Saturday, July 13, 2024

Understanding financial statements


Management may be classified into strategic management, product management, human resources management, financial & administrative management and marketing management. While most organizations have a financial or accounts department, it often strikes me that this department is limited to doing just that – accounting. Financial management however is more than that and provides analytical reports that inform management on the financial position of the company. The annual report of the company will include financial statements and management needs to find out what they say. Let us refresh our minds and look at some of the basics of accounting that will help.
Basically, accounting is the process of measuring and reporting an enterprise’s assets and liabilities, the owner’s equity being the difference between the two: Equity = Assets – Liabilities.
Assets are defined as an enterprise’s economic resources. However, in accounting, there are restraints on reporting their value. A business can report an asset only when it exists. For example, a company that signs a contract to build a dam can include the assets arising under that contract in its financial statements only when the work is done. Also, if somebody has taken a mortgage to buy a house, that house will only become an asset when the mortgage has been paid. Until then it is that person’s a liability and the bank’s asset. Most assets are recorded at their purchase price until there is evidence that prove that the value has changed.
Liabilities are present obligations either to convey assets or to render services to someone in the future as a result of past transactions. Most liabilities are payable in cash. The value of many liabilities can only be estimated. For example, consider the liabilities of an insurance company for claims that have not yet been reported. Liabilities that will be satisfied by providing services are easy to measure, like rents, subscriptions and ticket sales received in advance. The price of these has been established and either they have been performed or they have not – hence, the liability exists only for unperformed services.
The owner’s equity is the excess of assets over liabilities and therefore depends on how assets and liabilities are measured.
A financial report includes three major financial statements plus addition disclosures necessary for completeness. These disclosures are often called “footnotes” but “notes to the financial statements” would be a more accurate description. The three major financial statements are the following while most corporate financial statements also include the changes in the shareholders’ equity:
Balance sheet
Income statement, also called the profit & loss statement or earnings statement
Statement of cash flows
The balance sheet is a listing of, on one side, all the enterprises’ assets and on the other side the enterprises’ liabilities plus the owners’ equity. The assets are presented in order of liquidity. The first category is current assets, which comprises cash and assets that will be turned into cash (such as stock and debtors) within one year or the current operating cycle, if greater. Other categories include the long-term tangible assets, investments and intangible assets (copy rights, patents, goodwill for example). Intangible assets refer to assets that lack a physical presence, but hold significant value for businesses. They are the non-monetary resources and rights that contribute to a company’s competitive advantage, market position, and overall value. There may also be a category called other assets, for assets that managers are unable or unwilling to categorise.
Liabilities are classified between current liabilities, those payable within the period used to define current assets, and all other liabilities, which are called non-current liabilities such as long-term debts.
For corporate enterprises, shareholders’ equity is classified as paid-in capital, the amounts received as investments by the owners; retained earnings, the cumulative amount of earnings reinvested in the company; and treasury stock, a deduction for the cumulative amount paid buy the company to buy back its shares.
The income statement and cash flows are more dynamic than the static nature of the balance sheet. The balance sheet tells us where we are. The income statement and cash flow statement show us how we arrived there. They cover the period between two balance sheets. The income statement lists first the revenues of the company. Revenues are the gross increase in company value from selling goods and services to customers. Expenses are deducted from the revenues to obtain the profit or income. The make-up of the gross decrease in company value from the production and delivery of goods and services to customers. Expenses are the costs incurred to earn the revenues.
The statement of cash flows presents gross cash flows, both positive and negative, classified as operating cash flows, investing cash flows and financial cash flows. Operating cash flows are the flows relating to income statement items: collections from customers, payments to suppliers, employees, utilities, etc. Investing cash flows are the payments and receipts from buying and selling assets, buying other businesses, etc. Financing cash flows comprise the transactions by which the enterprise raises capital, including borrowing, debt repayments, dividend payments, proceeds from issuing share capital and amounts paid to buy back shares.
Now, using financial statements, comparisons can be made over time and period by period changes will provide information because each period’s statements have been prepared in a comparable way. More about financial statement analysis next week.

From: Mastering Management 2.0 – “How to read those financial reports” by Peter Knutson
Ton Haverkort

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