Importance of profit and loss accounts

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Question:

Explain the importance of profit and loss accounts, balance sheets, and cash flow statements. How these statements help different people in assessing financial health of a company.

Introduction:

The first purpose of the business is profit, which enables the business to fulfil rest of the three purposes namely survival, growth and service to the community. Financial management is a basic requirement to run the business and a legal obligation from government. It plays a key role in the decision making, setting a strategy and in overall success of any business.

Accounting is divided into two broad categories of financial accounting and management accounting. Financial accounting deals with day to day business operations and is termed as “Book keeping” , also it deals with the preparation of financial statements usually at the end of a business year. In short we can say that financial accounting is a post performance activity of the business.

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Management accounting's main focus is on forecasting and helping in decision making. Chartered Institute of Management Accountants (CIMA) defines management accounting as “The application of professional knowledge and skill in the preparation and presentation of accounting information in such a way to assist management in the formulation of policies and in the planning and control of the operations of the undertaking".

Profit and loss account (P&L):

This type of account shows the profit or loss for a a company has made over a financial year. It also describes how profit or loss arose. The top section of the account is known as trading account which record buying and selling of items for the business. Trading account records income from sales and direct cost associated to those sales. It also takes balance of the stock at the beginning and end of the financial year.

Example of profit and loss account:

Trading account of “Central Furniture plc”

Year ended 31 March 2011

Category

£

£

Sales

1,200,0000

Opening stock

150,000

Purchases

400,000

Less closing stock

220,000

Cost of sales

330,000

(330,000)

Other costs

(70,000)

Gross Profit

800,000

Trading, Profit and Loss Account for “Central Furniture plc”

Year ended 31 March 2011

Category

£'000

Description

Turnover (Sales Revenue)

1200

The amount of money generated by sales. For example 4000 beds at £300 each.

Cost of sales

400

The cost of making goods or buying them. For example raw material, labour cost, cost of machines and equipment

Gross profit

800

Turnover minus cost of sales

Overheads cost

320

Indirect cost. For example insurance, building repairs, stationery, postage, computer maintenance, salary and wages, sales and marketing cost, bank charges, bank loan, interest etc.

Operating Profit

480

Net profit = Gross profit less overheads

Interest and Taxation payable

200

Money to be paid to bank or Inland revenue

Net Profit after Tax and Interest

280

Money available to pay as dividends

Dividends

170

Paid to shareholders as reward for investment in the company

Retained Profit

90

Money left for reinvestment in the business

Balance sheet:

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The balance sheet is the most important statement of any business accounts. It provides the most important business information like value of the business at a specific time, summary of the business assets and liabilities, and business ability to pay back what it owes to the market. The vital parts of a balance sheet are fixed assets, current assets, current liabilities and long term liabilities. It is named as “Balance sheet” because it is a must that the total assets and total liabilities of the business must balance.

Preparing balance sheet is a legal responsibility of every company. There are strict deadlines to submit balance sheets to the HM Revenue and Customs (HMRC), and Companies house. Shareholders are the other interest group to know about the company's performance during the last financial year. Potential lenders and investors, people who would like to buy the business, employees and trade unions are also interested in the financial health of the business to safeguard their interests associated with the company.

The specific format of the balance sheet is divided into two sections. The first section of the balance sheet contains:

Assets

Fixed assets:

  • Property (factory), plant, machinery and equipment
  • Intangible assets like goodwill
  • Investment in subsidiaries, associates and joint ventures

Current assets:

  • Stocks
  • Receivables
  • Cash

Total assets

Liabilities

Current liabilities:

  • Short term debts
  • Payables
  • Tax
  • Provisions

Non current liabilities:

  • Long term debts
  • Pensions
  • Provisions

Total liabilities

Net assets (Total assets - Total liabilities)

The second section of the balance sheet contains:

Equity:

  • Share capital
  • Share premium account

Other reserves

Retained earnings

Total shareholders equity

Total equity

There are several variations to the above format. Most common change is a double side balance sheet. In which assets are placed on the one side and the way they are funded on the other side. Another variation is current liabilities being deducted straight away from current assets. There is no fixed template of the balance sheet. So it may differ from company to company and industry to industry as well. But what do not change are the three segments of the balance sheet that is assets, liabilities and share holders equity.

