Using and Understanding Financial Statements

Financial statements can provide deep insight into any company or individual; they tell a company's story. Financial statements can also reflect the management style of executives, effectiveness of sales tactics, future of the company, and even weak points in the company's strategies that competitors can easily exploit.

So why supply this information to the public? Aside from being mandatory for some companies, financial statements may be required by lenders so they know the type of person/business they are lending to, investors want to know if the company is a good investment, government agencies might want these statements for an audit, etc.

Financial statements can also help internal users correct over spending, budget allocation problems, accounts receivable or payable issues and determine possible areas for expansion or product creation.

The two main financial statements are:

1) Balance Sheet

2) Income Statement

The following paragraphs will give you an overview of each.

Balance Sheet

The balance sheet is a snapshot of the company's financial standing at a point in time. The balance sheet shows the company's financial position, what it owns (assets) and what it owes (liabilities and net worth). The bottom line of a balance sheet must always balance (i.e. assets = liabilities + net worth). The individual elements of a balance sheet change from day to day and reflect the activities of the company (this is why it's a snapshot at one point in time).

Analyzing how the balance sheet changes over time will reveal important information about the company's business trends.

Liabilities are obligations to creditors the business must pay back, such as money the company has borrowed. Net worth (shareholders' equity) is a different type of liability. It represents the owners' investment in the company and will never be paid back in the normal course of business.

Liabilities are a source of funds because the company is borrowing to get it; no money was spent in the process.

Assets, on the other hand, are a use of funds because money (sometimes investors' and creditors' money) was spent acquiring those assets.

Assets

Assets are what the company owns. Some examples of assets are:

  • Cash
  • Buildings
  • Machinery
  • Inventory

Assets are categorized on the balance sheet according to their characteristics.
The following paragraphs will explain the different types of assets.

Current Assets

Current assets are those assets that are expected to be converted to cash within 1 year. Current assets have the characteristic of being “liquid” because they can be sold for cash with ease. They are the sum of the following categories:

  • Cash
  • Accounts Receivable (A/R)
  • Inventory (Inv)
  • Notes Receivable (N/R)
  • Prepaid Expenses
  • Other Current Assets

Cash

Cash is the only game in town and is the most liquid asset. Cash pays bills and obligations; inventory, receivables, land, building, machinery, and equipment do not, even though they can be sold for cash and then used to pay bills. If cash is inadequate or improperly managed, the company may become insolvent and be forced into bankruptcy. Include all checking, money market, and short term savings accounts under cash. When a company doesn't have enough cash, they may have to borrow money; this in turn will cost the company money because they have to pay interest on the loan.

Accounts Receivable (A/R)

Accounts receivable is money owed to the business from its customers. An account receivable is created when a product is shipped to the customer before payment is received. The customer then has a certain time period to pay for their product, usually 30, 60, or 90 days. The process works like this: Inventory is sold and shipped, an invoice is sent to the customer, and later cash is collected.

Inventory

Inventory consists of the goods and materials a company purchases to re-sell at a profit. In the process, sales and receivables are generated. The company purchases raw material inventory that is processed (aka work in process inventory) to be sold as finished goods inventory.

For a company that sells a product, inventory is often the first use of cash. Purchasing inventory to be sold at a profit is the first step in the profit-making cycle (operating cycle), as illustrated previously. Selling inventory does not bring cash back into the company - it creates a receivable.

Only after a time lag equal to the receivable's collection period will cash return to the company; thus it is very important that the level of inventory be well-managed so that the business does not keep too much cash tied up in inventory, as this will reduce profits. At the same time, a company must keep sufficient inventory on hand to prevent stockouts (having nothing to sell) because this too will erode profits and may result in the loss of customers.

Notes Receivable (N/R)

Notes receivable is a receivable due the company in the form of a promissory note, arising because the company made a loan. Making loans is the business of banks, not operating businesses, particularly small companies with limited financial resources. Notes receivable is probably a note due from one of three sources:

  • Customers
  • Employee
  • Officers of the company

Customer notes receivable is when the customer who borrowed from the company probably borrowed because they could not meet the accounts receivable terms. If the customer fails to pay the invoice according to the agreed-upon payment terms, the customer's obligation may be converted to a promissory note.

Employee notes receivable may be for legitimate reasons, such as a down payment on a home, but the company is neither a charity nor a bank. If the company wants to help the employee, it can co-sign on the loan advanced by a bank.

An officer or owner borrowing from the company is the worst form of notes receivable. If an officer takes money from the company, it should be declared as a dividend or withdrawal and reflected as a reduction in net worth. Treating it in any other way leads to possible manipulation of the company's stated net worth, and banks and other lending institutions frown greatly upon it.

