How Do You Review Financial Statements? (Part 2)

In Part 1, I covered my suggestions for some areas on which to focus when reading a Balance Sheet. In this second part, I am concentrating on the Profit and Loss Account.

I am not going to pretend that I can cover everything in this short article but at least give you some pointers and maybe arm you with some questions.

However, I must stress a fundamental principle of reviewing financial statements. You need to understand the business. Different business structures or industries look totally different and will have different financial challenges, KPIs, pain points and therefore should have different financial strategies. Do you understand these for the business?

I am going to assume that you know your way around the 3 key financial statements, shown in the graphic – their purpose and what each of them shows. (If not, please do reach out, you are not alone and we can help you with this).

The Profit and Loss Account or Income Statement

So, picking up on my point above about knowing the business – ask yourself, what do you expect to see? Do you know the financial strategy of the business? Is it to grow the top line or perhaps the bottom line – with potentially a focus on margins or cutting costs?

So, when reading a P & L, I recommend that your review should include the following:

Analysis of Revenue

• Review changes in revenue from last year to this year. Management should be able to explain significant changes if the reasons for those changes are not evident from the financial statements themselves. This is where your understanding of the business should inform you – what would you expect to see?
• Review accounts receivable in conjunction with revenue. A significant increase in accounts receivable might indicate either problems with collectability of revenue or a significant increase in activity toward the end of the fiscal year.

Analysis of Expenses

• Compare the change in expenses from last year to this year. Review the notes to see if explanations for significant differences are noted. As above - what would you expect to see?
• Review the notes to the financial statements to determine whether there are potential expenses that have not been recorded because the amounts were not reasonably determinable at the year-end. (The notes should contain a section on Risk and indeed Contingent Liabilities which might alert you to potential future problems.)

Part 3 of 'How do you review your Financial Statements' will examine tips for reviewing the Cash Flow Statement. but if you would like to read the full article, it is posted on our website https://www.financialtrainingaustralia.com/blog

FTA welcomes any questions and if you need extra help, you can always give me a ring (+61 3 413 942 803) or drop me an email at [email protected].