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PART I
Using External Reports to Gauge Your Companyâs Health and Competitive Status
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CHAPTER 1
The Key Financial Statements and Their Starring Role
In This Chapter
- How financial statements are developed
- Who reads them and why
- Accounting methods and why they matter
- Key accounts used to produce reports
As a business owner, you want to know if youâve made a profit; the income statement gives you the answer, but is that the full picture? Even with an income statement, you still donât know what your company owns, what your company owes, and what equity you have in the business. You also have no idea whether your company is in a good cash position.
While your income statement shows a profit, how much of that profit actually reflects cash youâve already taken into the company? The answer depends on when your accountants recognize the revenue that your company earned. Believe it or not, that can be a complex issue, which weâll deal with in greater detail in Chapter 3.
If you want to review what your business owns and what it owes, you need to turn to the balance sheet. If you want a handle on how much cash has flowed into and out of your business, you need to review the statement of cash flows.
Before I get into the details of each of these statements, letâs start at the beginning by looking at what numbers are collected to develop these financial statements. Then we can delve into who reads these statements and why theyâre interested. Following that, Iâll talk about the two types of accounting methods that can be used and how they impact the financial statements that you get from your accountant. Then weâll take a quick look at the key numbers that are collected and how theyâre used to produce reports.
Financial reporting gives you a summary of what is happening financially in your company, based purely on the numbers. The key numbers in these reports give you a financial picture that includes the following:
- Assets: your companyâs cash, marketable securities, buildings, land, tools, equipment, vehicles, copyrights, patents, and any other items needed to run a business
- Liabilities: your companyâs debts; reflect the money owedâin such forms as loans, bonds, and unpaid billsâby your company to outsiders
- Equity: the money you and other investors have invested in your company
- Sales: the value of the products or services that your customers have purchased from your company
- Costs and expenses
- Costs: the money you spend to buy or produce your product or service
- Expenses: the money you spend to operate your business, such as expenditures for advertising, compensation for employees, operation of buildings and factories, and supplies to help people run the offices
- Profit or loss: the amount of money your company has earned or lost
- Cash flow: the amount of money that has flowed into and out of a business during the time period being reported
Without financial reports, youâd have no idea where your company stands financially. You could find out how much money your business has in its bank accounts, but you wouldnât know how much is still due to come in from customers, how much inventory is being held in the warehouse and on the shelf, how much your firm owes, or even how much your firm owns.
WHO READS THE REPORTS?
As a business owner, you wonât be the only person who reads the key external financial statements. Many people count on the information your company presents in its reports. Here are some key groups of readers and why they need accurate information.
- Executives and other managers: Managers need this financial information to know how well the company is doing financially so that they can identify any problem areas and make any needed changes to improve the companyâs financial performance.
- Other employees: Your workers need to know whether theyâre meeting or exceeding their goals and where they need to improve. For example, if a salesperson has to make $25,000 in sales during the month, he or she needs a financial report at the end of the month to gauge progress in meeting that monthly goal. If the salesperson believes that he or she met the goal but the financial report doesnât show that the goal was met, the salesperson would have to provide details to defend his or her production levels. Most salespeople are paid according to their sales production. Without financial reports, theyâd have no idea what their compensation is based on.
- Creditors: Creditors need to understand a companyâs financial results to determine whether they should risk lending more money to the company and to find out whether the firm is meeting the minimum requirements of any loan programs already in place.
- Investors: If you are not the only investor in the business, other investors need information to judge whether your company continues to be a good investment and whether they want to invest more money.
- Government agencies: These agencies need to be sure that your company complies with regulations set at the state and federal levels. If you operate a company that sells stock on a market, agencies also need to be certain that your company accurately informs the public about its financial position.
- Analysts: If you seek outside investors, they will likely look to analysts to determine whether it is wise to invest money in your company. If investors donât like what they see in the reports, they may decide not to invest. If they have previously invested in your company, they may even decide to sell their stakes.
- Financial reporters: If you own a public company, youâll need to respond to the financial press. The role of financial reporters is to provide accurate coverage of a companyâs operations to the general public. This helps make investors aware of the critical financial issues facing the company and any changes the company makes in its operations. If you own a private company, you have more control over how much information you must give to the press.
ARE YOUR BUSINESSâS FINANCIAL REPORTS PRIVATE OR PUBLIC?
If youâre operating a private company, you donât have to prepare external reports, except for those required by the government, such as the financial statement that you include in your business tax return. If you plan to raise additional cash by enticing investors or by borrowing funds, however, you will need to produce three key financial statements for external readers. Whether these statements must be released to the public depends on your businessâs structure.
Most small businesses are private companies, so they need to provide these statements only to a small group of stakeholders: managers, investors, suppliers, vendors, and the financial institutions with which they do business. As long as your company doesnât sell shares of stock to the general public, you donât have to make your financial statements public. Some companies, such as Publix Super Markets, are semiprivate. Although Publix stock is available only to employees, the company still has more than 85,000 common shareholders.
But if you do sell stock on a public market, such as the New York Stock Exchange or NASDAQ, you are considered a public company and you are required to file a series of reports with the Securities and Exchange Commission (SEC) or with the state in which you incorporate the business each year. Whether you file with the SEC or your state depends on the number of investors your company has. If your company has at least 500 investors or at least $10 million in assets, youâll have to file your financial statements with the SEC. Smaller companies that have incorporated and sold stock must report to the state in which they incorporated, but they arenât required to file with the SEC.
FILLING THE GAAP
Even if your company doesnât need to make its financial reports public, if you want to raise cash outside a very small circle of friends, you will need to prepare financial statements and have a certified public accountant (CPA) audit them or certify that the financial statements meet the requirements of the generally accepted accounting principles (GAAP). Few banks consider loaning large sums of money to businesses without audited financial statements. Investors who arenât involved in the daily management of a business also usually require audited financial statements.
To meet the demands of GAAP, financial reporting must be relevant, reliable, consistent, and presented in a way that allows the report reader to compare the results with those from prior years, as well as with other companiesâ financial results. Your accountant (whether he works full time for your company as an employee or is an outside contractor) will be aware of these rules and prepare your financial statements based on these rules, which take up hundreds of thousands of pages. A detailed discussion of GAAP is beyond the scope of this book, but if you want to learn more, visit the website of the Financial Accounting Services Advisory Board (www.fasab.gov/accounting-standards/authoritative-source-of-gaap). Letâs take a quick a look at the accountantâs role in the production of financial statements and discuss where you fit in.
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