So in short, we can say that balance sheet provides a clear picture to the managers and owners to take proper business decisions and formulate suitable business strategies. At the same time a strong balance sheet attract the shareholders and investors to invest their money into the business. That ultimately provides useful financial help to the company to expand their business and complete company's future strategic goals.

Example of Balance Sheet:

Balance Sheet for “Global Business plc”

Year ended 31 March 2011

Assets:

Fixed assets

10,000

Intangible Assets

5,000

Current Assets:

15,000

Bank

1,000

Stock

500

Debtors

2,000

3,500

Total Assets

18,500

Less

Creditors due in one year

Creditors

3,000

Loan

500

3,500

Creditors due after one year

loan

2,000

5,500

Net Assets

13,000

Capital & Reserves

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Issued share capital

2,000

Retained profit

11,000

13,000

Cash flow statement:

Cash flow statement was previously known as “Flow of cash statement”. It is a cash basis report covering the three important areas.

  1. Operating activities
  2. Investing activities
  3. Financing activities

Money coming into the business is known as cash in flow and money going out of the business is known as cash out flow. Cash flow statements of mature and large sized companies are different as compare to the newly entered companies in the industry. Also service industries and heavy industries cash flow statements will also present two completely different scenarios. But the purposes of the cash flow statement for any company remain same irrespective of their age, size or industry.

The first part of the cash flow statement is operating activities, which acts like an engine for the business. It illustrates the effectiveness of cash handling needed for the operational activities. Executives keep a watchful eye on operating cash to make sure it is increasing not decreasing and also cover day to day routine expenditures to maintain a smooth operation for the business.

New companies can have negative operating cash flow due to the fact that lots of investment has been made to set up the strong foundation of the business. Whereas in growing companies' receivables, inventories and accounts payable normally increase. Also stronger organisations keep a constant watch on investing cash in plants, machinery, equipments, and other fixed assets to keep them technologically strong and up to date.

Example of Cash flow statement:

Cash flow statement for “Modern Traders plc”

Year ended 31 March 2011

Cash at the beginning of the financial year

25,000

Operating Activities:

Cash receipts

725,000

Cash paid for:

Inventory

200,000

Operational and admin expense

100,000

Wages

125,000

Interest

15,000

Income Taxes

35,000

Net Cash Flow

250,000

Investing Activities:

Cash receipts:

Sales of property and machinery

40,000

Collection of principal on loan

Sales  of investment securities

Cash paid:

Purchase of property and machinery

90,000

Loan to other entities

Investment securities

Net Cash Flow

50,000

Financing Activities:

Cash receipts:

Issuance of stock

Borrowing

Cash paid:

Purchase of stock

Repayment of loans

50,000

Dividends

75,000

Net Cash Flow

125,000

Net increase in cash

75,000

End of the year cash

100,000

Financial health of a company:

Financial statements present very well formatted and organised monetary data of a business prepared for number of people who are interested in the company's financial health. These statements are intended to be understood by the people who have strong accounting knowledge and somehow are involved directly or indirectly with the company business.

There are many people and organisations interested in understanding and building relationship with the organisation. Mainly they are management, owners, investors, lenders, suppliers, employees, government bodies, competitors, shareholders, employees, and financial analysts, trade partners, rating agencies, labour unions, politicians, lobbyists, environmentalists, think tanks and many more.

The various types of financial statement users can be classifies into internal and external groups. Internal groups consist of people within the organization and external group belongs to the people outside the business but directly or indirectly involved in the business activity or can be affected due to the business activity.

Internal group:

  1. Owners: In case sole traders, owners play a vital role in management as well. Since they depend on the business for their financial needs, so they take utmost care to make sure that business is running smoothly. For this purpose they interpret the financial statements to make immediate changes and future decision making.
  2. Management: Financial statements provide appropriate guidelines to the managers for day to day and long term decision making. It helps to develop relationship with other companies in the same industry and set contractual terms for working together.
  3. Employees: Financial reports indicate the job security with the existing company. Mostly employees are considered as least effected by the financial statements. But actually employees are the first one to suffer in case of strong or poor financial statements. Employees get promoted, demoted or even fired in certain situations as well. These statements guide the employees to formulate their plan for future promotions and individual and collective bargains.

