Understanding Financial Statements: The Basics

Transcription

1 Coaching Program Understanding Financial Statements: The Basics As business owners or investors, most of us are at least familiar with the concept of financial statements. We understand that we need them for preparing tax returns, for handing over to a bank or credit company in order to secure a loan, and to offer up to a potential purchaser, if we re selling our business. We know that the balance sheet shows us our assets (things we own), our liabilities (things we owe), and our equity (the difference between assets & liabilities). We also know that the Income Statement shows us our income from sales and expenses. But for many people, that s where it stops. We feel this is truly unfortunate. There s so much more to financial statements than just the pieces of paper that make up the package. The true secret, and the power, of financial statements, lies in having the ability to understand what those numbers mean and how your business is trending, based on those numbers. Copyright 2010, Smart Money, LLC and US TaxAid Series. All Rights Reserved Page 1 of 30 This material is informational only. It is not meant, directly or indirectly, to provide formal legal and/or tax advice. Consult with your own attorney, CPA, and/or other advisor regarding your specific situation. We take reasonable precautions in the preparation of all material presented and believe it is accurate as of the date it was written. However, we assume no responsibility for any errors or omissions, and we specifically disclaim any liability resulting from the use or application of the information contained herein.

2 Accounting Terminology Remember the Accounting Equation Assets = Liabilities + Equity There are a few words you re going to come upon over and over again in financial statements and all general accounting. First we ll give you the technical definitions, and then we ll tell you what they are in general terms: Debit: An accounting entry that results in either an increase in assets or a decrease in liabilities or net worth. Opposite of credit. Credit. An entry in the financial books of a firm that increases a liability, owner's equity (capital) or revenue, or an entry that decreases an asset or an expense. Opposite of debit. Assets. The properties used in the operation or investment activities of a business. Liabilities. Claims by creditors to the property (assets) of a business until they are paid. Equity. The owner's rights to the property (assets) of the business; also called capital, member s capital, partner s capital, stock, additional paid-in capital, retained earnings or net worth. Copyright 2010, Smart Money, LLC and US TaxAid Series. All Rights Reserved Page 2 of 30

3 Income. For businesses, income can refer to a company's remaining revenues after all expenses and taxes have been paid. In this case, it is also known as "earnings". Expenses. Any expenses incurred in the ordinary course of business. Business expenses are deductible and are always netted against business income. Debits and Credits. Debits and Credits are the first two that will come up. They don t really refer to good or bad, positive or negative, but just note whether an entry is made to increase or decrease an account. Entries made on the left side of the equation (to assets) that increase are debits. Entries made on the right side of the equation (to liability or equity) that decrease are also debits. Entries made on the right side of the equation (to liabilities or equity) to increase are credits. Entries made on the right side of the equation (to assets) to decrease are credits. All accounting is based on the concept of balance. So what does balancing mean? Well, accounting and bookkeeping entries are divided into two categories: debits and credits. They re two sides of the same coin. Every time you make a debit transaction, there s a corresponding credit transaction. Every time you make a credit transaction there s a corresponding debit transaction. Copyright 2010, Smart Money, LLC and US TaxAid Series. All Rights Reserved Page 3 of 30

4 Examples of Debits and Credits 1. You use some of your cash to pay down an accounts payable account. You decreased your cash (credit) and decreased your accounts payable (debit). 2. You collected on some of your accounts receivable and deposited the cash. You increased your cash (debit) and decreased your accounts receivable (credit). 3. You bought inventory with cash. You decreased your cash (credit) and increased your inventory) debit. Every debit has a credit. Every credit has a debit. But it s not always that easy to determine when something should be a debit or a credit. You can t have one without the other! If your debits and credits don t balance to the penny, there s something wrong. Assets. Assets are things you own. They are shown on your records and financial records as debits, meaning they appear on the left side of the equation. When you add to your assets, you add to the debit side. When you remove or reduce assets, the deduction is shown on the credit side. When you add up all your assets, and then subtract all the reductions, or credits to your assets, you get your net overall asset value what you own at the end of the day. Copyright 2010, Smart Money, LLC and US TaxAid Series. All Rights Reserved Page 4 of 30

