Preface: Many entrepreneurs vaguely appreciate, and typically do not gain adequate value from the quality assurance of their businesses financial statements, namely because they are unaware of how to synthesize and analyze the information in-depth. In this blog, we will highlight key areas of a financial statement, and provide advice to improve the value of the CPA’s work to the entrepreneur.
Financial Statements – Synthesis and Analysis
Financial statements characteristically provide a minimum of three reports: i) a balance sheet ii) income statement iii) statement of cash flows. The balance sheet shows the financial position of the business at specific period of time, i.e. fiscal year end or the quarter, say Q1. The balance sheets lists only three main segments – Assets, Liabilities, and Equity. The balance sheet is like a bank statement, it’s only accurate for that specific day.
The income statement typically follows the balance sheet, measuring operating performance, i.e. revenues, cost of sales, and operating expenses, for a specific period of time, e.g. fiscal year, or quarter. The income statement is a summary of the businesses bank account activity for period. The income statement begins with revenue. Revenue is the income obtained from the sale of products or services. Just because a business has significant net income for the period, is not to say the business has adequate liquidity (ability to pay current liabilities with cash obtained from current assets).
Typically, businesses use accrual accounting with a few exceptions. With accrual accounting, when inventory (an asset) is sold, the inventory account decreases, say $50 on the balance sheet, and a cost of sales (an expense) on the income statement increases $50, simultaneously. Then from the sale, revenue increases, say $100, on the income statement, and accounts receivable (an asset) increase $100 on the balance sheet. When a business purchases inventory, the inventory account on the balance sheet increases, say $50, and accounts payable account (a liability) on the balance sheet increases, say $50, too. When the accounts payable are paid, cash (an asset) decreases, say $50, and accounts payable decreases, say $50. When a business pays salaries expense, cash on the balance sheet decreases, say $20, and the salary account (an expense) on the income statement increases, say $20. In this example the income statements net income is revenue from inventory sold, $100, less the cost of sales, $50, less salaries expense, $20, for $30 dollars of net income. ($100-$50-$20 = $30 of net income). At the end of the period, the net income is adjusted to equity on the balance sheet, and income statement is balanced to zero to prepare the net income report for the next period.
Revenue with the accrual method of accounting does not say that that cash is received. Revenue can lead to an increased accounts receivable. This is just one angle where net income is not net cash flow. Cash basis statements do not have the complication of accruals with accounts receivable and payables, but most developed businesses cannot use cash basis accounting with IRS regulation on methods of accounting.
Financial statements are classified into major categories. Income statement classifications can include i) classes of revenue, i.e. departments, location, but typically, accountants group the classes of revenue for financial statements into one line, revenues. Then following revenue is ii) cost of sales, then iii) operating expenses, i.e. advertising, salaries, depreciation, office supplies, repairs, and iv) other revenue and expenses, i.e. interest expense, gain/loss on sale of assets, miscellaneous income. Classes on the balance sheet include the major groups, i.e. assets, liabilities and equity, in specific subsets, with current assets, long term assets, current liabilities, and long term liabilities. Current on a financial statement is an item that is liquid or payable within 12 months.
Current assets include cash, accounts receivable, inventory, or say pre-paid expenses. Long-term assets include property, plant and equipment, patents, goodwill, or investments in subsidiaries. Current liabilities include anything payable in the next 12 months, i.e. accounts payable, accrued salaries, customer deposits, taxes payable, or the current portion of debt. Long-term liabilities are often bank debt or term notes, or capital leases for say equipment.