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Unlock This CourseFinancial documents are like a business's health check-up report. Just as a doctor uses test results to understand your health, business managers use financial documents to understand how well their company is performing. These documents tell the story of where money comes from, where it goes and what the business owns or owes.
Think of it this way: if you wanted to know if your favourite football team was doing well, you'd look at their league table, goals scored and wins. Similarly, businesses use financial documents to see if they're "winning" in the market.
Key Definitions:
Every business produces three essential financial documents. The Profit and Loss Account shows if the business made money, the Balance Sheet shows what it owns and owes and the Cash Flow Statement tracks actual cash movements. Together, they give a complete picture of financial health.
The Profit and Loss Account (P&L) is like a business's report card for a specific period, usually a year. It shows whether the business made a profit or loss by comparing all the money coming in (revenue) with all the money going out (expenses).
A typical P&L account follows a simple structure that tells the story of how a business performed:
The total money earned from selling goods or services. This is the starting point and shows the business's earning power.
Direct costs of making or buying the products sold. For a bakery, this would include flour, eggs and other ingredients.
Revenue minus Cost of Sales. This shows how much profit is made before considering other expenses like rent and wages.
TechStart Ltd, a small software company, had revenue of £200,000 last year. Their cost of sales (mainly software licences and hosting) was £80,000, giving them a gross profit of £120,000. However, after paying rent (£30,000), salaries (£70,000) and other expenses (£15,000), their net profit was only £5,000. This shows they need to either increase sales or reduce costs to improve profitability.
A balance sheet is like taking a photograph of everything a business owns and owes at a specific moment in time. It's called a balance sheet because it must always balance - what the business owns must equal what it owes plus what belongs to the owners.
The fundamental rule is: Assets = Liabilities + Owner's Equity
Everything the business owns that has value. This includes cash, stock, equipment, buildings and money owed by customers.
Everything the business owes to others. This includes loans, money owed to suppliers and unpaid bills.
The value that belongs to the business owners. It's what would be left if all debts were paid off.
While the P&L shows profit, the cash flow statement shows actual cash movements. A business can be profitable on paper but still run out of cash if customers don't pay on time or if too much money is tied up in stock.
Cash is the lifeblood of any business. You can't pay wages with profit - you need actual cash. Many profitable businesses fail because they run out of cash, which is why monitoring cash flow is crucial for survival and growth.
Financial ratios are like comparing different players' statistics in football. They help us understand performance by comparing different numbers from financial documents. Here are the most important ones for decision making:
These ratios show how good a business is at making profit:
Gross Profit ÷ Revenue × 100. Shows what percentage of sales becomes gross profit. Higher is better.
Net Profit ÷ Revenue × 100. Shows what percentage of sales becomes final profit after all expenses.
Net Profit ÷ Capital Employed × 100. Shows how efficiently the business uses invested money.
These show whether a business can pay its short-term debts:
Current Assets ÷ Current Liabilities. A ratio of 2:1 means the business has £2 of current assets for every £1 of current debt. Generally, between 1.5:1 and 2:1 is considered healthy.
Retail Success Ltd has a current ratio of 2.1:1 and a gross profit margin of 45%, while Struggling Stores Ltd has a current ratio of 0.8:1 and a gross profit margin of 15%. This analysis immediately shows that Retail Success is in a much stronger financial position - they can easily pay their debts and make good profits on their sales. Struggling Stores may face cash flow problems and should focus on improving their pricing or reducing costs.
Financial analysis isn't just about calculating numbers - it's about using those numbers to make smart business decisions. Here's how managers use financial documents:
Before investing in new equipment or expanding the business, managers look at financial documents to see if they can afford it and whether it will improve profitability. They might ask: "Do we have enough cash?" or "Will this investment give us a good return?"
Banks use financial documents to decide whether to lend money to a business. They look at profitability, cash flow and debt levels to assess risk. A business with strong financial ratios is more likely to get a loan with better terms.
Managers regularly compare current financial performance with previous periods and industry averages. If profit margins are falling or cash flow is tightening, they can take action before problems become serious.
Financial documents can reveal warning signs like falling profit margins, increasing debt levels, or poor cash flow. Smart managers spot these early and take corrective action, such as reducing costs, improving efficiency, or seeking additional funding.
While financial documents are incredibly useful, they have limitations. They only show past performance, not future potential. They don't capture everything important about a business, such as employee morale, customer satisfaction, or market reputation. Also, different accounting methods can make comparing businesses difficult.
Smart decision makers use financial analysis alongside other information like market research, customer feedback and industry trends to get a complete picture before making important decisions.