5 Basic changes in an asset account, showing current value, increases, decreases and ending value Value of assets at 1/1/10 $10,000 Purchases & Additions $ 5,000 Assets Debit Credit Net Sales & Breakages $2,000 Value of assets at 12/31/10 $13,000 Liabilities. Liabilities are things you owe. They are shown on your records as credits, and appear on the right side of the equation. When you add to a liability it increases the right, or credit, side. But when you reduce a liability, by making a payment, for example, that payment is recorded on the left, or debit side. To determine your total net overall liabilities, you would add up all of your liabilities, reduce the total by all payments or other reductions, and arrive at your net overall liability value what you owe at the end of the day. Basic changes in a liability account, showing starting debts, increases, decreases and ending debt amount Liabilities Debit Credit Net Total Liabilities at 1/1/10 $18,000 Payments made $12,000 Additional debts incurred $10,000 Total Liabilities at 12/31/10 $16,000 Copyright 2010, Smart Money, LLC and US TaxAid Series. All Rights Reserved Page 5 of 30

6 Equity. Equity is the difference between your total assets and your total liabilities, and represents what your business is worth to you. It also appears as a credit in the accounting equation. Naturally, you ll want equity to be positive. That means your business is operating in the black, and is making money. If it s negative, your business owes more than it owns. It s losing money. But whether or not this is a sign of trouble, depends on many other things. Are you in a building phase, where you expect a return down the road? Have you had some unexpected, unplanned for expenses? Just seeing a negative number on a financial statement doesn t give you the whole story. Using the example above, our accounting equation would look like this: Assets ($13,000) = Liabilities ($18,000) + Equity (-$5,000) In other words, the business has a negative equity of $5,000 at December 31, So far so good? Great! Now let s confuse things by looking at Income and Expenses, which are reported in your financial statements backwards to Assets and Liabilities. Remember the Profit Equation Profit = Income - Expenses Income. Income is money you ve earned. Without getting too technical, it is shown in your accounting records as a credit. As you earn money, those amounts are credited to your income account, making it larger. Reductions to your income are shown as debits. Charge backs, Copyright 2010, Smart Money, LLC and US TaxAid Series. All Rights Reserved Page 6 of 30

7 refunds and expenses are all examples of things that would reduce your income, and so they are recorded in your financial statements as debits. Basic changes in an income account, showing gross income less refunds and commissions paid Income Debit Credit Net Gross income earned in 2010 $100,000 Refunds and Commissions Paid Out $8,000 Total Gross Income in 2010 $92,000 Expenses. Expenses are costs to your business. They are deducted from your income, and so they are processed as debits. As your expense amounts increase, the accounts will be debited in your financial records they will be getting larger. On the other hand, if you overpay an expense and receive a refund, it would be shown as a credit. It is reducing your overall expense. Basic changes in an expense account, showing gross income less refunds and commissions paid Expenses Including Taxes Debit Credit Net Total Expenses paid in 2010 $75,000 Overpayment of Taxes $1,000 Total Expenses in 2010 $74,000 Copyright 2010, Smart Money, LLC and US TaxAid Series. All Rights Reserved Page 7 of 30

8 Using the example above, our profit equation would look like this: Profit ($18,000) = Gross Income ($92,000) Expenses ($74,000) In this example, the business had a net profit of $18,000 during With the basic terminology out of the way, we can start to take a look at the 3 elements of a Financial Statement: the Balance Sheet, Income Statement and the Statement of Cash Flows. You could also look at them like this: o Balance sheet (the snapshot) o Income statement (the movie) o Cash flow statement (the bridge between the two) Each statement is important on its own, but it s better when read together. You need all three to see the entire picture. Balance Sheet The Balance Sheet is made up of the elements of the First Equation: Assets = Liabilities + Equity. It s called a Balance Sheet because, well, it balances. If you survived basic algebra, then you know that everything on either side of the equal sign needs to balance. Your liabilities and equity must add up together to be the same amount as your total assets. If not, something is improperly recorded or missing. Copyright 2010, Smart Money, LLC and US TaxAid Series. All Rights Reserved Page 8 of 30

