The first step in developing a financial management system is the creation of financial statements. To manage proactively, you should plan to generate financial statements on a monthly basis. Your financial statements should include an income statement, a balance sheet and a cash-flow statement
Simply put, the income statement measures all your revenue sources vs. business expenses for a given time period. To help explain things easily, let's consider an apparel manufacturer as an example in outlining the major components of the income statement:
Sales. This is the gross revenue generated from the sale of clothing less returns (cancellations) and allowances (reduction in price for discounts taken by customers).
Cost of goods sold. This is the direct cost associated with manufacturing the clothing. These costs include materials used, direct labor, plant manager salaries, freight and other costs associated with operating a plant (for example, utilities, equipment repairs, etc.).
Gross profit. The gross profit represents the amount of direct profit associated with the actual manufacturing of the clothing. It's calculated as sales less the cost of goods sold.
Operating expenses. These are the selling, general and administrative expenses that are necessary to run the business. Examples include office salaries, insurance, advertising, sales commissions and rent.
Depreciation. Depreciation expense is usually included in operating expenses and/or cost of goods sold, but it is worthy of special mention due to its unusual nature. Depreciation results when a company purchases a fixed asset and expenses it over the entire period of its planned use, not just in the year purchased. The IRS requires certain depreciation schedules to be followed for tax reasons. Depreciation is a noncash expense in that the cash flows out when the asset is purchased, but the cost is taken over a period of years depending on the type of asset.
Whether depreciation is included in cost of goods sold or in operating expenses depends on the type of asset being depreciated. Depreciation is listed with cost of goods sold if the expense associated with the fixed asset is used in the direct production of inventory. Examples include the purchase of production equipment and machinery and a building that houses a production plant.
Depreciation is listed with operating expenses if the cost is associated with fixed assets used for selling, general and administrative purposes. Examples include vehicles for salespeople or an office computer and phone system.
Operating profit. This is the amount of profit earned during the normal course of operations. It is computed by subtracting the operating expenses from the gross profit.
Other income and expenses. Other income and expenses are those items that don't occur during the normal course of business operation. For instance, a clothing maker doesn't normally earn income from rental property or interest on investments, so these income sources are accounted for separately. Interest expense on debt is also included in this category. A net figure is computed by subtracting other expenses from other income.
Net profit before taxes. This figure represents the amount of income earned by the business before paying taxes. The number is computed by adding other income (or subtracting if other expenses exceed other income) to the operating profit.
Income taxes. This is the total amount of state and federal income taxes paid.
Net profit after taxes. This is the "bottom line" earnings of the business. It's computed by subtracting taxes paid from net income before taxes.
The balance sheet provides a snapshot of the business's assets, liabilities and owner's equity for a given time. Again, using an apparel manufacturer as an example, here are the key components of the balance sheet:
Current assets. These are the assets in a business that can be converted to cash in one year or less. They include cash, stocks and other liquid investments, accounts receivable, inventory and prepaid expenses. For a clothing manufacturer, the inventory would include raw materials (yarn, thread, etc.), work-in-progress (started but not finished), and finished goods (shirts and pants ready to sell to customers). Accounts receivable represents the amount of money owed to the business by customers who have purchased on credit.
Fixed assets. These are the tangible assets of a business that won't be converted to cash within a year during the normal course of operation. Fixed assets are for long-term use and include land, buildings, leasehold improvements, equipment, machinery and vehicles. Intangible assets: These are assets that you cannot touch or see but that have value. Intangible assets include franchise rights, goodwill, noncompete agreements, patents and many other items.
Other assets. There are many assets that can be classified as other assets, and most business balance sheets have an "other assets" category as a catchall. Some of the most common other assets include cash value of life insurance, long-term investment property and compensation due from employees.
Current liabilities. These are the obligations of the business that are due within one year. Current liabilities include notes payable on lines of credit or other short-term loans, current maturities of long-term debt, accounts payable to trade creditors, accrued expenses and taxes (an accrual is an expense such as the payroll that is due to employees for hours worked but has not been paid), and amounts due to stockholders.
Long-term liabilities. These are the obligations of the business that aren't due for at least one year. Long-term liabilities typically consist of all bank debt or stockholder loans payable outside of the following 12-month period.
Owner's equity. This figure represents the total amount invested by the stockholders plus the accumulated profit of the business. Components include common stock, paid-in-capital (amounts invested not involving a stock purchase) and retained earnings (cumulative earnings since inception of the business less dividends paid to stockholders).
The cash-flow statement is designed to convert the accrual basis of accounting used to prepare the income statement and balance sheet back to a cash basis. This may sound redundant, but it's necessary. The accrual basis of accounting generally is preferred for the income statement and balance sheet because it more accurately matches revenue sources to the expenses incurred generating those specific revenue sources. However, it also is important to analyze the actual level of cash flowing into and out of the business.
Like the income statement, the cash-flow statement measures financial activity over a period of time. The cash-flow statement also tracks the effects of changes in balance sheet accounts.
The cash-flow statement is one of the most useful financial management tools you will have to run your business. The cash-flow statement is divided into four categories:
1. Net cash flow from operating activities. Operating activities are the daily internal activities of a business that either require cash or generate it. They include cash collections from customers; cash paid to suppliers and employees; cash paid for operating expenses, interest and taxes; and cash revenue from interest dividends.
2. Net cash flow from investing activities. Investing activities are discretionary investments made by management. These primarily consist of the purchase (or sale) of equipment.
3. Net cash flow from financing activities. Financing activities are those external sources and uses of cash that affect cash flow. These include sales of common stock, changes in short- or long-term loans and dividends paid.
4. Net change in cash and marketable securities. The results of the first three calculations are used to determine the total change in cash and marketable securities caused by fluctuations in operating, investing and financing cash flow. This number is then checked against the change in cash reflected on the balance sheet from period to period to verify that the calculation has been done correctly.