The Simplest Explanations of Financial Statements – What They Are, How to Use Them
The simplest statement is the profit and loss statement, also called P & L. This P & L indicates if the organization is generating profits or losses with its operations during a set period of time. The second statement is the balance of payments or Balance Sheet. It offers a vision of the assets, liabilities and estate. The third one is the Cash Flow and it refers to the movements of money in and out of the organization's accounts.
The Financial Statements answer these questions:
Profit or loss statement: Are we making money?
Balance Sheet: Are we creating wealth?
Cash Flow: Are we able to fulfill our obligations?
If you do not have much time, and you can only get education in a small small part of the finances, learn about cash flow. This is the main financial tool that helps us to determine the external financing requirements. When I am talking about external requirements I mean the cash needs are not covered by the income of your company.
Profits and Losses (P & L)
The P & L is also called the income statement. The whole objective of the P & L is to give you an idea about the capacity of wealth generation. In order to do that, in a very simple way; the income must be greater than the debits. There are sophisticated methods to perform the evaluation of the P & L, in this example we will consider that the main objective of the company is to sell products or services.
How to Understand the Profit and Loss Statement
Operational Income – Direct Costs = Gross Profit
Gross Profit – Indirect Costs (+ non-operational income) = Net Profit
Net Profit – Taxes = Profit and / or Losses
In an ideal world your organization has a profit and shares it with several other people or organizations including employees, suppliers, owners, lenders and even the government in the form of taxes. There are many software packages that can help your create an income statement. Yet, the commercial world is not a spread sheet; it is a series of rational and irrational decisions related, out of which you only control one decision: yours. The old rule of thumb was that basically a company should not sell a product or service for less than the cost it spends on producing it. Well, it does not work that way. YouTube, the video site, does not sell the service of hosting and delivering videos, but the service of promoting products next to the videos. Neither does Google, which provides a very high value -internet search- for free. In the process, providers of internet connection benefit yet Google does not use them as clients or customers, they are -yes, stakeholders.
Thinking that any company can be as Google is an utopia. Most companies have to be able to offer a value that is higher than an alternative to a client who will be convinced that such deliver is possible.
The income statement formula for most companies shareholders three concepts: gross margin, net margin or profit, and net profit.
Gross margin is the direct result from operations.
Revenues (income) from sales or activities directly related to the organization's purpose minus expenses directly associated to sales. If you have multiple products or services include the price and cost of each one on a separate sheet. In this way you will see which are the most or least profitable. You also will notice you may lose on certain product in order to achieve a greater sale and gain a profit. Make sure to include the cost of time specifically dedicated to accomplish a sale and with that compute sales that did not happen (this time is also part of the direct cost).
Calculate the gross profit by subtracting the direct cost of all your sales compared to your operation imports. Include the ones that you have not collected, but have already sold and delivered. Also consider other costs (indirect costs) which do not vary with sales, these typically are your administrative expenses. As well as in the previous case, include the expenses you owe even if you have not met them.
Calculate the net profit subtracting the indirect expenses from the gross profit and adding in the incoming which are not directly related to the purpose of the organization.
Finally take in account the taxes and expenses on debt, like interest if you have a loan, and depreciation and amortization if you have machinery, equipment or other property. Calculate your profits or losses by subtracting these expenses to get the net profit.
There are several specifications to the P & L which are specific to each business model. Make sure to verify this with an accountant or an accounting expert who can explain you the differences regarding this general model. I like to have a clear indication of my claims tied to clients, revenues and expenses. I know as a fact that it will take longer than expected to get clients, I just do not know how long. I also want to evaluate how the revenues are growing, by selling more to existing clients or by capturing more clients. Assumptions to be considered include: number of clients, average sale per client and special conditions such as discounts, credits or payment plans. Whether you are starting up or growing, knowing these assumptions will be very valuable when you are seeking funding as well as following up on your plan. There are many examples of income statements online.
Now let's go to the balance sheet. In this case, you split your company in three great areas: assets, liabilities (debt), and equity. We call this financial statement a Balance Sheet because assets must be equal to the sum of liabilities plus equity.
