Definition: A written report of the financial condition of a firm. Financial
statements include the balance sheet, income statement, statement
of changes in net worth and statement of cash flow.
The first step in developing a financial management system is
the creation of financial statements. To manage proactively, you
should plan to generate financial statements on a monthly basis.
Your financial statements should include an income statement, a
balance sheet and a cash-flow statement
Income Statement
Simply put, the income statement measures all your revenue
sources vs. business expenses for a given time period. To help
explain things easily, let's consider an apparel manufacturer as an
example in outlining the major components of the income
statement:
Sales. This is the gross revenue generated from the sale
of clothing less returns (cancellations) and allowances (reduction
in price for discounts taken by customers).
Cost of goods sold. This is the direct cost associated
with manufacturing the clothing. These costs include materials
used, direct labor, plant manager salaries, freight and other costs
associated with operating a plant (for example, utilities,
equipment repairs, etc.).
Gross profit. The gross profit represents the amount of
direct profit associated with the actual manufacturing of the
clothing. It's calculated as sales less the cost of goods sold.
Operating expenses. These are the selling, general and
administrative expenses that are necessary to run the business.
Examples include office salaries, insurance, advertising, sales
commissions and rent.
Depreciation. Depreciation expense is usually included in
operating expenses and/or cost of goods sold, but it is worthy of
special mention due to its unusual nature. Depreciation results
when a company purchases a fixed asset and expenses it over the
entire period of its planned use, not just in the year purchased.
The IRS requires certain depreciation schedules to be followed for
tax reasons. Depreciation is a noncash expense in that the cash
flows out when the asset is purchased, but the cost is taken over a
period of years depending on the type of asset.
Whether depreciation is included in cost of goods sold or in
operating expenses depends on the type of asset being depreciated.
Depreciation is listed with cost of goods sold if the expense
associated with the fixed asset is used in the direct production of
inventory. Examples include the purchase of production equipment
and machinery and a building that houses a production plant.
Depreciation is listed with operating expenses if the cost is
associated with fixed assets used for selling, general and
administrative purposes. Examples include vehicles for salespeople
or an office computer and phone system.
Operating profit. This is the amount of profit earned
during the normal course of operations. It is computed by
subtracting the operating expenses from the gross profit.
Other income and expenses. Other income and expenses are
those items that don't occur during the normal course of business
operation. For instance, a clothing maker doesn't normally earn
income from rental property or interest on investments, so these
income sources are accounted for separately. Interest expense on
debt is also included in this category. A net figure is computed by
subtracting other expenses from other income.
Net profit before taxes. This figure represents the
amount of income earned by the business before paying taxes. The
number is computed by adding other income (or subtracting if other
expenses exceed other income) to the operating profit.
Income taxes. This is the total amount of state and
federal income taxes paid.
Net profit after taxes. This is the "bottom line"
earnings of the business. It's computed by subtracting taxes paid
from net income before taxes.
Balance Sheet
The balance sheet provides a snapshot of the business's assets,
liabilities and owner's equity for a given time. Again, using an
apparel manufacturer as an example, here are the key components of
the balance sheet:
Current assets. These are the assets in a business that
can be converted to cash in one year or less. They include cash,
stocks and other liquid investments, accounts receivable, inventory
and prepaid expenses. For a clothing manufacturer, the inventory
would include raw materials (yarn, thread, etc.), work-in-progress
(started but not finished), and finished goods (shirts and pants
ready to sell to customers). Accounts receivable represents the
amount of money owed to the business by customers who have
purchased on credit.
Fixed assets. These are the tangible assets of a business
that won't be converted to cash within a year during the normal
course of operation. Fixed assets are for long-term use and include
land, buildings, leasehold improvements, equipment, machinery and
vehicles. Intangible assets: These are assets that you cannot touch
or see but that have value. Intangible assets include franchise
rights, goodwill, noncompete agreements, patents and many other
items.
Other assets. There are many assets that can be
classified as other assets, and most business balance sheets have
an "other assets" category as a catchall. Some of the most common
other assets include cash value of life insurance, long-term
investment property and compensation due from employees.
Current liabilities. These are the obligations of the
business that are due within one year. Current liabilities include
notes payable on lines of credit or other short-term loans, current
maturities of long-term debt, accounts payable to trade creditors,
accrued expenses and taxes (an accrual is an expense such as the
payroll that is due to employees for hours worked but has not been
paid), and amounts due to stockholders.
Long-term liabilities. These are the obligations of the
business that aren't due for at least one year. Long-term
liabilities typically consist of all bank debt or stockholder loans
payable outside of the following 12-month period.
Owner's equity. This figure represents the total amount
invested by the stockholders plus the accumulated profit of the
business. Components include common stock, paid-in-capital (amounts
invested not involving a stock purchase) and retained earnings
(cumulative earnings since inception of the business less dividends
paid to stockholders).
Cash-Flow Statement
The cash-flow statement is designed to convert the accrual basis
of accounting used to prepare the income statement and balance
sheet back to a cash basis. This may sound redundant, but it's
necessary. The accrual basis of accounting generally is preferred
for the income statement and balance sheet because it more
accurately matches revenue sources to the expenses incurred
generating those specific revenue sources. However, it also is
important to analyze the actual level of cash flowing into and out
of the business.
Like the income statement, the cash-flow statement measures
financial activity over a period of time. The cash-flow statement
also tracks the effects of changes in balance sheet accounts.
The cash-flow statement is one of the most useful financial
management tools you will have to run your business. The cash-flow
statement is divided into four categories:
1. Net cash flow from operating activities. Operating
activities are the daily internal activities of a business that
either require cash or generate it. They include cash collections
from customers; cash paid to suppliers and employees; cash paid for
operating expenses, interest and taxes; and cash revenue from
interest dividends.
2. Net cash flow from investing activities. Investing
activities are discretionary investments made by management. These
primarily consist of the purchase (or sale) of equipment.
3. Net cash flow from financing activities. Financing
activities are those external sources and uses of cash that affect
cash flow. These include sales of common stock, changes in short-
or long-term loans and dividends paid.
4. Net change in cash and marketable securities. The
results of the first three calculations are used to determine the
total change in cash and marketable securities caused by
fluctuations in operating, investing and financing cash flow. This
number is then checked against the change in cash reflected on the
balance sheet from period to period to verify that the calculation
has been done correctly.