Nutshell: Money talks – but do we speak its language?

Financial reports and accounts are a window on how well our organisation is performing. Reading them fluently helps us to make better decisions.

In Charles Dickens’ classic tale David Copperfield, a Victorian clerk, Mr Micawber, makes a remarkably clear statement about financial probity:

“Annual income twenty pounds, annual expenditure nineteen six, result happiness. Annual income twenty pounds, annual expenditure twenty pound ought and six, result misery.”

While it doesn’t seem especially trendy in the world of fast-scaling start-ups to do something as dull as generate profit when we could be generating vast turnover, Mr Micawber offers a no-nonsense reminder that – at its core – the key to decisions that make financial as well as business sense is the relationship between ‘money in and money out’. 

It’s not always as simple as this, of course. We may choose to take a short-term financial hit in one area or product line to invest for the future. We may start off with a robust, fully funded plan and then have to change tack as events get in the way or markets change.

What is clear, though, is that leaders need to have in their arsenal an understanding of the relationships between incomings and outgoings, how these are reported, and how a comprehension of key financial KPIs can help us to make better decisions. We really do need to know that sales income is not the only indicator of success, the difference between gross and net profit and why cash is king. 

The big three

Company (or management) accounts and reports summarise an organisation’s financial activity and performance. There may be a whole range of reports that look at different elements of an organisation’s financial performance in fine detail, but there are three key ones that all leaders need to be able to read and interpret – and they are interlinked and dependent on one another. These are:

• Profit and loss (P&L) statements (also known as income statements)
• Balance sheets
• Cash flow statements

An at-a-glance comparison of their key features is provided below.

Making sense of these reports means that we need to familiarise ourselves with some basic financial concepts and terminology that make up each report. For example, in a P&L statement, we need to know the difference between:

• direct costs: expenditure directly related to the creation of a product or service – for example, raw materials or parts, direct people and equipment costs associated with the production, sales and shipping costs of that specific product or service, and
  
  
• indirect costs: expenditure on people costs (salaries and pensions) and things such as office costs and marketing that are not tied to a specific product or service, but are needed to run the business more generally.

A P&L will always relate to a specific accounting period – usually a month or a year – and can help us to calculate gross profit and net profit.

Understanding what these things mean takes the mystery out of financial reporting and will help us to feel more confident about it. There’s no shame in admitting we’re not up to speed on some of the individual terms;­ even renowned entrepreneur Sir Richard Branson (who has dyslexia) admits he was in his fifties before he understood the difference between gross and net profit.

These concepts are not difficult if explained well, but they can feel unfamiliar at first – so we should never be afraid to ask if we do not understand something. Our Glossary of financial terms provides a quick guide to some of the essentials. Terms that appear in the Glossary are identified in bold throughout this nutshell.

The profit and loss (P&L) statement

The P&L statement displays our organisation’s total revenue (the total amount of money brought in by a company's operations) versus its total expenditure (the direct and indirect costs of doing business) over a specific period of time (often a month or a year).

It is a measure of whether or not our business is profitable – telling our financial story. P&L statements are often known as the financial reporting ‘war horse’, because they can be used in so many ways – for example, for budgeting, to monitor financial performance or illustrate financial trends and comparisons. They can also be used at different organisational levels: for the business as a whole, for team or project budgets, and at a product level too.

How to read a P&L:

The literal ‘top line’ of a P&L statement shows our organisation’s total revenue, which is the money it has earned by selling its products and services. (This is sometimes referred to as ‘turnover’, but the two terms are not strictly interchangeable.)

After this, we will find listed the total ‘cost of goods sold’ (COGS) which – as we’ve seen – are the direct costs of getting our products or services to market.

Next comes other ‘operational expenses’ (indirect costs such as labour costs and office rent).

These may be fixed costs that remain the same regardless of production output (for example, rental costs and insurance) or variable costs – which vary according to the amount of output produced. These include labour, raw materials and delivery costs.

