Preparing Financial Statements

Understanding financial statements, decide the success of small businesses. They direct, and help businesses avoid breakdowns in the business. Financial statements assist in preparing taxes, and applying for loans. That is not the end of their value. Financial statements build a company’s balance sheet.

The balance sheet is a snapshot of a business’s finances. Balance sheets need three things; assets, liabilities and net worth. The elements of a balance sheet change with daily operations, and log the business’s activities. Tracking the changes of a balance sheet over time will show the real financial state of a business. Understanding how well processes are running will strengthen the operations of the company.

Liabilities and net worth on a balance sheet are sources of funds. Liabilities and net worth are creditors, and investors who provided cash to a business. They enable a business to expand operations. These funds create assets. Assets represent the use of funds. A business uses cash, or other funds provided to buy assets. They include business owned property that has value.
Liabilities represent obligations to creditors while, net worth represents the owner’s investment in the business. Creditors and owners are “investors” in the business with the difference being the time-frame in which repayment is expected. Current Assets are anything of value that is owned, or due to the business. These are included under the Asset section of a Balance Sheet. Current assets mature in less than one year.

Cash is what pays bills, and obligations. Inventory, receivables, land, building, machinery and equipment do not pay obligations. Selling equipment has cash value, but is not considered an asset. Mismanaged cash forces a business into bankruptcy. Cash includes all forms of short-term cash sources.

Accounts receivable are payments due from customers. Inventory sold, and shipped needs an invoice. Invoices are agreement for payment at a later date. The receivable exists for the period between the selling of inventory, and the collection of cash. Receivables are equal to sales on a spreadsheet. As sales rise, the investment you must make in receivables also increases.
Materials purchased to create profit, is inventory. The business purchases raw material, to sell as finished goods inventory. A business that sells a product, inventory is the first use of cash. Selling inventory does not create cash, it creates a receivable. Collected at the agreed time, a receivable becomes cash. Goods sold are not immediate cash. Inventory management is important. Unsold inventory ties up cash. Keeping inventory low allows a company to grow, by freeing up cash. Inventory shortages will result in lost sales.

Notes receivable are claims due to the business from a loan made, like promissory notes. Notes receivable are claims due from one of three sources customers, employees or officers of the business. Customer receivables are when a customer fails to pay an invoice according to the agreed-upon payment terms. Customer obligations may be converted to promissory notes. If an officer takes money from the business, it is declared as a dividend, or withdrawal. It is reflected as a reduction in net worth on the balance sheet. Treating it differently will manipulate the businesses stated net worth.

Intangible assets are prepaid expenses, at a later date. Example of this is insurance. It is prepaid, and expensed each month. If using standard accounting procedures intangibles get expended as purchased. An exception is, purchased patents. They are amortized over the life of the patent. Intangibles are assets with an unknown life span. They may never mature into cash. For analysis purposes, intangibles get ignored as assets, and deducted from net worth. Their value is unknown. Examples are patents, or Research and development.
Other assets consist of miscellaneous accounts, deposits and long-term notes receivable. They are converted into cash when the asset is sold, or note is paid. Total Assets represent the value of all the assets owned by a business.

Current liabilities are obligations that require payment within 12 months. A business’ current liabilities are the bills that can cause it to go bankrupt. Constant monitoring of all current liabilities is vital to the businesses’ success. A company needs to be able to forecast production needs to ensure funds will be available to pay current liabilities. Keeping current on liabilities will keep creditors happy. This allows a business to keep a healthy line of credit established. Having access to short term credit will allow a business to have cash on hand to pay for materials, and inventory.
Non-current liabilities are obligations payable the following year. The non-current part of long-term debt is the part of a loan not due in the next 12 months. Contingent liabilities are potential liabilities, without due dates. They are avoidable liabilities, like lawsuits. Long term debt provides cash for long-term asset buying.

Notes payable are promissory notes with short-term due dates of less than 12 months. Most are payable on demand. If not they have specific maturity dates less than one year. Notes payable include only the principal amount. Any interest owed gets listed under accruals. Proceeds from notes payable, finance inventory and receivables. The use of funds must be short-term so the asset can create cash before the obligation is due. Businesses should only borrow money to cover seasonal swings. The money will cover increased costs in inventory needed to cover demand.
Accounts payable are obligations to suppliers, who have provided a service to the business. Accounts payable are like accounts receivable. Taking advantage of payment terms will keep costs down. Allowing the business to sell the goods produced, before payment is due on materials.
Accrued expenses are obligations owed, but not billed. These include wages, and payroll taxes. These expenses will get paid over a period of time like interest on a loan. Labor-related categories will vary with payroll policies. For example, if wages get paid weekly, the accrual is one week’s payroll, and payroll taxes.