9 Assets When you look at the assets on a Balance Sheet, you ll typically see them broken down into two categories: current and fixed. Current assets are cash and anything else that will either be used up or converted into cash within one year. Inventory is a great example of a current asset. It s an asset because your business owns it, and it s current because you are trying to turn it over as quickly as possible. Another example is accounts receivable. This is money your business is owed when the work or product has been done or provided. (On the other hand, if you are prepaid for products or services, then that money is really a liability. Until you do the work or deliver the product, it s a debt you owe your customer). Fixed assets are those with a longer lifespan, and they are usually tangible things such as equipment, vehicles, buildings and real estate, and machinery. Historical Asset Value. Assets will show up on the balance sheet based on their historic cost. In other words, if you paid $500,000 for an office building years ago and it s now worth $2m, it s still going to appear on your Balance Sheet as being worth $500,000. And if you ve built up an asset out of little or nothing, the new value won t show either. For example, if you have an amazing system you developed and patented, the only value showing up for the system on your Balance Sheet will be the cost of filing the patent (i.e., attorney fees, filing fees, and so on). Your Balance Sheet won t show the true fair market value of your patent (i.e., what a buyer would pay). Copyright 2010, Smart Money, LLC and US TaxAid Series. All Rights Reserved Page 9 of 30

10 This one little idiosyncrasy of generally accepted accounting standards wreaks havocs on businesses that hold or build appreciating assets. You know your assets are worth $2m, but your Balance Sheet says otherwise. That s why you ll often see companies including notes to the financial statements, especially when the financials are being prepared to show someone else. The true fair market value is shown in the notes, rather than on the balance sheet. This is just one reason why understanding how to read financial statements is so important! Liabilities Liabilities, like assets, are also broken down into current and longterm categories. A current liability is something you ll repay within a year. This would include the taxes you pay each year, credit card bills, and your monthly expenses. Long-term liabilities are debts that are repaid over a longer period of time. Mortgages, car loans, and leases would all fit into this category. Equity The last thing represented on a Balance Sheet is Equity, or Owner s Equity. The reason we don t call it Business Equity is because the net worth of the business belongs to you, the owner. Remember, if your business has more assets than liabilities, this number will be positive, but it will be negative if your business owes more Copyright 2010, Smart Money, LLC and US TaxAid Series. All Rights Reserved Page 10 of 30

11 than it owns. It doesn t necessarily mean that your business is failing! Most businesses lose money in the early days. But if you re consistently losing money, it is something you will want to keep an eye on. Sample Balance Sheet Assets Current Assets Liabilities Current Liabilities Cash $50,000 Short-term Debt $30,000 Accounts Receivable $40,000 Accounts Payable $50,000 Merchandise Inventory $100,000 Salaries Payable $110,000 Total Current Assets $190,000 Total Current Liabilities $190,000 Fixed Assets Long-Term Liabilities Plant & Equipment $30,000 Note Payable $20,000 Less: Accumulated Depreciation ($2,000) Total Long-Term Liabilities $20,000 Total Fixed Assets $28,000 TOTAL LIABILITIES $210,000 Owner s Equity $8,000 TOTAL ASSETS $218,000 TOTAL LIABILITIES & OWNER S EQUITY $218,000 Why a Balance Sheet is a Snap Shot, Not a Movie When we create a Balance Sheet, we re showing you a business s financial picture at one specific moment in time. By itself, it isn t an accurate picture. For example, take a look at the information above. Do you see the Salaries Payable amount of $110,000 listed under Liabilities? Copyright 2010, Smart Money, LLC and US TaxAid Series. All Rights Reserved Page 11 of 30

12 The reason Salaries Payable appears here, as a liability rather than an expense, is that at this moment in time there was payroll that had accrued. Maybe the Balance Sheet had been prepared 3 days before payroll? Whatever the reason, the money was owing to the employees, but the checks hadn t yet been written and distributed to the employees. If you can imagine, 3 days later the Balance Sheet would have looked very different. The $110,000 liability for Salaries would be gone, reducing the overall Liability amount. Most likely the Cash amount on the left side would be different too. After all, the business needed to pay its employees that amount, which means it needed more than the $50,000 we see in the bank. So where did that money come from? To find out how the business found the money to pay those salaries, you d next want to look at the Income Statement. Income Statement The Income Statement is made up of the elements of the Second Equation: Profit = Income Expenses. It s probably the statement you are most used to seeing and the first one you ll take a look at each month for your business. This piece of your financial statement picture shows your business s income, expenses and profit (or loss) for the period of time it reports. You ll also hear it called a Profit & Loss Statement. Copyright 2010, Smart Money, LLC and US TaxAid Series. All Rights Reserved Page 12 of 30

