of some financial aspects of a business firm.

It may show a position of a period of time as in the case of a Balance Sheet, or may reveal a series of activities over a given period of time, as in the case of an Income Statement. Thus, the term ‘financial statements’ generally refers to two basic statements: the Balance Sheet and the Income Statement.

The Balance Sheet shows the financial position (condition) of the firm at a given point of time. It provides a snapshot that may be regarded as a static picture. “Balance sheet is a summary of a firm’s financial position on a given date that shows Total assets = Total liabilities + Owner’s equity.”

The Income Statement (referred to in India as the profit and loss statement) reflects the performance of the firm over a period of time. “Income statement is a summary of a firm’s business revenues and expenses over a specified period, ending with net income or loss for the period.”

However, financial statements do not reveal all the information related to the financial operations of a firm, but they furnish some extremely useful information, which highlights two important factors profitability and financial soundness.

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Introduction to financial statements

Balance sheet and cash flow statement

Your bank balance is an asset on your balance sheet.
This cash also appears on your cash flow statement under opening or closing balance.

Decreases in non-cash assets show up in the cash flow statements as positive because cash has been received. The cash line will change but total assets will remain the same on the balance sheet.

Inventories are the result of cost of goods sold, which are also listed on your profit and loss statement, eg bread for sale at a bakery.

When you buy a fixed asset, eg vehicle or laptop, it also shows up on the cash flow statement as a capital expense.

When you buy or sell long-term assets, they also show up on the cash flow statement under cash flow from investing.

These items are also listed on your cash flow statement as a non-cash liability. Paying them off means a decrease in your non-cash liabilities as well as your cash assets.

When you pay income tax it shows up on the cash flow statement under operating cash flows, and on the profit and loss statement.

Retained earnings links to the profit and loss statement because it’s an accumulation of all years’ profits, minus any dividends paid.

It’s also common to see assets — liabilities = equity

Assets are the tools of your trade which help you do your business, eg a van for a delivery company, a secret recipe for your house cocktail, or a written agreement with a supplier.

Your balance sheet shows what each asset is worth, which is important if you want to raise money or sell your business.

These types of assets are common line items on a balance sheet. Which will be on yours depends on what your business does and what it owns.

Current assets: Items expected to convert into cash within 12 months, including:

• Inventory: What you sell to make money for your business, eg shoes in a shoe shop.
• Accounts receivable: Money you’ll get in the near-future by customers paying on credit. Offering some credit can help build good relationships. But too much is a risk. You might not have enough cash to invest in your business — or cover your bills.

Fixed assets: Items expected to last longer than a year, eg land or equipment. These are not for sale (that’s inventory), and they are depreciated in value over time.

Intangible assets: Ideas, practices or agreements you have bought from someone else, including:

• Intellectual property, eg secret recipes or patents.
• Goodwill: Value added to a business by assets that can’t be itemised, eg a reputation for making better cheese scones than a nearby rival, or loyal relationships with suppliers. Goodwill should only be on your books if you bought a business and paid a higher price due to its goodwill. Talk to your accountant about turning it into an itemised asset instead, eg brand value or a formalised supplier agreement.

Prepaid expenses: Money you’ve paid in advance for goods or services to help run your business, eg paying in advance for a 12-month insurance policy. It’s an asset because your business will receive value from it in the near future.

Capital expenditure: An accounting term to track money invested in current or fixed assets, also known as capex. When buying a new asset or upgrading an existing one, eg replacing your businesses computers, the money will be counted as capex.

Financial assets: Investments in other businesses, eg shares or bonds. Or it could be an asset that’s not part of your regular business activities, eg a tech company buying a vacant lot to sell in a few years to make money.

Working capital is often calculated in accounting software and spreadsheets. It’s also a good idea to calculate your working capital ratio. This is your readily available assets divided by your current liabilities.

Working capital ratio (current ratio) explained

This is money you owe, or will have to pay in the future, eg PAYE tax due the following month. Tracking liabilities in a balance sheet help you get to know the cost of running your business and the bills heading your way. This puts you in a better position to plan your spending and saving, and spot risks on the horizon.

These types of liabilities are common line items on a balance sheet.

Current liabilities: What you’ll have to pay out within a year, including

• income tax
• salaries
• unused employee leave or holiday pay
• bonuses for employees likely to hit agreed targets
• loan/mortgage instalments for next 12 months. The rest of the loan is listed in non-current liabilities
• unearned, or deferred, revenue — pre-paid orders and other money you are been paid in advance.

Unearned revenue is a liability because you haven’t yet done what you’ve been paid to do, and costs linked to supplying it haven’t yet come out of your pocket. Once the sale is completed, the amount paid is no longer a liability — it’s recorded as revenue on your income statement.

