Understanding financial statements.

HI, I’m Rob Lockhart from Westpac’s Davidson Institute. I’m here to talk to you today about ‘Understanding financial statements’. Now it’s been my experience that many people go into business with little or no financial management training and they often leave the financial side of the business up to someone else – you know possibly employing a bookkeeper for the day to day and relying on their accountant for required financial reporting.

But to my way of thinking, given that the owner often has a significant investment in their business, as well as relying on it to provide them with an income, not to mention they are also responsible for the day to day decision making, then it’s important to understand what the financial statements can tell you about what’s happening in your business.

So, this video looks at the most used financial statements, breaking them down to help you better understand the story they tell you about your business. So, over the next 20 minutes or so we’re going to cover: The Income Statement, the Balance Sheet, and the Statement of Cash Flows.

Firstly, the Income Statement. I tend to look at this one first as I find this is the one most people are more familiar with you know because they understand that the Income Statement, or Profit & Loss as its also known, shows the financial performance, or profitability of the business, over a period of time.

Let’s start by breaking the Income Statement down. The Income Statement collates all the income that the business has generated, the Expenses it has incurred, and calculates the Profit or Loss over a period of time, which is commonly a financial year.

The expenses are often broken down into Cost of Sales, which are those costs directly related to making Sales, and Operating Expenses. Now our Cost of Sales expenses are commonly things like Stock, direct freight, and direct labour. Our operating Expenses are those relating to the regular business operations, such as rent, wages, training, insurance, accounting and many more.

Sometimes you will also see ‘Other’ or ‘Extraordinary’ Expenses which are those not directly related to operations, such as interest on financing. You may also hear the Income Statement referred to as the Profit & Loss Statement or Statement of Financial Performance.

Let’s have a look at an example. The Income Statement on the screen is for Anna’s Guesthouse & Gift Store, showing 3 consecutive financial years. Now while the statements you receive from your accountant will generally only have 2 years, for the purposes of financial analysis it’s useful to look at the trends over 3 or more years.

As you can see it starts with the income Anna makes from Sales, then subtracts the Cost of Sales to arrive at the Gross Profit. Now any savings you can make on your Cost of Sales, whether through obtaining discounts from your suppliers or improving efficiencies, are going to help to increase your Gross Profit.

We often refer to this Gross Profit as being the richest number in the Income Statement because any improvements you can make to your Gross Profit, don’t alter the rest of the Expenses so should in theory improve your Net Profit.

The rest of the Expenses are the Operating Expenses such as salaries, advertising, vehicles, supplies, and so on. We take those Operating Expenses away from the Gross Profit to give you your Operating Profit.

Now Anna has some Interest costs and has also received some income unrelated to her normal operations. Subtracting the Interest Expenses and adding the other income we arrive at her Net Profit Before Tax. Now because she is profitable there is some Tax to be paid, which then leaves her with a Net Profit After Tax or it is sometimes referred to as NPAT.

Now we can see in Anna’s case that even though her Sales are increasing her Profits are actually decreasing so to my way of thinking this warrants a closer look at what is actually happening in her business.

Anna’s Sales and Gross Profits are increasing so let’s have a closer look at her Operating Expenses to see if there’s anything that stands out as reducing her profitability. Well Salaries have increased quite a bit, so you would need to consider whether this increase in Sales justified this increase in salaries – similarly with those advertising expenses as well.

The next big increase here is particularly concerning –Bad Debts have doubled! This would indicate that they’re not collecting their Debtors as efficiently which potentially impacts their cash flow as well as their profitability.

Moving on, we also have a notable increase in Depreciation. Now that in itself isn’t so much concerning, but it does indicate something else to us about the business. An increase in depreciation would normally mean there has been an increase in depreciable Assets. That is, they may have bought another vehicle or some new equipment or something. And we’ll see if that’s the case when we have a look at Anna’s Balance Sheet shortly.

So these are some of the things that are affecting Anna’s Operating Profit. But there is one more big increase in her Expenses and that’s her Interest expense. Now, before we lay the blame on those pesky banks for increasing Interest rates let’s consider what’s really causing such a big increase. It is of course an increase in borrowings.

We noted that an increase in depreciation indicated more Assets so perhaps she has borrowed for these … or perhaps, as we also noted from the increase in bad debts, her cash flow may have needed some help and she is using an Overdraft. But whatever it is, this expense has had a real impact on her profitability, so the cause needs to be identified. And we’ll look at that some more when we delve into the Balance Sheet.

So let’s have a look at this Balance Sheet, which I find is the one people are less familiar with. It is simply a statement of the business’s financial position at a specific point in time.

The first thing the Balance Sheet records is all the things that a business owns. These are known as Assets. Then it looks at where the money came from to accumulate those Assets – and it’s either provided by the owners of the business in the form of Net Worth, or Equity, or it’s borrowed from others – called Liabilities.

The Balance Sheet may also be known as a Statement of Financial Position and it shows a snapshot of the business’s financial position at a specific point in time. Now let’s look at each element of the Balance Sheet in a little more detail … we are going to start with the Assets. In the Balance Sheet the Assets are broken down into 3 categories. Current Assets turn into Cash within 12 months. Things like Cash, Stock and Debtors.