13 If a balance sheet is a snap shot, showing you your business s overall assets, debts, and equity at a specific date, an income statement is more like a movie. It s showing you a summary of the income and expenses of your business over a period of time. But it s still not a clear picture. An Income Statement doesn t show you how the income and expenses relate to other aspects of your business. For example, say you had a huge, one-time sale in June. If you looked at your income statement for that month, it would reflect that sale. That will make your business picture look pretty rosy. Likewise, a large expense could make your business appear to be less profitable than it really is. To get a real picture you need to widen your scope, and look at each month compared to other months, other years, and against your year-to-date numbers. Income Statement Basics Gross Profit = Gross Income Cost of Goods Sold Net Income = Gross Profit G&A (general & administrative) Expenses Gross Income Depending on your business, income is broken down into two categories: sales income and service income. Just as it sounds, sales income comes from products you sell, and service income comes from services your business provides. We separate the two so you can properly match up your expenses. You ll have expenses related to selling goods packaging, shipping, etc., that don t relate to your services. Likewise, there will be expenses Copyright 2010, Smart Money, LLC and US TaxAid Series. All Rights Reserved Page 13 of 30

14 related to your service. For example, we subscribe to all kinds of legal and accounting publications, to stay on top of developments. Those help us to provide a better service, to our clients. But they don t directly impact the process of creating and packaging a CD to sell on our website. By separating out your income and matching up your expenses, you can track the areas of your business that are working and those that need work. You may be okay with one part of the business subsidizing the costs of another part, or you may want to think about changing things, or even moving on entirely. Cost of Goods Sold (COGS) The cost to provide a service or sell a product is the Cost of Goods Sold for your business. For example, if you travel to provide services, then all of your costs associated with that travel (air fare, hotel, meals, car rental, gas, etc.) would be included in your cost of goods sold. When you re selling a product, it s different. Now you need to include the costs associated with selling that product (packaging materials and postage). You will also need to include your costs for creating or buying the product. So, if you buy products for resale and keep an inventory, the cost of that inventory, including shipping and taxes, is also included in your COGS as soon as you sell the item. Copyright 2010, Smart Money, LLC and US TaxAid Series. All Rights Reserved Page 14 of 30

15 Why Inventory is an Asset AND an Expense Inventory is something that confuses a lot of people. It should be an expense. After all, inventory is something you sell. It costs you money to buy or to manufacture. So, why isn t it considered an expense or a liability to your business? Why does it appear on your Balance Sheet as an asset? Well, actually inventory is both an asset AND an expense. It s all a question of timing. When you buy or manufacture inventory for your business you are creating an asset. It s worth something. As you buy or manufacture more inventory, the overall amount goes up in value. As long as the inventory remains unsold, it s considered an asset. Audit Prevention Tip: NEVER file a tax return with nothing showing for Inventory (if you carry inventory). The IRS is expecting to see an amount, given that you re operating a business that sells goods. It is very unlikely that you can truly demonstrate that you had zero inventory at December 31st. Even if you watch your costs and keep your inventory low, put at least a minimal amount on your return. Submitting a tax return without an inventory amount is an IRS red flag It s only through the process of selling the asset that you can begin to offset the expenses involved in buying or creating it against the income you generate from its sale. Copyright 2010, Smart Money, LLC and US TaxAid Series. All Rights Reserved Page 15 of 30

16 The Biggest Reason Cash Doesn t Equal Income Sonja was excited with the growth of her business. But she also knew she wouldn t have to pay much in taxes because there wasn t much in the bank account. She d never taken out profit or a salary. So because it had all gone into her business, she was home free! Right? WRONG! Sonja had built up her inventory to get ready for the sales that were coming and although they used up her cash, they weren t an expense to the company. She had converted one asset (cash) to another asset (inventory) and Sonja had to suddenly worry about how she was going to pay her tax bill. How to Calculate COGS (Cost of Goods Sold) for Your Business Inventory With inventory, it s critical that you know the cost where you start and the cost where the year ends. Your inventory value may go up and down during the year, but those two costs are key. You can t calculate your COGS without knowing those two numbers. The formula for COGS is: COGS = Beginning Inventory + Purchases Ending Inventory Copyright 2010, Smart Money, LLC and US TaxAid Series. All Rights Reserved Page 16 of 30

