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Our November, 2002
newsletter is entitled "Understanding Financial Statements."
Our newsletters feature articles on various aspects of
preparing a business plan and over time should lead you through
the entire business planning process.
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Understanding
Financial Statements
Financial statements are documents that business
owners must prepare to satisfy lenders and to file annual tax
returns. However, financial statements are also a valuable management
tool. They provide a "picture" of your business and
reflect the financial performance of your company. This information
can be used to enhance the quality and timing of business decision.
The
two basic components of financial statements are the balance
sheet and the income statement, or statement of
earnings.
The balance sheet is often
described as a "picture of your business taken at a specific
point in time." It shows:
- What you own (assets),
- What you owe (liabilities), and
- The resulting net worth of your business (equity).
The balance sheet should always
be balanced. This means that assets should equal liabilities plus
equity.
The income statement summarizes
the income and expenses of your business or operations over a
period of time. Unlike the balance sheet, which is a picture at
a specific point in time, the income statement tells you what
has happened over a period of time.
The balance sheet and income statement
are related to each other. The income, or loss, shown on the income
statement is reflected on the balance sheet as an increase, or
decrease, in equity. The balance sheet will still be in balance
as the income or loss will be offset by an increase or decrease
in assets and in liabilities.
Key
Elements of Financial Statements
- Assets - Items that have
future value to the business, such as cash, inventory, accounts
receivable, property and equipment, and goodwill.
- Current assets - Assets
that are expected to be converted to cash within the next year.
- Liabilities - Obligations
of the business such as accounts payable and loans.
- Current liabilities -
Liabilities that must be paid within a year.
- Long term debt - Debt
that will be repaid over more than one year.
- Working capital
- The amount of current assets minus current liabilities.
- Gross profit - Sales less
the direct cost of producing those sales.
- Net profit - Sales less
all expenses of the business.
- Cash flow - Incoming cash
less outgoing cash.
Using Ratios to Analyze Financial Information
There are three categories of ratios used to analyze financial
information: - liquidity ratios,
- leverage ratios, and
- operational
ratios.
Liquidity
Ratios provide a measure of the short-run ability of
the enterprise to meet its current debt requirements. These ratios
include:
- Current ratio (Current
Assets/Current Liabilities) provides a measure of the ability
of the enterprise to meet its current debt. The ratio provides
an indication of the current assets which are available to cover
the current liabilities.
- Quick ratio (Current Assets
less Inventory/Current Liabilities) provides a measure of the
ability of the enterprise to meet its current debt without having
to convert inventory into cash. The ratio provides an indication
of the current assets less inventory which are available to
cover the current liabilities.
- Inventory turnover (Cost
of Sales/Average Inventory) indicates how many times during
the year the inventory is turned into cash.
- Accounts receivable turnover
(Net Sales/Average Accounts Receivable) indicates how many times
during the year the accounts receivable are turned into cash.
It also provides some indication of the quality of the receivables
and an idea of how successful the enterprise is in collecting
its outstanding receivables.
Leverage
Ratios provide a measure of the ability of the enterprise
to meet its debt requirements. These ratios include:
-
Total debts
to assets ratio (Total Debt/Total Tangible Assets)
measures the proportion of the enterprise's total tangible assets
that are financed through debt.
- Debt
to equity ratio (Total Liabilities/Adjusted Equity)
provides a comparison between the amount borrowed from creditors
and the amount invested by owners. It will also provide an indication
of whether the enterprise is over or under capitalized.
Operating
Ratios provide a measure of how successful the company's
operations are. These include:
-
Gross margin
percentage (Gross
Profit/Sales) indicates how much of each dollar of sales is available
to cover expenses and contribute to profit.
- Return on assets percentage
(Earnings Before Income Taxes/Total Assets) indicates the effectiveness
of management in using assets to generate earnings.
- Return on investment percentage
(Earnings Before Income Taxes/Adjusted Equity) indicates the
return generated on capital invested in the enterprise by the
owners.
- Net earnings margin percentage (Earnings
Before Income Taxes/Sales) indicates how much of each dollar
of sales was converted to earnings.
__________________________________________________________
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