UNDERSTANDING AND USING FINANCIAL STATEMENTS FOR THE MANAGING OF SMALL BUSINESS

Transcription

1 Page 1 of 12 UNDERSTANDING AND USING FINANCIAL STATEMENTS FOR THE MANAGING OF SMALL BUSINESS Aaron Caillouet, Nicholls State University William Lapeyre, Nicholls State University ABSTRACT Most small business managers possess the basic knowledge to maximize their use of financial statements for decision-making. Because they already understand the "language of business", they need simply to understand statement format, purposes, and to apply simple ratios. This article examines the important role of financial statements to enable managers of small business to be able to make rational judgments. Small business managers do not always have the technical staff that managers of larger businesses have for statement analyses. A review of financial statement purpose, examples of financial statements, and principal ratios from Robert Morris Associates and their application is provided here to illustrate the basics of understanding and using financial statements for the managing of small business. INTRODUCTION Financial statements may seem somewhat complicated to many. Most managers however, have the tools necessary to get the maximum use from statements. Accounting has often been characterized as the "language of business". Hence, managers are already equipped to understand and use financial statements in the operation of their businesses. It becomes a matter of learning the various formats and how they all fit together. Once the manager learns the purposes of the different statements he or she can then apply several simple ratios and perform trend analyses to help discover the past and present situation. The foundation is then set to chart the direction of the firm for future success. It is very important for them to understand and use financial statements because the statements play an important role in the decision-making process. Management strategy includes the establishment of a company mission, setting goals, strategy formulation and implementation. The use of financial information is necessary to the success of effective strategy. Having attainable yet challenging goals is integral to the process. Without

2 Page 2 of 12 the data, goal-setting would be impossible. A review of the background of accounting theory is important to understand the structure of financial statements and why they are presented in their particular formats. It should include the establishment of generally accepted guidelines, identification of users and of concepts that form a basis for financial statements. Generally Accepted Accounting Principles (GAAP) Four financial statements are prepared to report business activity and results - the income statement, the statement of stockholders' equity, the balance sheet and the statement of cash flows. They are prepared in that order and are based on what is known as generally accepted accounting principles (GAAP). GAAP is the widely accepted agreement on the guidelines for accounting theory and practice. Financial vs. Managerial Statements The financial statements noted above are called general-purpose because they are prepared for all users, both internally and externally. Because they are prepared for all users they have to be prepared according to GAAP for consistency. They provide decision-making information for company managers as well as creditors, stockholders, potential investors and the IRS. Consequently they need to be uniform. This article analyzes GAAP-prepared financial statements only. Managerial statements are prepared for internal purposes only to aid the manager in decision-making. They are used to facilitate decisions on a more operational basis. They are not restricted to GAAP, hence companies can be innovative in the type of information they need for themselves. Because of their potential uniqueness to different firms, this article does not attempt to analyze the numerous formats possible under managerial reporting. Accounting Concepts and Conventions Basic concepts and conventions govern the preparation of financial statements. Balance Sheet. The balance sheet presents the financial condition of a company at a specific date. It consists of assets, liabilities and stockholders' equity. Assets are economic resources which are expected to provide future benefits. Liabilities are obligations of the firm while stockholders' equity is the book value of the firm's worth which includes investment and retained profits and is the difference between assets and liabilities.

