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.
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
Trading, Profit and Loss Account for “Central Furniture plc”
Year ended 31 March 2011
Balance sheet:
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:
Current assets:
Total assets
Liabilities
Current liabilities:
Non current liabilities:
Total liabilities
Net assets (Total assets - Total liabilities)
The second section of the balance sheet contains:
Equity:
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
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.
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
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:
External group:
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.
