Dollars And Sense Of Financial Statements

Finance, it is often said, is the language of business. This may well be true, but there are a lot of us who don't understand the language and could be described as 'financially illiterate.' It doesn't have to be that way and you don't need an accounting background to become financially literate.

Accountants record a written history of the various transactions a business makes in terms of the dollars involved in each transaction. The summary of this history is reported to managers and those outside the business as financial statements or financial reports.

The two best-known financial statements are the position statement - or balance sheet - and income statement - or profit or loss statement. (A sample position statement and income statement are included at the end of this article. Refer to the samples as you read this article.)

POSITION STATEMENT

A position statement shows the condition of a business at a given point in time: the date shown at the top of the statement. The position statement can be likened to a snapshot of the business. This statement shows what the business owns - assets; what the business owes - liabilities; and net worth - the equity or ownership interest of the business.

Assets are things of value owned by a business. Examples include cash, inventory of goods for sale, accounts receivable (sums owed to the business by others), land, buildings, furniture, and fixtures. Assets are further classified as current or fixed. Current assets are those likely to be turned into cash within one year in the normal course of business. Fixed assets represent the permanent resources of the business, which are not held for resale.

Liabilities are sums owed by a business to others outside the business. Examples of liabilities include accounts payable (sums owed for goods or services provided on credit), notes and/or mortgages payable, and accrued items. Accrued items are obligations that are not yet due but are recognized as an amount due at a future time. For example, a retailer may collect sales taxes on each transaction but does not remit the money thus collected to the state until the end of an accounting period. The tax money is an obligation to pay the state, and the money does not really belong to the business. Liabilities are also classified as current or long term. Current liabilities fall due within one year. Long-term liabilities, or deferred liabilities, are due beyond one year.

Net worth represents the interest or equity that the owners have in the business. Net worth is shown in different forms depending on the legal organization of the business. A business organized as a corporation will show net worth as capital stock and retained earnings. Capital stock represents the sum the owners have invested in the business. Retained earnings represent the sums earned by the business that have not been paid out to the owners as dividends. A partnership or proprietorship will show net worth as the owner's investments and perhaps the drawings, or profits, paid out to the owners.

Because of the double-entry accounting system used to keep financial records, the formula for the position statement can be stated as:

Assets = Liabilities + Net Worth

INCOME STATEMENT

The income statement (profit or loss) shows what happened to a business over the period of time indicated at the top of the statement. For example, 'the three months ended March 31, 20xx,' or 'the year ended Sept. 30, 20xx.' This statement shows the revenue that came into the business, how it was spent, and what was left over as profit. An income statement can be likened to a motion picture of a business taken over a period of time.

Typically, revenue is shown as sales. Sales represent the value of goods and services sold to customers. Next is shown the cost of sales (or cost of goods sold) which is the amount the business paid for what it sold. When cost of sales is deducted from sales, the result is a figure called gross profit. Gross profit simply represents the difference between what the business sold and what it paid for what was sold. It is not a profit in the strict sense of the word.

Gross profit is reduced by expenses. Expenses represent sums given up by the business in support of sales. Examples of expenses include rent, salaries/ wages, insurance, advertising, heat, light and power, interest, and outside services.

Operating profit is the result of subtracting expenses from gross profit. Operating profit is further adjusted by other additions and deductions and income taxes to result in net profit. Net profit is the final profit available to the owners or the profit that can be 'taken to the bank.' The formula for the income statement is:

Sales - Cost of Sales = Gross Profit

Gross Profit - Expenses = Operating Profit

Now that you have a basic idea of what information is shown by these two financial statements, we can present a 'quick check' of what to look for when you see a financial statement. A word of caution: Each industry or line of business has its own operating characteristics. A manufacturer's statement will differ from a retailer's. Within an industry, the operating characteristics will vary from business to business.

For example, a business that makes all sales for cash and does not extend credit to its customers will have different financial requirements and characteristics than one that routinely extends credit. The following are simple ratios that can be used to make a cursory analysis of financial statements:

DEBT-TO-NET-WORTH

Solvency is one of the first things to look at in evaluating a business. Solvency is the ability to meet financial obligations as they come due, the ability to pay bills on time. A measure of long-term solvency is the ratio of debt to net worth. The formula for this ratio is:

(Current Liabilities + Long Term Liabilities) / Total Net Worth = X to X

This measures the degree to which the owners or investors in the business have supplied the needed capital for the business as opposed to outsiders. The higher the net worth in relation to debt, the greater the protection afforded to outside creditors. It used to be considered that net worth should exceed debt, but today many businesses function well with debt exceeding net worth.

CURRENT RATIO

A common measure of short-run solvency is the current ratio. The current ratio provides an indication of the ability of the business to meet current obligations. The formula for this ratio is:

Current Assets / Current Liabilities = X to X

The traditional benchmark for the current ratio is 2:1. However, many operating characteristics of a business can influence where this ratio should be. A 2:1 ratio today is considered strong. The quality of the assets represented by current assets can be just as important as the ratio itself. For instance, a large, obsolete inventory may not produce enough cash for a business to retire its debts, or slow collection of receivables may hamper a business.

INVENTORY TURNOVER

For a line of business that maintains a substantial inventory, inventory turnover is important. Inventory must be sold to produce cash which is used, in turn, to pay bills. A rough measure of inventory turnover is:

Sales / Inventory = X times

Generally, the greatest number of turns is preferred. That is, the faster a business can sell its inventory, the more cash is generated, and the less likely that the inventory will become obsolete.

RETURN ON INVESTMENT

Turning to the income statement, the first thing to look at is whether the business earned a profit for the period. Assuming a profit is earned, a measure of the quality of that profit is return on investment:

Net Profit / Beginning Net Worth = X %

Return on investment (ROI) is a measure of how well the business is performing. The percentage can be compared to past performance, to other similar businesses, or to other investments. Note that the calculation for return on investment must be annualized if the statement data is for less than a year before valid comparisons can be made.

EXPENSES TO SALES

The income statement provides information on how much the business paid out in expenses. Expense control is an important task of management. This ratio indicates what percentage of sales were absorbed by expenses:

Total Expenses / Sales = X %

Obviously, the lower this percentage, the better the chance of having a portion of the sales dollars ending up as profit.

Don't expect to become a financial expert. Nor can you use this information alone to form valid conclusions about the financial condition of a business. You can, however, use this information to help communicate with financial experts, to make some dollars and sense of financial statements.

SAMPLE COMPANY INCOME STATEMENT FOR THE 12 MONTHS ENDING DECEMBER 31, 20xx

SAMPLE COMPANY POSITION STATEMENT DECEMBER 31, 20xx