A financial statement
provides an accounting-based picture
of a business’s financial position. There are four statements that make up your
financial overview package. These
include the Balance Sheet, the Income Statement, the Statement of Cash Flows, and the Statement of Retained Earnings.
Understanding financial statements is not always the easiest
of things, but certainly one of the more important parts of ensuring you are
making the best financial decisions for your business.
As the business owner you should know enough
to create a solid base of understanding from which you make decisions for managing
your business finances.(We at
Arizona Tax Advisors– your
Corporate Tax Consultantrecommend
utilizing the expertise of your accountant to fully understand your numbers and
the impact of those decisions.) Let’s take a look at the basics.
Basics of Balance Sheets– ALE’s…grab
a beer and let’s talk about Assets, Liabilities, and Equity!
The balance sheet
reports a business’s assets, liabilities, and equity at a particular pointintime. It “balances” the assets with the liabilities
and equity, thus the name “Balance Sheet”, (Assets = Liabilities + Equity).
Assets are
the items you own which are convertible into cash, your total resources; all
property available for payment of debts. (Dictionary.com)
Liabilities
are the moneys you owe – your debts.(Dictionary.com)
Equity
includes the monetary value of a property or business beyond any amounts owed
on it in mortgages, claims, liens, etc.
It also means ownership, especially when considered as the right to
share in future profits or appreciation in value. Additionally, it refers to the interest of
the owner of common stock in a corporation, and finally, the excess market
value of the securities over any indebtedness.(Dictionary.com).
Now that we understand the players, let’s move on!
Remember, to do its job, the balance sheet has two sides - Total Assets, and Total Liabilities and Equity. These two sides must be equal.
The total assets side of the balance
sheet starts by listing Current
Assets. A current asset will usually
convert to cash within one year.
Current assets include Cash and
marketable securities, Accounts
receivable, and Inventory.
Listed next are the Fixed
Assets, also known as Non-current Assets. A fixed asset has a useful life exceeding one
year. In other words, it most likely will not be converted to cash within a
year. Fixed assets include physical
(tangible) assets such as net
facility and equipment, and other
long-term assets. The net facility and equipment total is calculated
by taking the original cost of your non-current assets (land, buildings,
vehicles, furniture, equipment, etc.) and subtracting the accumulated
depreciation. (Methods of depreciation
are a discussion for another time! We
might need a refill on that beer!)
The total liabilities and equity side of the balance sheet first
lists Current Liabilities. A current liability represents the company’s
obligations due within one year.
This includes Accrued wagesand
taxes, Accounts payable, and Notes payable (those coming due within
the year). Current liabilities also include the Current Portion of Long Term
Debt (CPLTD) such as the payments required on your mortgage within the year,
etc.
Next listed is Long-term
debt, things like long-term loans, and bonds with maturities of more than one
year.
When a company has issued stock, the next on the list is the
Stockholders’ equity.
Understanding the balance sheet allows for better management
of many underlying issues such as using the best fixed asset depreciation
method,ensuring appropriate levels of liquidity are maintained, calculatingnet
working capital, etc.
The Idea Behind Income Statements
Income statementsshow the total revenues that a firm earns
and the total expenses the firm incurs to generate those revenues over a
specific periodoftime.
Again, your balance sheet reports a company’s financial snapshot at a
given time while the income statement covers a specific period of time.
The income statement calculates your operating income, interest
paidon financing, and taxes. This
report ultimately gives the net profit available to equity holders in the
company. For managerial decisions, this
means understanding things like if your expenses are too high, if it is time to
improve your processes, if you are not charging enough for items or services,
or if you need to talk to your venders about better pricing.
Income statements and balance sheets are the most common
financial documents, and they give us critical information to help us run a
successful business.
They show us how we
have been doing.As a financial decision maker, we also need a tool to show us the
flow of cash in and out of the business.
As they say, “Cash is king”(and that is not a
reference to Johnny Cash, one of the kings of country music!)Having cash puts
you in a more stable position with better buying power, and affords you greater
protection against loan defaults and foreclosures.
This is where we need our
“Statements of Cash Flows”.
The Importance of Statements of Cash
Flows (Cash Flow Statements)
Cash flow statements show the cash
flow of the company over a given
periodoftime.
They report the amount of cash a company has
generated and distributed during a particular time period; bottom line, the
difference between cash sources and uses.
A cash flow statementdiffers
from an income statement in that it looks at cash and cash equivalents without
adding the noncash entries of theIncome Statement, like depreciation. The income statement also uses Generally
Approved Accounting Principles, commonly known as GAAP. GAAP procedures require a company to use
accrual-based accounting meaning the company recognizes revenue at the time of
sale, and shows their production and other expenses on the income statement as
the sales takes place. Sometimes, however, the company receives payment before
or after the time of sale, while the expenses related to making the product for
the sale often occur much sooner than the actual sale. Again, this is where the statement of cash
flowstells its story.
The statement of cash flows includes Operating Activities,
Investing Activities, Financing Activities and Supplemental Information. What exactly does that mean?
1.
Operating
Activities – converts the items reported on the income statement from the
accrual basis of accounting to cash. (Remember GAAP procedures mentioned
above.)
2.
Investing
Activities – reports the purchase and sale of long-term investments and
property, plant and equipment.
3.
Financing
activities – reports the issuance and repurchase of the company’s own bonds
and stock, and payment of dividends.
4.
Supplemental
information – reports the exchange of significant items that did not
involve cash, and reports the amount of income taxes paid and interest paid.
To someone reviewing a company’s statement of cash flows, a
comparison of the cash from operating activities to the company’s net income
can tell them if the company’s earnings are “high quality” (consistently
greater) or raise a red flag as to why the reported net income is not turning
into cash (consistently less).
Investors may note that the company is consistently
generating more cash than it is using and will be able to increase dividends,
buy back some of the stock, reduce debt, or acquire another company. These are perceived as good for stockholder
value.
So now let’s look at the portion of the company’s profits
that it keeps to reinvest in the business or pay off debt. These dollars are reported, not surprisingly,
on a Statement of Retained Earnings.
Understanding a Statement of Retained
Earnings
The Statement of
Retained Earningsshows the changes, duringareportingperiod, of a
company’s net income (profit) minus the monies (dividends) paid out to shareholders. The balance is retained by the company
for internal use. These are your retained earnings, and may also be
referred to as retained profit or accumulated earnings.Retained earnings do not
represent surplus funds, but rather redirected funds often reinvested in the
organization. Retained funds are used for
things like paying debt obligations,promoting growth and development, improving
liquidity, orpurchasing an asset. A
typical reporting period is one year (ex. December 31, 2018 vs. December 31,
2017).
The purpose of releasing a statement of retained earnings is
to improve market and investor confidence in the organization. It is used to analyze the health of the
company.
The information included in this brief article is meant to
inform. It is not meant to replace
expert advise from your accountant. The
fundamentals explained here will not fix all that “ALE’s” you, but it is a
start.
Cheers to you, for
understanding your financial statements and putting them to great use to manage
your company! As always, we are here to
help with any questions and concerns you may have.
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Advisors we offer: personal
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