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Understanding Financial Statements

Watch the video below or scroll down to read the recap

The Bluefield WV Economic Development Authority (BEDA) hosts workshops to fit the need of the region's business owners. This class taught by Carol Jackson with the First Microloan of West Virginia, provided an overview of financial statements all business owners should review regularly. She also covered how to interpret the information, how to identify a potential opportunity to improve financial performance, what lenders look for, and the importance of understanding what your company’s statements say about your business.

 

Some key takeaways from the Presentation:


Financial statements are a way to help you understand what's going on with your business and how it's doing


The Importance of Understanding Financial Statements

  • A common mistake among businesses is failing to collect and analyze basic financial data

  • Many entrepreneurs run their companies without any kind of financial planning

  • 10% of business owners routinely analyze their companies' financial statements as part of the managerial planning process

  • Financial planning is essential to running a successful business and is not that difficult

Business Transaction

  • A business transaction is a financial event that changes the resources of your business

Components of a Financial Statement

Assets

Everything that your business owns

Cash - Cash is a current asset. In accounting, cash = currency, coins, checks, money orders, and funds on deposit in a bank. Can include checking accounts, savings accounts and certificates of deposit


Accounts Receivable - Your accounts receivable is a current asset. They are claims for future collection from customers...otherwise, the money your customer owes your business


Inventory- Supplies or goods used to produce your product or for resale


Pre-paid Expenses- Expense items acquired and paid for in advance of their use, such as rent or insurance


Long-term or Fixed Assets- Typically land and equipment, or if you own the building where your business is located


Liabilities

Debts that you owe to others, loans, payments, or obligations owned by your business. These are also called Accounts Payable. These are short-term obligations that your business must pay in the future for goods/services. Examples would include utilities, advertising, or inventory purchases


Employment Taxes - are the payroll taxes withheld from your employees' paychecks and the employer taxes accused with each paycheck


Long-term Liabilities - Loans or notes payable owed to banks or to investors are liability accounts. Current Liabilities = The principal payments your business owes for the next 12 months. Long-term Liabilities = The principal payments your business owes longer than one year.


Owner's Equity - Basically everything that's left. The owner's financial interest, sometimes stockholders' equity, owners' equity (proprietorship), or net worth. It's made up of the initial or later-stage investments in the business as well as any retained earnings that are reinvested in the business. Examples would be capital stock, retained earnings, or net income.


Accounting Rule Simplified - Own - Owe = Net Worth | Own = Owe + Net Worth | Assets = Liabilites + Owner's Equity | Your Business = How it was financed (capital structure)


Balance Sheets - (also called a statement of financial position or a statement of assets and liabilities) a snapshot of a business's financial condition at a specific time, usually at the close of an accounting period. They help you, a banker, or investors get a handle on the financial strength and capabilities of the business. Any financing group will ask for this statement. (Carol showed an example of a balance sheet at video marker 9:48)


Sales- The sales figures represent the amount of revenue (income) generated by the business. Net sales are total sales less any product returns or sales discounts.


Cost of Goods Sold - The costs directly associated with making or acquiring your products. Example: Leather used to make shoes. Merchandise purchased for resale.


Gross Profit - is derived by subtracting the cost of goods sold from the net sales. It does not include any operating expenses or income taxes. Net Sales - Cost of Goods Sold = Gross Profit. This equation helps with determining your pricing to ensure you're making a profit.


Expenses - the daily expenses incurred in the operation of your business. Examples: Advertising, interest, supplies, real estate taxes, rent, payroll, meeting and travel, utilities


Net Income Before Taxes - is arrived at by subtracting Total Expenses from the Gross Profit.

Net Income = the amount of money the business has earned after paying income taxes to federal and if applicable state and local governments.


