Chapter 1 of the Business finance basics section in the 'Achieving financial success' series

Chapter 1 of the Business finance basics section in the 'Achieving financial success' series

By David Jenkins*

Keeping the books for your business can provide valuable information to enable you to gain a clear picture of the financial position of your business and an insight into how to improve business operations.

Good financial systems will assist in monitoring the financial situation, managing the financial position and measuring the success of your business.

In this first section, we will look at the three key financial statements and then discuss how you can use this information to improve business operations through ratio analysis and preparing an operating budget.

You can read the Introduction to this series here » The related Glossary is an important resource. And readers are encouraged to read this page first »

Chapter 1: Understanding financial statements

Please note: this chapter is not designed to assist you with the preparation of financial statements but to introduce you to what they look like and how they can be used to benefit your business.

Every business requires some assets to be able to run the operations and ultimately make a profit.

This could be as simple as having cash in the bank, but is more likely to be a number of assets, such as stock (only unsold stock is an asset), office equipment and perhaps commercial premises.

All of these items need to be paid for, so, when starting up a small business, the owner or owners will need to invest some of their own money as well as perhaps borrowing some from a lender such as a bank or investor.

There are three financial statements that record financial information on your business. They are:

profit and loss statement (sometimes referred to as the statement of financial performance or income statement)

balance sheet (sometimes referred to as the statement of financial position)

statement of cash flows.

Financial statements record the performance of your business and allow you and others to diagnose its strengths and weaknesses by providing a written summary of the financial activities for a given period.

To proactively manage your business, you should plan to generate these financial statements on a monthly basis, review the results and analyse for improvements.

Let’s look at the financial statements and see how they can assist in monitoring your business’s financial performance.

Profit and loss statement

The profit and loss statement is a summary of a business’s income and expenses over a specific period.

It should be prepared at regular intervals (usually monthly and at financial year end) to show the results of operations for a given period.

Profit or loss is calculated in the following way:

[Note: Calculating the cost of goods sold varies depending on whether the business is retail, wholesale, manufacturing or a service business. In retailing and wholesaling, computing the cost of goods sold during the reporting period involves beginning and ending inventories. This, of course, includes purchases made during the reporting period. In manufacturing, it involves finished-goods inventories, plus raw materials inventories, goods-in-process inventories, direct labour and direct factory overhead costs.

In the case of a service business, the revenue is derived from the activities of individuals rather than the sale of a product, so the calculation of cost of goods sold is a smaller task because of the low-level use of materials required to earn the income.]

Case study - Joe’s Motorbike Tyres

Joe has decided to start up his own business and has been doing some research. He will sell motorbike tyres to motorbike manufacturers. He is going to leave his employment and has saved some money to help him through the start phase.

He has decided that in the first year he is going to focus on getting the business established, so he believes that a small profit (before interest and tax) of $5,000 should be achievable. His research has shown him that the expenses to set up and operate the business will be approximately $15,600 for the year.

Profit   .............................................  $5,000 plus operating expenses ............ $15,600
Total cash needs  ....................   $20,600  

From this information, Joe can see that he will need at least $20,600 to cover the operating expenses and achieve his profit goal. Joe’s research has also highlighted that it is reasonable to expect to sell at least 1,000 tyres in the first year. Joe has negotiated with a supplier to provide the tyres at cost price of $31.20 each.

Now we can work out, according to Joe’s estimates, what sales need to be made to reach the profit goal. (Note that we do not consider Goods and Services Tax (GST) anywhere in this guide. For more information on GST, contact Inland Revenue or your accountant.)

Profit   ...........................................  $5,000 plus operating expenses ............ $15,600
plus cost of 1,000 tyres  ........   $31,200 (cost of goods sold)
Joe will need a total of  .............$51,800 to achieve his target profit.

Minimum selling price ($51,800 divided by the 1,000 tyres he will sell) equals $51.80 per tyre.

Joe thinks he will be able to sell the tyres for $52.00 per tyre, so at the end of the first year, if all goes according to plan, his profit and loss statement would look like this. (Note that we do not consider income tax anywhere in this guide. For more information on income tax, contact Inland Revenue or your accountant.)

Note: cost of goods sold calculation

Towards the end of the year, Joe manages to purchase 100 more tyres on credit from his supplier for an order in the new year. This leaves him with $3,120 of stock on hand at the end of the year.

Joe’s cost of goods calculation

Opening stock                                      $         0  
add stock purchased during the year    $34,320 (1,000 tyres @ #31.20 each)
equals stock available for sale               $34,320  
less stock on hand at end of year          $  3,120 (   100 tyres @ $31.20 each)
Cost of goods sold                                   $31,200  

Where a business is a service business - that is, you are selling services not goods or products - the profit and loss statement will generally not include a cost of goods sold calculation. In some instances, where labour costs can be directly attributed to sales, you may consider including these costs as a cost of goods (services) sold.

