How to analyse financial statements

business.gov.au names the balance sheet, the profit and loss statement and the cash flow statement as the main financial documents to review: the first lists assets and liabilities at a date, and the other two cover a period. To analyse them together, they have to describe the same stretch of time.

• A profit and loss statement and a cash flow statement covering the same period, such as a financial year.
• A balance sheet at the start of that period and one at the end, since the balance sheet describes a single date.
• The same set for an earlier period, so there is something to compare with.
• Your budget for the period, if you have one.

Before you start, check that the books were complete and reconciled at each date, and that both periods were kept on the same basis. business.gov.au explains that cash accounting records a sale when payment arrives while accrual accounting records it when it takes place, so a switch between the two can move income from one period into another.

Put the two periods side by side and work out the change in each line. Read the largest changes first, then ask whether they move together the way you would expect. When sales rise, the cost of goods sold usually rises with them. If rent jumps while sales stay flat, that needs its own explanation.

business.gov.au's health-check list makes a good set of first questions: are sales falling, are margins thin, is spending running over budget, how much does the business already owe, and does cash swing between highs and lows? Its guidance on valuing a business also points to looking at trends in your finances over past years when estimating future profit.

A rise in an expense can be fine if sales rose more. To see the shape of the business, divide each line of the profit and loss statement by sales for the same period, provided sales are above zero. The result shows how much of each dollar of sales went on each cost and how much was left.

Every line measured in dollars grew, so a quick look says the year went well. The second view says more. The goods cost more for each sale, so the margin left after them fell, and low profit margins are on business.gov.au's list of things to look out for. Only a smaller share going on other expenses kept net profit per dollar of sales from falling further. The next question is whether supplier prices rose, prices to customers fell, or the mix of products changed.

Profit and cash rarely match. The balance sheets at the start and end of the year show where the difference went: more money owed by customers, more stock on the shelves, loan principal repaid and money the owner took out all use cash without reducing profit, while owing suppliers more holds cash back.

Here a profitable year still ended with less cash, mainly because stock and customer balances grew. That links back to the cost figures above: if supplier prices rose, the margin shows it in the goods already sold, and the cash shows it in the dearer stock still on hand. A full reconciliation of profit to cash has more lines than this, and your accountant can prepare one.

• One-off items, such as a large repair, an insurance payout or the sale of equipment, that won't repeat next year.
• Seasonal timing, when one period holds a busy month the other doesn't.
• Periods of different length, such as a first year of trading that ran for only part of a year.
• Changes in how things were recorded, such as moving a cost from one account to another, or a different basis of accounting.
• Estimated figures. business.gov.au says estimates in its statement templates should be clearly labelled, and it is worth knowing which figures are estimates before relying on a trend.
• Late entries, when bills for one period were entered in the next.

Ratios compress the comparisons above into single figures you can track over time, such as how quickly customers pay or how much of the balance sheet is funded by debt. Our guide to financial ratios explains the main families and what each one measures.

Then compare the results with what you set out to do. business.gov.au treats the end of the financial year as the time to check results against the goals set at its start and to set goals for the year ahead.

Finish with a short note: the main things the statements showed, the reason for each where you know it, and what you will do about it. Keep it with the statements, so next year's analysis starts by checking whether those actions worked.

business.gov.au recommends a financial health check at least once a year. If the analysis raises a question you can't answer, such as whether the business is viable, it suggests getting professional advice early, for example from a business adviser or a bookkeeper.