17 Your COGS amount is important, because it hits your financial records. If you underestimate your COGS, your inventory looks like it s worth more on paper. But if you overestimate it, your inventory becomes undervalued. Neither is particularly good, because they don t show you a true, accurate picture of your business s value. You may also have COGS without an inventory. For example, let s say you have a service business. You hire others (a COGS of your business), which is an expense against the money you make. No inventory here! But there is still a COGS. Gross Profit Gross profit is an important measure of how profitable your product or service is. Generally speaking, service industries have a much higher margin (in other words, the gross profit is higher) then product sellers. If your gross profit is a gross loss, you ve got a serious problem. That means you re selling your product or service for more than the cost of delivery. In the beginning, that might be necessary so that you can establish prototypes and markets, but after a short time, you should have gross profit. General & Administrative Expenses Your general and administrative costs are the expenses of your business. They represent the debts your business owes after those debts have been paid. Before payment, those debts are liabilities. So, when your bookkeeper calculates payroll, he will deduct the appropriate income and payroll taxes from the checks. Until the money is sent to the Copyright 2010, Smart Money, LLC and US TaxAid Series. All Rights Reserved Page 17 of 30

18 government, it is a payroll liability. Once the payroll taxes are sent in to the IRS, the amount is reclassified as an expense. Net Income/Net Loss The difference between gross profit and G & A is your net income or loss. If you have more income than expenses, you have a profit. If it s the other way around, then you ve got a loss. This amount flows back through the books to become part of your equity. Again, the sequence is: Gross Profit = Gross Income Cost of Goods Sold Net Income = Gross Profit G&A Expenses Sample Income Statement Net Sales $1,500,000 Cost of Goods Sold $500,000 Gross Profit $1,000,000 G&A $400,000 Income from Operations $600,000 Interest Expense $10,000 Income Before Taxes $590,000 Income Taxes $90,000 Net Income $500,000 Earnings Per Share $5.00 Copyright 2010, Smart Money, LLC and US TaxAid Series. All Rights Reserved Page 18 of 30

19 Statement of Cash Flow The last financial statement is the statement of cash flow. It s the most important of the three Financial Statements, because it deciphers the cash flow for you. It s the translator, the one that bridges your Income Statement and the Balance Sheet. And, it s probably the one you ll have the most trouble learning to read. The Statement of Cash Flow begins with the net income of your business and deducts items that impact cash but don t impact net income. Examples of that are increases or decreases in inventory or accounts receivable. An increase in inventory will not change your net income, but it certainly will impact your cash you ll be spending cash to buy inventory, but the inventory may or may not be sold. The Statement of Cash Flow also adds back items that impact your net income but don t cost you any cash. The best example of that is depreciation. We call depreciation the phantom expense, because while it hits the books as an expense, it doesn t impact your cash. The Statement of Cash Flow also breaks down other types of income, such as income from investments your business has made and income it receives from financing, and it deducts the direct costs from those other income sources as well. If you had a line of credit, for example, the Statement of Cash Flow would show all deductions you made for repayments, interest, insurance, and any other costs to service that debt. Let s go into some more detail on these points. Copyright 2010, Smart Money, LLC and US TaxAid Series. All Rights Reserved Page 19 of 30

20 Understanding the Cash Flow Cycle We ll start with a visual representation to help you understand how cash flows through your financial statements: We ve gone through the first part, showing you how to get from Gross to Net Income. Now let s take Net Income through the next part of the Statement of Cash Flow: Operations, Financing and Investments. Copyright 2010, Smart Money, LLC and US TaxAid Series. All Rights Reserved Page 20 of 30

21 Following the Cash Flow Cycle Cash Flow From Operations First, we adjust your business s Net Income by the cash that is received by or spent in operations. If you ve bought inventory, we ll deduct that from your cash amount. You ve got less cash, because you wrapped it up in inventory costs. If your inventory value is lower than it used to be, we ll add that money back into your cash, because you re spending less cash on inventory. Likewise, if you ve depreciated some of your business s assets, we ll add those depreciation amounts back in to your cash. You didn t write a check for the depreciation it was a paper expense only. Copyright 2010, Smart Money, LLC and US TaxAid Series. All Rights Reserved Page 21 of 30

