NAVIGATING THE THREE MAJOR FINANCIAL STATMENTS

NAVIGATING THE THREE MAJOR FINANCIAL STATMENTS

The underlying purpose of every company is to make money. So if you're a manager, part of your job is to help your company earn a profit-ideally, a bigger one each year.

Of course, you may work in the nonprofit or government sector, where making money isn't the most important goal. But you will still have to monitor the money that comes in and goes out.

Wherever you work, you can improve the financial health of your organization by reducing cost, increasing revenue, or both. You can help the organization make good investments and use its resources wisely.

The best managers don't just watch the budget- they look for the right combination of controlling costs, improving sales, and utilizing assets more effectively. They understand where revenue comes from, how the money is spent, and how much profit the company is making. They know how good a job the company is doing at turning profit into cash.

To learn all this, managers rely primarily on three documents:

• The income Statement

• The balance sheet

• The cash flow statement

These are called financial statements, or just financials. Publicly traded companies- Those that sell stock to the public on an exchange- make summary financial statements available to everyone, usually on a quarterly bass. Privately held companies- owned by one person, a family, or a small group of investors- often keep their financial statements private. But nearly every company produces detailed financials for internal use.

Accounting methods

You don't have to be an accountant to understand finance. But you do have to know just a couple of important things about accounting.

First, financial statements follow the same general format from one company to another. Individual line items may vary somewhat, depending on the nature of the business. But the statements are usually similar enough that you can easily compare performance. The reason for the similarity is that accountants all follow the same set of rules. In the United States, Those rules are called "generally accepted accounting principles, or GAAP".

Second, GAAP allows two different methods of accounting. Cash- Based Accounting is typically used by very small companies. It's really simple The company records a sale whenever it receives cash for a product or a service and records an expense whenever it issues a check.

The other method, Accrual Accounting, is a little more complicated and far more common. The company records a sale whenever it delivers a product or a service, not when cash changes hands. It records an expense whenever it incurs one, not when it actually writes a check. The key to this method is what accountants call the matching principle: Mach every cost to the revenue that is associated with it.

Let's look at an example. Amalgamated Hat Rack, an imaginary company that manufactures hat racks from imitation moose antlers, records revenue each time it ships racks to a customer. Because the customer hasn't paid yet, revenue always includes estimates of cash the company will receive in the future.

When Amalgamated orders 2,000 brass hooks from a supplier, it doesn't record the expense of those hooks all at once; rather, it records part of the expense with every sale. If each hat rack has five brass hooks, the accountants record the cost of five brass hooks every time one hat rack is sold.

Why use the accrual method? Because it gives you a more accurate picture of profit. If you work for a hat rack company, you want to know whether each hat rack you sell is profitable. To answer that question, you have to track the costs you incur and the revenue you bring in every time you make one and ship it to a customer.

The Income Statement

The income statement tells you whether the company is making a profit- that is, whether it has positive net income- according to the rules of accrual accounting. (Income is just another word for profit, which is why the income statement is also called a profit-and-loss statement, or P&L.) It shows a company's revenue, expenses, and profit or loss for a specific period of time-typically a month, a quarter, or a year.

How does an income statement present this profit picture? It begins with the company's revenue or total net sales(same thing) during the period it covers. It then lists all the various costs, including the cost of making the goods or delivering the services, overhead expenses, taxes, and so on, and subtracts them from revenue. The bottom line-what's left over-is the net income, or profit.

Let's look more closely at the line items that appear on the income statement. Cost of goods sold(usually abbreviated as COGS) is what it cost Amalgamated to manufacture the hat racks. That includes raw materials, labor, and any other costs directly related to production.

Subtract COGS from revenue and you get gross profit, which shows how much the company made before paying its overhead, taxes, and so on. You can use this number to calculate gross margin, which doesn't appear on the income statement but is still an important number. Just divide gross profit by revenue. Amalgamated Hat Rack's gross margin is $1.6 million divided by $3.2 million, or 50%.

FIGURE 1

Operating expenses-also known as sales, general, and administrative expenses(SG&A), or simply overhead-include the salaries of administrative employees, rents, sales and marketing expenses, and any other cost not directly attributed to manufacturing a product or delivering a service. The cost of the company's phone system, for example, would be included on this line.

Depreciation is a way of estimating the cost of assets that a relatively long time. A computer system, for example, might have a useful life of three years. So it doesn't make sense to record its entire cost in the first year. Rather, the company spreads the expense over the system's useful life. If the accountants employ a simple straight-line method of depreciation, they would record one-third of the total cost on the company's income statement each year.

Subtract operating expenses and depreciation from gross profit and you get operating income, often called earnings before interest and taxes, or EBIT. Subtract interest costs and taxes from EBIT and you get net income, or profit-the famous bottom line.

The Balance Sheet

A balance sheet is a snapshot: It summarizes a company's financial position at a given point in time, usually the last day of a year or a quarter. It shows what the company owns(its assets), what it owes(its liabilities), and the difference between them, called owners' equity or shareholders' equity.

A balance sheet is called that because it always balances. That is, all the assets must equal all the liabilities plus owners' equity. This is sometimes known as the fundamental accounting equation, and it looks like this:

Assets = Liabilities + Owners' equity

Here's why the equation holds true.

