Financial Statement Definition:
A written report of the financial condition of a firm. Financial statements include the balance sheet, income statement, statement of changes in net worth and statement of cash flow.
The first step in developing a financial management system isthe creation of financial statements. To manage proactively, youshould plan to generate financial statements on a monthly basis.Your financial statements should include an income statement, abalance sheet and a cash-flow statement
Income Statement
Simply put, the income statement measures all your revenuesources vs. business expenses for a given time period. To helpexplain things easily, let's consider an apparel manufacturer as anexample in outlining the major components of the incomestatement:
Sales. This is the gross revenue generated from the saleof clothing less returns (cancellations) and allowances (reductionin price for discounts taken by customers).
Cost of goods sold. This is the direct cost associatedwith manufacturing the clothing. These costs include materialsused, direct labor, plant manager salaries, freight and other costsassociated with operating a plant (for example, utilities,equipment repairs, etc.).
Gross profit. The gross profit represents the amount ofdirect profit associated with the actual manufacturing of theclothing. It's calculated as sales less the cost of goods sold.
Operating expenses. These are the selling, general andadministrative expenses that are necessary to run the business.Examples include office salaries, insurance, advertising, salescommissions and rent.
Depreciation. Depreciation expense is usually included inoperating expenses and/or cost of goods sold, but it is worthy ofspecial mention due to its unusual nature. Depreciation resultswhen a company purchases a fixed asset and expenses it over theentire period of its planned use, not just in the year purchased.The IRS requires certain depreciation schedules to be followed fortax reasons. Depreciation is a noncash expense in that the cashflows out when the asset is purchased, but the cost is taken over aperiod of years depending on the type of asset.
Whether depreciation is included in cost of goods sold or inoperating expenses depends on the type of asset being depreciated.Depreciation is listed with cost of goods sold if the expenseassociated with the fixed asset is used in the direct production ofinventory. Examples include the purchase of production equipmentand machinery and a building that houses a production plant.
Depreciation is listed with operating expenses if the cost isassociated with fixed assets used for selling, general andadministrative purposes. Examples include vehicles for salespeopleor an office computer and phone system.
Operating profit. This is the amount of profit earnedduring the normal course of operations. It is computed bysubtracting the operating expenses from the gross profit.
Other income and expenses. Other income and expenses arethose items that don't occur during the normal course of businessoperation. For instance, a clothing maker doesn't normally earnincome from rental property or interest on investments, so theseincome sources are accounted for separately. Interest expense ondebt is also included in this category. A net figure is computed bysubtracting other expenses from other income.
Net profit before taxes. This figure represents theamount of income earned by the business before paying taxes. Thenumber is computed by adding other income (or subtracting if otherexpenses exceed other income) to the operating profit.
Income taxes. This is the total amount of state andfederal income taxes paid.
Net profit after taxes. This is the "bottom line"earnings of the business. It's computed by subtracting taxes paidfrom net income before taxes.
Balance Sheet
The balance sheet provides a snapshot of the business's assets,liabilities and owner's equity for a given time. Again, using anapparel manufacturer as an example, here are the key components ofthe balance sheet:
Current assets. These are the assets in a business thatcan be converted to cash in one year or less. They include cash,stocks and other liquid investments, accounts receivable, inventoryand prepaid expenses. For a clothing manufacturer, the inventorywould include raw materials (yarn, thread, etc.), work-in-progress(started but not finished), and finished goods (shirts and pantsready to sell to customers). Accounts receivable represents theamount of money owed to the business by customers who havepurchased on credit.
Fixed assets. These are the tangible assets of a businessthat won't be converted to cash within a year during the normalcourse of operation. Fixed assets are for long-term use and includeland, buildings, leasehold improvements, equipment, machinery andvehicles. Intangible assets: These are assets that you cannot touchor see but that have value. Intangible assets include franchiserights, goodwill, noncompete agreements, patents and many otheritems.
Other assets. There are many assets that can beclassified as other assets, and most business balance sheets havean "other assets" category as a catchall. Some of the most commonother assets include cash value of life insurance, long-terminvestment property and compensation due from employees.
Current liabilities. These are the obligations of thebusiness that are due within one year. Current liabilities includenotes payable on lines of credit or other short-term loans, currentmaturities of long-term debt, accounts payable to trade creditors,accrued expenses and taxes (an accrual is an expense such as thepayroll that is due to employees for hours worked but has not beenpaid), and amounts due to stockholders.
Long-term liabilities. These are the obligations of thebusiness that aren't due for at least one year. Long-termliabilities typically consist of all bank debt or stockholder loanspayable outside of the following 12-month period.
Owner's equity. This figure represents the total amountinvested by the stockholders plus the accumulated profit of thebusiness. Components include common stock, paid-in-capital (amountsinvested not involving a stock purchase) and retained earnings(cumulative earnings since inception of the business less dividendspaid to stockholders).
Cash-Flow Statement
The cash-flow statement is designed to convert the accrual basisof accounting used to prepare the income statement and balancesheet back to a cash basis. This may sound redundant, but it'snecessary. The accrual basis of accounting generally is preferredfor the income statement and balance sheet because it moreaccurately matches revenue sources to the expenses incurredgenerating those specific revenue sources. However, it also isimportant to analyze the actual level of cash flowing into and outof the business.
Like the income statement, the cash-flow statement measuresfinancial activity over a period of time. The cash-flow statementalso tracks the effects of changes in balance sheet accounts.
The cash-flow statement is one of the most useful financialmanagement tools you will have to run your business. The cash-flowstatement is divided into four categories:
1. Net cash flow from operating activities. Operatingactivities are the daily internal activities of a business thateither require cash or generate it. They include cash collectionsfrom customers; cash paid to suppliers and employees; cash paid foroperating expenses, interest and taxes; and cash revenue frominterest dividends.
2. Net cash flow from investing activities. Investingactivities are discretionary investments made by management. Theseprimarily consist of the purchase (or sale) of equipment.
3. Net cash flow from financing activities. Financingactivities are those external sources and uses of cash that affectcash 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. Theresults of the first three calculations are used to determine thetotal change in cash and marketable securities caused byfluctuations in operating, investing and financing cash flow. Thisnumber is then checked against the change in cash reflected on thebalance sheet from period to period to verify that the calculationhas been done correctly.
