How to Understand and Use Your Annual Financial Statements

Each year your accountant completes your financial statements and income tax returns for your business. These documents are more than your annual compliance obligation, as they can help you better understand and improve what is happening in your business.

Our top insights to help you to understand your financials are as follows:

  • Accrual: Your financials will most likely be prepared on an accrual basis. This means your income and expense accounts include more than just cash transactions, they also include non-cash transactions such as depreciation or other transactions you have not yet paid for. The overall profit or loss figure is therefore not a clear representation of the total business performance.
  • Gross profit and net profit: It is important to understand the difference between the two. Gross profit represents the profit generated from the core business function (i.e., selling goods or providing services). The net profit, often referred to as ‘the bottom line’, is the gross profit less all overhead expenses.
  • Income tax expenses: This is the tax expense related to your taxable business profit for the year.
  • Current assets: All assets of the business expected to be realised within 12 months. This will include accounts receivable/debtors which is money that customers owe the business.
  • Fixed assets: All the property, plant and equipment, and furniture and fittings of the business. These items are usually subject to a depreciation claim.
  • Current liabilities: All liabilities of the business that need to be paid within 12 months.
  • Accounts payable/creditors: Money that the business owes to suppliers.
  • Non-current liabilities: Liabilities of the business that do not need to be paid for at least 12 months.
  • Equity: Equity is equal to the total assets minus the total liabilities of the business. If equity is positive, then the business assets are greater than the business liabilities. If equity is negative then the opposite applies, and directors need to consider the solvency position of the business.

Once you understand the information being presented on financial statements, you can use this information for deeper analysis of your business performance. Several basic analysis techniques are as follows:

  • Current Ratio: Comparing current assets to current liabilities of a business provides insight into the financial health of the business. If the financials repeatedly, or drastically, show that the current liabilities outweigh current assets, the financial health of your business needs serious attention. If this is the case, the business will typically require more cash, and it will need to become more liquid. If the ratio between current liabilities and assets is poor, the business is likely to have poor cashflow management, or be generating an insufficient level of profit.
  • Gross Profit Ratio: Sales are important for any business, however incorrect sales can be damaging to your business. The gross profit margin is calculated by dividing the gross profit by the sales. A low ratio for your industry requires investigation, and may be caused by incorrectly pricing your products and services, or inefficiencies in purchasing and production.

It is important that business owners understand their financial statements as these documents can be used to identify areas for improvement, and for growing a profitable business. To help you better understand your business results and target the key areas for improvement, consult your local Accru adviser.

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