Understanding Financial Statements

Today's blog gives some more pragmatic information on your business. They can't nor should all cover the soft skills right?

Financial statements are an important management tool. When correctly prepared and properly interpreted, they contribute to an understanding of the current financial condition, problems, and possibilities of a company.

What does the bank look for when processing a credit application?

• Immediate liquidity (cash) and how cash is being used in the business’ operations
• Assets you have available to use as collateral
• Long-term earnings potential (ex. how much profit will this business likely make in the future?)
• The cash available to pay interest on a loan
• Cash you have available to repay the principal of a loan
  

There are three basic financial statements:

• Balance Sheet
• Income Statement
• Statement of Cash Flows

The Balance Sheet

This is sometimes called the Statement of Financial Condition or the Statement of Financial Position. It represents the financial position of the business entity at a moment of time – a snapshot. Most often the balance sheet from one or more preceding years is presented to provide meaningful information on how the company is performing.

The Balance Sheet is so named because it represents the following equation:

Assets (Resources of the business) = Liabilities (Amounts owed) + Equity (Deficit) (net worth (positive or negative)

Assets increase or decreases as resources are bought, disposed of, become more or less valuable, or are used in the course of operations.

• Current Assets are those assets of a company that are expected to be realized in cash, sold or used during the next 12 months. These assets generally include cash, accounts receivable (ex. from patients or insurance companies), inventories (ex. healthcare products and other items you’re selling) and certain costs such as insurance, security deposits, or rent paid in advance.

• Property and Equipment are assets with a life greater than one year like computers, adjusting tables, x-ray equipment, etc. that are used in the regular operations of the business. A good rule of thumb is to expense items less than $1,000 to the income statement instead of recording as an asset.

• Accumulated Depreciation is the aggregate of charges to expense or to write-off the cost of property and equipment over its estimated useful life. It is the result of a bookkeeping entry and does not represent any current cash outlay. Under generally accepted accounting principles (GAAP), we have to expense property and equipment as it is being used. For example, if you expect a computer to last 3 years, you write 1/3 off each year to depreciation expense. Land is never depreciated.

Liabilities increase or decrease as obligations to creditors are incurred or repaid.

• Current liabilities are those obligations that are reasonably expected to be paid within one year using current assets. These liabilities generally include bank debt, accounts payable, income taxes payable and accrued expenses such as salaries, retirement plan contributions, and interest. The balance in a liability account at any given time is the amount of money the company owes. For example, the company owes Bank of North Georgia $20,000 for equipment on February 1^st and makes a payment of $1,500 on February 28^th. Of that $1,500 payment, $500 is interest and $1,000 is a reduction to the loan balance. So, the liability on the balance sheet as of 3/1 would be $19,000. If the bank wants to see a balance sheet with the current part shown separately, your accountant could figure out the next 12 months’ principal reductions and show them in a separate liability account. So, you would have two liability accounts that, if you add them up, equal the $19,000. One liability account would show up in “current liabilities” and the other would be in “long term liabilities” (below).

• Long-term liabilities are total debt less current liabilities (above) and include those obligations that are not expected to be paid within one year. Mortgages and capital leases are common long-term liabilities.

Equity increases or decreases as a result of income or loss from operations of the business (the results of the current year income statement). It also increases when owners contribute capital to the business and decreases when the capital is withdrawn from the business.

• Common Stock and Preferred Stock represent the ownership interests in a corporation. Limited liability companies (LLCs) have members’ equity, which is shown instead of stock on the balance sheet.

• Retained Earnings are the portions of all the company’s past earnings that were not distributed to the owners. If the retained earnings are negative, they’re called “accumulated deficit”.

• Total Liabilities and Stockholders’ Equity (Deficit) is always equal to total assets.

The other primary financial statements present a summary or activities over a period of time, usually a fiscal year.

The Income Statement

This is sometimes referred to as the Statement of Operations or the Profit and Loss Statement and presents a summary of activities over a period of time, usually a fiscal year. This example below represents revenues less associated expenses and the resulting net income.

Revenue (or sales) (ex. fees earned from services provided to patients or sales of products to patients)

- Cost of revenue (cost of producing goods for sale) (ex. staff salaries and cost of products actually sold to patients)

= Gross profit (measure of the profit from sales of products or services)

- Administrative expenses (general costs associated with the operation of a business) (ex. rent, office staff salaries, utilities)

= Income from operations

+/- Other income and expense (not directly related to the primary operations of the business) (ex. interest income)

- Business income taxes

= Net income (loss) (measure of the earnings performance of the company after considering all elements of income and expense)

Another term to be familiar with is EBITDA (earnings before the deduction of interest expenses, taxes, depreciation and amortization) is an approximate measure of a company's operating cash flow based on data from the company's income statement. This measure is also of interest to a company's creditors, especially bankers, since EBITDA is essentially the income that a company has free for interest payments.

The Statement of Cash Flows

This provides information about the sources and uses of cash for the period, as analyzed onto three major classifications:

	Cash provided by or used in operations
+/-	Cash provided by or used in investing activities
+/-	Cash provided by or used in financing activities
=	Net increase or decrease in cash

• Operating activities include selling products and providing services. Cash inflows include all receipts from the sale of products or services and from interest and dividend income. Cash outflows for operating activities include cash payments for the purchase of inventory, wages and benefits to employees, etc.

• Investing activities include purchasing and selling property and equipment (ex. computers and exam equipment), buying and selling stocks or bonds, and lending money and collecting on those loans (ex. usually loans to business owners).

• Financing Activities include borrowing and repaying money to owners and lenders as well as money paid to owners out of equity (profits).
  

Standards and Regulations

Generally Accepted Accounting Principles (GAAP) is a set of guidelines that provides the basis for the preparation of most financial statements. In situations where GAAP-basis statements aren’t necessary because the bank or licensing board may require something different, an OCBOA (Other Comprehensive Basis of Accounting) may be used. Common examples of OCBOA statements include income-tax-basis, cash and modified-cash-basis. Generally, OCBOA financials are less expensive than GAAP basis ones a CPA would prepare for you.

Sharon Dunn, CPA, is a financial services and audit professional. She has 25 years’ experience in public and industry accounting. She may be reached at sharondunnwright@yahoo.com.