3 Page 3 of 12 The balance sheet is prepared based on at least five concepts. 1. Entity. Accounting data for the firm is kept separately from that of persons associated with the company. In other words, there can be no co-mingling of data that is personal in nature with that of the company data. The entity is measured solely on its own. 2. Monetary. All information must be able to be measured quantitatively in order to be recorded. Items that have no money value do not appear in the balance sheet. 3. Historical Cost. With some exceptions, assets are recorded at their original cost and remain at cost unless the value decreases. This preserves objectivity in statements. Establishing market value by appraisal or indices allows the application of subjectivity. 4. Going-concern. The assumption is made that the entity will continue to exist indefinitely. This allows consistency and measurability regardless of the condition or stage of the entity. For example, the write-off (depreciation) of assets is not changed even if the owner expects to liquidate the business in the near future. 5. Double-entry. Every transaction has to have at least two items in order to preserve the balance sheet equation: Assets Liabilities + Stockholders' equity. Income Statement. A summary of the revenues and expenses of an entity for an accounting period is called an income statement. A normal accounting period (fiscal year) is one year in duration. The income statement and balance sheet are related in that the income statement helps explain the change in stockholders' equi- ty. Net income less dividends is added to retained earnings (a balance sheet item) to help update the value of the business. The income statement employs all of the following concepts and conventions. 1. Periodicity. Activities are measured for a specific period of time, usually a year. Comparing data from year to year (trend analysis) facilitates effective decisions. 2. Matching. Any event which affects revenues and expenses needs to be recognized in the same period. To do otherwise would destroy comparability from one period to the next due to distortions in the net income in each period. 3. Consistency. An entity should use the same method of recording transactions from year to year unless there is sound reason to change methods. This also allows for effective comparability from period to period.

4 Page 4 of Conservatism. In order to achieve reliability in the statements and acceptance by users, they are prepared conservatively. Revenues are recognized only when they are reasonably certain and expenses are recognized as soon as they are reasonably possible. 5. Realization. Revenues are generally recognized when the goods are delivered to customers or when services are rendered. Note that revenues are recognized without regard to the timing of payments for the goods or services. 6. Materiality. Events that are insignificant can be ignored since they have no material impact on the final results. FINANCIAL STATEMENTS ILLUSTRATED As discussed there are four general-purpose external financial statements. The following are examples of the four income statement, statement of stockholder's equity, balance sheet and the cash flow statement. A comparative balance sheet is also illustrated to show how the cash flow statement is prepared. Blake-Morgan Sales, Incorporated Income Statement (Single-Step) Year Ended December 31, 1990 Revenues Net Sales $950,000 Gain on Sale of Equipment 10,000 Total Revenues $960,000 Expenses Cost of Goods Sold $690,000 Selling Expenses 90,000 General and Administrative Expenses 120,000 Interest Expense 13,000 Total Expenses 913,000 Net Income $ 47,000 Blake-Morgan Sales, Incorporated Statement of Stockholders' Equity Year Ended December 31, 1990 Balance, January 1, 1990 $433,000 Net Income 47,000 Cash Dividends (5,000) Stock Issued 50,000 Balance, December 31, 1990 $525,000 Blake-Morgan Sales, Incorporated Balance Sheet December 31, 1990 Assets Current Assets Cash $ 50,000 Accounts Receivable 100,000 Inventory 150,000 Supplies 20,000 Prepaid Expenses 5,000 Total Current Assets $325,000 Long-Term Investments 50,000 Property, Plant, and Equipment Land $200,000 Buildings $150,000 Less: Accumulated Depreciation 50, ,000 Furniture and Fixtures $100,000 Less: Accumulated Depreciation

5 Page 5 of 12 10,000 90,000 Total Property, Plant, and Equipment 390,000 Intangible Assets Goodwill 20,000 Total Assets $785,000 Liabilities and Stockholders' Equity Current Liability Accounts Payable $150,000 Salaries Payable 10,000 Total Current Liabilities $160,000 Long-term Debt Bank Notes Payable 100,000 Total Liabilities 260,000 Stockholders' Equity Common Stock $400,000 Retained Earnings 125,000 Total Stockholders' Equity 525,000 Total Liabilities and Stockholders' Equity $785,000 Blake-Morgan Sales, Incorporated Comparative Balance Sheet December 31, 1990 and 1989 Increase Decrease* Assets Cash $ 50,000 $ 40,000 $ 10,000 Accounts Receivable 100,000 90,000 10,000 Inventory 150, ,000 10,000 Supplies 20,000 15,000 5,000 Prepaid Expenses 5,000 10,000 5,000* Long-term Investments 50,000 60,000 10,000* Land 200, ,000 20,000 Buildings 150, ,000 50,000 Accumulated Depreciation- Buildings (50,000) (40,000) (10,000) Furniture and Fixtures 100,000 50,000 50,000 Accumulated Depreciation-F&F (10,000) (6,000) 4,000) Goodwill 20,000 20, Total Assets $785,000 $659,000 $126,000 Increase Decrease* Liabilities Accounts Payable $150,000 $140,000 $ 10,000 Salaries Payable 10,000 6,000 4,000 Bank Notes Payable 100,000 80,000 20,000 Total Liabilities $260,000 $226,000 $34,000 Stockholders' Equity Common Stock $400,000 $350,000 $50,000 Retained Earnings 125,000 83,000 42,000 Total Stockholders' Equity $525,000 $433,000 $92,000 Total Liability and Stockholders' Equity $785,000 $659,000 $126,000 Blake-Morgan Sales, Incorporated Statement of Cash Flows Year Ended December 31, 1990 Cash Flows From Operating Activities: Net Income $ 47,000 Add: Depreciation $14,000 Increase in Accounts Payable 10,000 Increase in Salaries Payable 4,000 Decrease in Prepaid Expenses 5,000 33,000 $80,000 Deduct: Increase in Accounts Receivable $10,000 Increase in Inventory 10,000 Increase in Supplies 5,000 25,000 Net Cash Flow From Operating Activities $55,000 Cash Flows From Financing Activities Cash Received From Common Stock Sale $50,000 Cash Received From Bank Note 20,000 $ 70,000 Less: Cash Dividends 5,000 Net Cash Flow From Financing Activities 65,000