Assets are tangible and intangible items the company owns and can convert to cash. That is the old school of economics. Assets need to generate income and that subtle difference: Converting to cash or generating income has a large impact on the well being of a company. Assets have the capacity to generate income actively. We must do something with them; for example, the money in the bank, a chair, a trademark, inventories and even a patent. If the purpose of an asset is to have a cash value, that purpose is not creating wealth, on the contrary, an asset that is waiting to be converted to cash looses value.
There are four types of assets: tangible and intangible, based on whether its value can be commonly agreed upon or not, and short term and long term assets, based on the speed of which an asset can be converted into cash. Tangible assets are for example office supplies, desks, vehicles and machinery, intangible assets are web site, logo, brand recognition, relationships with vendors or buyers and intellectual property-patents, trademarks, and knowledge. Short- term assets which can be sold rapidly if the company needs cash, whereas long term assets which can not be sold quickly.
Liabilities (debts) are obligations that the company 'owes', basically they include the value of loans as well as invoices and salaries to be paid. There are two types of liabilities: Short and long term. The short term ones are debts which must be paid within 12 months. The long term debts are the ones that have to be paid in a longer period than 12 months.
The equity is the value of the ownership of the firm, depending on the legal system of each country, equity could be easier or harder to sell. Generally speaking there are two main types of business: based on people or based on capital. Equity for people's based firms is harder to sell, usually the owner or owners of a firm are unequivocally linked to its brand. For example, when hiring a law firm, a doctor, a consultant or a hair dresser, the company's value is linked to the owners' reputation. In some cases, quality control surpasses this perception, as in the case of large law firms. Equity in people's based firms are usually called participation, and the law in most countries limits the power of capital in lieu of the power of people's decisions. Changes in ownership in people's based firms are usually agreed upon by consensus. In the case of capital based firms the value of the company is not linked to individuals but to capital invested, the equity is also referred to as stock or shares. The company is managed by a team that might or might not be related to the owners. These companies can sell parts of their ownership -called shares- at relative ease. In some cases, these shares are sold at the financial markets.
Companies which shares are sold in financial markets are called public companies. Companies which shares are not traded openly in financial markets are called private companies. Public companies must meet certain regulations that frame the conditions in which management can make decisions. In both privately and publicly held companies, owners are called shareholders and are represented by board members. As a group, board members decide the strategy of the firm. People purchase shares as investment tools, they expect the shares to provide rewards in two forms: they increase in value -also referred to as capital appreciation and- and they generate disputes. The balance sheet provides a healthy check point of how assets -which build wealth- are funded, by debt or equity. The funding article explains the details of funding based on debt or equity.
How to understand the Balance Sheet
Assets generate income
Liabilities (debts) generate obligations
Equity (property) generates rewards
Total assets (short term assets + long term assets) = total liabilities (short term liabilities + long term liabilities) + equity.
This very unusual and practical way of viewing your Balance Sheet makes a huge difference when you want to create wealth!
Cash flow lenders only the way cash or money goes in and out of the firm, the organization or even your personal finances. Understanding the flow of cash is very important because a firm can be profitable (as per the income statement), which can be creating value (as per the balance sheet) but may go into bankruptcy because it has no cash to pay for its obligations. Many people underestimate the impact of delayed payment, nor do they understand how being in debt can be good or can not estimate how much investment is needed.
How to understand Cash Flow
IN: All the money that comes in as a result of sales, interests, refunds, and any other income.
OUT: All the money that flows out as a result of payments to suppliers, rent, salaries, responsibilities, utilities, any other cost, loan repayments, pre-payments and any other expired directly related or not to the organization.
The required investment (regardless of the source, either as debt or equity), is calculated by the amount of cash required to cover the accumulated deficit that occurs when there is not enough money coming in to pay for what is going OUT. Usually there is a 10% extra for sundries or unexpected expenses added to the investment.
Cash flow is the difference between the cash that comes in and flows out of a company. A negative cash flow requires a capital contribution or investment.This investment can be achieved through the creation of a future payment obligation, ie, debt, or through the sale of one part of the company's property / assets, ie, its equity. The cash flow allows for financial planning, foreseeing when there is a negative cash flow that requires extra capital. That is the basis of funding.
I know many cases of companies that went bankrupt due management failed to realize a negative cash flow and reacted too late. Cash flows must be preceded and validated. If you manage or plan to manage a company, or even a non-profit, learn about finance and above all understand the estimated and real cash flow. This is the best way of having a healthy financial strategy and balancing your life, so you are proactive and not reactive.