Checking deferred revenue will help you manage cash flow. It also shows potential buyers or investors a fuller picture of your business’s earning potential and sales to be completed.

Accounts payable: Money your business owes for goods or services, eg to a vendor or supplier.

Keep track of these figures to plan your spending, make sure bills are paid, and keep an accurate idea of costs for each job or project. Potential buyers or investors will look at accounts payable to see if your finances are under control.

Non-current liabilities: Money you’ll have to pay out over a number of years, also known as a long-term liability, including:

• Long-term debt, eg loans and mortgages: Total amount borrowed, minus payments for the next 12 months — these are a current liability.
• Long-term leases, eg hire purchase of a vehicle: Total amount borrowed, minus payments for the next 12 months — these are a current liability.

Equity aka the net value of your business

This measures the accumulated money in your business, including money from you or an investor. Positive equity means your assets are worth more than your liabilities. Negative equity means your liabilities outweigh your assets.

These types of equity are common line items on a balance sheet. For small- to medium-sized businesses, equity might be retained earnings alone. For larger businesses, balance sheets tend to include shares and other types of equity. If you have business partners, or an investor who owns part of the business, this is where their stake will show up.

Retained earnings: It’s the cash reserves your business has built up.

Here’s how your balance sheet works it out:
Previous statement’s retained earnings + net income — dividends paid to shareholders = current retained earnings

It’s important to master retained earnings when you want to grow. A positive number means you have money to invest back into your business or pay off debt faster.

Negative retained earnings means your business has built up more losses than income over time — it isn’t earning enough, or is spending too much. Fast-growing businesses might have negative retained earnings. This is OK if it’s planned and for a short time only. If it’s not planned — or becomes a unexpected pattern — it shows you need to look again at how to make your business profitable. It’s a red flag for you, and to any investors or buyers.

Total shareholder equity: Also known as net assets, this is funds contributed by the owner — and any others with a stake in the business — plus retained earnings. Potential investors like to see an owner with equity, commonly called skin in the game, before they agree to put money into a business.

This means revenue, net profit, net profit margin — your net profit as a percent of your year-to-date revenue — and monthly operating costs.

Profit and loss statement

Unlike cash flow statements, which only record cash, revenues on P&L statements include those received in cash and those sold on credit. On balance sheets, these are classed as current assets or accounts receivable.

COGS on a P&L statement include opening and closing inventories. On a balance sheet, these are a current asset. Include goods you buy to sell to customers. If bought on credit, they are also a current liability (accounts payable) on the balance sheet.

Your gross profit is your revenues minus costs of goods sold. It should be a positive number.

If you pay any of these costs in cash, you’ll see it on the cash flow statement.
If paying on credit, these are a liability (accounts payable) on the balance sheet.

These costs will also appear on other financial statements.
Accounts payable (liability) and pre-paid expenses (asset) are on the balance sheet. Changes are recorded in the cash flow statement under operating cash flow.

This is paid over the time period. The balance sheet records the total amount borrowed as a liability and the vehicle as an asset. The cash flow statement records loan repayments under financing activities.

This is the money your business earns from all sources before you pay expenses, taxes and other bills.

If your business makes money in different ways, eg you run a café, a market stall and sell wholesale to other businesses, each gets its own line in the revenues section.

The aim in business is always to have money coming in — showing as positive number in the revenue section. But if your expenses are higher than your revenues, you’ll end up with a net loss.

Expenses aka money you spend

The expenses part of the income statement lists all the things that your business has spent money on. Some of the terms only apply to some businesses, so don’t worry if your income statement doesn’t show all of them.

These types of expenses are line items on an income statement.

The cost of goods sold, also called cost of sales, is the amount of money it takes to make the product or service you’re selling — how much you spend on materials, labour, and expenses. It can also take into account your stock at the beginning and end of a year. It’s a good idea to talk with an advisor about how your business can measure and record stock levels.

It’s used to calculate your gross profit and contribution margins.

Also called gross margin. The higher your gross profit, the more money your business has to cover operating expenses and earn net profit.

Here’s how your statement works it out for you:
Gross profit = total revenues — cost of goods sold

If your income statement shows negative gross profit — below zero — it might be because:

• your costs of goods sold (cogs) are too high
• your prices are too low
• there’s a mistake in your final stocktake or your accounting, eg costs incorrectly codes as cogs.

Also called operating costs or overheads, this is the cost of running your business, including rent, marketing and taxes. Many statements include depreciation and amortisation.

It’s a good idea to give each expense its own line under operating expenses. This makes it easier to:

• see changes over time and spot trends, eg rising electricity bills
• get clues about how to cut costs, eg comparing power companies’ prices
• track the effect of changes you make, eg switching to a new electricity company.

