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There are three key financial documents that you might come across: the profit and loss account, balance sheet and cash flow forecast. You will not necessarily be asked to produce these documents but you will find it useful to have an understanding of what they are if your colleagues refer to them. This article outlines the purposes and constituent parts of each of the key documents.
Every organization needs to be able to account for the money used to run its operations and understand if it has sufficient funds available. They do this as 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 organization.
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 in your organization.
The Profit and Loss Account
This is often referred to as the P&L. The P&L allows you to understand whether, over a chosen period of time (often a month or year), the income of an organization has been greater than the expenditure. In other words, it shows whether the organization is making a profit/surplus or a loss/deficit.
The Balance Sheet
The balance sheet provides a snapshot of the financial viability of the organization. It provides a picture of the value of the assets and liabilities of the organization.
The organization might have made a profit for a chosen period but still have problems with the balance sheet at the end of it.
In particular, its assets might be less than its liabilities. This happens because debts (liabilities) are due to be paid by the organization but there aren’t enough assets (cash in the bank or cash due from debtors) to cover the payment in the coming period. If this is the case, the organization is technically bankrupt.
The balance sheet also shows the value of the organization in terms of the profit/surplus it has made to date and any funds that people have put into the organization in order to have a share in its ownership.
The Cash Flow Forecast
The cash flow forecast is a way of projecting the likely cash that will flow through the organization and is useful for predicting any shortfalls that may arise. 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 cash are different things. Income is another word for the sales that have been invoiced or the funding that has been awarded. Cash is the physical money going into your organization’s bank account when the invoice or funding is paid.
Planning
For planning and budgeting purposes, organizations often prepare forecasts of the P&L and balance sheet, as well as the cash flow forecast. In large organizations the finance department will be involved in the detailed production, but they will often consult colleagues from outside the finance department to ensure that their forecasts are as accurate a reflection of the organization’s activities as possible.
Reporting
In the same way that an organization uses financial documents to plan they will also use the P&L and balance sheet to report on their progress. Many organizations have a legal obligation to publicly publish their P&L and balance sheet at the end of their financial year. To ensure that the outside parties (e.g. banks, lenders, investors, etc.) can understand the figures and use the information sensibly, there are a number of technical guidelines and laws to help with producing the P&L and balance sheet. This makes the financial documents easier to read and interpret. It also ensures that the published financial documents of all organizations are consistent. This allows outside parties to compare the finances of one company against another. Outside parties might want to do this in order to make investment decisions, for example.
When the financial documents are publicly published they are known as the statutory accounts. When the documents are produced for use only within the organization, they are collectively referred to as the management accounts.
You can learn more about key financial documents in the Finance Management Skillbook.
