Which are considered to be the working areas of accounting? (select all that apply)

Learn about financial statements and reports including profit and loss, cash flow and balance sheets.

Understanding financial statements

Financial statements are historical. They show you how your business has been operating in areas such as profitability, cash flow, assets and liabilities.

There are 3 major financial statements to understand:

• profit and loss statement
• balance sheet
• cash flow statement.

These statements are important to help you:

• meet your regulatory requirements
• understand and manage the overall success of your business
• plan for future growth.

You should produce financial statements regularly and keep them up to date.

Profit and loss statements

A profit and loss statement, also known as an income statement, shows the profitability of your business over a specific period. It can cover any period of time, but is most commonly produced monthly, quarterly or annually.

A profit and loss statement is a useful tool for monitoring business activity.

• As a business owner, it highlights where your business is succeeding and where it may be struggling.
• For investors, it shows the financial health of a business before they decide to invest, or to see what return they are getting on an existing investment.

Contents of a profit and loss statement

Your profit and loss statement will generally be split into 2 sections:

• Revenue—all income from your
  • primary business activities (e.g. sales of products and services)
  • secondary activities (e.g. bank interest)
  • any other financial gains (e.g. profit on sale of assets).
• Expenses—what you're spending on primary activities (e.g. material and labour costs), secondary activities and any other losses during the period (e.g. losses on disposal of assets).

Revenue

The most important part of the revenue section of your profit and loss statement is total sales. Secondary revenue and other income can be unpredictable, so you should focus on your primary sales revenue to grow your business.

Secondary sources of revenue can include:

• bank interest
• financial gains (e.g. profit on sales of property or assets).

Note how much sales have risen or fallen since your previous profit and loss statement.

Breaking sales figures down into individual products or product lines will help you see which products are performing well and which products need attention.

Always look to maintain or increase revenues over time. A pattern of falling revenue may indicate that your business is in trouble.

Expenses

The 2 main sets of figures in the expenses section of a profit and loss statement are:

• cost of goods sold (the cost of direct labour and any raw materials used to produce your goods or services)
• operating expenses (the cost of indirect labour and any other costs not directly linked to producing goods or services).

Aim to minimise your business costs wherever possible. Rising material costs could mean you need to find a different supplier, or find more efficient production methods. Some increases are inevitable, with inflation likely to cause costs to increase across a market over a period of time.

Operating expenses can be harder to reduce. For example, if your rent rises it may not be practical to move to alternative premises, or moving may be more expensive than paying the increased rent amount.

Check your profit and loss statement for any sudden or unexpected spikes in costs, rather than gradual increases over time (due to factors such as inflation and annual employee pay rises).

How to calculate profit

Use your profit and loss statement to extract important figures to explain your business's profitability:

• Gross profit = Total revenue - Cost of goods sold
  This is the difference between total sales and the cost of producing the goods or services you sell. This is an indicator of overall production efficiency and a key figure for setting prices and sales targets.
• Gross profit margin = (Gross profit ÷ Total revenue) x 100
  This shows what proportion of gross profit you keep from each dollar of revenue generated (e.g. 20% gross profit margin means you keep a gross profit of $0.20 for every $1.00 of revenue generated).
• Operating profit = Gross profit - Operating expenses
  This shows profit generated from core operations. It does not include expenses from interest or taxes (often called earnings before interest and tax, or EBIT).
• Net profit = Total revenue - (Costs of goods sold + Operating expenses)
  This is also known as the 'bottom line'—net profit is the total amount earned (or lost) after paying all expenses.

Balance sheets

A balance sheet (also known as a statement of financial position) is a summary of all your business assets (what your business owns) and liabilities (what your business owes). At any point in time, it shows you how much money you would have left over if you sold all your assets and paid off all your debts. This is also known as ‘owner's equity’.

There are 3 sections in a balance sheet, represented by the following:

Formula: Owner's equity = Assets - Liabilities

It is called a balance sheet because, at any given moment, each side of this equation must 'balance' out.

Assets

Cash flow statements

A cash flow statement shows how much cash is moving in and out of your business over a period of time. This reflects the 'liquidity' of your business.

Having enough cash available to pay your debts and buy materials and assets is an important part of business planning. A cash flow statement will quickly tell you if you are likely to have any issues in this area.

Cash flowing in is most often the money you get from sales, but it may also be from:

• debt repayments
• selling unnecessary assets
• rebates
• grants.

Your outgoing cash includes expenses such as:

• payments to suppliers
• wages and super
• bills
• maintenance
• other business expenses.

Read more about managing cash flow and cash-flow invoices and payments.

There are normally 3 sections in a cash flow statement, each relating to a different area of your business.

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