It is often overlooked that the reports made by accountants are not made FOR accountants. Which is why understanding financial statements should definitely NOT be a job for the accountant but instead for the business person. Whether that business person own a small business or work as an executive for a multi-national corporation, it is irrelevant. Anyone that is involved in business should have a basic understanding of the financials.
The idea of looking at a long list of numbers in columns and actually making something useful out of it may seem impossible. Often just the thought of rummaging through the ‘numbers’ is daunting if not downright scary!
The reality is that it is not as difficult as it may seem.
The purpose of the financial statements is to give the user the ability to understand the current health of the organization, determine a value they place on the organization, and make predictions for decisions.
Here are some examples of situations where the financial statements are useful.
For example, a person may be interested in purchasing a small business such as a restaurant. A buyer may need to determine the price he or she will offer. The buyer is probably interested in the resources currently available to the operations. Does the business include the restaurant building or is it rented? How much debt does that business have? They call that leverage. If the business is over-leveraged it may be riskier than the buyer wants. The potential buyer probably also may be interested in the profits the managers made in previous years. That information may help the buyer get an understanding of what he or she might expect to make. That all may help him or her determine the offer.
Another, typical user is an investor. Investors are similar to potential buyers. They want to know what the business has available. They want to know how much debt has been incurred. They will also want to know what profit was earned in past years.
A third user that is very typical in business is a creditor. Think banker or really anyone that is possibly making a loan to the business. Creditors are trying to determine if the managers that run the business will have the available funds to pay them back. Creditors typically focus on what the business currently owes and how much profit has been made so far. They use this information to make a decision as to whether or not they will lend the business money.
Now that you understand what the financial statements are used for, let’s consider the financial statements that are used most of the time.
First, let’s consider the Balance Sheet. Simply put the balance sheet shows what stuff the business has and how it got that stuff. The stuff owned by the business is called Assets. Assets are resources that the manager or owners that run the business, have available to run the business. For example, a trucking company has trucks. These trucks represent resources that are available for managers to put to use to make profits. The more trucks, the more potential for making profits.
Assets generally include the cash the business has, the inventory the business has to sell, supplies used in the business, and buildings and equipment that is needed for the business. Those are the main assets but the type of assets really is dependent on the type of business. For example, you might see a lot of inventory in a grocery store business, but a lawn service may not have any inventory but instead a lot of equipment.
In addition to understanding what resources the business has, it is also important to know how the business acquired it. To get the necessary resources, a business either needs to take on debt or use invested money.
Let’s say you want to start your own restaurant. You might save up and invest in the business yourself. But if you don’t have enough, you might ask others to invest with you. Another option is to take debt. The benefit of investors is you don’t have to pay them back like you do with loans. The problem with investors is they have a say in what happens. If you want to keep control, you take loans. But the loans add risk since they must be repaid. The Balance sheet gives you an understanding of how much debt was used vs investment in order to gain the resources necessary to run the business.
Next, let’s consider the Income Statement or also called the Profit Loss Statement. Most businesspeople intuitively understand the importance of determining profitability. The Income Statement provides the profit of the business for a specified period of time. Usually that period is a month, quarter, or year. The Income statement’s bottom line is the Net Income. It is derived by taking all the revenue earned and subtracting the expenses for that same period of time.
The Income statement will also consider any gains or losses on the sale of property, equipment or buildings used by the organization. For example, maybe your restaurant has a delivery truck used for catering. If you sell the truck for a good price you may end up making a gain on that sale. If the price is less than the value on the books, you could instead see a loss. The gain or losses are also included in the net income.
The final financial statement we will review is called a Statement of Cash Flows. The balance sheet already has the balance of cash available in the accounts. So why do you need another statement on cash? Cash is crucial to the business staying open by meeting its day-to-day needs such as payroll and suppliers. There is usually a timing difference from when a business earns profit and when the business receives cash. For example, if the restaurant completes a catering job in February the restaurant has earned revenue. But if the client does not pay for the job until March, then there is a timing difference from the time the business earned the profit and when the business received the cash. In the meantime, the business needs to pay the suppliers and employees for the work completed in February.
The Statement of cash flows fills in the gap of information. First, the statement provides cash from or used by three different areas of the business. The areas of focus are operations, investment, and financing. how much cash was brought in from the operations meaning collecting cash from running a restaurant.
The second, focus is investment. Investment means the managers buy resources needed. So, an investment would be a commercial oven used by the restaurant. The managers are investing in the business. Another way the business may invest could be to actually buy stocks or bonds in a different business. So, if the restaurant used some extra cash to buy stock in Microsoft, that use of cash would be an investment activity.
The third section of the statement of cash flows is the financing activities. This is getting money needed to buy the equipment, buildings, and other resources. Businesses may get financing from investors or from creditors. Typically, financing is only needed from time to time such as when the business first starts up.
If you are looking at a business’s statement of cash flow, it would typically show less risk if the cash was coming into the business from operations. Usually, investing activities are using cash so that is typically a negative cash flow. The financing activities are typically cash coming into the business unless the managers decide to pay off debt. Then it would be normal to see the financing act ivies as a negative cash flow.
Now that you understand the three main financial statements you can begin evaluating businesses on your own. Look over the balance sheet and see what kind of assets are there. Are the assets what you expect? If not, you may want to research that aspect. For example, you may want to know why there is so much inventory for an airline.
Then consider the balance sheet debt and equity. How much does the business owe compared to the assets? Too much debt may seem risky.
Consider the profits of the business. How much profit does the business have this year compared to previous years? Is it increasing or decreasing? What about other businesses in the same industry?
Now review the cash. Does the business have a healthy amount of cash to cover its current loans? Where did the cash come from, operations, investing, or financing activities?
This is just a start for analyzing the business but it is a good start that many people are unable to do. You can now begin to evaluate the business for yourself and as you get more practice you can develop more tools to analyze the business on a deeper level!