Income Statement - (Profit and Loss Statement) records all revenues for a business during a given period, as well as the operating expenses for the business. This statement enables you to determine the operating performance of your business. Note: It does not matter what 12-month reporting period you use, as long as you keep it consistent and it coincides with your taxes. (Carol shows an example of an income statement at video marker 16:52)


Cash Flow Analysis - Shows the change in the firm's working capital over a period of time by listing the sources and uses of funds. Actual cash flow analysis shows how your business is doing.


Accounts Receivable - The larger and more advances your business is, the more likely you are to have accounts receivable. Remember, a sale is not a sale until you collect the money.


Cash and Profits = Cash does not equal profit. The profit is the difference between a company's total revenue and total expenses. Cash is the money that is free and readily available to use. Cash flow measures a company's liquidity and its ability to pay its bills.


Cash Management - A business can be earning a profit and be forced to close because it's out of cash. Knowing your company's cash flow cycle is key. (Carol shows a cash flow chart at video marker 24:22)


Valuing Accounts Receivable - (Chart is shown at video marker 25:46) A bank can value your account receivable for a loan.


Cash Flow vs. Profit and Loss - Not the same thing but they're close. If you're on a cash basis, you're only paying attention to cash when it comes in and cash when it comes out. If you're on an accrual method, you count everything, as soon as you let a customer charge a purchase on credit, you count it, even though you don't have the money yet. With that system, you don't just have money in and out, you have receivables and payables. (Carol showed a sample cash flow statement at video marker 29:35)


Ratio Analysis - A method of expressing the relationships between any 2 elements on a financial statement. These are important barometers of a company's health. These help determine how your company is doing.


Interpreting Ratios - The standards vary from industry to industry, the key is the watch for "red flags". Critical numbers measure key financial and operational aspects of a company's performance. Example: Sales per labor hour at a supermarket, food costs as a percentage of sales at a restaurant.


Liquidity Ratios - The business' short-term ability to pay its current and unexpected debts.

Working Capital = current assets - current liabilities

Current Ratio = current assets / current liabilities (2:1 preferred)

Quick Ratio = (current assets - inventory) / current liabilities (1:1 preferred)

Debt to Equity Ratio = total debt / total equity

Debt Ratio = total debt / total assets


Operating Ratios - Ratios that reflect activities crucial to making a profit in your business.

Inventory Turnover = cost of goods sold / average inventory

Receivables Turnover = annual credit sales/accounts receivable

Average Collection Period = 365 / receivables turnover - This tells the average number of days required to collect accounts receivable. Two Steps...

  1. Receivables Turnover = credit sales/accounts receivable

  2. Average Collection = days in accounting period/receivables turnover ratio

Probability Ratios

Ratios that compare earnings to the resources available in the business. Think of these ratios as answering the question "How well did I do given what I had to work with?"


Gross Profit Margin = (sales - cost of goods sold) / sales

Return on Assets = net income/total assets

Return on Equity = net income/shareholder equity


Putting Your Ratios to the Test

When you're comparing your company's ratios to your industry's standards, ask the following questions:

  1. Is there a significant difference in my company's ratio and the industry average?

  2. If so, is this a meaningful difference?

  3. Is the difference a good or bad difference?

  4. What are the possible causes of this difference? What is the most likely cause?

  5. Does this cause require that I take action?

  6. If so, what action should I take to correct the problem?

Carol gives an example of interpreting ratios at video marker 41:00-46:30 and a Trend Analysis of Ratios at 46:42.

 

Let's Get in Touch!


Carol Jackson, Loan Officer

First Microloan of West Virginia, Southern Region | cjackson@firstmicroloanofwestvirginia.org | 304-281-0488

Faith Blackwell, Administrative & Marketing Assistant Bluefield WV Economic Development Authority | fblackwell@bluewv.org


Jim Spencer, Executive Director Bluefield WV Economic Development Authority | jspencer@bluewv.org | (304) 902-2332 x 1



Bluefield WV Economic Development Authority Logo (The words "My Bluefield" underneath an outline of the Bluefield, West Virginia Skyline)


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