22 All aspects of the operation of your business (accounts receivable, accounts payable, deferred income, accrued expenses, and others like this) are accounted for in the cash flow from/to operations. Because the Statement of Cash Flows starts with Net Income, some changes are made to it to reflect cash that don t seem to make sense: Q: Why is it a negative if my Accounts Receivable goes up? A: A/R is reflected in income, but you don t have it in cash yet. So reduce your net income to get to the true cash number. Q: Why is it a negative if my inventory goes up? A: Inventory isn t an expense, but it used your cash. So you won t see it reflected in Net Income, but you need to subtract it to get to the cash number. Q: Why is it positive if my accounts payable goes up? A: You are using your creditor s money here. You got an expense for net income, but it didn t cost you any cash. So add back the money to net income. Q: Why is it positive when I cash in my stock, even though I lost money? A: The stock didn t give you net income, but it did give you cash. So add it to the net income Copyright 2010, Smart Money, LLC and US TaxAid Series. All Rights Reserved Page 22 of 30

23 Cash Flow from Financing Next up is the category of financing. There are two primary sources of cash flow changes due to financing. Your cash flow increases when you take out a loan and your cash flow decreases when you pay back a loan. But neither of these changes are reported on your Income Statement (they show up on your Balance Sheet). However, they are going to impact your cash, so we ve got to figure them in somewhere. Loan amounts are added to cash, increasing it, while payments are subtracted from cash. If most of your business s cash is coming from financing it could spell trouble. What s happening is that your business isn t being funded by sales it s being funded by loans. In the beginning, that might make sense as your business is brand new and you re bootstrapping it. However, if it continues, you could be in trouble. Plenty of Cash, What s the Problem? Why is it a negative if my Accounts Receivable goes up? Cash in your account could mean: Selling off assets, Borrowing money, or It could mean profit. Know the SOURCE of your cash. Copyright 2010, Smart Money, LLC and US TaxAid Series. All Rights Reserved Page 23 of 30

24 Cash Flow from Investments The third adjustment is cash flow from investments. If you increase your investments you ve used cash flow to do so. In other words, you ve tied up cash by making those investments. You have decreased the cash flow of your business. But it doesn t correspond to your net income numbers. Making investments doesn t mean a decrease in the net income of your business. So, you need to subtract the amount used for investments from net income to arrive at cash flow. It s a little different when your business sells off an investment. There may be an impact on net income to the extent that there is reportable gain or a loss. The sale of the principal, or the original investment, will not be reflected in net income. But it will affect cash flow. Just like with cash flow from financing, cash flow from investing could be a sign of trouble. Your business may have cash in the bank, but it came from selling off assets. It didn t come from business operations. As you look at your statement of cash flow, and consider: Which way is the cash flowing for each of the categories? Temporary changes in cash flow, either way, aren t necessarily a sign that you ve got a problem, but they could be warning signs if there is a persistent pattern. Copyright 2010, Smart Money, LLC and US TaxAid Series. All Rights Reserved Page 24 of 30

25 Cash Change At the end of the Statement of Cash Flow you ll find the cash change. This affects the cash line item on the asset portion of the balance sheet. If the Statement of Cash Flow makes your head spin a little, that s okay. It may take you awhile to understand it all, but don t give up. It s vital that you understand how cash flow works. Copyright 2010, Smart Money, LLC and US TaxAid Series. All Rights Reserved Page 25 of 30

26 Here s an example of a Cash Flow Statement. Let s go through the Operations, Investing and Financing in real-time: Sample Statement of Cash Flow Cash Flow from Operations Net Earnings $2,000,000 Additions to Cash Depreciation $10,000 Decrease in Accounts Receivable $15,000 Increase in Accounts Payable $15,000 Increase in Taxes Payable $2,000 Subtractions from Cash Increase in Inventory $(30,000) Net Cash from Operations $2,012,000 Cash Flow From Investing Equipment $(500,000) Cash Flow From Financing Notes Payable $10,000 Cash Flow for Fiscal Year Ended 12/31/09 $1,522,000 In this case, the business started with Net income of $2m. They added back in the phantom expense of depreciation that had accrued through the year. Then, they compared the amounts for Accounts Receivable, Accounts Payable and Taxes Payable at December 31 st to the amounts from January 1st. The business s Accounts Receivable amount had gone Copyright 2010, Smart Money, LLC and US TaxAid Series. All Rights Reserved Page 26 of 30

