chapter 38
MAKING A STATEMENT
How To Create Financial Statements
By J. Tol Broome Jr.
a freelance business writer and banker with 28 years of
experience in commercial lending
In the last chapter, we explored establishing a good bookkeeping system for your new business. And while a well-organized bookkeeping system is vital, even more critical is what you do with it to establish your methods for financial management and control.
Think of your new bookkeeping system as the body of a car. A car body can be engineered, painted and finished to look sleek and powerful. However, the car body won’t get anywhere without an engine. Your financial management system is the engine that will make your car achieve peak performance.
You may be wondering what exactly is meant by the term “financial management.” It is the process you use to put your numbers to work to make your business more successful. With a good financial management system, you will know not only how your business is doing financially, but why. And you will be able to use it to make decisions to improve the operation of your business.
Why is financial management important? Because a good financial management system enables you to accomplish important big-picture and daily financial objectives. A good financial management system helps you become a better macromanager by enabling you to:
• Manage proactively rather than reactively
• Borrow money more easily; not only can you plan ahead for financing needs, but sharing your budget with your banker will help in the loan approval process
• Provide financial planning information for investors
• Make your operation more profitable and efficient
• Access a great decision-making tool for key financial considerations
TIP
How does your business measure up against others? Check out
Annual Statement Studies, a massive and detailed comparison of financial data from the Risk Management Association’s (RMA) member institutions. Find out more at RMA’s website at
rmahq.org (click on “Products and Services,” then “RMA Bookstore”).
Financial planning and control help you become a better micromanager by enabling you to:
• Avoid investing too much money in fixed assets
• Maintain short-term working-capital needs to support accounts receivable and inventory more efficiently
• Set sales goals; you need to be growth-oriented, not just an “order taker”
• Improve gross profit margin by pricing your services more effectively or by reducing supplier prices, direct labor, etc., that affect costs of goods sold
• Operate more efficiently by keeping selling and general and administrative expenses down more effectively
• Perform tax planning
• Plan ahead for employee benefits
• Perform sensitivity analysis with the different financial variables involved
Creating Financial Statements
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 (see pages 663, 666 and 670, respectively).
AHA!
Many business owners make the mistake of preparing financial statements only at year-end when the IRS requires it. The consequence is reactive financial planning. If you want to be a proactive financial manager, generate monthly financial statements and use them to make the key financial decisions that affect the daily success of your business.
A good automated accounting software package will create monthly financial statements for you. If your bookkeeping system is manual, you can use an internal or external bookkeeper to provide you with monthly financial statements.
Income Statement
Simply put, the income statement measures all your revenue sources vs. business expenses for a given time period. Let’s consider an apparel manufacturer as an example in out lining the major components of the income statement:
• Sales. This is the gross revenues 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 (e.g., utilities, equipment repairs, etc.).
• Gross profit. The gross profit represents the amount of direct profit associated with the actual manufacturing of the clothing. It is 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. (See the “Schedule Of Operating Expenses” on page 664 for a more detailed list of operating expenses.)
•
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 do not occur during the normal course of business operation. For instance, a clothing maker does not 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 is computed by subtracting taxes paid from net income before taxes.
Income Statement
ABC Clothing Inc.
| Year 1 | Year 2 |
|---|
| Sales | $1,000,000 | $1,500,000 |
| Cost of Goods Sold | -750,000 | -1,050,000 |
| Gross Profit | 250,000 | 450,000 |
| Operating Expenses | -200,000 | -275,000 |
| Operating Profit | 50,000 | 175,000 |
| Other Income and Expenses | 3,000 | 5,000 |
| Net Profit Before Taxes | 53,000 | 180,000 |
| Income Taxes | -15,900 | -54,000 |
| Net Profit After Taxes | $37,100 | $126,000 |
Schedule Of Operating Expenses
ABC Clothing Inc.
| Year 1 | Year 2 |
|---|
| Advertising | $5,000 | $15,000 |
| Auto Expenses | 3,000 | 7,500 |
| Bank Charges | 750 | 1,200 |
| Depreciation | 30,000 | 30,000 |
| Dues & Subscriptions | 500 | 750 |
| Employee Benefits | 5,000 | 10,000 |
| Insurance | 6,000 | 10,000 |
| Interest | 17,800 | 15,000 |
| Office Expenses | 2,500 | 4,000 |
| Officers’ Salaries | 40,000 | 60,000 |
| Payroll Taxes | 6,000 | 9,000 |
| Professional Fees | 4,000 | 7,500 |
| Rent | 24,000 | 24,000 |
| Repairs & Maintenance | 2,000 | 2,500 |
| Salaries & Wages | 40,000 | 60,000 |
| Security | 2,250 | 2,250 |
| Supplies | 2,000 | 3,000 |
| Taxes & Licenses | 1,000 | 1,500 |
| Telephone | 4,800 | 6,000 |
| Utilities | 2,400 | 2,400 |
| Other | 1,000 | 3,400 |
| Total Operating Expenses | $200,000 | $275,000 |
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 will not 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.
