Introduction to the Key Financial Documents
There are three key financial documents for you to consider, as follows: ~ Profit and Loss Account ~ Balance Sheet ~ Cash Flow Forecast and Statement We’re going to spiral around these key areas, learning just a little about them to begin with, as a foundation for what follows. Then we’ll cover some other subjects that will build on this foundation.
This will prepare us for returning to these three documents later in the module to learn about them in a bit more depth. You will find it useful to have an understanding of these three key financial documents in case your customers or colleagues refer to them.
This section outlines the purposes and constituent parts of each of the key documents. Every organisation needs to be able to account for the money on which it depends to run its operations and to be sure that it has sufficient funds available. They do this as a means of planning for the future.
The profit and loss account, balance sheet and cash flow forecast all have a different focus, but there are links between them and it is often necessary to look at all three in order to truly understand the overall financial health of the organisation. Often the technical nature of financial documents puts people off and makes them think that they can’t understand them. In fact, all financial documents are based on some simple principles which, once grasped, will allow you to make sense of the more complex forms you may find.
The Profit and Loss Account This is often referred to as the P&L. This allows us to see whether, over a chosen period of time (often a month or year), the income of an organisation has been greater than the expenditure. In other words, it shows whether the organisation is making a profit (surplus) or a loss (deficit). It is also known by other names, especially in the USA – ‘Income Statement’ or ‘Earnings Statement’.
The Balance Sheet
The balance sheet provides a snapshot of the financial viability of the organisation. It provides a picture of the value of the assets and liabilities of the organisation – at one moment in time. The organisation might have made a profit for a particular period but still have financial problems that can be seen in the balance sheet produced on the last day of that period. In particular, its assets might be less than its liabilities.
This happens if debts (liabilities) are due to be paid by the organisation but there aren’t enough assets (cash in the bank or cash due from debtors) to cover these payments in the coming period. If this is the case, the organisation is technically bankrupt. The balance sheet also shows the value of the organisation in terms of the cumulative profit (surplus) it has retained to date and any funds that people have put into the organisation in order to have a share in its ownership.
The Cash Flow Forecast and Statement
The cash flow forecast is a way of projecting the likely cash that will flow through the organisation and is useful for predicting any shortfalls that may arise. Like any forecast, it is a plan.
However, when cash flow is used in retrospect, to record what has already happened, it is called a Cash Flow Statement. It is different to the P&L as it shows only cash and it records the likely timing of cash payments and receipts. The P&L shows income and expenditure in the period when an invoice is issued or received, not when the actual cash is physically received or paid out.
Income and Receipts are different things
Income is another word for the sales that have been invoiced, or the funding that has been awarded. Receipts are the physical money coming into your organisation’s bank account when the invoice or funding is paid. It is important to bear in mind that income and receipts are different things. Similarly, ‘Expenditure’ and ‘Payments’ are different things. Expenditure is another word for spending commitments, where you have agreed to the expenditure, but not yet paid. Payments are when the physical money goes out of your bank account when you
pay your bills. This key difference is a major aspect of finance to remember. On the one hand we have ‘Receipts and Payments’ (which are all about cash) – and on the other hand we have ‘Income and Expenditure’ (which are all about commitments). It is due to this key distinction that companies have to make important adjustments to their profit and loss account and balance sheet at the end of each financial period.
For example, if we have consumed electricity and gas, we need to bring these commitments into the profit and loss account, even though we may not have to pay the bill until the next financial period. Similarly, if we have sold our services and invoiced the customer, we need to bring this income into the profit and loss account, even if the customer doesn’t have to settle until the next financial period.