Contingent liabilities are potential liabilities that are not listed on the balance sheet. They get placed in the footnotes, because they may never become due. Contingent liabilities include lawsuits, and warranties. A lawsuit may not end in litigation. Liabilities belong in the footnotes to represent a potential liability. It will remain there until it either becomes a liability, or is no longer a threat to the business.

Total liabilities represent the sum of all monetary obligations of a business and claims creditors have on its assets. Equity is represented by total assets, minus total liabilities. Equity or net worth is the most patient, and last to mature source of funds. It represents the owners’ share in the financing of all the assets.

The income statement, also known as the profit, and loss statement, includes all income and expense accounts over a period of time. This financial statement shows how much money the business will make after expenses are accounted for. An income statement does not reveal hidden problems, like insufficient cash flow. Income statements are read from top to bottom, and represent earnings and expenses over a period of time.

Businesses need a cash flow analysis to start, operate, and expand operations. Even with a cash flow analysis, many small business owners often have trouble managing, and maintaining cash. Inaccurate cash flow analysis or lack of available cash can affect the everyday operations of your business, and eligibility to receive a loan.

Cash flow is the movement of money in and out of a business. The processes of cash flow are explained in the following sentences. Inflow which comes from operations is the sale of goods, services, loans, lines of credit and asset sales. Outflow occurs during operations, as business expenditures, loan payments and business purchases. It is necessary to balance these, and maintain a reasonable balance of cash on hand at all times.

A cash flow system will manage funds to pay costs of operations, and help the business forecast potential problems in the future. Profit, loss statements, and income statements are used to determine projections of future cash flow trends. A cash flow statement will also accounts for non-cash items, and expenses to project proper financial statements. Cash flow analysis statements display changes, and available net cash. Cash flow analysis statements are separated into three parts.

Two types of cash flow are inflow, and outflow. Inflow is any cash that is coming into the business.  Outflow is the flow of cash leaving the business.  Inflows and outflows is what are used to balance accounts.  All businesses boil down to inputs, and outputs.  The point is to have more inputs than outputs.

The operating activities section evaluates net income, and loses of a business. Assessing sales, business expenditures and income from non-cash items the business can adjust the in, and outflows of cash transactions to determine a net figure.
The investment activities section reports purchases, and sales of long-term investments. Examples are property, assets, equipment and securities. When a company purchases equipment for the business it is considered an inflow.

Financing activities, this section covers cash flow trends of money related to financing a business. A loan has both inflow, and outflow of cash.  The loan would be considered an inflow.  While the payments made on the loan would be considered an outflow. Both the inflow and outflow will be recorded in this section.

Break-even Analysis is the point that the business will be able to cover expenses.  At this this point the business will begin to make a profit.  Lenders will expect borrowers to be able to forecast a break-even point.

To calculate break-even point, a business will need to identify both fixed and variable costs. Fixed costs are expenses that do not vary, known as overhead costs. Fixed costs are not affected by sales volume. These are expenses regardless of sales volume. Variable costs vary with sales volume. Cost of purchasing inventory, shipping and manufacturing a product effect your variable cost. To calculate break-even point uses this equation: Fixed costs/ (unit selling price – variable costs).

Debt-to-equity ratio is the amount of debt the company has, divided by the company’s assets. This is the amount of money borrowed related to the amount of money invested in the business. Having larger amounts of capital invested in the business, the easier it will be for a company to obtain funding.  Reinvesting into the business shows the seriousness of the owner, and eases the minds of investors, because they know they can recoup any losses by selling assets.
Businesses with high equity ratios should seek debt financing. If a business has high debt, the first step is to increase equity to receive a loan. With that in mind if a company is struggling to survive it may look at selling the business.  A business should only seek a loan if it is vital to expanding operations, not to stay alive.

Lenders will want to know the following before giving a loan. The ability to repay the funds received from a lender must be outlined in the loan package. Banks want to see both cash flow of the business and sources of collateral. Banks prefer to make loans with businesses that have been operating for a few years.  This is why starting out as a bootstrap maybe needed. If a business can show regular profits for several years, lenders are more likely to loan.  Start-ups will need to make sure that the business plan is exact, and outlines financial projections accurately.
Lenders use credit reports to determine the ability of a client to repay. Terms will be determined by the information inside the credit report. Understanding what is on a credit report is vital. Errors often appear on credit reports, and are correctable. Credit reports are available through the three credit bureaus.

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