External group:

  1. Investors (current and potential): Current investors need to understand and assess the financial statements because of the simple reason of potential financial growth of the company that will earn profit for them as well. People looking for ward to invest money in companies will get a clear picture of financial health of the organisation. Based on the output potential investors can decide to invest the money in the business. Shareholders invest the money into a business to make money with minimal personal efforts.
  2. Depending on the financial health of the company investors will invest the money for a short or longer period of time. Some investors may seek a take over as well. This normally happens if the company is performing poorly and the new investor is confident of converting the company into a success by restructuring and making positive changes.

  3. Government agencies: Companies House require financial statement by law from all registered companies irrespective of small, big, private or public. All these statements are published at Companies House official publication.  Companies House is responsible for protecting corporate and consumer law and prosecuting the offenders as well.
  4. HM Revenue is another government agency which checks the financial strength of the company and make sure that the tax is paid according to the rules and regulations set by the government in tax policy.

  5. Financial institutions: Government and private banks provide short term (working capital) and long term loans to the companies to cover day to day operational costs or long term plans of expansion or buying heavy machinery and equipment. A company progressing smoothly will attract lots of lenders as compare to the company in financial troubles. Banks make money through charging interest to the companies against the money given as loan, and it is quite evident that financially strong companies will only be able to pay back loan and interest on top of it.
  6. Suppliers: Suppliers provide raw material or other services to the partner businesses. Mostly suppliers work on credit basis. So they are very keen to know the financial health of the company. A strong company will get more suppliers with good credit and flexible term and conditions whereas a company exhibiting poor financial statements will be in trouble as suppliers will not be guaranteed for the timely payments against the services or raw material provided.
  7. Competitors (current and potential): The current competitors are interested to benchmark the best performance of the company and potential competitors are interested to know about the financial health of the industry before entry.  Financial statements establish a trend for the whole industry and provide guidance to the new entrants to the industry. Also new entrants can figure the amount of investments, profit and growth.
  8. Investment advisors: Stock exchange brokers, money managers and investment analysts are the other group of people who are interested in company financial statements. This group help the investors by guiding them to buy, sell or hold their company shares. Based on their recommendations, mostly investors put their money into different companies. Normally this group has a strong clientele to serve, so they act like advisors for investments.
  9. General mass and media: General public and media are interested in financial statements to cover certain company or industry's growth or decline. They take statements not as a mode of information for some financial activities but to use it as business news.
  10. Rating agencies: In order to assign credit rating to a business, rating agencies analyse the financial strength of a company through financial statements
  11. Labour unions: Labour unions need to know the company financial strength to negotiate collective bargaining for members. Financial health is a clear indicator of company's profit and provides a base for wage increase.
  12. Joint venture partners (current and potential): Business partners need to know the financial viability of the company to carry on with the business smoothly. Franchisor and franchisee compare the business operations and profit earned at various places and situations.

  13. Other groups:
  14. There are some of the other groups of the society who are interested in the financial statements as well. For example:

    • Politicians and lobbyists to formulate the appropriate financial policies for different industries
    • Consumer advocates protect the consumer rights from the business world. They mostly focus on ethical parts of the business but knowledge about financial strength of a company can help them to push the company to spend extra money towards the betterment of the consumer.
    • Environmentalists want the companies to spend a reasonable amount of funds towards the environment protection.
    • Think tank is interested in financial statements to compare the current changes with predicted ones and formulate the strategic changes in coming years for particular industries.

Conclusion:

Financial statements are legal responsibility of every company registered to do the business in the UK. Companies prepare financial statements like profit and loss accounts, balance sheets, and cash flow statements for their own sake to run the business in a managed way. These statements keep the management up to date at any point of the business. Any operational day to day decision or long term strategic decision can not be taken without having a clear financial picture. These statements help to make short term and long term decisions.

We have internal and external groups interested in financial health of a company. Owners, management and employees form the internal group of people interested in financial outcomes to take their respective responsibilities in an appropriate and efficient manner. Owners take risk to run the business, managers are responsible to run the business and employees need to know about their job security and future growth.

Important players of external group are government, investors, lenders, competitors, suppliers and labour unions. All of them are engaged directly or indirectly with the financial health of a business. If the business grows, everybody grows and vice a versa. That is why; all these people show their great concern towards the financial health of the company and work together to make it a success.

The last group keeps an eye more on social issues and make sure that companies with healthy finance spend good money in development of the society also. Basically their function is to create a healthy environment and a good name for the company and society also.

Financial statements make everybody's life easier and different groups look into these statements with a different point of view. But end of the day everybody is working towards creating a financially, socially and ethically healthy society for themselves and generations to come.