Prentice Hall's one-day MBA in finance & accounting (4 page)

My main purpose is to explain the basic content and structure of each financial statement in order to provide stepping-stones to later chapters, which develop models of profit, cash flow, and financial condition for management decision-making analysis. External financial statements are not designed for
management
use; they are designed for outside investors and lenders who do not manage the business. External financial statements report results, but not how and why the results happened.

THREE FINANCIAL IMPERATIVES,

THREE FINANCIAL STATEMENTS

Without a doubt, managers should understand the external financial statements of their business that are reported to
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shareowners and lenders, whether the managers own shares in the business or not. Financial statements are the basic touchstone of every business. A separate, distinct financial statement is prepared for each of the three financial imperatives of every business:

•
Make profit.
The
income statement
(also called the
profit
and loss statement
) summarizes the revenue and expenses of the business and the profit or loss result for a period of time such as one year.

•
Generate cash flows.
The
statement of cash flows
summarizes the various sources and uses of cash of the business for the same period as the income statement.

•
Control financial condition.
The
balance sheet
(also called the
statement of financial condition
) summarizes the various assets and liabilities of the business at the end of the income statement period, as well as how much of the excess of assets over liabilities was invested by the shareowners in the business and how much is attributable to the cumulative profit over the life of the business that was not distributed to its shareowners.

A business is profit-motivated, so its income statement (the financial statement that reports the profit or loss of the business for the period) occupies center stage. The market value of the ownership shares in the business depends heavily on the profit performance of the business. A business has to earn enough operating profit to pay the interest on its debt, so its lenders also keep sharp eye on profit performance.

A Business Example

I use a realistic business example to illustrate and explain the three external financial statements. This business manufactures and sells products to other businesses. It sells products from stock; in other words, the business carries an inventory of products from which it makes immediate delivery to customers. The business sells and buys on credit. It has invested in many long-life operating resources—buildings, machines, equipment, tools, vehicles, and computers. The business was started many years ago when several persons invested the initial ownership capital in the venture.

The business borrows money from banks on the basis of
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short-term notes (having maturity dates less than one year) and long-term notes (having maturity dates three years or longer). The business has made a profit most years, but suffered losses in several years. To grow the business the shareowners invested additional capital from time to time. But the main reason for the increase in owners’ equity is that the business has retained most of its annual profits in order to build up the capital base of the company instead of distributing 100 percent of its annual profits to shareowners.

For the year just ended, the business recorded $26 million sales revenue; this amount is net of discounts given customers from list or billed prices. The company’s bottom-line profit after deducting all expenses for the year from sales revenue is $2.2 million. Bottom-line profit is called variously
net income,
net earnings,
or just
earnings.
(The example assumes that the business did not have any nonrecurring, unusual, or extraordinary gains or losses during the year.) Profit equals 8.5 percent of sales revenue, which is typical for this industry ($2.2

million profit ÷ $26 million sales revenue = 8.5%).

The business uses
accrual-basis accounting
to measure profit and to prepare its balance sheet (statement of financial condition). All businesses of any size that sell products and have inventories and that own long-lived operating resources use accrual-basis accounting. Accrual-basis accounting is required by financial reporting standards and by the federal income tax law (with some exceptions for smaller businesses). Business managers should have a good grip on accrual-basis accounting, and they should understand how accrual-basis accounting differs from cash flows.

ACCRUAL-BASIS ACCOUNTING

Before introducing the financial statements for the business example, I present Figure 2.1, in which cash flows are separated from the accrual-basis components for sales and expenses. (I culled this information from the accounts of the business.) Figure 2.1 is
not
a financial statement. Rather, I present this information to lay the groundwork for the business’s financial statements. This figure presents the basic building blocks for sales revenue and expenses and for cash flows
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Note:
Amounts are in millions of dollars.

Revenue and expense cash flows

Note:
Cash flows include amounts related to last year’s and next year’s revenue and expenses.

Accrual-basis sales revenue and expenses

Note:
Revenue and expenses are of this and only this year; only one year is involved.

$3.2

$22.5

$3.5

Cash collections during

Cash collections during

Sales made during the

the year from sales

year from sales made

year but no cash col-

made last year or for

$25.7 during the year.

$26.0 lected during the year;

sales to be made next

cash will be collected

year.

next year or was

already collected last

year.

less

less

$7.5

$14.9

$8.9

TEAMFLY

Cash payments during

Cash payments during

Expenses recorded dur-

the year for expenses of $22.4 the year for expenses of $23.8 ing the year but not last year or next year.

the year.

paid during the year;

cash was paid either in

previous year or will be

paid next year.

$3.3

$2.2

Net cash flow during year

Net profit for year according

from operating, or profit-

to accrual-basis profit

making activities.

accounting methods.

FIGURE 2.1
Cash flow and accrual components of sales revenue and
expenses for the year just ended for the business example.

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during the year. This information also is very helpful to understand the balance sheet, which is explained later in the chapter.