Within expenses, we might also come across some trickier concepts such as ‘depreciation’ –a calculation of the falling value of fixed assets, such as vehicles and buildings – and ‘amortisation’ – a similar concept but applied to intangible assets such as research spending and intellectual property. Both are used to spread the cost of expensive assets over several accounting periods. For example, we may depreciate the cost of new office furniture over its projected lifetime. Our finance colleagues will do this in accordance with accounting rules about what is and isn’t allowed.

To calculate our gross profit, we deduct our COGS from our revenue. Our ‘gross profit margin’ can then be worked out as a percentage by dividing our gross profit by our total revenue (and multiplying this by 100). This indicates how efficiently we are using our resources to produce our goods or deliver services.

Organisations often set benchmarks and KPIs around gross profit/margin for certain business activities and we should compare our figures with industry averages where possible.

Meanwhile, to work out our net profit – or ‘bottom line’ ­– we deduct all business costs from total revenue (including administration and overheads). It will come as no surprise to learn that this figure sits at the bottom of the P&L statement.

Our ‘net profit margin’ is net profit divided by revenue (multiplied by 100) and is a measure of profitability. A 10% net profit margin is considered average, a 20% margin is considered high (or ‘good’), and a 5% margin is low – although, again, this varies according to industry and sector, and our business objectives at any given time. For example, we might be prepared to accept lower margins on a new or evolving area of business.

Another P&L measure might be EBIDTA (earnings before interest, tax, depreciation and amortisation), which shows net profit before the deduction of interest, taxes, depreciation and amortisation. EBIDTA is a measure of the company’s general financial performance and can be used to analyse and compare profitability among companies and industries. It will not, of course, factor in the costs of capital investment such as property or equipment.

The balance sheet

A balance sheet records a company’s assets, liabilities, and shareholder equity, giving a comparison of ‘what is owned (its assets) versus what is owed (its liabilities)’ at a particular point in time.

How to read a balance sheet:

An asset is something that is owned by, or provides a benefit to the company. It can be tangible (physical – such as vehicles or equipment) or intangible. The latter do not exist in a physical form and include patents and goodwill (a company’s reputation, brand, intellectual property, and commercial secrets).

In addition, assets will either be ‘fixed’ or ‘current’:

• Fixed assets are kept for the long term and cannot be quickly converted into cash – for example, buildings, land, machinery, office furniture and vehicles.
  
  
• Current assets are cash or cash equivalents – the latter being highly liquid investments with a maturity of three months or less. These could be saleable inventory (stock) of goods, for example. The precise amounts of money owed to other organisations (debtors – also known as accounts receivable) are also shown here.

Likewise, a liability – which is any money a company owes to outside parties – may be ‘current’ (to be repaid within the year) or ‘long-term’ (to be repaid over a longer period).

People we owe money to are known as an organisation’s creditors (or accounts payable).

There are a whole host of calculations (known as ratios) that use elements of a balance sheet to assess the financial health of a business. These look at the relationships between these different elements.

For example, to gain a swift understanding of the value of our business, we can calculate its ‘net asset value’ (NAV) by adding up our total assets and deducting our total liabilities from this figure. In our example below, we can see that the NAV is £13,000.

Or, to work out our business’ short-term viability – our ability to cover short-term obligations and cash flows – we can calculate its current (or working) liquidity ratio by dividing its current assets by its current liabilities. So, in our example, we would divide current assets (which total £3,500) by ‘creditors falling due within one year’ (£3,500), giving us a ratio of 1.

The higher the ratio result, the better a company's liquidity and financial health. A ratio of less than one is clearly worrying, as it means the business doesn’t have enough liquid assets to cover its short-term liabilities. Acceptable current ratios vary by industry, but a ratio of between 1.2 to 2 is generally considered good. The latter means that the business has two times more current assets than liabilities to covers its debts.

Balance sheets are typically prepared monthly, quarterly and annually, but can be drawn up at any time to show an organisation’s current financial position.

