1.5. Taking the Pulse of a Business: Financial Statements
I devote a good deal of space in this book to discussing financial statements. In Chapter 2, I explain the fundamental information components of financial statements, and then Part II gets into the nitty-gritty details. Here, I simply want to introduce you to the three primary kinds of financial statements so you know from the get-go what they are and why they're so crucial.
NOTE
Financial statements are prepared at the end of each accounting period. A period may be one month, one quarter (three calendar months), or one year. Financial statements report summary amounts, or totals. Accountants seldom prepare a complete listing of the details of all the activities that took place during a period, or the individual items making up a total amount. Business managers occasionally need to search through a detailed list of all the specific transactions that make up a total amount. When they want to drill down into the details, they ask the accountant for the more detailed information. But this sort of detailed listing is not a financial statement.
Outside investors in a business see only summary-level financial statements. For example, investors see the total amount of sales revenue for the period but not how much was sold to each and every customer.
1.5.1. Meeting the balance sheet and the accounting equation
One type of accounting report is a "Where do we stand at the end of the period?" type of report. This is called the statement of financial condition or, more commonly, the balance sheet. The date of preparation is given in the header, or title, above this financial statement.
A balance sheet shows two sides of the business, which I suppose you could think of as the financial yin and yang of the business:
Assets: On one side of the balance sheet the assets of the business are listed, which are the economic resources owned and being used in the business. The asset values reported in the balance sheet are the amounts recorded when the assets were originally acquired — although I should mention that an asset is written down below its historical cost when the asset has suffered a loss in value. (And to complicate matters, some assets are written up to their current fair values.) Some assets have been on the books only a few weeks or a few months, so their reported historical values are current. The values for other assets, on the other hand, are their costs when they were acquired many years ago.
Sources of assets: On the other side of the balance sheet is a breakdown of where the assets came from, or their sources. Assets are not like manna from the heavens. Assets come from two basically different sources: creditors and owners. First, the creditors: Businesses borrow money in the form of interest-bearing loans that have to be paid back at a later date, and they buy things on credit that are paid for later. So, part of total assets can be traced to creditors, which are the liabilities of a business. Second are the owners: Every business needs to have owners invest capital (usually money) in the business. Also, businesses retain part or all of the annual profits they make, and profit increases the total assets of the business. The total of invested capital and retained profit is called owners' equity.
Suppose a business reports $2.5 million in total assets (without going into the details of which particular assets the business holds). I know that the total of its liabilities, plus the capital invested by its owners, plus its retained profit, adds up to $2.5 million. Otherwise its books would be out of balance, which means there are bookkeeping errors.
Continuing with this example, suppose that the total amount of the liabilities of the business is $1.0 million. This means that the total amount of owners' equity in the business is $1.5 million, which equals total assets less total liabilities. Without more information we don't know how much of total owners' equity is traceable to capital invested by the owners in the business and how much is the result of profit retained in the business. But we do know that the total of these two sources of owners' equity is $1.5 million.
A pop quizHere's a teaser for you. If a business's total assets equal $2.5 million and its total liabilities equal $1.0 million, we know that its total owners' equity is $1.5 million. Question: Could the owners have invested more than $1.5 million in the business? Answer: Yes. One possibility is that the owners invested $2.5 million but the business has so far accumulated $1.0 million of losses instead of making profit. The accumulated loss offsets the amount invested, so the owners' equity is only $1.5 million net of its cumulative loss of $1.0 million. The $1.0 million of cumulative loss is money down the rat hole. Owners bear the risk that the business may be unable to make a profit. A loss falls on the owners and, accordingly, causes a decrease in the owners' equity amount reported in the balance sheet. |
The financial condition of the business in this example is summarized in the following accounting equation (in millions):
$2.5 assets = $1.0 liabilities + $1.5 owners' equity
Looking at the accounting equation, you can see why the statement of financial condition is called the balance sheet; the equal sign means the two sides balance.
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1.5.2. Reporting profit and loss, and cash flows
NOTE
Other financial statements are different from the balance sheet in one important respect: They summarize the flows of activities over the period. (An example of a flow number is the total attendance at Colorado Rockies baseball games over its entire 82 home game regular season; the cumulative count of spectators passing through the turnstiles over the season is the flow.) Accountants prepare two types of financial flow reports for a business:
The income statement summarizes the inflow from sales revenue and income, which is offset by the outflows for the expense during the period. Deducting expenses from revenue and income leads down to the well-known bottom line, which is the final net profit or loss for the period and is called net income or net loss (or some variation of these terms).
Alternative titles for this financial statement are the statement of operations and the statement of earnings. Inside a business, but not in its external financial reports, the income statement is commonly called the profit and loss statement, or P&L report.
The statement of cash flows summarizes the business's cash inflows and outflows during the period. The accounting profession has adopted a three-way classification of cash flows for external financial reporting: cash flows from making sales and incurring expenses; cash flows from investing in assets and selling assets; and cash flows from raising capital from debt and equity sources, returning capital to these sources, and making distributions from profit to owners.
1.5.3. Respecting the importance of this trio
I explain more about the three primary financial statements (balance sheet, income statement, and statement of cash flows) in Chapter 2. They constitute the hard core of a financial report to those persons outside a business who need to stay informed about the business's financial affairs. These individuals have invested capital in the business, or the business owes them money; therefore, they have a financial interest in how well the business is doing.
The managers of a business, to keep informed about what's going on and the financial position of the business, also use these three key financial statements. They are absolutely essential in helping managers control the performance of a business, identify problems as they come up, and plan the future course of a business. Managers also need other information that is not reported in the three basic financial statements. (In Part III of this book, I explain these additional reports.)
The three primary financial statements constitute a business's financial center of gravity. The president and chief executive officer of a business (plus other top-level officers) are responsible for seeing that the financial statements are prepared according to applicable financial reporting standards and according to established accounting principles and methods.
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I have met more than one business manager who doesn't have a clue about his or her financial statements. This situation is a little scary; a manager who doesn't understand financial statements is like an airplane pilot who doesn't understand the instrument readouts in the cockpit. Such a manager could run the business and "land the plane safely," but knowing how to read the vital signs along the way is much more prudent.
Business managers at all levels need to understand financial statements and the accounting methods used to prepare them. Also, lenders to a business, investors in a business, business lawyers, government regulators of business, entrepreneurs, anyone thinking of becoming an entrepreneur and starting a business, and, yes, even economists should know the basics of financial statement accounting. I've noticed that even experienced business journalists, who ought to know better, sometimes refer to the balance sheet when they're talking about profit performance. The bottom line is found in the income statement, not the balance sheet!