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Understanding Your Financial Statements

The Importance of financial statements.

In my experience as an Accountant for over 10 years, I’ve found that my clients have had one universal issue: Understanding their Financial Statements. This blog post has been on my list of things to get around to doing for a while, as I feel that small business owners need to be empowered as much as possible This is as empowering as it gets – knowing a bit of the accounting jargon and understanding the numbers and accounts better.

I recently met with a new client who advised me that he had actually studied accounting just so that any accountant that he would have dealings with could not “Pull the wool over his eyes”. In my experience, I have met some fellow professionals that have left a bitter taste in my mouth, so I am not surprised that the average entrepreneur feels this way. I personally pride myself in complete transparency which is why I do business the way that I do, and started this blog: To empower my clients and readers with the tools that they need to succeed in business.

Before we begin going over the various elements of financial statements, it’s important that you understand the critical role that these reports play in your business. These are drawn up not just for the various statutory compliance obligations, but to benefit you in many ways.

They help you make better decisions.

Financial statements are a vital tool when it comes to making crucial business decisions as they give you clear, accurate records as to how your business is actually performing. With this information you can then track your business’s financial fitness. They also play a crucial role in helping you determine how much disposable cash is available for business use. This information greatly assists in times when you may have to make certain growth or management decisions, as you’ll have accurate figure to base your decisions on.

Tax returns.

Keeping your accounting up-to-date – and having financial statements drawn up based thereon – will ensure that you have all the information you need for tax season. The information found in your financial statements is the information that you will use to base your various income tax returns on.

 

Proof of your success.

They provide historical records of how well your business is doing financially. This will assist when making not only the crucial business decisions we spoke of earlier, but will also be used should you ever need to secure additional funding.

 

Statutory compliance.

Various laws such as the Companies Act of 2008, require companies to have financial statements completed within 6 months of their financial year end. This is not only limited to registered entities. You will also be required to have financial statements drawn up if you are a sole proprietorship or partnership within the same time frame.

As of 1 September 2018, the Companies and Intellectual Properties Commission (CIPC) announced that submitting AFS or FAS will be a mandatory requirement when submitting your CIPC Annual Returns. The South African Revenue Services (SARS) also require these documents for verification’s and audits. Further reasons to get compliant as quickly as possible as the CIPC will start the deregistration process should you miss a submission, and SARS love handing out penalties and interest.

The Elements of Financial Statements.

To help you understand the financial reports and statements that your accountant prepares for you a bit better, we’re going to cover the most used statements which are the Balance Sheet and Profit & Loss Statement.

 

The Balance Sheet.

 

1. Assets.

These are possessions of the business that will bring the business benefits in the future. In other words, it’s everything the company owns. Some examples of assets include your customer accounts, vehicles, bank accounts and investments.

 

2. Liabilities.

Simply put, liabilities are the debts of the business. They are everything that the company owes to another entity or individual. Liabilities include items such as supplier accounts, loans, credit cards, bank overdraft and your company’s tax liability. Your company will incur a liability if they do not have the cash on hand to purchase something and should need to apply for credit to do so.

 

3. Equity.

This sums the net worth of your small business once you’ve totalled up everything that your business owns (Assets) and have deducted everything owed to creditors (Liabilities).

For a sole proprietorship/ partnership, equity is referred to as “owners’ equity” whereas in a corporation, it is referred to as “shareholders’ equity”.

 

The Profit & Loss Statement.

 

1. Revenue/ Turnover.

Revenue is money that is made by your business from its various activities. This could be from sale of goods/ services to your customers. It could further include fees earned, interest revenue, and interest income. If the income is earned as a result of a main business activity, it is an operating revenue, whereas if it is accumulated as a result of a secondary activity (such as passive income), it is known as non-operating revenues/ other income.⁠

 

2. Cost of Sales.

These are the direct costs associated with the production of the company’s goods/ services. The amounts included in cost of sales could range from materials used to produce goods to the labour costs paid to staff assigned to make the goods/ carry out the services.

 

3. Gross Profit/ Loss.

The gross profit/ loss entry reflects the difference between your Sales/ Turnover and Cost of Sales. This is the amount before other income, operating expenses and taxes. Should you have a gross profit, this would mean that your sales/ turnover amount was higher than you cost of sales. If you find yourself in a gross loss situation, this would mean that your cost of sales was higher than your sales/ turnover and you had a deficit.

 

4. Other income.

This is income that is derived from other sources. Think interest on investments, royalties or any other fees collected that aren’t relating to your company’s core activities.

 

5. Expenses/ Operating Expenses.

These are the costs of running your company. Examples of these include interest expense, rent, utilities, wages, depreciation, current tax liability etc.

 

6. Net Profit/ Loss.

The net profit/ loss of a company is the amount after other income has been added and expenses/ operating expenses have been deducted from your gross profit/ loss. It can also be referred to as net earnings or net income.

AFS are formed by the general grouping of the line items of the above elements. Revenue, other income and expenses will form to make the Income Statement, also known as the Profit and Loss Statement. Assets, Liabilities and Equity will form to make the Balance Sheet. The changes in the elements will be in the Cash Flow Statement. Notes to Financial Statements are additional information at the end of the AFS. These help explain specific items in the statements and provide a clearer picture as to the business’s financial condition.

 

If you’ve found this blog post useful, I’d love to hear from you. Please leave a comment!

This post may contain affiliate links. Please read our affiliate disclaimer here.

Magdalene van der Walt

Magdalene van der Walt

Magdalene van der Walt is a business accountant, cloud accounting specialist and writer. She assists female and creative entrepreneurs become business-empowered by providing accounting services, e-books + resources, and practical advice so that they can manage their businesses with confidence. In 11 years of accounting work, she has gained extensive experience from her time employed in large, international firms and companies, as well as 6 years’ in running her own digital accounting business. Magdalene has been featured in Female Entrepreneur SA’s e-magazine Leading Ladies, has written 2 business e-books, and has developed several resources for the aspiring entrepreneur. She lives in Durban, South Africa with her fiancé, is a mother to a son, two daughters, and stepmother to another.

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