6 Page 6 of 12 Cash Flows From Investing Activities: Cash Received From Sale of Investments $ 10,000 Less: Cash Paid For Land $20,000 Cash Paid For Buildings 50,000 Cash Paid For Furniture & Fixtures 50, ,000 Net Cash Used For Investing Activities (110,000) Increase in Cash $10,000 Cash At The Beginning Of The Year 40,000 Cash At The End Of The Year $50,000 ANALYZING THE FIRM'S FINANCIAL POSITION AND PERFORMANCE Once the manager has a basic understanding of the four financial statements, he or she is able to analyze the firm's financial position in some detail. Analyzing a firm's financial position and performance helps form the basis for future planning. Ratios are used to evaluate the firm. Many ratios are available to use in analyzing information. Many financial professionals use the principal ratios contained in Robert Morris Associates' Annual Statement Studies. The ratios, how they are calculated, and their purpose are included in Table 1. TABLE 1 Principal Ratios Contained in Robert Morris Associates Annual Statement Studies Ratio Calculation Purpose A. Liquidity 1. Current ratio Current assets Shows the extent to Current liabilities which claims of short- term creditors are covered by assets expected to be converted into cash in the same period. 2. Quick ratio Cash and equivalents + Indicates the firm's Accts. and notes rec. ability to pay off Current liabilities short-term creditors in the very near future. 3. Sales/Receivables Net Sales Measures the average Accts. and notes time it takes to Receivable collect debt receivable owed by customers. 4. Cost of sales/ Cost of sales Provides information Inventory Inventory inadequate inventory. 5. Sales/Working Sales Shows sales capital Curr. assets minus productivity and curr. liab. utilization of working capital. B. Coverage ratios 1. Earnings before Earnings before Indicates the extent interest and Inter. and taxes to which the earnings taxes Annual inter. expense can decline while (EBIT/interest) retaining the firm's ability to meet annual interest cost. 2. Cash flow/current Net profit + Deprec., Measures the ability maturities of depletion, amortiz.