“Great companies are
built by people who
never stop thinking
about ways to improve
the business.”
—J. WILLARD MARRIOTT,
FOUNDER OF MARRIOTT
INTERNATIONAL INC.
•
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.
Balance Sheet
ABC Clothing Inc.
| | | Year 1 | Year 2 |
|---|
| Assets: | | |
|---|
| Current Assets: | | |
| Cash | $10,000 | $20,000 |
| Accounts Receivable | 82,000 | 144,000 |
| Inventory | 185,000 | 230,000 |
| Prepaid Expenses | 5,000 | 5,000 |
| Total Current Assets | 282,000 | 399,000 |
| Fixed Assets: | | |
| Land | 0 | 0 |
| Buildings | 0 | 0 |
| Equipment | 150,000 | 120,000 |
| Accumulated Depreciation | -30,000 | -30,000 |
| Total Fixed Assets | 120,000 | 90,000 |
| Intangible Assets | 0 | 0 |
| Other Assets | 10,000 | 11,000 |
| Total Assets | $532,000 | $590,000 |
•
Long-term liabilities. These are the obligations of the business that are not 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.
Balance Sheet
ABC Clothing Inc.
| Year 1 | Year 2 |
| Liabilities & Equity: | | |
| Current Liabilities: | | |
| Notes Payable—Short Term | 60,000 | 42,400 |
| Current Maturities of Long-Term Debt | 30,000 | 30,000 |
| Accounts Payable | 82,000 | 86,000 |
| Accrued Expenses | 7,900 | 13,500 |
| Taxes Payable | 0 | 0 |
| Stockholder Loans | 0 | 0 |
| Total Current Liabilities | 179,900 | 171,900 |
| Long-Term Liabilities | 120,000 | 90,000 |
| Total Liabilities | $299,900 | $261,900 |
| Owner’s Equity: | | |
| Common Stock | 75,000 | 75,000 |
| Paid-in-capital | 0 | 0 |
| Retained Earnings | 37,100 | 163,100 |
| Total Owner’s Equity | 112,100 | 238,100 |
| Total Liabilities & Equity | $412,000 | $500,000 |
• 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).
BY THE NUMBERS
All new businesses should produce an annual year-end financial statement. This statement should be prepared by your CPA, who will offer you three basic choices of financial statement quality:
1. Compilation. This is the least expensive option. Here, the CPA takes management’s information and compiles it into the proper financial statement format.
2. Review. In addition to putting management’s information into the proper format, the CPA performs a limited review of the information.
3. Audit. This option is the most costly but offers the highest quality. Audited financial statements are prepared in accordance with generally accepted accounting principles and are the type preferred by most lenders and investors.
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 is 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:
BALANCE BOOSTERS
A common problem for small-business owners is maintaining adequate cash-flow levels. And increasing sales is not always the answer. Here are some tips that enhance your bank balance regardless of whether or not sales are on the rise:
• Practice good inventory management. Don’t try to be all things to all people, particularly if you are a wholesaler or retailer. Keeping slow-moving inventory in stock “just in case” costs money.
• Concentrate on higher margin items. Focus your efforts on selling those items that generate the most profit rather than on the items that sell the fastest.
• Take full advantage of trade terms. Wait until the day a bill or an invoice is due to pay it. Your cash flow will be enhanced, and your valued supplier relationships will not be harmed because you will still be paying on time.
• Shop for lower priced suppliers. Before you get started, check with a number of different suppliers to see which one offers the best price and terms.
• Control operating expenses better. Utilities expenses can be lowered by minimizing the use of electricity and by adjusting the thermostat upward or downward a few degrees during the summer and winter months. Insurance and telephone service providers should be comparison-shopped on a regular basis. Keep a close eye on employee downtime and overtime. And shop for the best lease rates.
