If you are going to be effective in managing your finances as a business owner, then you must have an elevated and practical understanding of financial statements. Our financial statements tell the story of your business and by analyzing your financial statements a savvy finance professional can understand how your business makes money, your risks, and sources of concern. Good financial analysis is also required in coming up with strategies to address some deep rooted business problems and transform your business for the better.
Without an understanding and application of financial analysis, you could make the wrong decisions regarding your business or make sub-optimal decisions which could have been enhanced with the relevant data and information that financial analysis could have otherwise provided. Here are a few basics about financial statements that will guide you to deepen your understanding of the financial management practices required for your business.
Accounting Basics: The primary purpose of accounting is to provide a record of all financial transactions that take place in your business and use those records for the purpose of making better decisions regarding your business. In accounting, financial transactions are captured as either: assets, liabilities, income, expenses, cost of goods sold, capital or retained earnings.
Assets represent the things that your business owns and their value. Assets can be further categorized as fixed assets: assets that can be used over a period exceeding one financial year, e.g. land, buildings, furniture, equipment, etc., and current assets: assets that are used up in the production of goods and services within one accounting period, e.g. money (cash), raw materials (inventory), debtors (the amounts your customers owe you).
Liabilities represent the things that you owe or are liable to pay to others at any point in time. Just like assets, liabilities can be further categorized as long-term liabilities: amounts that you owe that can be paid over a period exceeding one year, like a mortgage loan or 5 year vehicle loan; and current liabilities: amounts that are due and payable within one year: this will include amounts owed to suppliers and vendors, amounts due to tax authorities, any amounts that you owe staff or providers of professional services, or monies that you collect on behalf of third parties that do not belong to your company and will be paid out to the actual owners within a short time.
In accounting, income represents the sources of revenue to your business: the value that you receive when your customers purchase your products and services. Whether you receive cash or not, accounting principles require that you recognize income once your goods and services are purchased by a customer, and an acknowledgement of that purchase is made by you and accepted by the customer.
Good accounting requires you to report your income based on the different business lines that you offer, so that you can track the income from the various aspects of your business and make decisions regarding each product line. For example, a hotel may want to separate income into: lodging, restaurant, and banqueting to be able to properly track the income from these three distinct sources of business.
Expenses on the other hand represent the amounts spent on purchasing goods and services that are used up in the production of your own products and services and for the smooth running and operations of your business. Expenses include things like utility bills, transportation, travel expenses, stationery, maintenance expenses for your building or equipment, rent, etc. Very closely related to your expenses is a group of expenses that are summed up and collectively known as Cost of Goods Sold: These are expenses that relate directly to your productive activity and vary with the level of production.
For example in a restaurant, your food stuff that you purchase and cook for guests will be part of your cost of goods sold, and will be separated from other expenses such as telephone bills and staff salaries. In a bookshop, books purchased for re-sale will be part of cost of goods sold. The concept of cost of goods sold is useful in determining how profitable the main productive activity of your business is as separate from the general administration and running of your business and other costs (activities) not directly related to production.
The capital of your business represents the value of the investments made by you and the other owners in the business. Capital is represented in shareholding: usually ordinary shares or preference shares of your company. The amount of capital captured in your financial statements is a function of the actual amount of money that the shareholders (owners) have put into the business. In Nigeria, the Corporate Affairs Commission requires companies to register their share capital and keep a record of all the investors and their investments in the company.
Finally, your financial statements include the amount of profit (the difference between your income, cost of goods sold and expenses – this profit is then used up to pay off your company tax, pay dividends to the shareholders of your business or retained for the future growth of your business.
Accounting Concepts & Conventions: The purpose of financial accounting is to ensure that your financial statements and records present a “true and fair view” of the activities of your business so that decision making – internally and externally regarding your business can be based on reliable information.
To ensure that your financial records and statements really give this true and fair view, accountants rely upon a number of concepts and conventions. As a business owner, it is important to understand these and work with your accountants and auditors to ensure that these concepts and conventions are applied in maintaining your accounting system.
A very important convention that is particularly important to business owners is that of SEPARATE ENTITY. In accounting and law, the business is a separate legal entity from the business owner, even if the business owner owns 100% of the shares of the company. It means that all financial transactions relating to the business must be kept separately from that of the owner or owners.
