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Understanding financial statements is not always the easiestof things, but certainly one of the more important parts of ensuring you aremaking the best financial decisions for your business. As the business owner you should know enoughto create a solid base of understanding from which you make decisions for managingyour business finances.(We at Arizona Tax Advisors– your Corporate Tax Consultantrecommendutilizing the expertise of your accountant to fully understand your numbers andthe impact of those decisions.) Let’s take a look at the basics.
A financial statementprovides an accounting-based pictureof a business’s financial position. There are four statements that make up yourfinancial overview package. Theseinclude the Balance Sheet, the Income Statement, the Statement of Cash Flows, and the Statement of Retained Earnings.
Basics of Balance Sheets– ALE’s…graba beer and let’s talk about Assets, Liabilities, and Equity!
The balance sheetreports a business’s assets, liabilities, and equity at a particular pointintime. It “balances” the assets with the liabilitiesand equity, thus the name “Balance Sheet”, (Assets = Liabilities + Equity).
Assets arethe items you own which are convertible into cash, your total resources; allproperty available for payment of debts. (Dictionary.com)
Liabilitiesare the moneys you owe – your debts.(Dictionary.com)
Equityincludes the monetary value of a property or business beyond any amounts owedon it in mortgages, claims, liens, etc. It also means ownership, especially when considered as the right toshare in future profits or appreciation in value. Additionally, it refers to the interest ofthe owner of common stock in a corporation, and finally, the excess marketvalue 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 balancesheet starts by listing CurrentAssets. A current asset will usuallyconvert to cash within one year. Current assets include Cash andmarketable securities, Accountsreceivable, and Inventory.
Listed next are the FixedAssets, also known as Non-current Assets. A fixed asset has a useful life exceeding oneyear. In other words, it most likely will not be converted to cash within ayear. Fixed assets include physical(tangible) assets such as netfacility and equipment, and otherlong-term assets. The net facility and equipment total is calculatedby taking the original cost of your non-current assets (land, buildings,vehicles, furniture, equipment, etc.) and subtracting the accumulateddepreciation. (Methods of depreciationare a discussion for another time! Wemight need a refill on that beer!)
The total liabilities and equity side of the balance sheet firstlists Current Liabilities. A current liability represents the company’sobligations due within one year. This includes Accrued wagesandtaxes, Accounts payable, and Notes payable (those coming due withinthe year). Current liabilities also include the Current Portion of Long TermDebt (CPLTD) such as the payments required on your mortgage within the year,etc.
Next listed is Long-termdebt, things like long-term loans, and bonds with maturities of more than oneyear.
When a company has issued stock, the next on the list is theStockholders’ equity.
Understanding the balance sheet allows for better managementof many underlying issues such as using the best fixed asset depreciationmethod,ensuring appropriate levels of liquidity are maintained, calculatingnetworking capital, etc.
The Idea Behind Income Statements
Income statementsshow the total revenues that a firm earnsand the total expenses the firm incurs to generate those revenues over aspecific periodoftime. Again, your balance sheet reports a company’s financial snapshot at agiven time while the income statement covers a specific period of time.
The income statement calculates your operating income, interestpaidon financing, and taxes. Thisreport ultimately gives the net profit available to equity holders in thecompany. For managerial decisions, thismeans understanding things like if your expenses are too high, if it is time toimprove 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 commonfinancial documents, and they give us critical information to help us run asuccessful business. They show us how wehave been doing.As a financial decision maker, we also need a tool to show us theflow of cash in and out of the business. As they say, “Cash is king”(and that is not areference to Johnny Cash, one of the kings of country music!)Having cash putsyou in a more stable position with better buying power, and affords you greaterprotection against loan defaults and foreclosures. This is where we need our“Statements of Cash Flows”.
The Importance of Statements of CashFlows (Cash Flow Statements)
Cash flow statements show the cashflow of the company over a given periodoftime. They report the amount of cash a company hasgenerated and distributed during a particular time period; bottom line, thedifference between cash sources and uses.
A cash flow statementdiffersfrom an income statement in that it looks at cash and cash equivalents withoutadding the noncash entries of theIncome Statement, like depreciation. The income statement also uses GenerallyApproved Accounting Principles, commonly known as GAAP. GAAP procedures require a company to useaccrual-based accounting meaning the company recognizes revenue at the time ofsale, and shows their production and other expenses on the income statement asthe sales takes place. Sometimes, however, the company receives payment beforeor after the time of sale, while the expenses related to making the product forthe sale often occur much sooner than the actual sale. Again, this is where the statement of cashflowstells its story.
The statement of cash flows includes Operating Activities,Investing Activities, Financing Activities and Supplemental Information. What exactly does that mean?
1. OperatingActivities – converts the items reported on the income statement from theaccrual basis of accounting to cash. (Remember GAAP procedures mentionedabove.)
2. InvestingActivities – reports the purchase and sale of long-term investments andproperty, plant and equipment.
3. Financingactivities – reports the issuance and repurchase of the company’s own bondsand stock, and payment of dividends.
4. Supplementalinformation – reports the exchange of significant items that did notinvolve cash, and reports the amount of income taxes paid and interest paid.
To someone reviewing a company’s statement of cash flows, acomparison of the cash from operating activities to the company’s net incomecan tell them if the company’s earnings are “high quality” (consistentlygreater) or raise a red flag as to why the reported net income is not turninginto cash (consistently less).
Investors may note that the company is consistentlygenerating 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 stockholdervalue.
So now let’s look at the portion of the company’s profitsthat 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 RetainedEarnings
The Statement ofRetained Earningsshows the changes, duringareportingperiod, of acompany’s net income (profit) minus the monies (dividends) paid out to shareholders. The balance is retained by the companyfor internal use. These are your retained earnings, and may also bereferred to as retained profit or accumulated earnings.Retained earnings do notrepresent surplus funds, but rather redirected funds often reinvested in theorganization. Retained funds are used forthings like paying debt obligations,promoting growth and development, improvingliquidity, orpurchasing an asset. Atypical reporting period is one year (ex. December 31, 2018 vs. December 31,2017).
The purpose of releasing a statement of retained earnings isto improve market and investor confidence in the organization. It is used to analyze the health of thecompany.
The information included in this brief article is meant toinform. It is not meant to replaceexpert advise from your accountant. Thefundamentals explained here will not fix all that “ALE’s” you, but it is astart.
Cheers to you, forunderstanding your financial statements and putting them to great use to manageyour company! As always, we are here tohelp with any questions and concerns you may have.
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