Balance sheet

The balance sheet provides a picture of the financial health of a business at a given moment in time (usually the end of a month or financial year).

It lists in detail the various assets the business owns, the liabilities owed by the business and the value of the shareholders’ equity (or net worth of the business):

• Assets are the items of value owned by the business.

• Liabilities are the amounts owed to external stakeholders of the business.

• Shareholders’ equity is the amount the business owes the owners.

HINT
This diagram shows how the balance sheet works. The business requires assets to operate, and these assets will be funded from the equity in the business or the profit from the operations of the business or by borrowing money from external parties.

The balance sheet can also be illustrated as:

The diagram above shows that the value of all of the assets of the business less the value owed to external stakeholders (liabilities) will equal the net worth of the business — that is, the value of the business after all debts have been paid.

Balance sheet categories

• Assets can include cash, stock, land, buildings, equipment, machinery, furniture, patents and trademarks, as well as money due from individuals or other businesses (known as debtors or accounts receivable).

• Liabilities can include funds made available to the business from external stakeholders by way of loans, overdrafts and other credit used to fund the activities of the business, including the purchase of capital assets and stock, and for the payment of general business expenses.

• Shareholders’ equity (or net worth or capital) is money put into a business by its owners for use by the business in acquiring assets and paying for the (sometimes ongoing) cash requirements of the business.

Balance sheet classifications

For assets and liabilities, a further classification is made to assist in monitoring the financial position of your business.

These classifications are referred to as “current” and “non-current”. Current refers to a period of less than 12 months and non-current is any period greater than 12 months.

Current assets will include items that are likely to be turned into cash within a 12-month period, including cash in the bank, monies owed from customers (referred to as debtors), stock and any other asset that will turn into cash within 12 months. Non-current assets are shown next on the balance sheet and are assets that will continue to exist in their current form for more than 12 months. These can include, for example, furniture and fittings, office equipment and company vehicles.

In the same way, liabilities are listed in order of how soon they must be repaid, with current liabilities (less than 12 months) coming first, then non-current liabilities (longer than 12 months), followed by shareholders’ funds (equity). Current liabilities are all those monies that must be repaid within 12 months and would typically include bank overdrafts, credit card debt and monies owed to suppliers. Non-current liabilities are all the loans from external stakeholders that do not have to be repaid within the next 12 months.

TIP
A prosperous business will have assets of the business funded by profits, rather than relying on funding from either external parties (liabilities) or continual cash injections from the owner (equity).

Following on from the case study of Joe’s Motorbike Tyres, this is what Joe’s balance sheet would look like at the end of Year 1:

Statement of cash flows

The statement of cash flows is a summary of money coming into, and going out of, the business over a specific period. It is also prepared at regular intervals (usually monthly and at financial year end) to show the sources and uses of cash for a given period.

The cash flows (in and out) are summarised on the statement into three categories: operating activities, investing activities and financing activities.

HINT
Statement of cash flows shows only the historical data and differs from a cash flow forecast.

Operating activities: These are the day-to-day activities that arise from the selling of goods and services and usually include:

• receipts from income
• payment for expenses and employees
• payments received from customers (debtors)
• payments made to suppliers (creditors)
• stock movements.

Investing activities: These are the investments in items that will support or promote the future activities of the business. They are the purchase and sale of fixed assets, investments or other assets and can include such items as:

• payment for purchase of plant, equipment and property
• proceeds from the sale of the above
• payment for new investments, such as shares or term deposits
• proceeds from the sale of investments.

Financing activities: These are the methods by which a business finances its operations through borrowings from external stakeholders and equity injections, the repayment of debt or equity, and the payment of dividends. Following are examples of the types of cash flow included in financing activities:

• proceeds from the additional injection of funds into the business from the owners
• money received from borrowings
• repayment of borrowings
• payment of drawings (payments taken by the owners).

As already mentioned, the statement of cash flows can be a useful tool to measure the financial health of a business and can provide helpful warning signals of potential problems. Three warning signs, which in combination can indicate the potential for a business to fail, are:

• cash receipts are less than cash payments (that is, you are running out of money)
• net operating cash flow is an “outflow” (that is, it is negative)
• net operating cash flow is less than profit after tax (that is, you are failing to collect your debts, paying creditors too quickly or building up inventory).

TIP
Use the cash flow statement to determine if you are spending more than you are earning or drawing out too much cash from the business.

Here is an example of Joe’s cash flow statement, showing the relationship between the profit and loss statement and the balance sheet.

A full-sized version of this page is available in the .pdf attachment, or here »

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David Jenkins is the New Zealand-based manager of the global professional accounting body, CPA Australia. You can contact him directly here »

You can read the Introduction to this series here » The related Glossary is an important resource. And readers are encouraged to read this page first »

We welcome your help to improve our coverage of this issue. Any examples or experiences to relate? Any links to other news, data or research to shed more light on this? Any insight or views on what might happen next or what should happen next? Any errors to correct?

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