Sales Revenue and Cash Flow from Sales Revenue

The revenue from most of the sales during the year was collected during the year—neither before the year started nor after the year ended. In Figure 2.1, observe that the company collected $22.5 million cash during the year from sales made during the year.* To complete the accrual-basis sales revenue picture for the year you have to consider sales made during the year for which cash was not collected during the year. To complete the cash flow picture you have to consider other sales-driven cash flows during the year, which are either from sales made last year or from sales that will be made next year.

In summary (see Figure 2.1 for data):

•
Accrual-basis sales revenue for year:
$22.5 million cash collections during the year from sales made during the year

+ $3.5 million sales made during the year but cash not collected during year = $26 million sales revenue for year

•
Sales revenue–driven cash flows during year:
$22.5 million cash collections during the year from sales made during the year + $3.2 million cash collections during year from last year’s sales or for next year’s sales = $25.7 million cash flow from sales revenue

Expenses and Cash Flow for Expenses

Many expenses recorded in the year were paid in cash during the year—neither before the year started nor after the year ended. In Figure 2.1, note that the company recorded $14.9

million total expenses during the year for which it paid out $14.9 million cash during the year. Many expenses are paid weeks after the expense is originally recorded; the business first records a liability on its books for the expense, and the liability account is decreased when it is paid. To complete the

*The business makes many sales on credit, so cash collections from sales occur a few weeks after the sales are recorded. In contrast, some customers pay in advance of taking delivery of products, so cash collections occur before the sales are recorded at the time products are delivered to the customers.

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cash flow picture you have to consider other cash flows during the year for expenses recorded last year or for expenses that won’t be recorded until next year. To complete the accrual-basis expenses picture for the year you have to consider expenses recorded during the year for which cash was not paid during the year. In summary (see Figure 2.1 for data):

•
Accrual-basis expenses for year:
$14.9 million expenses recorded and paid in cash during year + $8.9 million expenses recorded but cash was not paid during year =

$23.8 million expenses

•
Expense-driven cash flows during year:
$14.9 million expenses recorded and paid in cash during year + $7.5 million paid during year for last year’s expenses or for next year’s expenses = $22.4 million cash flow for expenses
Net Profit and Net Cash Flow for Year

Net profit for the year is $2.2 million, equal to $26

million sales revenue less $23.8 million expenses. In contrast, the net cash flow of revenue and expenses is $3.3

million for the year.
Both figures are correct.
The $2.2 million figure is the correct measure of profit for the year according to proper accounting methods for recording sales revenue and expenses to the year. The $3.3 million net cash flow figure is correct, but keep in mind that cash flows related to revenue and expenses of the previous year and the following year are intermingled with the cash flows of revenue and expenses of the year just ended.

THE INCOME STATEMENT

Figure 2.2 presents the basic format of the business’s income statement for the year just ended. The income statement starts with sales revenue for the year and ends with the net income for the year. Between the top line and the bottom line a business reports several expenses and subtotals for intermediate measures of profit. A company that sell products discloses the amount of its cost-of-goods-sold expense immediately below sales revenue, which is deducted to get the first profit line, called
gross margin.
The word
gross
implies that
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Note:
Amounts are in millions of dollars.

Sales revenue

$26.0

Cost-of-goods-sold expense

XX.X

Gross margin

XX.X

Operating expenses

XX.X

Earnings before interest and income tax

X.X

Interest expense

.X

Earnings before income tax

X.X

Income tax expense

X.X

Net income

$ 2.2

FIGURE 2.2
Format of external income statement for year.

other expenses have to be deducted from sales revenue to arrive at the final, or bottom-line profit.

One or more classes of operating expenses are disclosed in external financial statements. How many and which specific types of operating expenses? The disclosure of operating expenses varies from business to business; financial reporting rules are lax in this regard. Few businesses disclose the amounts of advertising expenses, for example, or the amounts of top-management compensation. Many businesses lump a variety of different operating expenses into a conglomerate account called
sales, administrative, and general expenses.
In most external income statements, total operating expenses are deducted from gross margin to arrive at the profit figure labeled
earnings before interest and income tax expenses
(see Figure 2.2).

I’m sure you’ve noticed that instead of dollar amounts for expenses and the intermediate profit lines between the top line and the bottom line in Figure 2.2 I show only placehold-ers (e.g., XX.X). Showing the dollar amounts for these items would serve no particular purpose here. I wish to emphasize the basic format of the externally reported income statement, not the data in this financial statement. In Chapter 3 I develop an internal profit report for managers that is a much different format than the external income statement, which is more useful for decision-making analysis.

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THE BALANCE SHEET

The usual explanation of the balance sheet is that it is the financial statement that summarizes a business’s assets and liabilities. Well, yes and no. If you have in mind a complete reckoning of all the assets of the business at their current market or replacement values you are off the mark. The balance sheet does not list all assets at current values. On the other hand, the balance sheet comes close to listing all the liabilities of a business. You may find these opening comments about the balance sheet rather unusual, and I don’t blame you if you think so.