Businesses often find it easier to cut costs rather than increase income. The goal is the same — better profit margins. This frees up money for what you’d most like to spend it on, eg new machinery, pay rises or a marketing push.

Operating profit or EBIT

Accountants tend to talk about EBIT — which means earnings before paying interest and tax — while most other people talk about operating profit.

It’s the money you make from carrying out your core business, after operating expenses have been paid. It paints a truer picture of how good your business operations are at turning earnings into profit.

If your operating profit is positive, that’s a good sign. Your business is selling products or services for more than it costs to make them and run the business. If it’s negative, your business isn’t earning enough to cover costs. You’ll need to look into how the business is operating.

Net profit aka your bottom line

Also known as profit after income tax, this is the money your business makes minus all its expenses. It’s the quickest indicator of the health of your business.

Here’s how your statement works it out:
Net profit = income – (cost of goods sold + operating costs + interest + tax + depreciation + amortisation)

A positive net profit — above zero — shows your business makes more than enough money to cover costs. This is also called net income. If your net profit falls below zero, it’s time to find ways to earn more and/or spend less.

Depreciation is for physical assets like vehicles, machinery or computers. Amortisation is for intangible assets like intellectual property, eg licensing someone’s patent for 10 years.

Cash from customers is like revenue on your income statement but is adjusted for non-cash items, eg accounts receivable.

Employee wages can be cost of goods sold and operating expenses on the income statement – it depends on your business model. On the cash flow statement wages are adjusted for changes in holiday pay that hasn’t been paid yet.

Cash paid to suppliers is like costs of goods sold on your income statement but it doesn’t include non-cash items, eg accounts payable.

Operating expenses are also found on your income statement and in more detail.

Accounts receivable and prepaid expenses are non-cash assets on the balance sheet. If these increase or decrease, it means cash has either been paid or received by the business.

When long-term assets are bought or sold, you’ll see it on the cash flow statement.
Long-term assets are also found on the balance sheet.

Loans can give you money and cost you money. They are liabilities and can also be found on the balance sheet.

The net change in cash is often looked at to show the trend of cash flow over the period – if it’s increasing or decreasing. It’s the difference between the opening and closing balances.

The opening and closing balance shows your cash balance at the beginning of the period and the end, eg the first and last day of the month. Your cash balance can also be found on the balance sheet as a current asset.

This shows the comings and goings of cash related to your core business, eg cups of coffee sold if you run a cafe, or call-outs and fit-outs if you’re a plumber.

Your cash flow statement works out net operating cash flows from these types of line items:

• cash from customers
• cash paid to suppliers
• cash paid for operating expenses
• changes in inventory
• changes in accounts receivable
• interest paid
• tax paid.

If your net operating cash flow falls below zero, you’re not earning enough to cover costs in your day-to-day business. You may need to rely on loans to pay your bills. If it’s unplanned, it can be a sign you need to change how you do business.

Cash flows from investing

This shows the comings and goings of cash if you buy and sell:

• shares in the financial market
• land
• intellectual property.

It also includes any one-off sales of a long-term asset, eg a work vehicle.

Cash flow statements for small businesses don’t always include net investing cash flows. So it may not appear, or your accountant or bookkeeper might put “nil” in this line.

Cash flows from financing

The cash you get from taking out a loan, and the cash your business spends on dividends or repaying long-term debt.

Net financing cash flow is the total cash remaining after all transactions related to financing are tallied. It’s likely to be a negative number if you pay dividends or pay off a loan or other debt.

Closing cash balance

The total of the statement’s:

• cash flows from operating
• cash flows from investing
• cash flows from financing
• opening cash balance (closing balance from previous cash flow statement).

This then becomes your opening cash balance on the next period’s cash flow statement.

Net change in cash

The difference between your opening and closing cash balances.

It’s a good idea to check whether this has increased or decreased each time you get this statement.

If your closing balance is positive, it shows your business can do one or more of these things:

• grow
• reduce debt
• carry out its day-to-day activities without sinking into unplanned debt
• pay dividends to investors.

But if the closing balance is negative, your business can’t cover costs solely with money made from day-to-day operations over this time period. To stay in business you might have to borrow or seek investors if you can make a strong case for growth.

One or two cash flow statements with negative net change in cash isn’t necessarily anything to worry about — it may be because your business is going through a period of growth. You might be hiring more staff or investing in a project. Either way, you’ll need to see returns from this spending soon.

But several statements in a row with negative net change in cash is a cause for concern. Talk to your accountant about possible reasons. It’s commonly down to late payments from customers or suppliers — you can fix this by invoicing promptly, and politely reminding people before and soon after your payment deadline.