Business | Financial documents

Welcome to Financial Documents: Unlocking the Business Story!

Hello future business experts! This chapter might sound intimidating, but it's actually one of the most practical and useful parts of the course. Don't worry if words like 'Balance Sheet' or 'Statement of Comprehensive Income' sound complicated—we'll break them down into simple, easy-to-understand concepts.

Think of a business's financial documents as its official report card and medical history combined. They tell managers, owners, and outsiders exactly how healthy the business is and whether it is making money.

Let’s get started and learn how to read the language of business finance!

1. Why Are Financial Documents Essential?

Financial documents are formal records of the financial activities and position of a business. They are crucial for several reasons:

• Tracking Performance: They show whether the business is making a profit or a loss over a period of time.
• Decision Making: Managers use them to make important choices, such as whether to invest in new equipment or cut costs.
• Legal Requirements: In many countries, businesses are legally required to produce and publish these reports.
• Attracting Investment: Banks and potential investors look at these documents to decide if the business is worth lending money to.

2. Statement of Comprehensive Income (The Profit and Loss Account)

The Statement of Comprehensive Income (often called the Profit and Loss Account or P&L) shows how much money a business has made or lost over a specific period (usually one year).

Analogy: Imagine this statement is your monthly bank statement summary. It shows all the money you earned and all the necessary bills you paid.

Key Components: The Step-by-Step Calculation of Profit

The P&L works like a subtractive recipe, starting high and removing costs until you reach the final profit.

1. Revenue (Sales Turnover):
   This is the total money earned from selling goods or services before any costs are taken out.
   Example: If a café sells 1,000 coffees at $4 each, the Revenue is $4,000.
2. Cost of Sales (COS):
   This is the direct cost involved in making the goods or providing the services that were sold. For a retailer, this is the cost of buying the stock. For a manufacturer, this includes raw materials and direct labour.
   
3. Gross Profit:
   This is the profit made before running costs (like rent and salaries) are deducted.
   \(Revenue - Cost\ of\ Sales = Gross\ Profit\)
4. Expenses (Overheads):
   These are the indirect costs (running costs) necessary to operate the business, but not directly linked to the product itself.
   Examples: Rent, salaries of office staff, utility bills, marketing costs.
5. Net Profit:
   This is the most important figure! It is the final profit remaining after all costs and expenses have been paid. This is the money the owners can take out or reinvest in the business.
   \(Gross\ Profit - Expenses = Net\ Profit\)

Did You Know?

The amount of Net Profit a business pays in taxes to the government is often calculated directly from this document!

3. Statement of Financial Position (The Balance Sheet)

While the P&L shows performance over a period of time, the Statement of Financial Position (often called the Balance Sheet) provides a snapshot of the business's assets, liabilities, and capital at a specific date (e.g., 31st December).

Analogy: If the P&L is a video showing the progress over a year, the Balance Sheet is a photograph showing exactly what the business owns and owes at that moment.

What the Business Owns: Assets

Assets are items of value owned by the business that can be used to generate income. We split assets into two types:

1. Non-Current Assets (Fixed Assets):
   Items that the business expects to keep for more than one year. They are used for long-term operation.
   Examples: Buildings, machinery, vehicles, land.
2. Current Assets:
   Items that are expected to be converted into cash within one year.
   Examples:
   • Inventory (Stock): Goods waiting to be sold.
   • Trade Receivables (Debtors): Money owed to the business by customers who bought goods on credit.
   • Cash: Money in the bank or in hand.

What the Business Owes: Liabilities

Liabilities are debts owed by the business to external parties. These are split based on how quickly they must be repaid:

1. Non-Current Liabilities (Long-Term Liabilities):
   Debts that must be repaid over a period of more than one year.
   Examples: Long-term bank loans, mortgages.
2. Current Liabilities:
   Debts that must be repaid within one year.
   Examples:
   • Trade Payables (Creditors): Money owed by the business to suppliers.
   • Bank Overdrafts: Short-term borrowing from the bank.

The Owner's Stake: Capital (Equity)

Capital (sometimes called Equity or Owner's Funds) represents the money initially invested by the owners plus any profits retained in the business. It is the amount that would be returned to the owners if all assets were sold and all liabilities were paid off.

The Fundamental Accounting Equation

The Balance Sheet always has to 'balance'. This means the total value of what the business owns must equal the total value of the claims against the business (what is owed to outsiders + what is owed to the owners).

4. Who Uses These Financial Documents and Why?

Different people have an interest in a company's financial documents, and they use them for different reasons. These interested parties are called stakeholders.

Managers and Owners

• Reason: To assess performance, compare current results with previous years, and set future targets.
• Document focus: P&L (to check profitability) and Balance Sheet (to check liquidity and gearing).

Banks and Lenders

• Reason: To decide whether to grant a loan and to assess the risk of lending money.
• Document focus: Balance Sheet (they look closely at liabilities and current assets to ensure the company can pay back the debt).

Government (Tax Authorities)

• Reason: To calculate how much tax the business owes (Corporate Tax).
• Document focus: P&L (Net Profit figure).

Suppliers (Creditors)

• Reason: To decide whether to allow the business to buy goods on credit.
• Document focus: Current Assets and Current Liabilities (to see if the business has enough short-term cash to pay its immediate bills).

Don't worry if this seems tricky at first...

The key is to remember the core purpose: The P&L tells you if you made money, and the Balance Sheet tells you what you own and owe at a single moment. Practice identifying where the main items (like 'Rent' or 'Machinery') belong, and you will master this chapter quickly!

Final Takeaway

Understanding these documents is not just about passing an exam; it’s about understanding the language of success. Good job making it through this essential topic! Review the key formulas, especially the Net Profit calculation and the Accounting Equation, and you’ll be ready for any question on financial documents.