Financial statements help stakeholders assess a business’s financial performance and position using structured summaries of income, assets, and liabilities.
The Purpose of Financial Statements
Financial statements are formal documents that present a comprehensive overview of a business’s financial activities. These are used to evaluate performance over time, assess financial health, and support strategic decision making. For AQA A-Level Business, the two primary financial statements you need to understand are the income statement and the balance sheet.
These statements are typically produced annually and are essential for both internal stakeholders (such as managers and employees) and external stakeholders (such as investors, lenders, and regulators). They allow users to analyse key metrics like profitability, liquidity, and financial stability.
The income statement focuses on the business’s ability to generate profits over a set time period.
The balance sheet provides a snapshot of the financial position at a specific point in time, detailing what the business owns (assets) and owes (liabilities), as well as the amount invested by the owners (capital or equity).
Understanding these documents is crucial for interpreting how well a business is performing and whether it is financially secure.
The Income Statement
Purpose of the Income Statement
The income statement (also called the profit and loss account) is used to measure a company’s financial performance over a particular accounting period. It reveals how revenue is transformed into net profit and allows managers and stakeholders to assess whether the business is running efficiently and profitably.
It is particularly useful for:
Monitoring trends in income and expenditure.
Identifying changes in profitability year on year.
Determining whether operating costs are under control.
Making investment or budgeting decisions.
Key Components of the Income Statement
Revenue (Sales or Turnover)
This is the total value of goods and services sold by the business during the period.
It is the starting point of the income statement and often referred to as the "top line".
High revenue indicates strong sales performance, but it doesn’t always translate into high profit if costs are also high.
Cost of Sales (or Cost of Goods Sold)
This represents the direct costs of producing goods or delivering services.
Examples include raw materials, direct labour, and manufacturing costs.
Not included are indirect costs like rent or salaries of administrative staff.
Gross Profit
Formula: Gross Profit = Revenue – Cost of Sales
This figure shows how much profit the business has made after covering the direct costs of production.
A low gross profit margin may indicate high production costs or low pricing strategy.
Used to assess how efficiently a business is converting revenue into profit before deducting overheads.
Operating Expenses (Overheads)
These include fixed and indirect costs such as:
Rent
Salaries of office staff
Utility bills
Marketing expenses
Depreciation
These costs are essential to keep the business running but are not directly tied to production.
Operating Profit (also known as EBIT – Earnings Before Interest and Tax)
Formula: Operating Profit = Gross Profit – Operating Expenses
This figure reflects the profitability of the business from its core operations, excluding costs related to financing and taxation.
It is a critical indicator of how well the business controls its indirect costs and overheads.
Interest and Tax
Interest is the cost of borrowing, paid to lenders.
Tax is paid on the business’s profits, usually to the government.
These figures are deducted after operating profit.
Profit for the Year (Net Profit)
Formula: Profit for the Year = Operating Profit – Interest – Tax
This is the final profit figure and is referred to as the “bottom line”.
It shows how much profit is left after all costs, including finance and taxation.
Important for shareholders, as it affects dividend payouts and the overall valuation of the business.
The Balance Sheet
Purpose of the Balance Sheet
The balance sheet (also known as the statement of financial position) shows the financial position of a business at a specific moment in time. It is a summary of:
What the business owns (assets),
What it owes (liabilities), and
The value of shareholders' equity or investment (capital employed).
It enables stakeholders to:
Understand how the business is financed.
Assess the liquidity and solvency position.
Identify whether the business has enough assets to cover its liabilities.
Track changes in financial structure over time.
Key Components of the Balance Sheet
Assets
Resources that are owned or controlled by the business and expected to generate future economic benefit.
Divided into two main categories:
Current Assets – short-term resources that are expected to be converted into cash within one year:
Cash and cash equivalents
Inventories (stock)
Trade receivables (money owed by customers)
Short-term investments
Non-current Assets – long-term investments that will benefit the business over many years:
Property, plant, and equipment
Vehicles and machinery
Intangible assets like patents and trademarks
Liabilities
Financial obligations that the business must repay to external parties.
Also divided into:
Current Liabilities – debts due within the next 12 months:
Trade payables (money owed to suppliers)
Short-term loans and overdrafts
Tax liabilities
Non-current Liabilities – long-term obligations repayable after more than a year:
Long-term loans
Mortgages
Bonds payable
Equity (Shareholders’ Funds)
Represents the owners’ claim after all liabilities have been settled.
Includes:
Share capital (money invested by shareholders)
Retained earnings (profits kept in the business rather than distributed)
This section can be used to assess how much of the business is funded by the owners versus debt.
Capital Employed
The total value of resources available to the business to generate profit.
Formula: Capital Employed = Equity + Non-current Liabilities
Alternatively, it can be calculated as:
Capital Employed = Total Assets – Current Liabilities
Using Financial Statements to Analyse Business Performance
Profitability
The income statement is key for evaluating profitability, which is the ability of a business to generate profit relative to its revenue and costs.
Key profitability indicators derived from the income statement include:
Gross profit margin
Operating profit margin
Net profit margin
These figures show how well the business converts sales into profit, and how effectively it controls production and operating costs.
