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In your Accounting or Finance class, you might have encountered the term financial statements. Financial statements or also known as financial reports are the numerical reports which record all the financial activities and position of a business, individual, or other entity. To be effective in business, you must understand accounting and financial reporting. By simply having knowledge about the structure and flow of money in business, you will be able to understand the following predicaments in business decision-making:
- How an enterprise can be rapidly growing, highly profitable and out of money all at the same time, and why this state of affairs is fairly common.
- Why working capital is so very important and which management actions lead to more, which leads to less.
- The difference between cash in the bank and profit on the bottom line, and how the two are interrelated.
- When in the course of business affairs a negative cash flow is a sign of good things happening, and when it’s a sign of impending catastrophe.
- Limits of common product costing systems and when to apply (and, more importantly, when to ignore) the accountant’s definition of cost.
- Why a development investment made today must return a much greater sum to the coffers of the company in later years.
- How discounts drop right to the bottom line as lost profits and why they are so very dangerous to a company’s financial health.
- How risk is different than uncertainty, and which is worse.
- Why a dollar in your pocket today can be worth a lot more than a dollar received tomorrow.
- The necessity (and limitation) of forecasting cash flows over time when making capital investment decisions.
- When to use NPV analysis and when to use IRR, and why it is important in capital investment decision-making.
Gordon B. Baty, the book author of “Entrepreneurship” once said, “Accounting is a language, a means of communicating among all the segments of the business community. It assumes a reference base called the accounting model of the enterprise. While other models of the enterprise are possible, this accounting model is the accepted form and is likely to be for some time. If you don’t speak the language of accounting or feel intuitively comfortable with the accounting model, you will be at a severe disadvantage in the business world. Accounting is a fundamental tool of the trade.”
As you read through this article, we will discuss each of the three main financial statements and learn how to report them.
The primary goal in financial reporting is the dissemination of financial statements that accurately measure the profitability and financial condition of a company. Though in some cases where reports can be manipulated by maximizing the growth expectations and downplaying contingencies, it is still critical to keep track of all transactions and elements that are part of the financial statements. Before starting to create a financial report, what kind of business dealings do you think should be considered to be added in the financial statements?
The following are common business dealings which need financial reporting:
- selling stock
- borrowing money
- receiving orders
- shipping goods
- invoicing customers
- receiving payments
- paying sales commissions
- writing off bad debts
- prepaying expenses
- ordering equipment
- paying deposits
- receiving raw materials
- scrapping damaged product
- paying suppliers
- booking manufacturing variances
- depreciating fixed assets
- valuing inventory
- hiring staff and paying salary, wages and payroll taxes
- computing profit
- paying income taxes
- issuing dividends
- acquiring a business
Basically, your goal behind creating a financial report is to assist you with your business dealings. Through financial manipulations using the report, you will be able to predict financial flow and come up with better financial decisions for your business transactions.
Now, we will discuss each three main financial statements starting with the Income Statement, next is the Balance Sheet, and then lastly, the Cash Flow Statement.
The income statement or also known as the profit and loss report consists of the calculation of the income, expenses, and profits over a stated period of time. It provides you critical insight regarding the health of a business (profitability). However, it does not tell the whole picture about a company’s financial health, anything the company receives as cash or how much cash it has on hand since it will fall under the cash flow statement while all reports on assets, liabilities, and equity will be under the balance sheet. Basically, the income statement only reports on the making and selling activities of a business over a period of time.
This can be easily understood with the following formula:
Of course, the formula is just the basic form of the income statement. However, each variable consists of many factors such as the:
- Net Sales – the total amount the company will ultimately collect from a sale (where income is generated).
- Cost of Goods Sold – expensed costs after all costs to manufacture products are added together to the value of inventory until the products are sold. Once inventory is sold, the cost is then taken out of the inventory and entered in the Income Statement as part of the cost of goods sold.
- Other Costs – expenditures for raw materials, wages, manufacturing overhead, etc. It is what you spend to buy or make products for inventory.
- Gross Margin – the amount leftover from sales after product manufacturing costs are deducted. Also sometimes called gross profit or the company’s manufacturing margin.
- Operating Expenses – the expenditures that a company makes to generate income, also called SG&A expenses, meaning, sales, general, and administrative expenses. Common groupings of operating expense are the following:
- Sales & Marketing Expense
- Research & Development (R&D) expenses
- General & Administrative (G&A) expenses
- Other Expenses – for developing and selling products as well as for running the general and administrative aspects of the business such as legal fees, salary, chemicals for R&D lab, etc.
- Income from Operations – refers to what’s leftover after expenses and costs are deducted from sales.
- Non-operating Income & Expense – interest incurred while paying loans or when receiving interest on cash balances in the company’s account.
- Net Income – the difference between sales and the cost plus expense. If the cost plus expense is more than the sales, the company will show a loss, otherwise, the company will show a profit. Though it doesn’t mean that income means cash, hence, even if a company shows a lot of net income, this does not guarantee its solvency.
In Accounting, you might be familiar with the saying that can be taken from the basic equation of accounting which states, “What you have minus what you owe is what you’re worth.”
In the Balance Sheet, the basic equation of accounting is presented in a different form such as:
As you already know, this equation must always be in balance. It presents the financial picture of the enterprise on a specific date that the financial report was written. This means the balance sheet reports what the enterprise has today (assets), how much the enterprise owes today (liabilities), and what the enterprise is worth today (equity).
