Financial statements is main product of the accounting process. Understanding the logics behind a financial statements helps the management, share holders, investors, and other interested parties to know the company’s financial conditions easier. It is common (and understandable), however, that many of the parties do not quiet understand it for not all of them are accounting-savvy.
Believe it or not, in fact I have been seeing that—ironically—many of the accounting persons do not really understand the logic behind a financial statements either—mostly entry-level staffs.
No shame is necessary in this case, if you are one of them. The accounting schools simply have not enough time to complete their job. So it produces accounting graduates who are technically accounting-savvy, but lack of accounting and financial logic. What I mean is that they can make journal entries, adjustments, trial balances, even create financial statements with no mistakes, but they have no clues when the management asks them some important questions, such as:
1. The income statement shows a highly revenues number, but why does it show low profit? They may tend to answer with “it is due to a high costs or expenses.” Well, everybody knows the ‘revenues – (cost + expenses) = profit/loss’ formula. But that does not make sense either. While it is true that higher cost results in lower profit, shouldn’t ‘high sales’ minus ‘high costs’ still result in ‘high profit’?
2. The income statement shows a low revenues number, but why does it show loss on its bottom line? Shouldn’t low cost and expenses occur when fewer activities are happened in the production—so the bottom line is still positive (or maybe zero in the worst case)?
3. The company made good sales and has been accumulating significant value of net worth, but why so many vendors are complaining about late payments?
4. Owners equity significantly increases, but why no dividend distributed to the shareholders?
Such conditions could (or in fact) be happened often—particularly in the small medium enterprises. And those questions could be unsolved for days (if not weeks) since the accounting people who make the statements could not find the root of the problems.
The accounting staffs should be, at least, able to explain “why?” Better yet if they are capable of proposing solutions to fix the problems and prevent those from happening in the future.
Through this post, I would like to invite you to join me in exploring the logic behind a financial statement.
Reading the financial statement, a company owner can get information about how his/her company is going. What information does the financial statements tell about?
First of all, one would need to put his/her feet on a company owner’s shoes to really understand the logic behind a financial statement. So, please forget who you actually are, use a company owner’s point of view instead, until the end of the discussion.
Okay, as a company owner, what would you like to know about condition of your company, in the financial aspect?
Let me guess (by using my common-sense as a financial consultant.) As a business owner you want to know the following conditions:
1. Is Your Company Okay?
‘Okay” in this particular context means: it runs well. To be able to run well, your company would need:
(a) Sufficient cash to finance its daily operation.
(b) Sufficient cash to pay: (a) liabilities to vendors that have been supplying your company with raw materials, products or services; (b) liabilities to the banks that have granted your company with loans; and (c) liability to shareholders that have invested money to the company.
(c) Sufficient inventories (raw materials to feed the production and finished goods to be sold.)
(d) Sufficient facilities to support its activities
In a single question: Does the company have enough ‘assets’ to keep the operation running smooth?
Your company’s ‘Balance Sheet’ answers the questions well. Here is a set of basic yet super-vital equations related to a balance sheet that you need to know at the first place (if you’re a junior accountant or accounting student, this isn’t a new stuff):
Assets = Liabilities + Owner’s Equity
Net Assets (Net Worth) = Assets – Liabilities
Net Assets (Net Worth) = Owner’s Equity
Those are what your company’s balance sheet all about. For visualization purpose, have a look at the next balance sheet example:
From the above balance sheet, you get the following information instantly:
Lie Dharma Company’s asset is 137 in total. That is 70 bigger compare to its liability—which is only 67. The 70 is called “net assets” or “net worth.” It means that if you decide to sell the company, you will get 70 net—after settling all the liabilities (to vendors and banks).
Therefore, Lie Dharma Company should, logical, has no problem to pay all the bills. But what if, in other hand, you also get phone calls from key vendors complaining about late payments? The balance sheet now does not look make sense, does it?
So, there is a puzzle you want the balance sheet to answer:
Lie Dharma Company made good sales and has been accumulating significant value of net worth, but why vendors are complaining about late payments?
Answering such specific question requires you to move your attention to the other elements of the balance sheet. On the assets group of the balance sheet, you can find an account called “Cash” values 10. On the opposite of the asset group—the “Liability” you can find “Accounts Payable”—where all bills have been accumulated—values 30. Offsetting those two accounts, you will get a conclusion that Lie Dharma Company has insufficient cash to settle all bills. It has 20 cash deficit.
As the owner of the Lie Dharma Company, you may start wondering:
- Why could this be happened?
- How do I solve the problem?
- How to prevent such problem from happening in the future?
Balance sheet is designed to answer almost any questions you may have in the financial area, as long as you know the logic behind the numbers.
To find the root of the problem, ask yourselves this question: Out of total asset values 137, why the cash balance is only 10, where is the rest?
Look at other accounts under the asset group, you will find the following accounts:
- Accounts Receivable = 85
- Inventory = 32
- Fixed Assets = 10
Now you can see that most of the asset’s values are in the “Accounts Receivable.” That is why Lie Dharma Company has cash deficit and is unable to settle all bills although the balance sheet shows positive net worth. It made great sales but most of them were credit that either have not due yet or have slow payment.
To solve the problem, you will need to put more effort in collecting the receivables with the following plans:
- Call on customers where invoices have been due already but have not paid yet
- Offer customers with ‘early payment-discounts’ where invoices have not due yet.