Other Current Assets

Other current assets consist of prepaid expenses and other miscellaneous current assets that are expected to be converted to cash within 1 year.

Fixed Assets

Fixed assets are assets that last longer than one year and not intended for resale. They include assets such as:

  • Land
  • Buildings
  • Machinery and Equipment
  • Furniture and Fixtures
  • Leasehold Improvements

Fixed assets are used in the process of creating products or services.

Intangibles

Intangibles represent the use of cash to purchase assets with an undetermined life; they may never mature into cash. For most analysis purposes, intangibles are ignored as assets and are deducted from net worth because their value is difficult to determine.

Intangibles consist of assets such as:

  • Research and Development
  • Patents
  • Market Research
  • Goodwill
  • Organizational Expense

In several respects, intangibles are similar to prepaid expenses - the use of cash to purchase a benefit which will be expensed at a future date. Intangibles, like fixed assets, are recouped through incremental annual charges (amortization) against income. Standard accounting procedures require most intangibles to be expensed as purchased and never capitalized (put on the balance sheet). An exception to this is purchased patents that may be amortized over the life of the patent.

Other Assets

Other assets consist of miscellaneous accounts such as deposits and long-term
notes receivable from third parties; they are turned into cash when the asset is
sold or the note is repaid. Total assets represent the sum of all assets owned by
or due to the business.

Liabilities and Shareholders' Equity

Liabilities and net worth are sources of cash listed in descending order from
the most nervous and current creditors to mature obligations (current liabilities)
to the least nervous and never due obligations (net worth).

There are two sources of funds: lender-investor and owner-investor. Lender-investor consists of trade suppliers, employees, tax authorities, and financial institutions. Owner-investor consists of stockholders and principals who loan cash to the business. Both lender-investor and owner-investor have invested cash or its equivalent into the company; the only difference between the investors is the maturity date of their obligations and the degree of their nervousness.

Current Liabilities

Current liabilities are those obligations that must be paid within one year. These are liabilities that can create a company's insolvency if cash is inadequate. A happy and satisfied set of current creditors is a healthy and important source of credit for short-term uses of cash (inventory and receivables).

An unhappy and dissatisfied set of current creditors can threaten the survival of the company. The best way to keep these creditors happy is to keep their obligations current.

Current liabilities consist of the following obligation accounts:

  • Accounts Payable - Trade (A/P)
  • Accrued Expenses
  • Notes Payable - Bank (N/P Bank)
  • Notes Payable - Other (N/P Other)
  • Current Portion of Long-term Debt

Proper matching of sources and uses of funds requires that short-term (current) liabilities must be used only to purchase short-term assets (inventory and receivables).

Notes Payable

Notes payable are obligations in the form of promissory notes with short-term maturity dates of less than 12 months. Often, they are demand notes (payable upon demand); other times they have specific maturity dates (30, 60, 90, 180, 270, and 360-day maturities are typical). The notes payable always include only the principal amount of the debt. Any interest owed is listed under accruals.

The proceeds of notes payable should be used to finance current assets (inventory and receivables). The use of funds must be short-term so that the asset matures into cash prior to the obligation's maturation. Proper matching would indicate borrowing for seasonal swings in sales, which cause swings in inventory and receivables, or to repay accounts payable when attractive discount terms are offered for early payment.

Accounts Payable

Accounts payable are obligations due to trade suppliers who have provided inventory or goods and services used in operating the business. Suppliers generally offer terms (just like you do for your customers), since the supplier's competition offers payment terms. Whenever possible, you should take advantage of payment terms, as this will help keep your costs down.

If the company is paying its suppliers in a timely fashion, days payable will not exceed the terms of payment.

Accrued expenses are obligations owed but not billed, such as wages and payroll taxes or obligations accruing, and not yet due, such as interest on a loan. Accruals consist chiefly of wages, payroll taxes, interest payable, and employee benefits accruals such as pension funds. As a labor-related category, it should vary in accordance with payroll policy (i.e., if wages are paid weekly, the accrual category should seldom exceed one week's payroll and payroll taxes).

Non-Current or Long-Term Liabilities

Non-current or long-term liabilities are those obligations that will not become due in the coming year. In other words, a debt that has a term longer than 12 months.

A list of some long-term liabilities follows:

  • Mortgages
  • Bonds
  • Notes Payable
  • Commercial Paper
  • Deferred Taxes

These are just some of the types of long-term liabilities.