• Extend bank loans on longer terms. Many banks are more than willing to extend the term on a loan to businesses in search of cash-flow relief. For instance, by extending the term on a $20,000 loan (at 9 percent interest) from two years to three, a business realizes annual cash-flow enhancement of $3,336.
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.
Cash-Flow Statement
ABC Clothing Inc.
| Year 1 | Year 2 |
|---|
| Net Cash Flow From Operating Activities: | | |
|---|
| Cash received from customers | $918,000 | $1,438,000 |
| Interest received | 3,000 | 5,000 |
| Cash paid to suppliers for inventory | (853,000) | (1,091,000) |
| Cash paid to employees | (80,000) | (120,000) |
| Cash paid for other operating expenses | (69,300) | (104,400) |
| Interest paid | (17,800) | (15,000) |
| Taxes paid | (15,900) | (54,000) |
| Net cash provided (used) by | | |
| operating activities | ($115,000) | $58,600 |
| Year 1 | Year 2 |
|---|
| Net Cash Flow From Investing Activities: | | |
|---|
| Additions to property, plant and equipment | (150,000) | 0 |
| Increase/decrease in other assets | (10,000) | (1,000) |
| Other investing activities | 0 | 0 |
| Net cash provided (used) by investing activities | ($160,000) | ($1,000) |
| Net Cash Flow From Financing Activities: | | |
|---|
| Sales of common stock | 75,000 | 0 |
| Increase (decrease) in short-term loans (includes current maturities of long-term debt) | 90,000 | (17,600) |
| Additions to long-term loans | 120,000 | 0 |
| Reductions of long-term loans | 0 | (30,000) |
| Dividends paid | 0 | 0 |
| Net cash provided (used) by financing activities | $285,000 | ($47,600) |
| Net Increase (Decrease) In Cash | $10,000 | $10,000 |
Cash-Flow Analysis
The cash-flow statement enables you to track cash as it flows in and out of your business and reveals to you the causes of cash-flow shortfalls and surpluses. The operating activities are the daily occurrences that are essential to any business operation. If these are positive, it indicates to the owner that the business is self-sufficient in funding its daily operational cash flow internally. If the number is negative, then it indicates that outside funds were needed to sustain the operation of the business.
SAVE
Many new business owners can’t afford to seek paid professional advice. Here are three free resources for invaluable financial guidance: 1. Your banker: Even if you aren’t borrowing money for startup, get to know a loan officer where you have your checking account. Meet periodically to discuss the financial direction of your venture. 2. Other business owners: Make the time to network with other small-business owers. 3. SCORE: This is a national volunteer organization set up for the sole purpose of helping new business owners succeed.
Investing activities generally use cash because most businesses are more likely to acquire new equipment and machinery than to sell old fixed assets. When a company does need cash to fund investing activities in a given year, it must come from an internal operating cash-flow surplus, financing activity increases or cash reserves built up in prior years.
Financing activities represent the external sources of funds available to the business. Financing activities typically will be a provider of funds when a company has shortfalls in operating or investing activities. The reverse is often true when operating activities are a source of excess cash flow, as the overflow often is used to reduce debt.
The net increase/decrease in cash figure at the bottom of the cash-flow statement represents the net result of operating, investing and financing activities. If a business ever runs out of cash, it can’t survive, so this is a key number.
Our hypothetical clothing business, ABC Clothing Inc., provides a good example. In Year 1, the growth in the business’s accounts receivable and inventory required $115,000 in cash to fund operating activities. The purchase of $150,000 in equipment also drained cash flow. ABC funded these needs with the sale of common stock of $75,000 and loans totaling $210,000. The outcome was that the company increased its cash resources by $10,000.
Year 2 was a different story. Because the company had a net income of $126,000, there was a good deal more cash ($58,600) flowing in from customers than flowing out to suppliers, employees, other operating expenses, interest and taxes. This enabled ABC to reduce its overall outside debt by $47,600 and increase its cash balance by $10,000.
“Formula for success:
Rise early, work hard,
strike oil.”
—J. PAUL GETTY, FOUNDER
OF THE GETTY OIL COMPANY
When you start your business, you’ll be able to use the cash-flow statement to analyze your sources and uses of cash not only from year to year, but also from month to month if you set up your accounting system to produce monthly statements. You will find the cash-flow statement to be an invaluable tool in understanding the hows and whys of cash flowing into and out of your business.
As a new business owner, you will need accurate and timely financial information to help you manage your business effectively. Your financial statements will also be critical budgeting tools as you seek to achieve financial milestones in your business.