- Review the credit policy—shorten the payment term, be more selective in providing credit sales—to prevent the same problems occurring in the future.
As a conclusion, by understanding the logic behind a balance sheet one is able to know the company’s financial conditions, in the form of a comparison between company’s assets versus liabilities. That is why a balance sheet often called “Financial Position” report.
Another important part of a balance sheet one shouldn’t miss about is the ‘date of the balance sheet.’ On the example, the date shows “As of January 31, 2012,” means this is company’s financial position as of January 31, 2012. In other words, the balance sheet is the “Company’s financial Snapshot” on the January 31’ 2012.
2. Is the company in the profit or loss position?
Knowing the company’s net worth and its ability to finance liabilities, simply does not enough. As the owner, you also want to know whether:
- The company is in the profit or loss position
- The company is operated in the efficiently manner or the exact opposite
- The company’s resources are mostly spent in creating products/services or in other activities
The company’s “Income Statements” answers all the questions. Have a look at the next income statements example:
Here are main elements of Lie Dharma Company’s income statements and how they’re constructed (look at the corresponding alphabets):
(a) Revenues = 187
(b) Cost of Goods Sold (COGS) = 50
(c) Gross Profit = 137
(d) Expenses = 132
(e) Net Profit = 5
(a) Revenues – (b) COGS = (c) Gross Profit
(c) Gross Profit – (d) Expenses = (e) Net Profit
Among those elements, what is the most important for you as a business owner? The “Net Profit,” isn’t it? In the example, Lie Dharma Company’s operation for the month (January 1 to 31, 2012) results in 5 profit—which is extremely small compare to 187 in revenues. Your net profit margin is only 3% (=5/187.) Having such small net profit margin you may start wondering “How could this be happened? Wouldn’t be better if I just close the business and invest somewhere else?”
So you call someone whoever responsible for the statement in the accounting department and ask the same questions. Except she/he has a good understanding of the logic behind the statements, she/he would tend to answer you with “It is due to high cost”.
While it is true that higher cost results in lower profit, shouldn’t ‘high sales’ minus ‘high costs’ still result in ‘high profit’? So you knew there must be something wrong with the statements and you want the accounting staff to sort it out.
Firstly, the accounting department may recalculate every single number on the statements and compared to the ledger. Next they may compare the ledger with thousands of journal entries they made and millions of papers they have in the cabinets.
Couple of days (if not weeks) later, s/he come back and says “All numbers are accurately counted and no double entries were found in the ledger”. That’s exactly what I meant with “accounting graduates who are technically accounting-savvy, but lack of accounting and financial logic.”
If you’re one of them, no offense here, but you really owe yourself to learn and understand what is behind the numbers. By using the logic, you wouldn’t need to spend days (or weeks) in reviewing it and solving the problems. What you really need to do first is simply scan and sense numbers that look strange or probably shouldn’t be there at all.
Start it by looking at the ‘Revenues = 187’; ‘Cost of Goods Sold = 50’; and ‘Gross Profit’ = 137. Do these numbers make sense? Does ‘187-50=137’ make sense? Or does ‘a 187 in revenues results in 137 gross profit’ make sense? Stop and try to focus on these relationships.
To know if it makes sense or not, I have actually put a small tool subsequent the ‘Gross Profit’ line called ‘Gross Profit Margin’ shows 73% (=137/187). If yours does not have it, you may want to add one, in the future. So the question is now becoming: Does 73% in gross profit margin make sense?
If cost accountants are available in your company, you can call one of them and ask: what is the gross profit margin set for the products/services sold? If they aren’t, perform a comparison analysis quickly—get the previous income statement, put it beside your current statements, and see if the trend looks normal. That’s the modest way which is a good start.
Some well experienced accountants do not even need any trend analyses just to get a right gross profit margin sense. But they have actually done with their homework by keeping themselves updated with industry benchmark for gross profit margin range. For example: ’25-to-30%’ for manufacturing sector; ’50-to-70%’ for services sector; ’70-to-100%’ for trading; 150-to-200%’ for retailer; etc.
If, for example, Lie Dharma Company is a manufacturer, then 73% is considered high gross profit margin. With this sense, you can be sure the problem must not be in the ‘Cost of Goods Sold’ nor the ‘Revenues’ area. The only left is the ‘Expenses’ group. You’re instantly getting closer to the root of the problem.
Move on the expenses group to find any strange numbers in there. Again, you can always do a quick trend analysis by comparing current versus previous statements. I didn’t create previous statement example for this purpose, but I put red color on the strange number in the expenses area—for the sake of logic and sense. ‘Telephone Expense = 35’ in this example is the root of the problem. It is not realistic that ‘telephone expense’—in a manufacturing company—is greater than ‘Salary Expense’.
“Didn’t the accounting staff tell you that all numbers have been recounted and correct?” You may ask. YES. If the telephone expense has correctly reflects its actual bill, then the problem is not the number, but those who used the phone in inefficiently manner. What you need to do next probably send the HR Department a memo for follow up. In addition, you may also suggest the management to enforce more serious control on the telephone usage.
Understanding the logic behind a financial statements is vital not only for accountant but also for whoever need to know company’s financial conditions. It needs times and experience to accumulate such good financial logic and sense. If you’re a junior accountant and still need to improve your skill in this particular area, you can always ‘learn as you go’. Keeping your curiosity in the high level is a good start, and your braveness in following your instinct will take care of the rest.