How to read your financial statements
Many business owners rely on their bank balance to tell them how the business is going, and look at the financial statements only when the accountant sends them at tax time. That’s like driving using only the rear-view mirror. Understanding three reports, even at a basic level, changes the decisions you make.
1. The profit and loss (P&L)
Shows income and expenses over a period, and the profit or loss left over. Read it from the top:
- Income (sales): is it growing, flat or falling? How does it compare with the same month last year?
- Cost of sales (direct costs): materials, stock and direct labour.
- Gross profit: sales less direct costs. The gross margin percentage shows whether your pricing works. A falling margin is often the first sign of trouble.
- Overheads: rent, wages for non-billable staff, vehicles, insurance, software, and so on. Are any growing faster than sales?
- Net profit: what’s left. Is it enough to pay you a fair wage and reward the risk of owning a business?
2. The balance sheet
A snapshot on a particular date of what the business owns (assets), what it owes (liabilities), and the difference (equity).
- Current assets: cash, money owed by customers (debtors), stock. Things that turn into cash within a year.
- Non-current assets: equipment, vehicles, property, goodwill.
- Current liabilities: suppliers, GST and PAYG owed to the ATO, credit cards, the next year of loan repayments.
- Non-current liabilities: longer-term loans.
- Equity: what’s left for the owners.
Things to check:
- Can you pay your short-term bills? Current assets should comfortably exceed current liabilities.
- Is the ATO balance under control? GST and PAYG sitting unpaid is a red flag.
- Loans to or from owners: in a company, money owed by shareholders can trigger Division 7A problems.
- Debtors: a growing balance means customers are paying more slowly.
3. The cash flow statement
Shows where cash actually came from and went over the period, split into operating activities (trading), investing (buying and selling assets) and financing (loans and owner contributions or drawings).
It explains the gap between profit and your bank balance, and tells you whether the business generates cash from trading, or is relying on borrowings and the owners to keep going. See profitable but cash poor?
Comparisons make numbers meaningful
A single number means little on its own. Compare:
- against last year, same period,
- against your budget,
- against industry benchmarks, where they exist,
- as percentages of sales, so you can compare months of different sizes.
Warning signs
- Gross margin falling
- Debtors growing faster than sales
- ATO liabilities building up
- Overdraft or credit cards creeping higher
- Profit on paper but cash always tight
- Drawings consistently higher than profit
Make it a habit
Set aside an hour a month to look at your P&L and balance sheet, with your KPIs. The reports are only as good as the bookkeeping behind them, so keep it reconciled.
Our On Track and Growth packages include quarterly or monthly management reports and a meeting with an advisor to go through them, so you understand what the numbers are saying and what to do about it. See business packages and what business advisory involves.