Fixed Assets are those that last longer than 12 months – things like motor vehicles, computers, desks, chairs, buildings and so on. Intangible Assets are those things that you can’t touch or feel but they add value to an organisation – and they are things like goodwill, licenses, patents, or intellectual property.

Liabilities and Net Worth are the sources of money to pay for the Assets. Net Worth, or Equity, is the business owners’ funds, while Liabilities are the money owed by the business to other businesses, organisations, or financial institutions (other people). Liabilities, like Assets, are broken down into Current and Long-term.

Current Liabilities are those that need to be repaid within the next 12 months – things such as Creditors, or short terms loans like Credit cards or Overdrafts. Long-term Liabilities are those that will be repaid over a term longer than 12 months – things like equipment finance or building loans or those types of things.

Net Worth or Equity is, as I said, the money the owners have invested in the business. Often it is the initial capital plus any retained earnings, that is Profits that are retained in the business instead of being distributed to the owners.

Let’s have a look at an example of a Balance Sheet. The one on the screen is for Anna’s Guest House & Gift Store again and it shows the financial position of the business at the end of the financial year for 3 consecutive years.

At the top are the Current Assets, those that will be turned to Cash within 12 months. As you can see they commonly include Cash, Debtors (people that owe the business money for Stock purchased or services received, and can also be called Accounts Receivable), then there is Stock (which may also be known as Inventory), and in the case of a service business they may show a thing called Work in Progress or WiP instead of Stock.

You’ll notice in this case that the Current Assets have increased significantly over the 3 years shown. Now this would be anticipated given Anna’s increase in Sales however you would need to look closer to establish whether those Assets are increasing at the same or maybe a greater rate than her Sales.

We are not going to look at that in detail in this video but it is covered in our video ‘Measuring Financial Performance’. There is one thing to note here, and that is that the Cash balance has decreased. Anna has a lot of Stock to sell, and plenty of Debtors to collect, but her cash position has deteriorated.

After the Current Assets, the Fixed Assets are then recorded. Fixed Assets, sometimes known as Long-term Assets, are those that the business will use over a longer period of time. Fixed Assets are recorded at the original value paid for them.

The Accumulated Depreciation amount is an accounting estimate of the value that has ‘gone away’ from those Long-term Assets usually due to wear and tear. We take Accumulated Depreciation away from the Fixed Assets to arrive at today’s book value.

Now we noted when we looked at Anna’s Income Statement that her Depreciation expense had increased, possibly due to an increase in her Fixed Assets. And you can see here that that is actually the case.

The third type of asset that is shown on the Balance Sheet are Intangible Assets – those things that you can’t touch or feel. The intangible asset shown as “Other” may be something such as an operating licence or perhaps a patent or copyright that the business owns.

The Balance Sheet shows us that there has been an increase in Assets over the 3 years … so where did the funding come from? Let’s have a look at the other half of the Balance Sheet to determine where this funding has come from. Similar to Assets, Liabilities are classified into Current and Long-term depending on when they need to be repaid.

Current Liabilities are those that need to be repaid in the next 12 months, and they are things such as an Overdraft or Credit cards, Creditors (which are the other businesses or people that this business has purchased Stock from but not paid for it yet, they can also be known as Accounts Payable). The Current Portion of Long-term Debt sometimes put as CPLTD (this is the principal repayments the business is due to make on long-term loans during the next 12 months).

Now you will note that like the Current Assets there have been significant increases in these Current Liabilities – and in particular the Overdraft. Now, think back to our discussion on the Income Statement and how we noted that the increase in Interest expense was likely due to an increase in borrowings. This is due to the increase in the Overdraft because if you look below you’ll see that the Long-term Liabilities have actually decreased.

And if we look further down, we can see that the Net Worth, or the owner’s money, is gradually increasing, with the Profits being retained in the business. That’s the Balance Sheet in a nutshell. In brief it tells us about the things a business owns, and where they sourced the funding to pay for them … which in essence, is the businesses financial position.

Now you may have noticed that on the way through I was highlighting how something in the Income Statement can tell us about something that might be changing in the Balance Sheet and vice versa. This indicates to me that these two statements, while often viewed in isolation from each other are actually intrinsically linked. And when we look at them together we get a much more holistic view of the entire business.

So let me take this one step further. I’d like to show you now, the Financial Operating Cycle. This is a cycle that operates in every business, no matter the size, industry or whatever. And when a business owner understands how their business’s Financial Operating Cycle works, then they’re much better informed, and can make much more effective financial decisions.

Now imagine for a moment that we’re just starting out in business. We break out the piggy bank and put as much money towards the business as we can. Our contribution to funding the business is called our Equity, or Net Worth. This is money from our own pockets.

Now we combine that with money that we borrow, our Liabilities. Together, our money and the money that we borrow make up all of the resources that we have available to operate our business, and we operate the business by purchasing Assets.

