Reading a set of accounts

The balance sheet: a photograph

The balance sheet describes a single instant. On one side sit the things the business controls, from cash and stock to equipment and amounts owed by customers. On the other sit the claims against those things: amounts owed to suppliers, loans, tax due, and whatever remains for the owners. The two sides are equal by construction, because everything the business has came from somewhere.

Read it for shape rather than size. Is what is owned mostly cash and stock that can be turned into money quickly, or mostly equipment that cannot? Is what is owed due next month or in five years? A business can be large and fragile or small and robust, and the balance sheet is where the difference shows.

The profit and loss account: a film

The profit and loss account covers a stretch of time instead of an instant. It starts with what was earned, subtracts what it cost to deliver, subtracts the running costs of existing at all, and reports what remains. The order matters: the difference between the first two lines shows whether the work itself is economically worth doing, and everything below shows whether the organisation around the work is affordable.

The word profit does not mean money in the bank. Under accrual recording, a sale counts when it is made and a cost counts when it is incurred, so a period can show a healthy profit while the bank balance falls. That is not a contradiction and not usually a deception. It is the reason the third statement exists.

The cash flow statement: the reconciliation of the other two

The cash flow statement explains the movement in the bank between two balance sheets, and sorts that movement into three kinds: cash from actually trading, cash spent on or received from long-lived assets, and cash raised from or returned to lenders and owners. It is the least glamorous of the three statements and usually the most informative.

The reason is that profit involves judgement and cash does not. How quickly an asset wears out, when a sale is complete, whether a debt will be collected, all involve estimates. Whether money arrived in the account does not. A persistent gap between reported profit and cash generated by trading is the single most useful signal a reader of accounts can look for.

Reading the three together

The useful habit is to treat any figure in one statement as a question addressed to the other two. Profit rose but cash fell: has the money gone into stock or into amounts owed by customers, both of which appear on the balance sheet? Cash rose but profit did not: was an asset sold, or was a loan taken? A change worth noticing in one statement almost always has a counterpart somewhere else, and finding it is what reading accounts actually consists of.

The illustration below shows the pattern at its simplest, with round numbers chosen only to make the arithmetic legible. The business reports a profit of 40 for the period, yet its cash falls by 15, because it has put 30 into stock and is owed 25 more by customers than it was at the start.

Illustrative period, round numbers only

  Profit for the period                       40
  Increase in stock held                     -30
  Increase in amounts owed by customers      -25
  Cost charged for wear on equipment          +5
                                          ------
  Movement in cash                           -15

Illustration only. The figures are chosen to show the relationship between profit and cash, and describe no actual business.