The REALISATION convention holds that income from your business is not accounted for only when cash is received, but actually when the goods and services have been legally exchanged, even if payment has not been received. This is how accounting systems are able to recognize and account for debtors and creditors. So, if you enter a contract for sale on credit terms, the value of the sale can be immediately recognized and accounted for as income, and also recorded as a debt until the actual cash payment is received.
The MONETARY MEASUREMENT convention also holds that you cannot ascribe value to anything in your business that does not actually have monetary value and for which no one has paid for. So, for example: the quality of your products, quality of leadership, track record, etc., cannot be valued and recorded on your financial statements until someone indicates they are ready to pay for them.
So if someone purchases a part of your business and is willing to pay an extra amount based on the quality of your leadership or brand, then that extra paid for the quality of your brand can be measured and recorded. You cannot just sit back and say the value of your brand is N5million when no one has paid for it at that price.
When preparing financial statements, accountants and business owners are also concerned about the concepts of MATCHING: ensuring that revenues and expenses relating to a particular period and transaction are matched against each other; PRUDENCE: profits should not be recognized until a sale has been actually made. For example, if you are a book publisher selling your books on a sale or return basis, it will be imprudent to declare a profit on books that are still in shops that still have a chance of being returned.
Also, if there is a chance that some of your debtors will not pay for goods and services that they have purchased on credit, then prudence requires you to make a provision in your profits for the possibility that some of those debts will not be collected. It will be again imprudent to just assume that all the debts will be collected especially if there is evidence that in the past, some of your debtors do not pay.
Finally, the concept of CONSISTENCY requires that business owners apply consistent basis for keeping and categorizing financial transactions – for example the rate of depreciation on specific assets or the provision that you make for bad debts. If you are not consistent with these, your financial records and statements may not allow an easy comparison from one year to another.
Statement of Financial Position: This is also known as the balance sheet. It is a statement of the financial position of your business at a specific date. It provides a “snapshot” of your business at any point in time that it is prepared. The items that are shown on the balance sheet are your assets, liabilities, capital, and retained earnings. The difference between the assets and liabilities will always equal the sum of the capital and retained earnings. In order words, the net position of what you own vs what you own must have been financed by the capital that you invested and whatever historical profits or losses you have incurred up to this present time.
Business owners are concerned with the ratio of long-term liabilities to capital: it shows how dependent the company is on borrowing to finance its operations. Also, the ratio of current assets to current liabilities indicates the ability of the business to meet its current obligations. If current liabilities are far more than current assets, it means the company is illiquid and will struggle to meet its short term obligations.
Statement of Profit or Loss: This statement captures the profitability or otherwise of your business over a specific period – a month, a quarter, or a year. The Gross Profit is arrived at by subtracting your Cost of Goods Sold from your Income, while the Net Profit is arrived at by subtracting your general administrative and running expenses from your Gross profit.
The Net Profit is what is assessed for tax purposes and the Net Profit after Tax is what is available to be distributed as dividends or retained for future use in the business. Business owners are concerned with the growth in revenues, gross profit and net profit and managing the ratio of cost to income. The statement of profit and loss helps business owners ascertain the financial performance of their business.
Statement of Cash Flows: The statement of cash flows is derived from the statement of financial position and statement of profit and loss, and tracks the movement of cash in the business. It categorizes cash into three: cash flows from operations (sales of products and services vs. general expenses); cash flows from investing activities (disposal of existing assets vs. purchase of new assets); and cash flows from financing activities (issuance of capital or borrowing vs. repayment of loans/dividends).
This financial statement helps you to identify the main sources of cash inflows and outflows for your business. A company that is unable to finance its core operations from its cash flow from operations and needs to dispose of fixed assets to do so may be a source of concern. Also, where too much of the cash raised from financing activities (new shareholders and/or debt) is spent on operational activities rather than on the acquisition of new assets, the business owner may be concerned.
Financial statements focus on the life-blood of your business – cash, sales, expenses. You do not need to have a background in finance, business, economics or accounting to be a successful business owner. However, you need to have a practical understanding of some of the basics of these issues for you to effectively lead your business and achieve your goals.
Even when you hire accountants and auditors for your business, you still need to oversee their work and use your understanding of finance, accounting and the principles, conventions and practices to make the right decisions for your business. So, please do not shy away from finance and accounting, rather: embrace them, deepen your understanding, learn more and add immeasurable value to the growth of your business.