Using those Assets, we generate Sales. Then we have a series of Expenses which, if managed well, then leaves us with a Profit. Now this is where I find most people stop … Profit is their one measure of success.

However, the next step is to consider how that Profit can be used to drive even more successful outcomes within the business. In effect, our Profit serves three masters within the business. Firstly, it serves the business by helping us to purchase more Assets.

Secondly, it serves our Creditors by helping us to reduce how much we owe them, and finally, it serves us as the owners and investors in the business, by paying us a dividend.

Used properly, and in the correct proportions, we can successfully grow our business and our personal wealth. By understanding this flow of funds through a business we can see that everything is interconnected.

Now, as you may have recognized across the top of the diagram is the Balance Sheet and, on the left, here, the Income Statement and we can see how the two are inter-related. Things that change in the Balance Sheet can have an impact on the Income Statement and changes in the Income Statement can have an impact in the Balance Sheet. By managing this whole cycle efficiently, we can create a sustainable business.

The next financial statement we are going to have a look at isn’t as well known as the Income Statement and the Balance Sheet, but it tells us about another vital aspect of the business. As its name suggests the Statement of Cash Flows looks at how cash is generated and used in the business to identify why the cash position has changed – either for the better or worse.

Now while the Income Statement shows how Profits were generated, as we all know Profits aren’t necessarily cash and we need cash available to continue to operate on a day to day basis.

Cash in a business is generated and used in 3 ways. Either through operations – the buying and selling of goods and services; investing – in Long-term Assets; or financing – the injection of capital or borrowed funds. The Statements of Cash Flows shows which of these have generated or used cash, how much, and what caused the change to the ending cash position.

Let’s see how that works using the figures for Anna’s Guest House & Gift Store. You’ll recall we noted earlier Anna’s cash position had deteriorated, so let’s see where her cash is getting used up. In terms of operations – this is how the Cash has changed due to the buying and selling of goods and services.

Firstly, the Cash receipts from Sales. This isn’t simply the Sales figure because we may also have collected Sales from the previous year or maybe not collected some income from this year. So, Sales is then adjusted by the change in Debtors, and any other income, to accurately reflect how much cash has been received. In Anna’s case, the cash receipts work out to be $2,059,000.

Then we need to take away Cash that was used to pay suppliers. Similarly, the cash payments to suppliers need to be adjusted to reflect the changes in Cash. Cost of Sales doesn’t actually reflect the cash used until we adjust it by the change in our Stock levels and the amount, we still owe our Creditors. So, in this case the adjusted amount, that is the Cash used, is $1,832,000.

Then all other cash payments for Expenses need to be shown. The net Operating Expenses of $300,000, and other Expenses such as Interest and Tax of $50,000. This calculates out to a negative cash flow from operations or if you like trading of $123,000.

But remember, this is just one type of source and use of Cash. Let’s have a look at investing and financing now. Cash flow from investing refers to the changes in Long-term or Fixed Assets. In Anna’s case there was an increase in her Fixed Assets and Intangible Assets which used $70,000 of Cash. So Operating activities has used $123,000 of Cash and Investing has used a further $70,000; which is $193,000 in total.

Where has the cash come from? Well let’s see what financing activities have occurred. The cash flow from financing activities refers to the changes to money borrowed from others or invested by the owner. We can see from Anna’s Balance Sheet that there was an increase in her Overdraft of $219,000 and a reduction or repayment of $30,000 to the long-term loan. This means that Cash of $189,000 was sourced from financing.

Having established that Operating used $123,000 Cash, investing in Fixed Assets used $70,000, and financing netted $189,000 Cash, this gives an overall negative cash movement of $4,000. This corresponds with the reduction in the Cash that we saw on the Balance Sheet.

I’ve got to admit, this is not an ideal scenario. However, funding your loss-making trade with additional debt is actually a common scenario for rapidly growing businesses. But by being aware that this is the case, the decision maker can then put actions into place to correct the trend and get the business onto a better footing.

But what if the situation was the opposite and the business was generating more cash than it was using? Well then of course the business has the option of using that cash to create efficiencies to reduce costs or to reduce debts to further reduce costs and risk, or maybe to make distributions to the owners.

This is how a formal statement of cash flows might be presented, though there are a number of different formats used. Today we have had a look at the Income Statement to gain a better understanding of what this statement tells us about the business’s financial performance.

We then looked at the Balance Sheet to gain a better understanding of the business’s financial position. Then we looked at the Financial Operating Cycle that shows the relationship between these two statements and gives a much more holistic view of the overall health of the business.

And finally, we looked at the Statement of Cash Flows to establish how Cash is being sourced and used in the business. Today we have really only looked at the bare bones of each of these statements but have started to get a feel or indication that even though the case study that we looked at was a growing business with increasing Sales, that all is not as good as it looks at first glance.

In our video Measuring Financial Performance we’ll take this a step further and use some financial ratios to measure how efficiently the business is operating and using its Cash. Thank you for watching our ‘Understanding financial statements’ video. We trust you found this information useful and relevant and I encourage you to check out the other webinars and resources on the Davidson Institute website to help build your financial confidence.