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How to understand key financial documents

Finance 101

Your balance sheet and profit and loss statement are two key financial documents as they help uncover what is going right and what can be improved in your business.

Some businesses only look at their financial documents once a year, often when provided by the accountant for the end of the year accounts. This can be months after the information was provided, and you can be dismissive of the data as it’s past history. But close inspection of these documents will give clues to the on-going health of your business.


What’s the difference?

The big difference between a profit and loss statement and balance sheet is that a profit and loss statement winds back to zero at the end of each financial year, recording sales and expenses for a fixed period of time only (usually April 1st to March 31st the following year).

A balance sheet, however, is a cumulative record of what has happened in your business right from when you first started (which could be years ago). The balance sheet summarises your assets (what you own) and liabilities (what you owe). The difference between the two is what you’re worth.


How to understand a balance sheet

Your balance sheet shows how sound and financially viable your business is (you have more assets than liabilities), and the structure of debt (borrowed from others or you may have your own funds invested). It provides a snapshot of your business’s financial strength at the end of a quarter or a full financial year. It summarises the:

  • Assets that you own, and

  • Liabilities that you owe.

The difference between your assets and liabilities can tell you what your business is worth (excepting any amount for goodwill).

On the assets side of the balance sheet are:

  • Fixed assets, such as machinery. These are generally longer-term assets and include intangible assets such as goodwill and intellectual property rights. If you bought a piece of equipment ten years ago, and still use it, then it’ll be on your balance sheet.

  • Current assets are short-term assets and includes stock, debtors (customers who owe you money) and cash.

Liabilities are similarly divided into short and longer-term items:

  • Current liabilities are amounts you owe that are due for payment within one year such as suppliers’ bills and overdrafts.

  • Long-term liabilities fall due after more than one year, for example, long-term bank loans and leases.

  • Shareholder funds include share capital (amounts paid into the company for shares) and reserves (including retained profit).

The capital employed in the business will always equal fixed assets, plus current assets, less current liabilities.


Using your balance sheet

Your balance sheet gives you a quick summary of your business performance and contains information and figures you can use to measure the health and profitability of your business. These are called key performance indicators (KPIs).

Some examples of these KPIs include your:

  • Return on capital employed. For example, if you have $2 million in capital, and earn $200,000 a year in profit, this is a 10% return on capital employed. Could you earn better returns in another investment? Ideally your return is more than you’d get from a savings account.

  • Return on equity. This is profit before tax (but after interest has been deducted) as a percentage of shareholders’ funds employed in your business. Similar to return on assets, is the business generating enough profit to justify the amount of money you have invested?

  • Financial strength. This looks at how large a proportion of your financing is borrowed, and how well you could cope if business conditions became difficult. Are you funding growth from debt or business reserves?

  • Control of working capital. This is current assets minus current liabilities to determine if you can pay suppliers if they suddenly all wanted payment.


Understanding your profit and loss statement

Your profit and loss statement will show you how much money you’re making – and the amount of tax you owe. It provides a picture of your business’s trading performance over a defined period, such as a month, quarter or financial year.

A profit and loss statement typically will follow this format:

Sales (turnover)

Less cost of sales (your direct costs like raw materials)

Equals: Gross profit

Less fixed or indirect costs (your overheads like rent and salaries)

Equals: Operating profit (your profit before tax)

Less tax payable

Equals: Net profit

Using your profit and loss statement

Your profit and loss statement will allow you to study your gross profit and net profit margins. These can reveal trends that enable you to make timely changes.

Gross profit margin

Your gross profit margin is your gross profit as a percentage of turnover. For example, if your turnover is $2 million and your cost of sales is $600,000, you’ve made a gross profit of $1.4 million (a gross margin of 70%).

Therefore every $100 of sales generates $70 that goes towards paying for expenses and towards your net profit. If your gross margin percentage starts to fall, find out why and take action. Some reasons may include:

  • Rising inventory costs

  • Offering discounts

  • Theft by customers or staff

  • Selling an increased proportion of products that have lower margins

Net profit margin

Your net profit margin compares your net profit (gross profit less fixed or indirect costs) to turnover. For a business with a turnover of $2 million and a net profit of $300,000, the net profit margin would be 15% ($300,000 ÷ $2,000,000).

If your net profit margin falls, it could mean you’re paying proportionately more in expenses than you should be.

If your turnover increases from $2 million to $3 million but your net profit only goes up from $300,000 to $350,000, this can look good until you see your net profit percentage:

  • $350,000 ÷ $3,000,000 = 11.6%.

That means your net profit margin has actually dropped from 15% to 11.6%. Your profit has increased by $50,000, but you’re actually not making as much profit as a ratio from that increased turnover. This could be fine, and you may have reasons this occurred. The key is to be aware of it.

In this scenario, identify which costs have increased out of proportion to the rise in sales, so you can identify the slippage.


Summary

Take time to understand your financial statements. Inside each you will find trends that can indicate if your business is financially sound and structurally secure. If not, you should have time to make changes to ensure your business longevity. Use your accounting software like Xero, MYOB or Wave to set up various scenarios and to be better informed.

Also ask your accountant or business adviser to help you understand how to get the information you need from your Balance Sheet and Profit and Loss statement.

Find out which key performance indicators are important to your business and how to use the information in your financial documents to monitor them.

  • Use your gross profit and net profit margins as benchmarks to set improvement goals. Try to improve both on internal benchmarks (your current performance against previous results) and external benchmarks (the average for your industry type).

  • Don’t rely on just an annual profit and loss account. You can’t effectively drive your business forward using a rear-view mirror that reflects data from years ago– you need more up-to-date figures. Use your accounting software to generate more frequent profit and loss accounts, such as monthly or quarterly statements. These enable you to take prompt action to fix any negative trends before they do serious damage to the business.

  • Keep on track by using MyBusiness Live (it’s free) to see each day what’s happening across all accounts and finances.


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