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Unlock This CourseFinancial statements are like a business's report card - they tell us how well a company is doing financially. Just like you might check your bank balance before buying something expensive, business owners and managers use financial statements to make smart decisions about their companies.
Think of it this way: if you were thinking about buying shares in a company or lending money to a business, wouldn't you want to know if they're making money or losing it? That's exactly what financial statements help us figure out!
Key Definitions:
Imagine trying to drive a car without a speedometer, fuel gauge, or any dashboard indicators. You'd have no idea how fast you're going or if you're about to run out of petrol! Financial statements are like a business's dashboard - they provide crucial information that helps managers steer the company in the right direction.
There are three key financial statements that businesses use to make decisions. Each one tells us something different about the company's financial health.
This statement shows whether a business made money or lost money over a specific period (usually a year). It's like checking if you earned more pocket money than you spent last month.
All the money coming into the business from sales. This is the "income" part of the income statement.
All the money going out of the business for costs like rent, wages and materials.
What's left when you subtract expenses from revenue. Positive = profit, negative = loss.
Pizza Palace's profit and loss account shows they earned £50,000 from pizza sales last year but spent £45,000 on ingredients, rent and wages. Their profit was £5,000. The owner can use this information to decide whether to open a second shop or find ways to reduce costs.
The balance sheet is like a snapshot of what a business owns and owes at a specific moment in time. It's similar to making a list of all your possessions and all your debts on a particular day.
Everything the business owns that has value - cash, equipment, buildings, stock and money owed by customers. These are split into current assets (easily turned into cash) and fixed assets (long-term items like machinery).
Everything the business owes to others - loans, money owed to suppliers and unpaid bills. Current liabilities must be paid within a year, whilst long-term liabilities can be paid over several years.
Now that we understand what financial statements show us, let's explore how businesses actually use this information to make important decisions.
Business managers compare their financial statements from different time periods to see if the company is improving or getting worse. This is called trend analysis.
TechStart's profit and loss accounts show their revenue grew from £100,000 to £150,000 over two years, but their expenses also increased from £80,000 to £140,000. Whilst revenue is growing, profit has actually decreased from £20,000 to £10,000. The management team decides they need to control costs better rather than just focus on increasing sales.
When businesses want to buy new equipment or expand, they use financial statements to see if they can afford it and if it makes financial sense.
Check if there's enough cash available for the investment without putting the business at risk.
Look at whether profits are stable enough to support loan repayments if borrowing is needed.
Estimate if the investment will generate enough extra profit to justify the cost.
The cash flow statement tracks the actual movement of cash in and out of the business. This is crucial because a business can be profitable on paper but still run out of cash to pay bills!
Cash generated from normal business activities like selling products and paying suppliers. This should be positive for a healthy business.
Garden Centre Green has high sales in spring and summer but very low sales in winter. Their cash flow statement helps them plan by showing they need to save cash during busy months to cover expenses during quiet periods. Without this planning, they might run out of money to pay staff wages in January even though they're profitable overall.
Smart business owners don't just look at their own financial statements - they also compare their performance with similar businesses in their industry.
This involves comparing key financial figures with industry averages or direct competitors to see how well the business is performing.
Profit margins, sales growth rates and efficiency measures help identify areas where the business is doing well or needs improvement compared to competitors.
Financial statements help businesses make big strategic decisions that affect their future direction.
Should the business grow bigger or focus on improving what it already does? Financial statements provide the evidence needed to make this choice.
Crusty's Bakeries has three shops and is considering opening a fourth. Their financial statements show that whilst Shop 1 and Shop 2 are very profitable, Shop 3 (opened last year) is still making losses. Instead of expanding, they decide to focus on making Shop 3 profitable first. This decision saves them from potentially losing money on a fourth shop whilst they still have problems to solve.
Different groups of people need information from financial statements to make their own decisions about the business.
Want to know if the business will give them good returns on their investment.
Need to see if the business can repay loans before lending money.
Want assurance that their jobs are secure and the company can pay wages.
Whilst financial statements are incredibly useful, they're not perfect. Smart decision-makers understand their limitations.
Financial statements only show what happened in the past, not what will happen in the future. They also don't capture everything important about a business, like employee satisfaction or customer loyalty. External factors like economic changes or new competitors can make historical financial data less relevant for future decisions.