Most business publish three financial statements, usually annually but sometimes more frequently. These are the profit and loss account (income statement), the balance sheet and the cash flow statement. In general terms these help to provide the answers to three basic questions about an business.
No matter which user group we are considering, it is possible to express in very general terms the questions that most users will be asking when they are reviewing a business’s published financial statements. Basically someone who is reading accounts will be trying to find the answer to one or more of the following three questions:
Question-1: What Return Is This Business Making?
The owners and potential investors will be interested in what sort of return they can earn from their investment in the business. IRS (Tax Office) will wish to calculate the amount of any taxation due. Competitors will be interested in whether the business is earning a higher or lower return than they are achieving themselves. These people will need to know:
- What revenue is the business generating?
- What costs are they incurring in generating that revenue, and do the costs exceed the revenue?
- If the business is making a profit, what have they decided to do with it? How much has been reinvested in the business for future growth? How much has been taken out of the business by the owners?
Questions of this sort can be answered by looking at the “profit and loss” account (income statement).
Question 2: What Is The Risk Associated with This Business?
A potential lender will wish to know whether there is a risk that the money to be lent will not be repaid. A supplier who has been asked to send goods with payment due later will want to know whether the bill will be paid when it falls due.
These people will need to know:
- What does the business owe to other people?
- What valuable items (assets) does the business possess as security for my loan?
- How much of the business’s capital is borrowed and how much has been invested by the owners?
The term used to describe the relative proportion of borrowed money and the owner’s investment is “gearing” or “leverage“. One of the first places to look in order to answer questions such as these is the business’s “balance sheet”.
Question 3: Does The Business Have Sufficient Cash?
We all know that it is not uncommon for an business to be generating a profit and yet still be desperately short of cash. We, then searching the reasons for this, which include the need to spend money in advance of making sales or carrying out fund-raising activities. The ability of the business to generate cash from its activities and to use the cash wisely is of utmost importance to its survival.
The questions which users will be asking in respect of cash include:
- How much cash does the business generate from its activities?
- Is there sufficient cash to cover the business’s investment for future growth?
- If there is not sufficient cash from the business’s own activities, what sources are used to make up the cash shortfall?
The “cash flow statement” will help to provide the answers to these questions.
TIPS: A mnemonic that you might find useful to remember ‘the three questions’ is ‘the three Rs’:
Return? – Profit and loss account (income statement)
Risk? – Balance Sheet
Readies? – Cash Flow statement.