Reading financial statements

Cue 1 Profit and loss account as a funnel narrowing from revenue to profit after tax.

AMARA 00:00 My accountant says we had a good year. My bank account disagrees loudly. Which one is lying?

NADIA 00:06 Neither, and that sentence is the reason this module exists. Profit and cash answer different questions, and a business can be excellent at one while dying of the other.

Cue 2 Balance sheet as two stacked columns that must reach the same height.

AMARA 00:18 Explain how that is possible.

NADIA 00:20 You record a sale when you make it, not when you are paid. So if you sold well in March on ninety day terms, March looks superb. The money arrives in June, and meanwhile you have paid your supplier, your staff and your rent.

Cue 3 Timeline: sale in March, cash in June, wages every month in between.

AMARA 00:38 So growth makes it worse.

NADIA 00:40 Growth makes it much worse, which is deeply counterintuitive. To sell more you buy more stock and you carry more unpaid invoices, and both are funded before a single customer pays you. The fastest growing business in a sector is often the one closest to running out of money.

Cue 4 Growth trap diagram: rising sales, rising stock and debtors, falling bank balance.

AMARA 00:59 Right. Take me to the profit and loss account. What do I look at first?

NADIA 01:05 Gross margin, not the bottom line. Gross margin tells you whether the thing you sell makes money before the cost of existing. If that is falling, no amount of overhead cutting saves you, because the problem is in the price or in what it costs to deliver.

Cue 5 Items missing from a balance sheet: staff, brand, current property value.

AMARA 01:24 And the balance sheet? It always balances, so what is it telling me?

NADIA 01:29 Rather less than people assume. It balances by construction, so the balancing is not evidence of anything. And it is a record of transactions rather than a valuation.

AMARA 01:40 Meaning what, in practice?

NADIA 01:42 Meaning your staff appear nowhere. Your reputation appears nowhere unless you bought somebody else's. Your building may be sitting at what it cost in 1994. People read a balance sheet as what a business is worth, and it is not that at all.

AMARA 01:59 So what is it good for?

NADIA 02:02 Structure. What you owe against what you own, how much falls due within the year, and how much of the business is funded by borrowing rather than by owners. Those are real and they are what a lender reads first.