Liquidity
The balance sheet reveals information about the business’s ability to meet its short-term obligations.
Liquidity refers to how quickly and easily assets can be turned into cash to pay debts.
While specific liquidity ratios are covered in subtopic 7.2.3, understanding current assets and current liabilities is essential to judge liquidity even before using ratios.
For example:
A business with high inventories but low cash may appear to have value, but could face issues paying bills.
Financial Stability and Solvency
The balance between debt and equity financing is crucial.
High levels of non-current liabilities suggest a business is highly geared, meaning it relies heavily on borrowing.
Financial stability requires a balanced capital structure:
Too much debt increases financial risk, especially if profits fall.
Too little debt might mean the business is missing opportunities for growth through investment.
The balance sheet allows stakeholders to evaluate whether the business is solvent (able to meet long-term obligations) and financially stable.
Practical Interpretation of Financial Statements
To interpret financial statements effectively:
Compare results over time: Track figures across several years to identify growth trends, cost increases, or declining profitability.
Benchmark against competitors: Comparing with similar businesses can reveal whether performance is in line with industry norms.
Look beyond the numbers: Use notes to accounts for context — these might explain one-off costs, asset revaluations, or unusual tax charges.
Analyse changes: A sudden increase in revenue with no corresponding increase in profit might point to inefficiencies or rising costs.
Understand context: A business in a high-growth phase might show negative profit due to reinvestment, which is not necessarily bad.
Why Financial Statements Must Be Used Together
Although the income statement and the balance sheet serve different purposes, they complement each other:
A business may appear profitable on the income statement but have poor liquidity, shown by a lack of cash on the balance sheet.
Conversely, a strong balance sheet may hide a lack of profitability.
Financial decision-making depends on using both documents in tandem to get a complete picture:
Profitability tells you how well the business operates.
Liquidity and solvency tell you whether it can survive and grow sustainably.
Understanding these core financial statements is the foundation of more advanced ratio analysis, which allows performance to be measured in a more precise, standardised way. The next topics will explore these ratios in detail.
FAQ
A profitable business can still struggle financially if it has poor cash flow, which is not shown in the income statement. Profit figures may include revenue from credit sales that have not yet been paid, meaning the business lacks actual cash to cover immediate expenses. Additionally, large non-cash profits (such as from asset revaluations) can inflate profitability while ignoring cash shortages. High inventory levels or delayed customer payments can also tie up cash, limiting the firm’s ability to pay wages, suppliers, or loans on time.
Operating profit shows the profit earned from the business’s core activities before deducting interest and taxes, giving insight into operational efficiency. Net profit, however, is the final figure after all expenses, including interest on loans and tax obligations, are deducted. This distinction matters because a business could have a strong operating profit but a weak net profit if it faces high interest payments or tax charges. Analysing both helps stakeholders assess management performance and the overall financial health of the business.
Inventory levels impact the cost of sales figure in the income statement. If inventory is overstocked, costs may be understated temporarily, inflating gross profit. Conversely, understocking can lead to missed sales and lower revenue. Changes in inventory valuation methods (e.g. FIFO or LIFO) also affect the profit figures reported. Analysts must be cautious when interpreting trends, as large swings in inventory may distort profit margins and not reflect true operational performance or demand consistency.
Capital employed represents the total long-term investment used to generate profits, including both equity and non-current liabilities. It is critical when assessing how effectively a business uses its financial resources, especially when calculating ratios like Return on Capital Employed (ROCE). High capital employed with low operating profit may suggest inefficient use of funds. Evaluating capital employed helps identify whether the business’s growth is being funded sustainably and whether too much reliance is placed on debt rather than retained earnings or equity finance.
Yes, intangible assets—such as patents, trademarks, or goodwill—can significantly affect how a balance sheet is interpreted. They may inflate the value of total assets without providing clear, measurable economic benefit, making it harder to assess liquidity or asset quality. Their valuation is often subjective and may vary between firms. Stakeholders should be cautious when comparing balance sheets, particularly across industries or companies with different accounting policies, as heavy reliance on intangible assets can distort a business’s true financial position.
Practice Questions
Analyse how the income statement can help a business assess its performance. (10 marks)
The income statement helps a business assess performance by showing whether it is making a profit or loss over a given period. It highlights key figures such as revenue, gross profit, and operating profit, which allow managers to analyse cost efficiency and sales effectiveness. Comparing profit margins over time can identify trends and pinpoint areas needing improvement. It also helps in setting targets, planning budgets, and evaluating the success of cost control measures. By using the income statement alongside other performance indicators, a business can make more informed strategic decisions and identify areas for financial improvement.
Explain the role of the balance sheet in assessing the financial position of a business. (10 marks)
The balance sheet provides a snapshot of a business’s financial position at a specific point in time. It outlines what the business owns (assets) and owes (liabilities), as well as the capital invested by shareholders. This information is vital for assessing liquidity—whether the business can meet its short-term obligations—and financial stability, by evaluating the balance between debt and equity. Stakeholders can identify potential risks such as over-reliance on borrowing. It also allows comparison over time or with competitors, helping assess solvency and capital structure. Overall, it supports better financial planning and strategic decision-making.