Assets are everything a company owns. The category includes cash, land, buildings, vehicles, machinery, computers, and even intangible assets such as patents.(It doesn't include people, because the company doesn't own its employees.)

Of course, a company has to acquire these assets. It can use its own money, which is the money its owners have invested in it plus the money the company itself has earned over time. Or it can use borrowed money. In balance sheet terminology, its own money is owners' equity, and borrowed funds are liabilities.

And because you can't get something for nothing, the assets need to equal liabilities plus owners' equity. If a company has $3 million in assets and $2 million in liabilities, it must have owners' equity of $1 million.

Balance sheet data are most helpful when compared with information from a previous year. In figure 2, "Amalgamated Hat Rack balance sheet as of December 31,2022 and 2021," a comparison of the figures for 2022 against those for 2021 shows that Amalgamated has increased its total liabilities by $74,000 and its total assets by $471,500, resulting in an increase in owners' equity.

FIGURE 2

Again let's look more closely at the terms. The balance sheet begins by listing the most liquid assets: cash and marketable securities, accounts receivable (what customers owe as of the balance sheet's date), and inventory, along with any costs that have been paid in advance (prepaid expenses). These are called current assets. Next it tallies assets that are less liquid- for example, buildings and machinery, known as property, plant, and equipment (PPE). These are called fixed assets or long-term assets.

Companies value their fixed assets according to what the assets originally cost. But because all fixed assets (other than land) depreciate over time, the accountants must also include any depreciation on those assets that they have recorded so far on income statements. Gross property, plant, and equipment minus accumulated depreciation equals net property, plant, and equipment- in other words, the current book value of the company's fixed assets.

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TIP: SHORT-TERM DEBT

The balance sheet distinguishes between short- and long-term debt must be paid in a year or less. It includes accounts payable, short-term notes, salaries, and income taxes.

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The line items under liabilities and owners' equity are pretty easy to understand. Accounts payable is what the company owes its suppliers; income tax payable is what it owes the government. Accrued expenses are funds owed for salaries or other costs not included under accounts payable. Shorts-term debt is debt that must be paid in less than a year.

These are the company's current labilities. Subtracting current liabilities from current assets gives you what's known as working capital, which indicates how much money the company has tied up in operating activities. So for 2022, Amalgamated had $2,165,500 minus $1,000,000, or $1,165,500, in working capital.

Most long-term liabilities are loans of one sort or another, so the balance sheet shows long-term debt and then total liabilities, which is just the sum of current and long-term liabilities. Owners' equity, as we have seen, is the total of what shareholders have invested in the company over time (contributed capital) and what it has earned and retained in past years (retained earnings).

The Cash Flow Statement

A cash flow statement gives you a peek into a company's checking account. Like a bank statement, it tells how much cash was on hand at the beginning of a period and how much at the end. It also shows where the cash came from and how the company spent it.

If you work for a large corporation, changes in the company's cash flow probably don't affect your daily work. Still, it's a good idea to stay up-to-date with the cash flow statement and projections, because they may come into play when you prepare your budget for the coming year. If cash is tight, you will probably be asked to spend conservatively. If it's plentiful, you may have opportunities to make new investments. The same goes for small companies, of course, where cash is often very tight. Even if the company is profitable, owners may sometimes wonder whether they can make payroll.

The cash flow statement shows how well your company is turning profits into cash, and that ability is ultimately what keeps a business solvent. We see in figure 3, "Amalgamated Hat Rack cash flow statement for the year ending December 31, 2022," that the company generated a net increase in cash of $166,000 in 2022. Note that this is not the same as net profit, which is shown on the income statement as $347,500. The income statement includes depreciation and other items that do not involve any cash. It records revenue and expenses as they are incurred rather than when cash changes hands. The cash flow statement shows investments in capital assets such as machinery that shown up on the income statement only as those assets are depreciated.

FIGURE 3

Notice, however, that the cash flow statement starts with net income and, through a series of adjustments, translates that into net cash. For instance, it adds depreciation back in, because depreciation is an expense that involves no cash.

Again, let's look at some key terms. The first big category is cash flow from operations. That just means all the cash the company took in or spent on ongoing operations-cash from customers, cash spent on wages and materials, and so on. A company's operating cash flow is a very good indicator of its financial health. If it's negative, the company may be in serious trouble. (A negative number on a cash flow statement is indicated by parentheses.)

The second big category is cash flow from investing activities. "Investing" in this context means money spent on assets such as machinery or vehicles and money realized from the sale of such equipment. For most companies, cash from investing activities should be a negative number. That means the company is investing some of its cash in assets that will generate future growth.

The third big category is cash flow from financing activities. This includes any cash received from a company's owners (shareholders) or paid to its owners in the form of dividends. It also includes cash received from loans and cash paid to lenders.

Add up all three major categories and get the increase in cash during the year. Of course, for some companies, it might be a decrease, particularly if the company is growing fast and investing heavily in capital assets. This figure corresponds to the increase or decrease in cash and marketable securities that appears at the top of a two-year balance sheet comparison.