Total Liabilities

Total liabilities represent the sum of all monetary obligations of a business as well as all claims creditors have on its assets.

Add current, long-term, and other liabilities together and you have total liabilities.

Shareholders' Equity or Net Worth

Total assets – total liabilities = shareholders' equity.

Shareholders' equity represents the value investors have in the business.

There are two components to shareholders' equity: capital stock and
retained earnings.

Capital Stock – This is the amount of money the owners have invested in
the business.

Retained Earnings – A company can do two things with the profit it makes.

1) It can distribute it to the owners in the form of dividend payments

or

2) It can retain those profits by putting it back into the business for improvements. If a company loses money during the year, the retained earnings account is reduced.

The Income Statement

The income statement indicates how profitable a company was over a certain period of time. The income statement records all income and expenses during the reported period; then shows what the net profit or net loss of the company was by subtracting the two numbers (income – expenses = net profit or loss).

If income exceeds expenses, the company makes a profit; conversely, if expenses exceed income, the company takes a loss.

The income statement is usually reported monthly, quarterly, or yearly.

There are more details to the income statement than just income expenses, and we will review them in the following paragraphs.

Sales or Revenue

This is the dollar amount of products and/or services the company sold to its customers during the reported period. This is also sometimes called the “top line” because it is the first item on the income statement and does not factor in expenses.

Later on we will talk about net profit, or “the bottom line.”

Cost of Goods Sold or Cost of Sales

This is how much it costs to produce the products sold during the reported period. These are only costs that are related to the productions of goods or services. Other costs like marketing and advertising are different and will be mentioned later.

When a company makes its products, it takes the costs (COGS) and adds it to the value of inventory (products not yet sold). Once the product is sold, those costs are moved (or subtracted) from the value of inventory and added to the cost of goods sold category.

Remember, a product needs to be sold before its costs are recorded in the Cost of Goods Sold category. Until then, this number is added to Value of Inventory
(which is on the balance sheet).

Some of the costs included in this category are:

  • Raw materials costs
  • Manufacturing costs
  • Labor costs
  • Factory costs

Gross Income

Gross income is sales – cost of goods sold. This is the income you make after you factor in the cost to produce the products sold during the reported period.

This number is important because it tells you how profitable your products are to sell, or your “gross profit margin.”

If your product has a small gross profit margin, you will need to sell a lot to make a profit (because you're not making much on each sale since the costs are high). However, if your gross profit margin is high, you don't have to sell a lot because you're making a good profit on each sale (since your cost to make that product is low).

You can see how important it is to keep your costs low.

Gross income does not factor in operating expenses like operating income, which we'll talk about later.

Operating Expenses or Selling, General,
and Administrative Expenses (SG&A)

These are day-to-day expenses of running the business. It's important to not that these are not expenses related to producing the company's product.

Some operating expenses are:

  • Selling expenses – advertising & marketing
  • Administrative expenses – salaries & wages (not labor)
  • General expenses – maintaining offices, rent, etc.

Some of these will vary with the type of business; however, the concept is the same: these are expenses related to the day-to-day operations of the business.

Depreciation Expense

This is the amount of money a company can deduct from its depreciable assets. This is not a cash expense; it's simply how much an asset has been “used up in dollars. Depreciation is a non-cash charge, or there is no cash paid out.

To say it another way, depreciation is the process in which a business gradually records the loss in value of a depreciable asset.

Some assets (machinery, cars) wear out (lose value) over time and a business is allowed to deduct this amount from its income. This reduces the company's
taxable income.

Operating Income

This is the income left over after cost of goods sold and operating expenses are subtracted from sales. Another way of arriving at this number is to subtract operating expenses from gross income.

This number is important because it shows how well the company can generate profits through its normal business operations. Operating income does not factor in taxes and interest expenses like net income does, which we'll talk about later.

Interest Expenses

This is how much the company is charged for borrowing money. This category includes interest expenses on all short and long-term loans and any other expenses related to borrowing.

Federal Income Tax

This is the amount a company has to pay to the government on the taxable income it generated during the reported period.

Net Income or Net Profit

This is the income left over after all expenses (cost of goods sold, operating expenses, taxes, interest, etc.) have been deducted. This is also called “the bottom line.”- it's the last line on the income statement.

The company can take this net profit and invest it back into the company (called retained earnings) or it may be distributed to shareholders' of the company in the form of dividends.

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References:

www.Business.Gov

Small Business Administration

Financial Accounting: The Impact on Decision Makers, 3rd Edition.

The Guide To Understanding Financial Statements, 2nd Edition