3. Financial statement

FINANCIAL STATEMENT 3

Good record keeping by a business is not only wise, but is required by many laws. Legal and financial  questions may be raised by various agencies, banks, and employees. These questions can be accurately  answered when written records of business proceedings are kept.

By recording daily transactions, the owner can learn from mistakes and avoid errors in the future. A record of all the events that occur in a business permits evaluation, improvement, and  a good chance for personal and financial success.
For a typical small business, it is suggested that the following records be kept:  cash receipts and cash payments journal, record of credit  sales ( sales journal), record of purchases ( purchases journal), record of wages ( payroll), operations statement ( profit and loss statement or income statement ), balance sheet. The results of operations and the present  financial position of the firm are reflected in two key financial statements: the income statement and the balance sheet. The income statement reports revenues, costs, expenses, and profits ( or losses) for a specific  period of time, showing the results  of operations during that period.  The balance sheet reports the financial  condition of  a firm on a specific date. The balance sheet is a snapshot, while the income  statement is a motion picture. The former tells what the company owns and owes on a certain day; the latter, what  is sells its products for and what its  selling costs are over a period  of time.
Management decisions  must be weighed in terms of their effect on these two basic financial statements.

The income statement ( the profit  and loss statement or the operations statement). This statement  is a summary of the income  and expenses of the business. The income statement summarizes these facts for any period  of time. Income statements may be made for a year, a month, a quarter, or a half-year. Some firms have weekly or daily income statements. Although  many items appear  on the income statement the basic idea is very simple. The formula is: net sales minus cost of goods equals profit.  Amount  taken is minus Amount paid out equals profit.
With a larger business, expenses change the formula somewhat:

Net sales – cost of goods sold = gross profit

Gross profit  -- expenses ( rent, light phone) = net profit

In business, there are two kinds of profit: gross profit  and  net profit.

Net sales – cost of goods sold = gross profit

Gross profit  --  operating expenses = net profit

The operations statement  is a summary of facts which have been recorded daily in the books of the business. No matter  how complicated it may look, it is based on the following  simple  formulas:

Gross profit = sales – cost of goods

Net profit = sales – cost of goods and expenses


The income statement might be compared to a  “ moving picture”. It describes  the business in action.  It summarizes  the results of past activities and gives hints of what the future holds. The final figure, net profit, is of the greatest importance . one might find, for instance, that even though sales has increased since  last year, profits were less. The operations statement  might show that expenses were too high, it might  also show  that the utilities increased  or there was too much loss on bad debts. Once a problem area is identified, steps can be taken to correct it.
When applying for a loan, the bank may want to examine  several operations statements. The bank is interested in how sales compare with expenses, how much inventory is carried,  and credit formation about the business from the operating  statement. Profit earned over a period of time, department  performance, inventory  size, overhead costs, and many other items are shown on the statement.

The balance sheet. In contrast to the operations statement, the balance sheet is a  “still picture” of the business.
A balance sheet is composed of assets, liabilities, and owners equity.  Note that the income statement reports on changes over a period of time and the balance sheet reports  financial conditions at a specific  point in time.
The words balance sheet  imply that the report  shows a balance, an equality between two figures. That is, the balance sheet shows a  balance  between assets on the one hand,  and liabilities plus  owner’s equity on the other. The balance sheet  shows that assets are divided into three categories:  (1) current assets ( cash or assets that can be turned into cash in one year or less), such as accounts  receivable;  (2) fixed assets ( land, building, furniture); and (3) intangible assets, such as patents  and copyrights.

Liabilities are divided  into two categories:(1) current liabilities ( obligations that must be paid within one year) , such as accounts payable, and (2)  long-term liabilities ( obligations that will not be paid within  one year), such as long-term loans and corporate bonds.

In a corporation, owners’ equity consists of common stock ( certificates  of ownership)  and retained  earnings ( earnings not distributed to owners). Because neither sole proprietorships nor  partnerships have common stock,  their owners’ equity is called a capital  account.

Imagine that you don’t owe anybody any money. That is, you don’t  have any liabilities. Then the assets you have  ( cash and so forth),  are equal to what you own ( equity). Translated into business terms you have a fundamental accounting equation that is rather obvious. If a firm has no debts, then:

Assets = owners’ equity

This means, that the owners of a firm own everything. If a firm has debts,  the owners own everything  except the money due others, or:

Assets – liabilities  = owners’ equity

If you  add an equal amount  to both sides of the equation ( you remember this operation from algebra), you get a new formula:

Assets = liabilities  + owners’ equity


This last formula is the basis  for the balance sheet.
The figures for the balance sheet come from the records kept by  the business.  Each  item on the balance sheet  is based on facts that  have been recorded daily in different  ledger accounts. The records used for the operations  statement are also used in preparing a balance sheet.

Current ratio. The assets are divided into current  assets and fixed  assets. The relationship  between current assets and current liabilities is a prime measure of liquidity of any firm. Liquidity  is the measure  of ability to pay debts as they become  due.
Current assets are assets that are in the form of cash  or will convert into cash within 90 days. Current  liabilities are those debts that will be due within one year. The relationship between current assets and current liabilities is called the current ratio. Sound financing demands that this ratio be at least 2 to 1. The current ratio is found by diving the current assets by the current liabilities .
Quick ratio. This ratio is also known as the acid test of liquidity. It is the relationship between  only  the most liquid assets ( cash and accounts receivable)  and the total  of the current liabilities. The conservative  rule is that  this ratio  should be at least 1 to 1. In other  words, cash plus receivables should equal or exceed the current liabilities.

Working capital. Working capital  is the difference between  current assets and current liabilities expressed in dollars.

The proprietorship ratio of owner’s equity ratio is the relationship between  the owner’s investment in the firm and the total assets being used in the business. This ratio  can be expressed  as a ratio of owner investment  to total  assets or as a percentage  of those total assets.
There are many other ratios  utilized in the analysis  of business firm operations. Most small firms that maintain adequate current ratios,  quick ratios, and working capital , proper inventories, and a 50 percent proprietorship  ratio will maintain sound financial structure.

Trading on equity. In connection with owner investment,  prospective  business owners and managers should become familiar with the phrase “trading on equity”. This phrase refers to the relationship between  the creditor  capital ( liabilities) in the business and the owner capital. Trading on too thin an equity is a term  used to describe  owners who have too little of their own money invested compared with the creditor  capital ( liabilities) used to finance  the business. A proprietorship ratio of 50 percent  indicates that the owner or owners have invested  half the value  of the total assets used in the business. When this ratio falls  below 50 percent , the outside creditors are  supplying  more of the firm’s  total  capital needs  than the  owners are. This indicates, in most cases , that further capital  will be more difficult  to obtain either from  current loans, sale of securities, or other investors. Such owners are truly  trading on too thin  an equity and probably need more investment capital on their own.