Demystifying the Financial Statement
Jim Biehl
Owners spend years amassing the knowledge and experience necessary to become masters at their craft. Passion for the work and the satisfaction of helping clients is what drives them – not necessarily administrative tasks like financial accounting and reporting. Yet, even when a trusted outsourced business partner manages back-end financials, it’s still important for company leaders to understand the need for these reports and to have a clear understanding of how they reflect – and can impact – the company’s operations. Let’s look at a key report, the financial statement, and demystify its purpose.
The financial statement is one of the most important documents for operating an organization as it reveals how the company’s resources are being used. Following is a brief analysis of each financial statement component; using a manufacturing company example.
Financial Statement Components
A financial statement is composed of three or four main reports, including the balance sheet, income statement, and statement of cash flows. For some businesses, there may also be a fourth statement on shareholders’ equity. Each statement provides valuable insight into a company’s financial condition.
Balance Sheet
The function of the balance sheet is to demonstrate the financial status of the entity at the end of a reporting period. The balance sheet will show what assets are owned, plus liabilities to banks, other lenders, vendors, or suppliers. Shareholders’ equity is the last piece of a balance sheet, and records show much owners have invested, plus or minus earnings (or losses). When reading a balance sheet, pay attention to current, non-current, and fixed assets, and current and long-term liabilities. Assets and liabilities are listed based on their ability to be converted to cash and their due dates, respectively.
To understand how an organization is performing, a good practice is to compare balance sheet data across time to see how economic activities are impacting the company’s overall financial position. This exercise is also useful as a benchmarking or competitive analysis tool.
ABC Company
Balance Sheets
| Assets | 2019 | 2018 | |
| Current Assets | |||
| Cash | $780,000 | $250,000 | |
| Accounts Receivable | A | 3,280,000 | 2,820,000 |
| Inventory | 1,790,000 | 1,670,000 | |
| Total Current Assets | B | $5,850,000 | $4,740,000 |
| Property and Equipment | 720,000 | 690,000 | |
| Other Assets | C | 140,000 | 160,000 |
| Total Assets | $6,710,000 | $5,590,000 | |
| Liabilities | |||
| Current Assets | |||
| Current Portion of Long-Term Debt | $150,000 | $150,000 | |
| Accounts Payable | 2,170,000 | 1,880,000 | |
| Accrued Expenses | 880,000 | 810,000 | |
| Total Current Liabilities | D | $3,200,000 | $2,840,000 |
| Long-Term Debt | 300,000 | 450,000 | |
| Total Debt | E | 3,500,000 | 3,290,000 |
| Stockholder’s Equity | F | 3,210,000 | 2,300,000 |
| $6,710,000 | $5,590,000 | ||
Balance Sheet Ratios
There are several ratios that help determine strengths and weaknesses in certain areas. For the balance sheet, some of the most common ratios to track include day’s sales outstanding (measurement of outstanding receivables), current ratio (measures the relationship between current assets and current liabilities), and debt to equity ratio (measures the relationship between liabilities and shareholder equity).
| 2019 | 2018 | ||
| Days Sales Outstanding | A / G / 365 | 38.16 | 37.75 |
| Current Ratio | B / D | 1.83 | 1.67 |
| Debt to equity | E / F | 1.09 | 1.43 |
Income Statement
The purpose of the income statement is to demonstrate the financial vitality of the organization over a period of time. Typically, it lists revenues, expenses, profits (and, when they occur, losses), taxes, as well as interest expense and interest income, if applicable. Supplemental expense schedules can be prepared to detail the nature of expenses within operating expenses (costs of goods sold) and general and administrative expenses.
ABC Company
Income Statements
| 2019 | 2018 | ||
| Sales | G | $31,380,000 | $27,270,000 |
| Cost of Goods Sold | 25,100,000 | 21,650,000 | |
| Gross Margin | $6,280,000 | $5,620,000 | |
| General & Administrative Expenses | I | 4,950,000 | 4,650,000 |
| Income From Operations | 1,330,000 | 970,000 | |
| Other Income (Expense) | (20,000) | (30,000) | |
| Income Before Income Taxes | 1,310,000 | 940,000 | |
| Income Taxes | 400,000 | 290,000 | |
| Net Income | J | $910,000 | $650,000 |
Income Statement Ratios
There are several ratios that can help determine a company’s strengths and weaknesses in certain areas. For the income statement, the most common ratios for our manufacturing company example includes the gross profit margin (a measurement of how efficiently a company used its resources to produce and sell products profitably), operating profit margin (measures how much profit a company makes on a dollar of sales, after paying for variable costs of production, such as wages and raw materials, but before paying interest or tax), and net profit margin (the percentage of revenue left after all expenses have been deducted from sales).
