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Understanding Financial Statements: A Health Checkup for Your Business

Financial Statements record the performance of your business and allow you to diagnose its strengths and weaknesses by providing a written summary of financial activities. There are two' primary financial statements: the Balance Sheet and the Statement of Income.

Liabilities are funds acquired for a business through loans or the sale of property or services to the business on credit. Creditors do not acquire business ownership, but promissory notes to be paid at a designated future date.

Shareholders' equity (or net worth or capital) is money put into a business by its owners for use by the business in acquiring assets.

At any given time, a business's assets equal the total contributions by the creditors and owners, as illustrated by the following formula for the Balance Sheet:

Assets       =       Liabilities     +     Net Worth

(Total                (Funds                (Funds
funds                 supplied              supplied
invested in          to the                 to the
assets of             business             business
the                     by its                  by its
business)            creditors)           owners)

This formula is a basic premise of accounting. If a business owes more money to creditors than it possesses in value of assets owned, the net worth or owner's equity of the business will be a negative number.

The Balance Sheet is designed to show how the assets, liabilities, and net worth of a business are distributed at any given time. It is usually prepared at regular intervals; e.g., at each month's end but especially at the end of each fiscal (accounting) year.

By regularly preparing this summary of what the business owns and owes (the Balance Sheet), the business owner/manager can identify and analyze trends in the financial strength of the business. It permits timely modifications, such as gradually decreasing the amount of money the
business owes to creditors and increasing the amount the business owes its owners.

All Balance Sheets contain the same categories of assets, liabilities, and net worth. Assets are arranged in decreasing order of how quickly they can be turned into cash (liquidity). Liabilities are listed in order of how soon they must be repaid, followed by retained earnings (net worth or
owner's equity), as illustrated in Figure 2-1, below, the sample Balance Sheet for ABC Company.

The categories and format of the Balance Sheet are established by a system known as Generally Accepted Accounting Principles (GAAP). The system is applied to all companies, large or small, so anyone reading the Balance Sheet can readily understand the story it tells.

Figure 2-1 ABC Company December 31, 20__-Balance Sheet

Cash             $ 1,896            Notes Payable,      $ 2,000
                                            Bank
   
Accounts          1,456           Accounts                  2,240
Receivable                            Payable

Inventory           6,822          Accruals                      940

Total Current  $10,174         Total Current         $ 5,180
Assets                                   Liabilities

Equipment and     1,168         Total Liabilities        5,180
Fixtures

Prepaid Expenses 1,278          Net Worth             7,440

Total Assets      $12,620         Total Liabilities   $12,620
                                               and New Worth

Balance Sheet Categories

Assets: An asset is anything the business owns that has monetary value.

* Current Assets include cash, government securities, marketable securities, accounts receivable, notes receivable (other than from officers or employees), inventories, prepaid expenses, and any other item that could be converted into cash within one year in the normal course of business.

* Fixed Assets are those acquired for long-term use in a business such as land, plant, equipment, machinery, leasehold improvements, furniture, fixtures, and any other items with an expected useful business life measured in years (as opposed to items that will wear out or be used up in
less than one year and are usually expensed when they are purchased). These assets are typically not for resale and are recorded in the Balance Sheet at their net cost less accumulated depreciation.

* Other Assets include intangible assets, such as patents, royalty arrangements, copyrights, exclusive use contracts, and notes receivable from officers and employees.

Liabilities: Liabilities are the claims of creditors against the assets of the business (debts owed by the business).

* Current Liabilities are accounts payable, notes payable to banks, accrued expenses (wages, salaries), taxes payable, the current portion (due within one year) of long-term debt, and other obligations to creditors due within one year.

* Long-Term Liabilities are mortgages, intermediate and long-term bank loans, equipment loans, and any other obligation for money due to a creditor with a maturity longer than one year.

* Net Worth is the assets of the business minus its liabilities. Net worth equals the owner's equity. This equity is the investment by the owner plus any profits or minus any losses that have accumulated in the business.

The Statement of Income

The second primary report included in a business's Financial Statement is the Statement of Income. The Statement of Income is a measurement of a company's sales and expenses over a specific period of time. It is also prepared at regular intervals (again, each month and fiscal year end) to show the results of operating during those accounting periods. It too follows Generally Accepted Accounting Principles (GAAP) and contains specific revenue and expense categories regardless of the nature of the business.

Statement of Income Categories

The Statement of Income categories are calculated as described below:

* Net Sales (gross sales less returns and allowances)

* Less Cost of Goods Sold (cost of inventories)

* Equals Gross Margin (gross profit on sales before operating expenses)

* Less Selling and Administrative Expenses (salaries, wages, payroll taxes and benefits, rent, utilities, maintenance expenses, office supplies, postage, automobile/vehicle expenses, insurance, legal and accounting expenses, depreciation)

* Equals Operating Profit (profit before other non-operating income or expense)

* Plus Other Income (income from discounts, investments, customer charge accounts)

* Less Other Expenses (interest expense)

* Equals Net Profit (Loss) Before Tax (the figure on which your tax is calculated)

* Less Income Taxes (if any are due)

* Equals Net Profit (Loss) After Tax

For an example of a Statement of Income, see Figure 2-2, the statement of ABC Company.

Figure 2-2 ABC Company December 31, 20__-Income Statement

Net Sales                        $68,116

Cost of Goods Sold          47,696

Gross Profit on Sales      $20,420

Expenses
Wages                             $6,948
Delivery Expenses                 954
Bad Debts Allowances         409
Communications                   204
Depreciation Allowance       409
Insurance                             613
Taxes                               1,021
Advertising                       1,566
Interest                                409
Other Charges                     749

Total Expenses             $13,282
Net Profit                         7,138
Other Income                      886

Total Net Income           $ 8,024

Calculating the Cost of Goods Sold

Calculation of the Cost of Goods Sold category in the Statement of Income (or Profit-and-Loss Statement as it is sometimes called) varies depending on whether the business is retail, wholesale, or manufacturing. In retailing and wholesaling, computing the cost of goods sold during the accounting period involves beginning and ending inventories. This, of course, includes purchases made during the accounting period. In manufacturing it involves not only finished-goods inventories, but also raw materials inventories goods-in-process inventories, direct labor, and
direct factory overhead costs.

Regardless of the calculation for Cost of Goods Sold, deduct the Cost of Goods Sold from Net Sales to get Gross Margin or Gross Profit. From Gross Profit, deduct general or indirect overhead such as selling expenses, office expenses, and interest expenses, to calculate your Net
Profit. This is the final profit after all costs and expenses for the accounting period have been deducted.

Financial Statements Article
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