7 Page 7 of 12 to meet current long-term debt expenses portion of long-term Curr. portion of long- debt with current term debt cash flow. C. Leverage ratios 1. Fixed/Worth Net fixed assets Indicates the extent Tangible net worth to which the value of the firm can cover fixed assets which are normally financed by long-term debt. 2. Debt/Worth Total liabilities Shows the Tangible net worth relationship between creditor's claims and owner's claims on assets. D. Operating ratios 1. Percent profits Prof. before taxes Measures the rate of before taxes/ Tangible net worth X 100 return on the Tangible net investment in worth current book value of the firm. 2. Profits before Prof. before taxes Measures the rate of taxes/total Total assets return on assets assets employed. 3. Net sales/net Net sales Indicates the fixed assets Net fixed assets productivity of sales on the net value of fixed assets employed. 4. Sales/Total Net sales Shows sales assets Total assets productivity in relation to total assets employed. E. Expense-to-sales ratios 1. Percent deprecia- Deprec.,depletion Indicates the tion, depletion, amortization proportion of non- amortization/sales Net Sales X 100 cash expenses in the income statement. 2. Percent lease Lease and Rental Measures the and rental expenses proportion of Lease expense/sales Sales X 100 and Rental Expenses in the income statement. 3. Percent officer's Officer's Shows the proportion compensation/sales Compensation of officer's Net Sales X 100 compensation in the income statement. Source: Robert Morris Associates, Annual Statement Studies The ratios are divided into five major categories. First, liquidity ratios measure the firm's ability to pay current debt. Second, coverage ratios measure the extent to which earnings are proportionately larger than certain liability related items. Third, leverage ratios measure the firm's use of debt and the ability to repay. Fourth, operating ratios measure the firm's ability to generate sales and profits. Fifth, expense-to-sales ratios measure selected expenses in the

8 Page 8 of 12 calculation of net income. Using Ratios. Ideal standards for the various ratios are impossible to determine, but a reasonable analysis is still possible. Ratios are very useful when they are compared to the same ratios of similar firms and to the firm's own previous ratio values. Robert Morris Associates (RMA) is only one of several secondary sources of industry and trade ratios available as references for comparison. Other principal secondary sources are Dun & Brad- street, Standard and Poor, the Almanac of Business and Industrial Financial Ratios and the Quarterly Financial Report published by the Federal Trade Commission. Trade associations, bankers, banks and other financial institutions are still other sources for comparison. It should be mentioned again that these sources provide ranges and averages for a particular classification. They should not be viewed as ideal goals, but only as indicators of performance by other similar firms. Trend Analysis. Analysis of trends can be very useful when ratios are compared to previous ratios. A change in ratio values indicate that changes are taking place in the performance or financial position. This helps alert management to problems or potential problems prior to them causing irreparable damage. Ratio comparison only indicates a change, so a more thorough analysis is probably required to determine the real cause of the problem. RATIO ANALYSIS FOR BLAKE-MORGAN SALES, INCORPORATED Several ratios from Robert Morris Associates have been selected to show how the calculations are made and what they mean. Keep in mind in all the calculations that a meaningful thorough analysis would include comparison to similar firms and prior periods of our firm. Current Ratio. The current ratio shows the extent to which claims of short-term creditors are covered by assets expected to be converted into cash in the same period. current assets = 325,000 = 2.03 current liab. 160,000 A ratio of 1.0 indicates that there is exactly enough cash or other assets that can be converted into cash within a year to pay the liabilities due in a year. So a ratio of 2.03 is generally considered to be adequate in most firms. It is not true however for all firms in all situations. Cost of Sales/Inventory. This ratio provides information on excessive or inadequate inventory.

9 Page 9 of 12 Cost of Sales = 690,000 = 4.60 Inventory 150,000 Since the cost of sales figure is for a year and the inventory represents a current quantity, the 4.60 is sometimes referred to as inventory turnover. That is, the inventory is turned over (sold) 4.60 times per year. The higher the ratio the better as long as we aren't sacrificing future sales by carrying an inadequate inventory. A 4.60 ratio also indicates an average inventory turnover of 79 days (365 days/4.60). Earnings Before Interest and Taxes. This is a coverage ratio indicating the extent to which the earnings can decline while still retaining the firm's ability to meet annual interest cost. Earn. before inter. and taxes = 60,000 = 4.62 Annual inter. exp. 13,000 To calculate earnings before interest and taxes the interest expense is added back to net income. Our statements did not have income tax. If they would have, it would also be added back. The ratio of 4.62 indicates that earnings are 4.62 times as large as the cost to service debt. Of course, the larger the number the better. But remember, trends are very important, especially with this ratio. Debt/Worth. Debt/worth is a leverage ratio indicating the relationship between creditors' claims and owners' claims on assets. Liabilities = 260,000 = 0.50 Net worth 525,000 A 0.50 ratio means that the book value of the firm is twice as large as the debt, or that liabilities are only one-third of total assets since assets = liabilities + net worth. This indicates that the firm is not too heavy in debt. Some companies operate with a much higher proportion of debt. Beware of a continuous trend upward. Prof. before taxes x 100 Assets = 47,000 x ,000 A 5.99 percent return on assets is not significant by itself. The industry plays a major role in the determination of adequate returns on assets. Some industries require high investment in assets, others do not. Industries with high investment in assets usually have lower returns than ones with lower asset investment. Sales/Total Assets. This ratio shows sales productivity in relation to total assets employed. Net Sales - 950,000 = 1.21 Assets 785,000 By itself we can only conclude that a ratio of 1.21 is better than a lower one and worse than a

