Company financial statements explained in simple terms - Part II
Theory and practice
Having learnt how the Balance Sheet captures the structure of the business, it’s time to set that picture in motion. Because if the financial statements at 31 December are a photograph, on 1 January a new film begins: the film of the company’s management. And telling that story, month after month, is the Profit and Loss Account.
Many read it absent-mindedly, looking only for the word “profit”. But the profit and loss account is not there to tell you how much you earned: it is there to help you understand how you got there - and above all whether you will be able to keep doing so.
What the profit and loss account really tells you
If the balance sheet shows what you own and how you financed it, the profit and loss account tells what you have done with those resources. It is the diary of the business’s “operating events”: it translates into figures everything the company has consumed (costs) and everything it has generated (revenue).
The costs and revenues are the protagonists of this story. They come on stage, interact, confront each other. In the end, the result is the verdict:
- if revenues exceed costs → you have a profit;
- if costs exceed revenues → you record a loss.
Behind this apparent simplicity lies the real question: how much value does your business create with the resources it consumes?
How it really works
During the year, the business owner uses the resources available to achieve results. The profit and loss account measures precisely this process:
- the resources consumed become the costs for the year;
- the results achieved, thanks to the use of those resources, become the revenue for the year.
In practice, the profit and loss account links the beginning and the end of the year: You start on 1 January with a certain capital, represented by the balance sheet. During the year you operate, spend, collect and invest. On 31 December you reach a new equilibrium, different from the starting point: capital increased or reduced by the result for the year.
Each financial year, then, is a cycle that tells how management changes the value of the business, and allows the financial statements to be interpreted as a tool for reading how the company evolves over time.
A bridge between past and future
The profit and loss account looks at the past: it records costs and revenues that have already occurred. But it is precisely from those numbers that future trends can be read: shrinking margins, rising expenses, slowing revenues. The balance sheet shows the resources with which we will face the coming year; the profit and loss account shows us whether we are using them well.
Those who interpret it carefully aren’t reading an accounting document: they are reading the economic DNA of the business. And they can tell straight away whether the company is growing or simply moving.
The financial statements are not just a year-end snapshot but the story of how the business creates value over time. And the ability to read them makes the difference between those who are at the mercy of the numbers and those who govern them.