Now, we will discuss every element included in the balance sheet.
The first section on the balance sheet is the Assets. It is all the cash, inventory, equipment, receivables, etc. that are valuable and quantifiable of a company. To break down different kinds of assets, the first thing would be the Current Assets. The current assets are all assets that are expected to be converted into cash in less than 12 months. The following are how assets are usually grouped and structured:
- Very liquid assets – cash and securities
- Productive assets – plant and machinery
- Assets for sale – inventory
- Accounts receivable – (special type of asset group) all obligations of customers
In the balance sheet, the assets are displayed in descending order of liquidity that is why cash is the first and foremost thing added while the fixed assets are considered as normally the least liquid. Meaning, the list of the order of liquidity in the current assets section of the balance sheet is the following:
In a manufacturing business model, Inventory includes three groupings:
- Raw material inventory – unprocessed materials that will be used in manufacturing products.
- Work-in-process inventory – partially finished products in the process of being manufactured.
- Finished goods inventory – completed products ready for shipment to customers when they place orders.
Take note that once a finished goods inventory gets sold, it becomes accounts receivable which is then turned into cash once the customer pays. As for Prepaid Expenses, these are things like prepaid insurance premiums, prepaid rent, deposits for utilities, salary advances, etc.
Of course, there are other asset types added in the balance sheet which are named: Other Assets and Fixed Assets. These are called the “non-current assets” which are not converted to cash during the normal course of business. Other assets include any intangible assets such as the value of patents, trade names, etc. While the Fixed assets are the so-called properties, plants and equipment, and others.
In the balance sheet entry, fixed assets at cost are recorded at the original price. Since fixed assets’ value depreciate over time, the accumulated depreciation is then deducted to arrive at the Net Fixed Assets. The accumulated depreciation includes all the depreciation charges taken since the asset was acquired. While the net fixed assets are the sum of its fixed assets’ cost minus the accumulated depreciation over the years. Basically, it is the so-called book value of an asset. After calculating each entry, you will then arrive with the Total Assets value.
The next critical section of the balance sheet is the Liabilities and Equity section. Liabilities are what you call the economic obligations of the enterprise such as funds owed to lenders, suppliers, etc. It is categorized and grouped on the balance sheet such as below:
- To whom the debt is owed
- Whether debt is payable within the year or is a long-term obligation
Just like in the Assets section where it is structured according to the liquidity of each entry, the Current Liabilities is grouped depending to whom the debt is owed like the following:
- Accounts Payable – owed to suppliers
- Accrued Expenses – owed to employees and others for services
- Current Debt – owed to lenders
- Taxes Payable – owed to the government
Any notes payable and the current portion of long-term debt are both components of current liabilities and are listed on the Balance Sheet under the current portion of debt. A loan with an overall term of more than 12 months from the date of the Balance Sheet is called long-term debt. After adding all the current liabilities and long-term debt, you will then get the total liabilities of a company.
The Shareholder’s Equity is a special kind of liability where it represents the value of the corporation that belongs to its owner. However, this kind of liability will never be repaid in the normal course of business. Also, take note that both “net worth” and “book value” mean the same thing as the shareholder’s equity. It has two key components called:
- Capital Stock – the original starting money that owners contributed as an investment which can be either common stock or preferred stock.
- Retained Earnings – all earnings of the company that have been retained but not paid out as dividends to owners but only serve as a pool of money to be used in the future for paying out dividends.
Basically, the shareholder’s equity is just the sum of investment made plus any profits, minus any dividends paid to the shareholders. It increases whenever there’s a profit or when new stocks are sold. While it decreases whenever there’s a loss or when paying dividends to shareholders.
The cash flow statement is a financial report of all cash and non-cash transactions. Basically, it tracks the movement of cash through the business over a period of time. It shows the cash on hand at the starting period, cash received in the period, cash spent in the period, and the cash on hand at the end of the period.
The Cash from Operations is recorded separately from other cash flows. It reports the flow of money in and out of the business from either making or selling the products or services. It is used to measure how well an enterprise is doing in its day-to-day operations. The following are considered as part of the cash from operations:
- Cash Receipts – inflows of money from operating the business (are not profits)
- Cash Disbursements – outflows of money used in operating the business
Of course, there are other kinds of major cash flow such as investments in fixed assets from buying a facility or machinery and also other financial activities such as selling stock to investors, borrowing money from banks, dividends payment, as well as taxes paid.
The Fixed Asset Purchases is the amount expensed to buy property, plant, and equipment as an investment in the long-term. It is not considered as part of the operations, hence, it is recorded as a separate entry in the cash flow of statement. Another separate entry is the Net Borrowings which is the difference between the new borrowings in a period and the amount paid back in the period. Most often companies borrow money to help with increasing the cash in hand to use for operations. Next in line would be the Income Taxes Paid which is deducted to pay what a company owes to the government. And lastly, the Sale of Stock which basically means literally – the sale of new stock to investors.
Below is a selection of Three Main Financial Statements model templates which are for general use or industry-specific. These are ready-made templates by financial modeling experts at eFinancialModels. So, feel free to download the ones to your liking to use as either a base to start with or as a reference for your own financial model.
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