Why a business produces financial statements
Definition
Financial statements: the formal reports a business produces at the end of its trading year to record what it earned, what it spent, and what it owns and owes, so its performance and position can be judged.
- Every day a business records sales, purchases, wages and bills, and at the end of the trading year those thousands of entries are pulled together into one small set of formal statements.
- The statements do two jobs: they record what has happened in a form that can be checked, and they report it to the people who need to know.
- Because they are prepared to a common standard every year, a reader can compare this year with last year, or one business with another, and trust that the two sets of figures mean the same thing.
Note
The two statements themselves, the income statement and the statement of financial position, and the lines inside each one, are taught in the article on the components of financial statements.
Assessing business performance
- Profit or loss: the statements show whether the year ended in profit or in loss, which is the clearest single test of whether the business is working.
- Direction of travel: because earlier statements are kept, this year's revenue and profit can be set against last year's.
- That turns one isolated result into a trend, which is what tells the owner whether the business is improving or slipping.
- Where the money went: costs are listed separately from revenue, so a fall in profit can be traced to a cause such as ingredients getting dearer or the rent going up, rather than being a mystery.
Example
- Greggs publishes its financial statements every year, so anyone can see whether its revenue grew and whether profit grew with it.
- If revenue rose while profit fell, the statements have already told you that costs rose faster than sales, which is the point at which managers start looking at suppliers and overheads.
Helping make business decisions
- Prices and costs: if the statements show costs climbing faster than revenue, the owner can raise prices, change supplier or cut a particular expense, and can point to a figure that justifies the change.
- Expansion: a business deciding whether to open a second branch uses past profit to judge whether it can fund the move from its own money or afford the repayments on a loan.
- Stopping something: where one product or one branch is losing money, the statements make the loss visible so it can be changed or closed instead of being quietly subsidised by the rest of the business.
Example
- Ashworth Joinery, a small furniture maker in Nottingham, compares two years of statements and finds revenue flat while expenses have risen by £9,000.
- The owner takes the workshop rent and the insurance renewal as her first targets, because the statements show her exactly which expense lines grew.
Who reads the statements inside the business
- Owners and shareholders: they judge whether the business performed well and whether the return on the money they put in is worth staying invested for.
- Managers: they use the statements to make the decisions above and to catch problems such as creeping overheads while they are still small.
- Employees: they read them to judge how secure their jobs are and whether the business can afford the pay rise they are about to ask for.
Who reads the statements outside the business
- Lenders: a bank such as Barclays reads them before agreeing to lend, because it wants evidence that profit is large enough and steady enough to cover the repayments.
- Investors: somebody thinking of buying shares reads the published statements to decide whether the business is worth putting money into, because that is the only detailed financial information available to them.
- Suppliers: they check them before offering credit, because supplying goods now and being paid in 30 days is only safe if the buyer will still be trading and able to pay.
- HMRC: the UK tax authority uses the profit figure to work out how much tax the business owes, which is why the figures have to be accurate as well as useful.
Note
The statements do not change from reader to reader; each reader brings a different question to the same pages, which is why one set of figures has to be reliable enough to answer all of them at once.
Published accounts and who can read them
- A limited company must produce financial statements every year and file them at Companies House, so they stop being private notes and become public documents.
- That means anyone can look them up, including people the company would rather not show them to: Aldi can read Tesco plc's published revenue and profit, and a small Ltd company's rival on the same high street can read its accounts just as easily.
- A sole trader does not publish accounts, so no competitor can look them up, but the owner still needs statements for HMRC and for any lender who asks.
Common Mistake
Publishing is a real cost of becoming a limited company: the loss of privacy lets a competitor see your revenue, your profit and how much you have borrowed.
Exam technique
When asked to explain why a business produces financial statements, pair a purpose with the reader who needs it, because a purpose with nobody reading it is only half an answer.
Self review
- What two jobs do financial statements do?
- Give two decisions a business could make better after reading its own statements.
- What does a bank look for in a set of financial statements, and how is that different from what HMRC looks for?
- Why can a competitor read a limited company's financial statements but not a sole trader's?
- Why does an employee have an interest in the accounts?