| 2019 | 2018 | ||
| Gross Profit Margin | H / G | 20.02% | 20.61% |
| Net Profit Margin | J / G | 2.90% | 2.39% |
Statement of Cash Flows
While income statements discern profit margin, the cash flow statement reveals whether the business is generating enough cash to pay its bills. This report answers where cash came from, what the cash was used for, and the overall change in cash balance during the period. It is divided into three sections: cash from operating activities, cash from investing activities, and cash from financing activities. Unlike a balance sheet, which provides users with a snapshot of financial performance at a specific point in time, cash flow statements cover changes in cash inflows and outflows over time. It contains the same financial information as the balance sheet and income statement, except the line items are combined into one statement and reorganized according to cash flow from operating, investing, or financing.
The first section, cash from operating activities, analyzes cash flow from net income and net losses. Investing activity cash flow can include securities as well as long-term physical assets, and financing cash inflows or outflows would likely include loan proceeds or paying back lines of credit.
ABC Company
Statements of Cash Flows
| 2019 | 2018 | ||
| Net Income | $910,000 | $650,000 | |
| Cash Flows from Operating Expenses | |||
| Depreciation and Amortization* | 70,000 | 60,000 | |
| Net Changes** in Assets and Liabilities from Operations: | |||
| Accounts Receivable | (460,000) | (410,000) | |
| Inventory | (120,000) | (100,000) | |
| Other Assets | (20,000) | 40,000 | |
| Accounts Payable | 290,000 | 260,000 | |
| Accrued Expenses | 70,000 | 20,000 | |
| Net cash provided by (used in) operating expenses | L | 780,000 | 440,000 |
| Cash Flows From Investing Activities | |||
| Purchase of Property and Equipment | M | (100,000) | (90,000) |
| Net cash provided by (used in) investing activities | (100,000) | (90,000) | |
| Cash Flows From Financing Activities | |||
| Payments on long-term debt | N | (150,000) | (150,000) |
| Net cash provided by (used in) financing activities | (150,000) | (150,000) | |
| Net Increase (Decrease) in Cash | 530,000 | 200,000 | |
| Cash | |||
| Beginning of Year | 250,000 | 50,000 | |
| End of Year | $780,000 | $250,000 | |
Cash Flow Ratios
For the statement of cash flows, the most common financial ratios to measure include free cash flow (how much money is left over to pay shareholders or expand the business after all other obligations are met), cash flow coverage (analyzes the company’s long-term financial solvency), and cash flow margin (provides insight into the amount of cash generated per dollar of business).
| 2019 | 2018 | ||
| Free Cash Flow | L – M | 680,000 | 350,000 |
| Cash Flow Coverage | L / N | 5.20 | 2.94 |
| Cash Flow Margin | L / G | 2.49% | 1.62% |
Footnotes and Management Discussion
The last piece of the financial statement is easy to miss. Most financial statements contain footnotes, which are important details that provide context to a company’s approach to financial management. Look for explanations of accounting policies and procedures, disclosures, or detailed information about taxes, retirement plans, and stock or pension plans. Though not necessarily part of any report in the financial statement, these areas still impact overall financial performance and obligations.
Practical Applications
The information contained in a financial statement has a variety of uses. Corporate governance is one of the most common ways that organizations will use the information contained in the financial statement. It serves as a foundation for buy/sell agreement valuations, management equity plan vesting, related party transactions, and establishing value for shareholder risk; the financial statement can also act as a basis for budgets/projections and as a management evaluation tool. Banks, lenders, vendors, and suppliers may request a financial statement to make decisions about lines of credit or other financing. In summary, the information contained in the financial statement is not only meaningful but drives many aspects of a company’s operations.
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Financial reporting can be complex, yet having a basic understanding of financial statements and the business story they tell, helps owners and shareholders better manage their company and make strategic plans for the future. If you have questions about financial statements or need assistance with an audit, tax or accounting issue, Clayton & McKervey can help.