Income statement and balance sheet - Why you should pay attention to them?
Learn how to interpret financial statements
The income statement shows the scope of activities, the company's income and expenditure and, the business result for the financial year. The balance sheet, on the other hand, presents the current assets and liabilities of the company.
Our article provides clarification on the following topics:
1. Why should an entrepreneur be interested in the profit and loss account and the balance sheet?
Every entrepreneur has a gut feeling about the profitability and cash position of their business. However, the income statement and balance sheet show the true, up-to-date situation.
In the best-case scenario, the income statement provides real-time information that can be used to support operational planning.
2. The key points of the income statement: turnover, profit, and profit for the financial year
The income statement is highly sector-specific; for example, the numbers for a service company and a company selling products will look very different. However, whatever the sector, the key figures in the income statement are turnover, profit, and profit for the financial year.
In simple terms, turnover is the total amount of goods or services sold during the financial year or reference period, minus the VAT and other taxes based on the volume of sales.
Profit is the difference between turnover, purchases, personnel costs, operating expenses, and depreciation, i.e., the operating result before financial items and taxes. The actual profit for the financial year is obtained by deducting financial income and charges, interest received and paid as well as taxes from the operating profit.
If the profit for the financial year is consistently negative, the operational precondition of the business is poor. The main purpose of the income statement is to provide information on the performance of the business and its ability to continue.
3. Comparison as a basis for analysing the income statement
It is always a good idea to compare the income statement with one of the previous financial years. Only, by comparison, one can detect the direction in which the business has developed. By comparing the numbers from one financial year to another, it is also possible to quickly identify the items that have undergone the greatest change. This enables the entrepreneur to identify, even at a quick glance, the items that require further examination.
The numbers of your own company can also be compared with the numbers of other companies in your sector. In this way, it is possible to see how one's own costs and revenues compare with those of other companies in the industry.
4. The balance sheet shows where the capital is stashed
The balance sheet shows where the company's capital is tied up. It shows the value of stock and inventory, as well as the company's receivables and other available assets. The balance sheet also shows the proportion of the company's capital invested by shareholders, capital generated by operations, and external financing.
The financial resources in the balance sheet enable the entrepreneur to determine how much money the company has available for future investments. For example, hiring staff is often a big investment for a small business. In this case, the company's financial situation must be carefully analysed.
The balance sheet also shows the amount of receivables the company has. In some industries, invoicing times can be relatively long. Long invoicing times accumulate sales receivables. A large amount of sales receivables may jeopardise the solvency of a company, especially if the company does not have large cash reserves and the costs of sales are realised before revenues.
5. A joint review of the income statement and the balance sheet
The income statement and the balance sheet individually tell different stories. However, by examining them side by side, the entrepreneur can go deeper in analysing their finances.
For example, the profit or loss for the financial year is always transferred from the income statement to equity on the balance sheet. A positive result increases equity and a negative result reduces it. Sometimes, equity can become completely negative. You can read more about this topic here: What if a limited company's equity goes into the red?
An entrepreneur can also look at the turnover rates of different capital items through the ratio of the value of the inventory in the balance sheet to the turnover in the income statement, for example. A high inventory value and a low turnover may indicate that the goods are not selling. In this case, the goods in stock are unnecessarily tying up the firm's capital.
Also, larger costs over several accounting periods are not directly added to the income statement as an expense but are divided over different accounting periods. An example of such an expense spread over more than three accounting periods could be a van purchased for company use. This van is logged in the company's balance sheet and is then taken to the income statement in the form of depreciation, piece by piece.
6. Notes to the accounts provide the background to the financial statements
Although the financial statements focus on the income statement and the balance sheet, it is also worth looking at the notes to the accounts. This is because they provide the basis for the implementation of the financial statements. Read more about financial statements: Financial statements for a sole trader or small limited company
The notes to the accounts show, for example, the company's related entities and any consolidation relationships, the plans for free capital, and the collateral used to obtain external financing. This information is not shown in the balance sheet or income statement.
The notes also show whether basic assumptions have been used in the preparation of the financial statements. For example, depreciation should be the maximum depreciation allowed by the tax authorities. However, it may be as well to use a different, industry-specific depreciation plan. In this case, it is important to look at the correct measurement of the depreciation plan and, independently of the depreciation plan, at any changes to the depreciation plan. The effect of the length of accounting periods should also be taken into consideration and the value of stocks should always be calculated on the same basis. This way, a reliable comparison can be made between the company's accounts and those of previous financial years or with those of similar companies. If the balance sheet and profit and loss figures vary widely from year to year, the assumptions made in the notes to the accounts should be checked.
