Financial Statements Explained: Balance Sheet & Income Statement
Achieving Business Objectives Through Financial Insight
Effective financial diagnosis helps companies achieve core objectives:
- Survival: Continuing operations and meeting all commitments over time.
- Profitability: Generating sufficient income to adequately reward shareholders and fund necessary investments.
- Growth: Increasing sales, market share, and overall profits.
Limitations of Financial Statement Analysis
Analyzing financial statements comes with several important limitations to consider:
- Historical Data Reliance: Analysis is usually based on historical data, which may not always provide sufficient forward-looking perspective on the company’s future direction.
- Snapshot in Time: Company details often refer to the financial year-end date (e.g., December 31st). For many companies, this final situation may not be fully representative due to significant seasonality in sales, production costs, collections, or payments.
- Potential for Manipulation: Accounts can sometimes be manipulated, meaning they may not always adequately represent the true financial reality.
- Lack of Comparative Data: It is not always possible to obtain comparable sector data to benchmark the company’s performance effectively.
These limitations underscore the importance of exercising adequate caution when drawing conclusions from financial statement analysis.
Understanding the Balance Sheet
The Balance Sheet is a fundamental accounting statement that reflects a company’s financial position at a specific point in time. It comprises the company’s assets, liabilities, and equity. The balance sheet is structured around the accounting equation: Assets = Liabilities + Equity.
Assets represent what the company owns and what it is owed. Liabilities represent what the company owes to others. Equity represents the owners’ contributions and retained earnings.
Assets: What a Company Owns and Is Owed
Assets are resources controlled by the company from which future economic benefits are expected to flow.
- Assets: What the company owns (e.g., property, equipment, cash).
- Rights: What the company is owed (e.g., accounts receivable).
- Investment: How the company’s funds have been utilized.
Fixed Assets (Non-Current Assets)
Assets that are expected to remain in the company for more than one year. This includes property, plant, equipment, and long-term deferred expenses.
Current Assets
Assets that are expected to be converted into cash, sold, or consumed within one year or the company’s operating cycle, whichever is longer.
Stocks (Inventory)
These are materials and products the business processes, holds for sale, or uses in production.
Available (Cash and Equivalents)
Money and credit institution accounts with immediate availability.
Attainable (Receivables)
Assets that are not part of inventory or cash, but are expected to be collected, such as accounts receivable.
Liabilities and Equity: Sources of Funding
Liabilities and Equity represent the sources of funding for a company’s assets.
- Debts: What the company owes to external parties.
- Capital: Contributions from the owners (shareholders’ equity).
- Funding Source: Where the company’s financial resources have been obtained.
Equity (Shareholders’ Equity)
All liabilities that are not considered debt, representing the owners’ stake in the company.
Long-Term Liabilities
Composed of all debts with a maturity exceeding twelve months, including provisions for risks and charges, and long-term debt.
Current Liabilities
Includes debts maturing within twelve months and coincides with short-term creditors.
Understanding the Profit and Loss Account (Income Statement)
The Profit and Loss Account, also known as the Income Statement, summarizes a company’s revenues, costs, and expenses over a period of time, typically a quarter or a year.
Result = Income – Expenditure
Net Sales
Includes revenues from the company’s primary operating activities, from which sales discounts, rebates, and sales taxes are deducted.
Variable Manufacturing Costs
All manufacturing costs directly attributable to sales, such as raw materials, direct labor, and direct factory costs. Consumption of raw materials is calculated from purchases and changes in inventory.
Variable Marketing Expenses
All marketing costs directly attributable to sales or the delivery of sales, such as commissions. All variable costs are often collectively referred to as the cost of sales or cost of goods sold.
Depreciation
The periodic wear and tear of tangible and intangible assets.
Structure Expenses (Operating Expenses)
All those costs incurred due to the company’s operational structure and not directly attributable to sales.
Financial Income and Expenses
This group includes all financial expenses and revenues of the company. This encompasses not only bank charges (interest and fees) but also interest charged by financial firms, cash discounts received or given, and costs related to trade effects (e.g., bill discounting).
Corporation Tax
The tax on the profit for the period, distinct from other taxes (e.g., property tax) that the company pays and which are often included in structure expenses.
Value Added Tax (VAT)
A consumption tax on goods and services, typically collected by businesses on behalf of the government.