10 Page 10 of 12 higher one. The higher the better. Other conclusions have to be drawn from comparisons to similar firms and to our past performance. Other Ratios. Table 2 is presented to show results of all calculations that are possible using the Robert Morris Associates' ratios. Our financial statements do not give the information needed to compute all ratios. TABLE 2 Selected Ratios Contained in Robert Morris Associates' Annual Statement Studies B-M RMA B-M RMA Ratio Sales Comparables Ratio Sales Comparables Current Ratio 2.03 X.XX Fixed/Worth 0.74 X.XX Quick Ratio 0.94 X.XX Debt/Worth 0.50 X.XX Sales/Receivables 9.50 X.XX Profit/Assets 5.99 X.XX Cost of Sales/ 4.60 X.XX Profit/Worth 8.95 X.XX Inven. Sales/Working Cap X.XX Sales/Fixed 2.44 X.XX EBIT/Interest 4.62 X.XX Sales/Assets 1.21 X.XX As previously stated the ratios for Blake-Morgan Sales, Inc. seem adequate without the benefit of comparable Robert Morris (RMA) data. Nevertheless, the comparison to other firms is essential in the real life business situation. Trend analyses are also very important. Adequate ratios now could be on a negative trend when comparing them to past performance. The manager should then take immediate action to stabilize the trend for the near term and return it a positive posture in the future. In table 3 hypothetical current ratios are presented. Current 1 ratio is a negative trend, while current 2 is positive. As you can see, both have a 2.03 ratio in But the previous four years are much different. Current indicates a very positive ash trend, which means that decisions in the past regarding cash position are working, and probably do not need different strategy. Current 1 indicates an immediate change of strategy. While 2.03 is adequate now, a concentration of present cash strategy will have the company in a cash bind in the not-todistant future. TABLE 3

11 Page 11 of 12 Hypothetical Current Ratios For the Period Ratios Current Current CONCLUSION Managing a small business without financial information is like traveling without a map. You may reach your final destination but it's going to be a long expensive trip. Understanding and using financial statements are crucial to effective management in a competitive environment. They are necessary for a necessary management function - planning. Comparative ratio analysis of the present and past is the fuel for direction-setting. A basic understanding of the purposes of statements, simple ratios, and the "language of business" is all that is required to prepare the manager to meet the challenges of competitors. REFERENCES [l]anderson, N. H. (1981). Foundations of Information Integration Theory. New York: Academic Press. [2]Bazley, J., Nikolai, L., & Grove, H. (1991). Financial Accounting (2nd ed.). Boston: Pws- Kent. [3]Chatfield, M. (1977). A History of Accounting Thought. [4]Huntington: Robert E. Krieger Publishing Co. [5]Dominiak, C., & Louderback, J. (1991). Managerial Accounting (6th ed.). Boston: Pws-Kent. [6]Elliot, J., & Philbrick, D. (1990). "Accounting Changes and Earnings Predictability." The Accounting Review 65 (January). [7]Lere, J. (1991). Managerial Accounting: A Planning - Operating -Control Framework. New York: John Wiley & Sons. [8]Parker, R. H. (1969). Management Accounting: An Historical Perceptive. New York: Augustus Kelley Publishers. [9]RMA Annual Statement Studies. (1990). Philadelphia: Robert Morris Associates. [10]Wallace, W. (1990). Financial Accounting. Cincinnati: South-Western.

12 Page 12 of 12 [11]Yamey, B. S. (1960). "The Development of Company Accounting Conventions." Three Banks Review 47 (Spring).