All the answers to your unique business lifestage questions
Corporate turnaround specialists, Slatter & Lovett found that inadequate financial controls were responsible for 75% of business failures. That is, one or more of the following financial controls may be absent or inadequate:
- cash flow forecasts
- costing systems
- budgetary control
- monitoring of key performance indicators (KPIs)
and even when such information existed, management may not have understood how to use the information.
Why is this so? One of the reasons is that a large portion of management cannot ‘talk the language of business’.
Businesses exist to make a profit and to maximise returns to shareholders. So is it not essential that at least management understands what the financial statements represent and what the drivers of value are?
In this article we will look at the annual financial statements of a company and more specifically how the balance sheet, income statement and cash flow statement are created and intertwined.
We will achieve this by building up the financial statements as part of the process of a new business starting up and the events and requirements which unravel over time. The intention is not to cover every nuance, but rather to establish a framework and the basic principles thus enabling the user to better grasp the annual financial statements.
Before diving in let us first set out the following definitions:
- A balance sheet shows the assets and liabilities of the business at a particular date, or alternatively shows where the business obtains funding and what was purchased.
- The income statement shows income and expenses and profits for a particular period.
- The cash flow statement shows the amount of cash received and used by the business.
Also the concepts of profitability and cash flow are often confused so we will use a simple example to illustrate the difference between the two.
If we buy a cool drink for R7 and sell it for R10 then we have made a profit of R3. If this cool drink was sold for cash then we would receive payment of R10 from the buyer. However, if the cool drink was sold on credit we would not receive any payment at the time of the sale and would hopefully receive payment sometime in the future. In both cases the profit is the same (R3), but the timing of the cash flow is very different.
Each of the actions below is numbered and the numbers correspond to the entries in the balance sheet, income statement or cash flow statement.
Let us assume we are starting a new business, we have put together the business plan and are ready to get started.
- The first thing the business we will need is money. This is typically obtained from shareholders/ owners (equity) and loans (long term and short term generally from banks). These are known as financing activities and result in an inflow of cash into the business.
- The business now needs to invest in non-current or fixed (long term) assets such as property, motor vehicles, machinery and computers. These are known as investing activities and result in an outflow of cash from the business.
- Next we need some product to sell so we purchase stock. An increase in stock results in an outflow of cash from the business, while a decrease results in an inflow. Stock together with debtors and creditors make up the so-called working capital and are of a short term nature.
- Assuming the above stock was purchased on credit, we now have creditors/ accounts payable, that is, people or businesses to whom we owe money. An increase in creditors results in an inflow of cash from the business, while a decrease results in an outflow.
- We sell some stock and generate revenue. Also known as sales or turnover. Revenue = number of units sold x selling price per unit.
- The difference between the selling and the purchase price of the units sold is the gross profit.
- As the sales were on credit, we now have debtors/ accounts receivable, that is, people or businesses who owe us money. An increase in debtors results in an outflow of cash from the business, while a decrease results in an inflow.
- The business has various other expenses for administration, selling, marketing etc these are deducted from the gross profit and the profit remaining is called earnings before interest, tax, depreciation and amortisation (EBITDA). Simplistically, EBITDA will be used in the cash flow statement as the proxy for the cash flow from operations.
- When we purchased the various fixed assets (2 above) only the balance sheet and cash flow statement were affected. However, we are allowed to deduct an annual expense called depreciation, which further reduces profitability. Depreciation is calculated by taking the purchase price and dividing it by the number of years of its useful life. For example, depreciation for machinery purchased for R100 with a useful life of 5 years will be R20 per annum charge. Amortisation would apply in the same way and refers to patents and goodwill. Depreciation and amortisation are both non-cash flow items, that is, they are book entries and do not affect the cash balance only profitability.
- The lenders are now paid interest on their loans and we have earnings before interest and tax (EBIT). Also known as operating income.
- Taxes are deducted next resulting in net profit after tax (NPAT). Also known as net income.
- If the company decides to reward shareholders for their investment and the risks taken, they are paid dividends. There is no obligation to pay dividends.
- What is left of the profits after dividends are paid is called retained income and is retained in the business to help fund future growth, replacement or new machinery, motor vehicles etc.
The numbering of the items below ties in with the numbering of the paragraphs above.
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