In the UK, all registered companies are required to file financial accounts. However, publicly listed companies and large private companies are required to produce and publish more substantial, fully audited financial accounts. 

Financial accounts provide an insight into a company’s financial performance and financial standing, acting as the building blocks for an analysis of a company’s ability to generate profit, scale, and meet interest repayments. They are therefore essential tools for buyers, investors and lenders who are looking to assess the viability of proposed acquisitions, investments or loans. 

Some commercial law firms incorporate very basic financial accounts into the commercial case studies that they set during assessment centres and internships. Many commercial law applicants tend to underperform in relation to this element of interviews, but basic accounts are not difficult to understand and thus deserve some consideration. There are three key financial statements:

1. The income statement: this measures a company’s revenue, expenses (including interest and taxes) and after-tax profit over a year; 

2. The balance sheet (or Statement of Financial Position): this provides a snapshot of a company’s financial position on a particular date (usually the end of the company's financial year); and

3. The cash flow statement: this measures a company's cash inflow and outflow over the course of a year. 

Income statement

The income statement (known historically in the UK as the “profit and loss account”) details a company’s financial performance resulting from its day-to-day operations over a defined period of time (typically one year). It shows the income generated from a firm’s operations; the expenses relating to those operations; and the net profit (also known as the “bottom line”, as it appears at the bottom of the income statement). 

Revenue / turnover / sales: the total income generated from a firm’s operations within a period of time. This does not take into account costs, instead purely reflecting the money that has been received from sales. For example, if a company sells 10 handbooks for £10 each, its revenue would be £100.

Cost Of Goods Sold (COGS) / variable costs: costs of goods sold – also referred to as “variable costs” – includes the direct costs associated with each sale. These costs will therefore change in relation to the number of units produced or sold and might include, for example, the cost of manufacturing, packaging and delivering each individual product. Labour to some extent is a variable cost as over time, the number of employees may change to reflect a company’s level of output. However, in the short term, labour is generally deemed to be a fixed cost. 

Selling, General & Administrative costs / fixed costs: these costs include general expenses that do not directly relate to each individual sale. Examples include: the rent paid for an office or a factory; the cost of paying utility bills; or the cost of fuel for an aeroplane flight. These costs will all remain the same (or almost the same) regardless of whether a business sells 0 or 1,000 units.

Net profit: this refers to the amount of money remaining from the revenue after all related expenses (including tax) have been subtracted.

In case studies, candidates may be presented with basic financial accounts from the current year and the previous few years. If this is the case (depending on the issues you are asked to consider), start by analysing the profit figures to see how the company’s performance has changed. 

• If profits have increased year on year, this could indicate that the company could continue to thrive. Conversely, if the net profit has decreased, this could, on the face of it, suggest it may eventually run into financial difficulties. At this stage you should then try to discover (through looking at the accounts) why the net profit has decreased. 
• For instance, a decrease in revenue (which could cause a corresponding decrease in net profit) could suggest consumers are purchasing less of the company’s products, which in turn may indicate that new competitors have entered the market (or that existing competitors have developed a similar or superior product, perhaps at a more favourable price).
• If the revenue has remained the same or increased but the net profit has decreased, look at whether the costs have increased (which would also decrease the net profit). If costs have increased, does this suggest the company has failed to implement effective mechanisms to control costs (in which case think of potential solutions, for instance laying off staff or looking for cheaper suppliers?) or has the cost of raw materials increased (e.g. if the company produces apple juice, has the price of apples increased)? Alternatively, has the company made an investment (for instance purchased a factory) that has increased costs in the current year (and thus reduced the net profit) but may well contribute to an increase in net profit in future years?

Balance sheet

The balance sheet, also known as the statement of financial position, provides a snapshot of a company’s financial situation on a particular date. It lists the value of everything a business owns (its assets) and everything the business owes (its liabilities). All financial events in the life of a company must be accounted for through the recording of two corresponding entries in the balance sheet. 

Company assets (which form one side of the balance sheet) must have been supported through the use of some sort of financing (detailed on the other side of the balance sheet), either in the form of capital (equity) or through the company taking on debt (liabilities). 

Asset: something of value to a company. Tangible assets include machinery and factories. Intangible assets include intellectual property rights, customer loyalty and knowledge. On a Balance Sheet, it is generally the tangible assets that are accounted for.

For example, if a company raises £1 million through selling shares and takes out a loan of £1 million when it first incorporates (starts up and registers as a company), its total assets will amount to £2 million. This £2 million will be recorded as:

• £2 million cash in the “Current Assets” section of the Balance Sheet; and
• £1 million in the “Equity” (share capital) section and £1 million in the “Liabilities” section on the other side of the Balance Sheet. 

If the company subsequently purchases a building for £500,000, then cash (on the “Assets” side) will reduce to £1.5 million and a new category will be created (also on the “Assets” side), typically called Plant, Property & Equipment, the value of which will be £500,000. 

In the meantime, the Equity and Liabilities side of the Balance Sheet will remain unchanged as no new share capital has been received and no new debt has been taken on. 

If £500,000 of the loan is then paid off using cash, the “Assets” section will decrease by £500,000 (to reflect the fact that cash has been spent on paying off the debt) and there would be a corresponding decrease in the “Liabilities” section (to reflect the fact that the value of the outstanding loan has reduced to £500,000). 

The Balance Sheet is essential when analysing a company’s finances, as it contains information on the company’s capital structure. There is a typical example of a Balance Sheet below.

Capital Structure: this refers to the proportion of a company’s capital (financial resources) that is attributable to debt and the proportion of the company’s capital that is attributable to equity. This in turn can affect a company’s ability to raise additional capital or its attractiveness to investors. For instance, a company that is highly in debt will be perceived as a riskier investment by potential lenders or investors.

Cash flow statement

The cash flow statement is perhaps best explained by way of an example. Supermarkets buy goods from a large number of suppliers on credit. This means that the suppliers allow the supermarkets to take possession of the goods for a certain period of time (e.g. 30 days) before they must actually pay. Supermarkets then generally sell the goods on to customers in the interim period. Those customers typically pay immediately. 

Under such circumstances, accounts payable (the amount still owed to suppliers for goods already supplied under the credit agreement) is greater than accounts receivable (the amount owed to the supermarket by its customers). The fact that the supermarket effectively hoards cash received from customers for a certain period of time before paying back the suppliers means it is operationally cash positive (assuming the items received are sold).

One way of measuring the extent to which this applies to a business is through calculating its "working capital".

Having a low (or negative) working capital figure can mean that the company lacks sufficient current assets to pay its current liabilities, suggesting it may to some extent be financially unstable. Note that if the company is genuinely unable to pay its debts, then it may well have to cease trading. If the working capital figure is too high however, this may suggest that the company is failing to invest its excess cash, which is financially inefficient. The optimal working capital figure often depends on the particular company and industry. 

The Cash Flow Statement shows the actual movement of cash in and out of a company over a period of time (typically 1 year). It is important to understand the fundamental difference between profit and cash. The profit figure contained within the Income Statement (which is determined by revenue and costs) is based upon the number of legally concluded transactions, regardless of whether any cash has yet been transferred (for instance if goods have been supplied on credit). However, the Cash Flow Statement shows the actual transfer of cash in and out of a company during a given time period and will detail the previous year-end cash balance and end with the new cash balance.