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Unlock This CourseEvery business needs to keep track of its money - how much it makes, spends, owns and owes. Financial documents are like a business's report card, showing how well it's doing. Learning to read these documents is like being a detective, looking for clues about whether a business is healthy or struggling.
Think of it this way: if you wanted to know how well your favourite football team was doing, you'd look at their league table, goals scored and wins versus losses. Financial documents do the same thing for businesses.
Key Definitions:
This document tells the story of a business's trading over a year. It starts with sales revenue (money coming in), then subtracts all the costs (money going out) to show if the business made a profit or loss. It's like your bank statement, but for a whole business.
The P&L account follows a simple structure that tells a clear story about business performance. Let's break it down step by step:
Every P&L account contains the same basic elements, arranged in a logical order that shows how profit is calculated:
The total money earned from selling goods or services. This is the starting point - everything else is subtracted from here.
Direct costs of making the products sold, like raw materials and factory wages. Subtract this from revenue to get gross profit.
Running costs like rent, advertising and office salaries. These are subtracted from gross profit to get net profit.
TechStart Ltd makes mobile phone accessories. Last year they had sales of £500,000, cost of sales of £200,000 and expenses of £150,000. Their gross profit was £300,000 (£500,000 - £200,000) and net profit was £150,000 (£300,000 - £150,000). This 30% net profit margin shows they're doing well!
If the P&L account is like a film showing what happened over a year, the balance sheet is like a photograph taken on one specific day. It shows what the business owns (assets) and what it owes (liabilities) at that moment.
Every balance sheet must balance - that's why it's called a balance sheet! The fundamental equation is:
Assets = Liabilities + Owner's Equity
Things the business owns that have value. Fixed assets like buildings and machinery last a long time. Current assets like stock and cash can be quickly turned into money.
Money the business owes to others. Current liabilities must be paid within a year (like supplier bills). Long-term liabilities can be paid over several years (like bank loans).
Raw numbers from financial documents don't tell us much on their own. It's like knowing a footballer scored 10 goals - is that good? We need to know if they played 5 games or 50 games! Financial ratios help us make meaningful comparisons.
There are several important ratios that help us assess different aspects of business performance:
Gross Profit ÷ Sales × 100. Shows what percentage of sales is left after paying for goods sold. Higher is better.
Net Profit ÷ Sales × 100. Shows what percentage of sales becomes actual profit. This is the bottom line!
Current Assets ÷ Current Liabilities. Shows if the business can pay its short-term debts. Around 2:1 is ideal.
Café A has sales of £100,000 and net profit of £15,000 (15% margin). Café B has sales of £80,000 and net profit of £16,000 (20% margin). Even though Café A makes more total sales, Café B is more efficient at turning sales into profit!
One year's figures tell us something, but the real insights come from comparing performance over time or against similar businesses. This is where financial analysis becomes really powerful.
There are three main ways to analyse financial performance, each giving different insights:
Comparing the same business over several years to spot patterns. Are profits growing? Are costs increasing? This shows if the business is improving or declining.
Comparing your business with similar companies in the same industry. This shows if you're performing better or worse than rivals and where you might improve.
The whole point of analysing financial documents is to make better business decisions. The numbers tell us what's happening, but we need to understand what actions to take next.
Financial analysis can reveal problems before they become serious. Here are some red flags to watch for:
If profit margins are declining, costs might be too high or prices too low. Action needed to improve efficiency or pricing.
Low current ratio or falling cash levels suggest the business might struggle to pay bills. Need to improve cash flow urgently.
Too much borrowing makes the business risky. High interest payments reduce profits and limit future options.
SportShop Ltd noticed their current ratio had fallen from 2.1 to 1.3 over two years and their net profit margin dropped from 12% to 8%. They analysed their costs and found they were holding too much slow-moving stock and their rent had increased significantly. They negotiated better supplier terms, reduced stock levels and moved to a cheaper location. Within a year, their ratios improved and profits recovered.
While financial documents are incredibly useful, they don't tell us everything about a business. It's important to understand what they can and can't show us.
Financial analysis has some important limitations that we need to consider:
Understanding how to analyse financial documents is a crucial business skill. It helps owners, managers, investors and lenders make informed decisions. Remember, the numbers tell a story - your job is to read that story correctly and decide what actions to take. Like any skill, it improves with practice, so keep analysing different businesses and comparing your predictions with what actually happens!