The cash flow statement 

“Revenue is Vanity, Profit is Sanity and Cash is King” – Alan Miltz

Keeping a careful eye on cash flow is vital – especially for small or new businesses, which often fail as a direct result of cash flow issues. Helping us to do this is the cash flow statement, giving us a detailed picture of how much money we actually have to run the business: whether we’ll have the funds to cover our bills, drive growth and deal with the unexpected in the future.

Cash flow statements summarise the inflows and outflows of cash (and cash equivalents, like grants and loans) during a given period. 

• Inflows include cash sales, receipts from trade debtors (customers allowed to pay on credit), sale of fixed assets and grants and loans.
  
  
• Outflows include payments to suppliers, wages and salaries, payments for fixed assets and interest on loans.

Note that cash flow differs from profit, which is the money we have after deducting business expenses from overall revenue. This is because accounting is not done on a cash basis, but is based upon amounts receivable and payable on an ‘accruals basis’ (accruals being amounts of money that have been earned or spent, but not yet paid; for example, unpaid invoices or VAT).

How to read a cash flow statement:

At the top of a cash flow statement, we will usually find our opening cash balance – which is the last financial period’s closing cash balance (usually a month or a year).

The latest period’s cash inflow and outflow is then typically broken down into:

• Operating activities. Cash flow related to our goods and services: revenue from sales and the costs of making and selling these, including salaries and tax payments.
  
  
• Investing activities. Cash flow from buying or selling assets (for example, property, patents, equipment) – involving cash not debt.
  
  
• Financing activities. Cash flow from debt and equity financing activities (for example, money from investors, selling stocks or taking out a loan).

The total cash derived from or expended by each of the three activities is totalled to generate the total change in cash for the period. This is then added to the opening cash balance to arrive at the closing cash balance at the bottom of the statement.

Our net cash flow (total cash inflow minus total cash outflow) represents the amount of money produced or lost by a business during a given period. Positive cash flow indicates that we have more money flowing into our business than out of it over a specified period, while negative cash flow means our cash outflow is higher than our cash inflow.

Positive cash flow is obviously a heartening indication of a company’s financial health, but negative cash flow is not always a bad sign; it might simply highlight a temporary mismatch or mean that we are investing in something important (such as IT or marketing) that will enable future growth.

To ensure we have sufficient cash to meet short-term obligations, we can calculate our current working capital by deducting our current liabilities from our current assets. Negative working capital means we are unable to pay our debts.

Cash flow statements are fundamental to cash flow forecasting – which is the process of estimating the flow of cash in and out of a business over a specific period of time. Such projections are important because we need to know how much cash we will have over the coming months – not just at this precise moment in time. A forecast can flag up cash shortfalls that might affect our ability to pay suppliers or employees, for example.

In practical terms, it means tallying inflows for a particular period and deducting outflows from this figure to find our net cash flow as shown below.

Wider benefits of financial literacy

Knowledge of basic accounting is no match for the insights of a qualified finance professional. There are myriad rules and regulations about what can be accounted for where and how, which is why we need qualified financial people in organisations.

However, a modicum of financial literacy is a skill that will stand us in good stead inside and outside of the workplace. Not only can we help to maintain the financial health of our organisation or department by making better decisions and predictions, but we can also use accounting principles to inform our personal investment decisions, to manage our mortgage or other debt, or just to keep our own day-to-day finances organised.

“Money is a good servant but a bad master,” pointed out Francis Bacon. The secret is to know how to master it.

Test your understanding

• Explain what a P&L statement is used for and the key information it shows.

• Highlight the difference between a fixed and current asset.

• Outline what cash inflow and outflow is typically broken down into on a cash flow statement.

What does it mean for you?

• Review the Glossary of financial terms to familiarise yourself with common financial language that may come up at work.

• If possible, look at a recent set of monthly or annual accounts for your organisation and test your reading of them in practice.