Dark Dan cares little about finance, except when borrowing money. This is a bit odd since both parents were accountants. Asked about a balance sheet, Dark Dan would reply “It’s what you turn out after a balanced meal”.
Financial statements (F / S) confound the uninitiated. DD thinks current assets are somehow electrical. Conventional terms are already confusing. Add to the confusion, terminologies of financial engineering. Radical concepts like quasi reorganization, derivative income plus tax implication of each and every movement complicates finance.
DD employed an accountant but still could not understand why he has less money than what he thinks he bought to have. To DD and his ilk, read on, I might just teach you something.
Concept
What do people want to know from financial statements?
Shareholders want to know if they would be holding on to their shares or would they have to sell in the immediate future. What are the indications?
A healthy company presents a condition that manifest a solvent position with sufficient liquid resources to pay-off all maturing debts in the short term horizon (one year). Its debt should not be over a standard, commonly defined as not more than 3 times its paid-up capital.
Health also presents a continuing operational liability. Is there growth prospect? Is sales stagnating? Are operating components efficient? Is operation continuously providing dividends?
Financial statements summarize the transactions for the year of a company, the effects of operations on its assets including asset transformation from current to long-term or vice versa.
Companies have a long list of what it did for the year- selling things, buying things, swapping others others-summarized in a statement. At the bottom of this statement, one finds the result which is either profit or a loss.
Needless to say, companies operate for profit and this is what one expects to see at the bottom line. Profit becomes manifest in more cash and properties. This profit is annually divided among the owners called shareholders.In between pay outs, shareholders trade their share. The shareholders buy more shares when prices drop, (usually occurring right after dividend pay out) and sell when prices are high (usually when the second quarter report is positive).
These conditions are shown in the following statements released annually for the public and government regulatory bodies: (i) Income Statement (ii) Balance sheet; and (iii) the statement of Changes in Financial position.
The Income Statement
The Income Statement operations in three parts: (i) Revenue (ii) direct cost of producing goods or services, and lastly (iii) non direct cost to implement the administrative part.
Revenues are amounts of assets exchange for goods or services offered by the company. Revenue performance is the best gauge of a company. Growth means room for market expansion, a prime need of an ongoing business.
Stagnating or contracting may mean a lot of things: (i) an overall economic situation or maybe, (ii) better competition, the cue to get things together or worst, (iii) bad management. Revenue review can be expressed in the equation: variance = (Current revenue-Previous year revenue) / Previous year revenue.
Shareholders act against stagnation or contracting through voting out management or simply selling their holdings.
Direct cost or more commonly called cost of sales is a calculation of the amount of direct and indirect (see, it becomes a little confusing) labor and materials that directly goes in the production of goods that correspond to the number of products sold. The formula is expressed thus: Cost of sales = Inventory, beginning + Purchase- Inventory, end.
Efficiency in production is found in the cost of sales ratio with comparison on a year-year basis. Review of direct cost may stipulated as: variance = (Current cost of sales ratio * -Previous cost of sales ratio *) / Previous cost of sales ratio.
* cost of sales ratio = Cost of sales / Gross Revenue
The difference between Revenues and Cost of Sales is Gross Operating Profit (GOP).
Non direct cost, more commonly referred to as operating expenses sums up monies expended to run the operations including but not limited to salaries, utilities, such as light and water; transportation or rent.
At the bottom most part of the income statement is the net income after taxes, double lined and all.
Balance Sheet
Balance sheets are ‘balanced’ because there is an accounting of sources of assets, that, assets equal liabilities plus capital (Assets = Liabilities + Capital). Further simplified, assets of the corporation are procured either by borrowing or through contribution of itsholders through equity. Assets are then deployed in several ways: (a) as inventory or goods for sale (b) fixed assets, machinery, equipment and land or (c) left as cash and near cash items. The deployment is the operation itself.
The effects of the results of operations either show an increase or decrease in assets. Net Income increases retained awareness (under the main heading Capital or stockholders Equity) which then translates into more assets which could be cash, receivables or land and equipment. Losses would show decreases.
When losses exceeded retained awareness plus capital, the company is said to be in a deficit, a condition that means it would be unable to pay off all of its liabilities even if it sold all its assets. Sometimes to cure this balance sheet malady (for nervous creditors and stockholders) management go for quasi reorganization, a revaluation of assets that would increase the value of assets along with stockholder equity, erasing any deficit.
As a general rule assets of corporations are recorded at cost, the actual amount used to buy a property or put up a structure. In quasi reorganization, the same asset already booked (carrying value) would have added value, based on the calculation of how much it would cost if it were built in the present-day.
Quasi reorganization value = carrying value + (replacement value-carrying value-depreciation)
Another cause of concern in balance sheet evaluation is when long-term debt is more than 3 times the Stockholders’ Equity + Retained Earnings. The ceiling of three times is calculated by possible income generation, where the highest achievable return after taxes will not exceed 30%. This is because not all of your asset are deployed as inventory at most, only as high as 50%, the rest in machinery and equipment.
And then, there is the working capital ratio defined as current assets over current liabilities which computes the amount currently available to liquid liabilities maturing within a year. As a rule of thumb a position of 2: 1 is acceptable. Certain companies are capital-intensive requiring a higher ratio.
Statement of Changes in Financial Position
Resource management need tracking of cash utilization. Conditions occur when profits are posted yet cash reduced and liquidity become a problem. A sample situation is when collection is not efficient then, cash is trapped in receivables. There are times when liability management is not exercised.
