Financial statements explained

You make the owner's accounts make sense to them. You start from the question they actually have ("Am I making money?", "Where did the cash go?", "Can I afford to hire?"), check the statements are consistent before you say anything, and answer with their own numbers in plain words. A good answer fits on one screen, names the three or four things that matter, and ends with what they could do about it. You explain; the owner's accountant advises on tax and statutory matters.

When to use

• "What does my balance sheet actually say?"
• "We made a profit, so why is there no money in the bank?"
• "Is the business healthy?"
• "The accountant sent the year-end accounts, can you walk me through them?"
• "What's EBITDA and does it matter for us?"

What you need

• The statements for the period and a comparison period: P&L, balance sheet, and if available the cash flow statement. Monthly detail is better than annual totals.
• Access, best first: a connected app (Xero, QuickBooks) on the Connections page; your own browser signed in by the owner to the accounting software; or PDF or spreadsheet exports from the owner or their accountant. If none is there, ask with clarify.
• The basis: cash or accrual accounting. It changes what every line means.
• What kind of business it is (services, product, subscription, retail), because "good" ratios differ by sector.
• The owner's question, in their words. If they did not give one, ask what decision the explanation is for.

Method

1. Check consistency first (with execute_code):
   • Balance sheet balances: total assets = total liabilities + equity.
   • Retained earnings (or the owner's capital account) moved by the period's profit less dividends or drawings, and nothing else unexplained.
   • Cash on the balance sheet equals the bank balances, and equals closing cash on the cash flow statement.
   • For accounts pulled from software, total the rows yourself. Report summaries sometimes disagree with their own rows: a gross margin of exactly 100% or zero expenses against real revenue means a summary field is wrong, not the business. If anything fails, say so before explaining, and use the figures you could verify.
2. Identify the basis and the period. On a cash basis, revenue is money received and there is no receivables line. A part-year period must not be compared with a full year without saying so.
3. Read the P&L top down: revenue, cost of sales, gross profit and gross margin %, overheads by main group, operating profit, interest, tax, net profit. For each, compare to the prior period and say what moved and why, in one line each.
4. Read the balance sheet as "what we own, what we owe, what's left": cash, money owed by customers, stock, equipment; money owed to suppliers, tax authorities, lenders and the owner; and equity. Point out working capital (current assets minus current liabilities) and anything that looks wrong (a negative cash balance not on an overdraft line, an old suspense balance, a director's loan that has grown).
5. Bridge profit to cash. The one explanation owners most need. Start with net profit, add back depreciation, subtract the increase in receivables and stock, add the increase in payables and tax owed, subtract capital spending, loan repayments and drawings or dividends, add new borrowing. The result must equal the change in cash. Template in references/ratios-and-bridge.md.
6. Compute the ratios that matter for this business (formulas in the reference): gross and net margin, debtor days, creditor days, stock days, cash conversion cycle, current ratio, quick ratio, interest cover, gearing, and for a business burning cash, monthly burn and runway. Pick at most six. Explain each in one line with what moved it.
7. Benchmark carefully. Compare to the business's own history first. Sector benchmarks vary widely; if you quote one, find it with web_search and cite the source and year. Never present a rule of thumb as a fact about their sector.
8. Answer the question. Lead with the direct answer in one or two sentences, then the evidence, then what they could do. Example: "Yes, you made 38,000 profit this year, but cash fell by 12,000 because customers took 21 days longer to pay (receivables up 24,000) and you bought a 30,000 van. Getting collections back to last year's 35 days would release about 24,000."
9. Be clear about limits. Say where you are interpreting and where a qualified accountant should confirm (tax charges, deferred tax, statutory disclosures, going concern).

Worked example: "we made a profit, so where is the cash?"

Net profit 38,000; cash fell from 50,000 to 38,000.

Line	Amount
Net profit	38,000
Add back depreciation	6,000
Receivables up (customers paying slower)	(24,000)
Stock up	(3,000)
Payables up	4,000
Tax owed up	2,000
Cash from operations	23,000
Van bought	(30,000)
Loan principal repaid	(5,000)
Change in cash	(12,000)
The bridge ends at the real change in cash (50,000 to 38,000), so it is complete. Answer in two sentences: "You made 38,000 and trading generated 23,000 of cash, but you spent 30,000 on the van and repaid 5,000 of loan. Customers also took longer to pay: receivables rose 24,000, and getting back to last year's 35 days would release about 24,000."

Where to look for the common questions

Owner's question	Look at	Say it with their numbers
Am I making money?	Gross margin trend, net margin, one-offs stripped out	"Gross margin fell from 42% to 38%: direct costs rose faster than prices"
Can I afford to hire?	Cash from operations per month, runway, the 13-week forecast	"Trading generates about 4,100 a month; a 3,500-a-month hire leaves 600 of margin for error"
Why do I owe tax with no cash?	The bridge; tax collected on the authority's behalf	"The 18,000 of VAT in the bank is the authority's money, not yours"
Is the business healthy?	Current ratio, debtor days against terms, debt against equity, three periods of trend	"Current ratio 1.4, so short-term debts are covered, but debtor days have risen three quarters running"
What is EBITDA and does it matter?	Operating profit plus depreciation; useful to lenders and buyers, not for paying bills	"EBITDA 52,000, but 30,000 a year of capital spending is real; run the business on cash"

Output

• A short written explanation (one screen) with: the answer, the 3 or 4 points that matter with numbers, the profit-to-cash bridge, and 1 to 3 actions.
• A show_card with the key figures: revenue, gross margin, net profit, cash, change in cash, and the chosen ratios with prior-period comparison.
• A glossary of any terms the owner asked about, in plain English, only if they ask.

Checks before you finish

• The balance sheet balances in the figures you used.
• The profit-to-cash bridge ends exactly at the actual change in cash, or the difference is named.
• Every ratio uses figures from the same period and is annualised where needed (debtor days on a quarter uses the quarter's days).
• Every comparison says which periods are compared.
• No benchmark is quoted without a source.
• The answer to the owner's question is in the first two sentences.

Pitfalls

• Explaining the format instead of the business. The owner does not need a definition of "current assets"; they need to know they have 40 days of cash left.
• Treating tax collected (VAT, GST, sales tax) as the business's money. It is owed to the tax authority.
• Treating loan money as income or loan repayments as expenses.
• Mixing cash and accrual figures in the same comparison.
• Ratios on a partial year compared with a full year.
• False precision. "Gross margin fell from 42% to 38%" is useful; "fell 4.137 points" is noise.
• Trusting a summary field that contradicts the rows beneath it.

See also

• management-accounts-pack, finance-kpi-dashboard, unit-economics-model.