How to read financial statements

How to Read Financial Statements

In this post, I'm going to show you that Financial Statements aren't difficult to understand and how everyone can get the information they need.

Whether your an employee or an employer the financial statements of the business you work in effect your job and subsequently your personal life. So you would think one of the basic things we would learn at high school is how to read them. But surprisingly it's not always the case.

So it becomes one of those mysterious pieces of information that we think only "clever" people understand or we say "My accountant looks after that for me". 

So many of us have or will go through the following scenario. We're working at our job. We hear rumours that the business may not be doing so well but we're not sure, more rumours fly around creating uncertainty. Rumours of potential job losses swirl around the office or yard. We get nervous, what's happening, we're not sure. No ones keeping us informed.

Then the first we hear there's an official problem with the business is you lose your job. It's gut-wrenching. What I always found more frustrating was why wasn't I told there was a problem within the business? Why was it kept a secret? The answer is they fear you will go before they want you to leave.

Now, let's go back 12-18 months and let's run a different scenario.

The company has open book management in place, you have weekly meetings where the MD and the management teams run through the companies financials.  He and the management team identify a cash flow problem. Staff are aware of what this means and they know what causes it.

The staff propose to hold less inventory. Also to order less but more often. They pay slightly more but inventory is turning over much more quickly. The admin team will double their efforts to chase down late payers. We ask key suppliers for an extra 30 days payment terms for the next 3 months. The warehouse team set-up an eBay store and start to eBay or the old return stock and package damaged stock turning it in cash. Old and slow-moving stock is reduced and turned into cash and not re-ordered.

As you can imagine the outcome is very different from the first scenario where the first we knew officially of trouble in the business is when we lost our job.

We have not only saved our job but the business is in a better position than it was 12 months ago, a win, win scenario. 

So let's look at the two key financial statements you need to know. Balance Sheet and Profit and Loss.

Balance Sheet

The balance sheet tells you overall how your business is doing. It tells you how liquid you are, your overall financial well being. The key number from the balance sheet is called the Ratio or Current Ratio as it can also be called. Key to note is its only a snapshot of that day in time. But will give you a good general idea of the state of the business.

You can run a balance sheet from any accounting software package. No matter the size of your business you need accounting software. Don't ever think my business is too small, just for the ease of running an accurate Balance Sheet and Profit and Loss report. It's invaluable. Xero and Quick Books are the most common.

To calculate the ratio you need the Current Assets total. Current Assets are things in your business that can be turned to cash within 12 months. Usually consists of your bank accounts and stock or inventory. 

Then you need your current liabilities. This is debts the business will need to repay in the next 12 months. In here will be supplier invoices, overdrafts, short terms loans, interest, pension commitments etc.

The Ratio formula is simply Current Assets divided by Current Liabilities. Simple! What this basically means is do you have enough liquid assets to cover your debts for the next 12 months. Basically how healthy is the business? There are lots of numbers on the balance sheet and much information can be taken from it, but the Ratio is all that's needed.

Ideally, you want to see the number above 2. This means you have twice as much liquidity compared to what you owe. A healthy place to be. A negative number means you don't have enough cash or liquid assets in the business to cover what you owe. This is a concern, not a disaster but you need to pay immediate attention to this number and put plans in place to remedy this.

Here is an example of a Balance Sheet.

Profit and Loss Statement

The Profit and Loss Statement (P&L) is the most important piece of financial information in your business or company you work for.

While the Balance Sheet tells you the overall health of your business the P&L tells exactly where your business is hurting and how to fix it.

The P&L is split into two parts. The top half deals with sales and cost of sales and associated costs. The bottom half is overheads. Then at the bottom is profit or what's left over.

The two key numbers you want from the P&L is Gross Profit and Net Profit. Presented as both a number and a percentage. 

Gross Profit is sales less cost of goods sold and the cost associated directly in those sales. For example, if I have £10,000 in sales and the cost of the product was £5000, we have £5000 in gross profit. But we had a cost of £1000 to get the product to us and £500 to get it to our customer. The gross profit is now £3500. To show as % its Gross Profit divided by Sales times by 100. in the above case or Gross Margin percentage is 35%.

Then after Gross Margin is Overhead, these are costs you have added to the business to allow it to run but are not directly related to the sales. So wages, rent, utilities, software subs, etc, etc.

The next key number is Net Profit. The formula is simply Gross Profit minus Overhead. So for the above scenario lets say we had the total overhead cost of £2500. Our Net profit is £1000. As a percentage its 10%.

If your business or the business you work in has a net margin of above 10% then it's doing well. Smaller businesses with low overheads can achieve close to 20%. Above this would make me want to look deeper into the financials. Is the owner paying himself a salary through the business would be my first question? 

If we or the staff don't know anything about the financials rumours starts to circulate. Examples:

• The business is making loads of cash
• The owner is paying himself too much
• Every £1 in sales the company must be making a net 50%.
• The owner is lining his basement in gold.

Usually all false. 

Below is an example of a P&L

Now if you have your own business go run your Balance Sheet and P&L and check the numbers. Check them weekly. Compare them against last month and last year and note the increase or decrease. Identify a trend and act fast when you do.

What if I'm an employee?

There's a great website called Companies House. Every business in the UK has to submit annual returns to Companies House. And if a company turns over £10m a year it has to submit fully audited accounts and you have access to much more information! Awesome!

So let's say I work for Cafe Nero. We see that the main company is called Nero Holdings. So I search Nero Holdings, go to Filing History and look for Full accounts and download. Simple.

Now I scroll through to the Balance Sheet, I see Current Assets at £242,809,000 and Current liabilities at £87,885,000. So Current ratio is 2.76. Great, business is in good shape. My job should be safe.

Now we find the P&L, although abbreviated we can see the numbers we need. Gross Profit is £64,401,000 Sales are £279,223,000. So Gross margin is 23.06%. A bit on the low side.

Overheads were £41,900,000, leaving a Profit of £22,501,000. So our net profit margin is 8.05%. Quite a good net profit margin.

You can do the above on any business that turns over £10m or more! I love it. It empowers the employees to learn more about the business they work in and maybe ask some questions if the numbers don't look good. Ask what's being done to address the problems in the business? Can I help? Can all the staff help?

So if you work in a company that turns over less than £10m (which is most companies) what can you look for?

You can again search the company, click Filing history and Full Accounts. Here we can find the Balance Sheet. You will be able to find Current Assets and Current Liabilities to calculate the Current Ratio or the overall health of the business.

What we don't get to see is sales, gross margin and therefore net margin. But a key line is Profit & Loss Account or P&L Account Reserve, it can be called many things but will have P&L as part of the description. This is on all sub £10m accounts. You will see a total for the latest year. This is the accumulated Profit and Losses of the company since inception. By working out the difference between the current year and previous year we can see if the business made or lost money. If the latest number is lower than the previous years then the company has made a loss. And probably time to ask the owners what's being done to improve the companies results and what you and the team can do to help.

I hope the above help you in your own business or as an employee in someone else's business understand how important financial statements area. And how they affect every single person, everywhere. It's up to us learn the key numbers and then ask questions of our employer and get involved in improving the numbers.

Best of luck

Paul Radin

See all the business posts.