27 down by $15,000 through the year. That was a good sign. It meant the business had been effective at collecting outstanding amounts owed to it by clients. Because the business had collected that money, it was added back in. When they looked at Accounts Payable from January 1 st and December 31 st, they found that the business owed more money than it did the year before. It had increased its liabilities by $15,000. Because the money hadn t yet been paid, it was added back in, increasing Cash again. Finally, the business looked at its Taxes. Because the business had made more money during this year than the previous year, it had a higher tax bill to pay on the profit. But, the check hadn t yet been written, so for the time being that money went back onto the Cash amount. Then the business looked at amounts that reduced its Cash. From January 1 st to December 31 st, the overall inventory value had increased by $30,000. Because the business had spent money to buy that inventory, that $30,000 amount was deducted from Cash. At the end of the day, after making the additions and subtractions, the business had Net Cash from Operations of $2,012,000. Those adjustments added $12,000 more than was reported on the business s Income Statement. But that s only part of the story! Copyright 2010, Smart Money, LLC and US TaxAid Series. All Rights Reserved Page 27 of 30

28 Turning to Cash Flow from Investing, you see a cash decrease of $500,000 for Equipment. What that means is that the business spent $500,000 on purchasing new equipment through the year. They increased their Equipment asset account by $500,000, and spent cash to do it. Finally, there is the entry under Cash Flow from Financing. There s an addition to cash of $12,000 from a Note Payable. That means the business received a loan in the amount of $12,000. At the end of the day, the Cash account was adjusted down to $1,522,000. Do you now see why your Net Income doesn t necessarily mean spendable, disposable cash? What would have happened if the business had paid out dividends or made purchases based on thinking it had $2 million in the bank? When you look at the Statement of Cash Flow for this business, you can also begin to get a feel for what s going on. This is a business that s growing rapidly. They ve had to invest in a lot of new equipment, either to keep up or get ahead. Inventory is also up, which again could point to business growth. Plus, you can see the business getting a handle on its receivables. Maybe an aggressive collection effort was put into place, to collect debts faster. Nothing can slow you down more than waiting for clients to pay. In this economy, we ve had lots of businesses fail because no-one wanted to buy their product or service. But we re convinced that plenty of other businesses failed because they couldn t get paid fast enough to keep the doors open and the lights on. Copyright 2010, Smart Money, LLC and US TaxAid Series. All Rights Reserved Page 28 of 30

29 Five Myths about the Cash Flow Cycle Cash flow is the lifeblood of your business, and also the most misunderstood part of business by many business owners. Here are five common myths regarding the Cash Flow Cycle. Cash Flow Myth #1: If there s cash in the bank, everything is fine. Use your statement of cash flow to find out why there is cash in the bank. If the cash is all from financing or selling off assets, that could be a warning sign of trouble ahead. Cash Flow Myth #2: There is no money in the bank, so we must not owe taxes. Net income does not equal cash flow. The money could have all been spent on items that are not tax-deductible. Make sure your tax planning is measured by more than how much is in the bank. Cash Flow Myth #3: Building inventory is a good thing. When you build inventory, you turn a highly liquid asset (cash) into a less liquid asset. That s part of the theory behind the business management theory of just in time inventory. Don t build inventory at the sake of your cash. Cash Flow Myth #4: As long as you re growing, things are going to turn out great! If your business is growing fast, you ll need to build up your inventory and staffing; and your G & A expenses are going to climb, too. Copyright 2010, Smart Money, LLC and US TaxAid Series. All Rights Reserved Page 29 of 30

30 Those are expenses that take your cash right now, even though you may have to wait to get paid. You ll see that in your statement of cash flow. Your business is growing, you have net income, but your operations will be sucking cash. Not enough or too much in sales can kill your cash flow. Cash Flow Myth #5: When cash is tight, concentrate on sales and forget about reporting; your gut response is all you need. Calculating cash flow, and the reasons for increases and decreases, is simply too complicated to just trust your gut. If you re serious about business, watch all three of your financial statements on a regular basis. Learn All Three Financial Statements The best way to learn to read the story of your financial statements is with practice. Review all three of your financial statements with your bookkeeper or accountant on a regular basis. As you master your own financial statements, you ll soon be able to read the real story of other people s financial statements. Copyright 2010, Smart Money, LLC and US TaxAid Series. All Rights Reserved Page 30 of 30