Inadequate financial controls are responsible for 75% of business failures. That is, one or more of the following financial controls may be absent or inadequate:
- cash flow forecasts
- costing systems
- budgetary control
- monitoring of key performance indicators.
Why is this so? One of the reasons is that a large portion of management cannot ‘talk the language of business.’ Businesses exist to make a profit and to maximise returns to shareholders. So is it not essential that management at least understands what the financial statements represent and what the drivers of value are?
Let’s look at the annual financial statements of a company and more specifically how the balance sheet, income statement and cash flow statement are created and intertwined. We will achieve this by building up the financial statements as part of the process of a new business starting up, and the events and requirements which unravel over time. The intention is not to cover every nuance, but rather to establish a framework and the basic principles, thus enabling the user to better grasp the annual financial statements.
Understanding your financials
- A balance sheet shows the assets and liabilities of the business at a particular date, or where the business obtains funding and what it purchases.
- The income statement shows income, expenses and profits for a particular period.
- The cash flow statement shows the amount of cash received and used by the business.
Each of the actions below is numbered and the numbers correspond to the entries in the balance sheet, income statement or cash flow statement.
Assuming we are starting a new business, we have put together the business plan and are ready to get started.
- The first thing the business will need is money. This is typically obtained from shareholders or owners (equity) and loans (long-term and short-term, generally from banks). These are known as financing activities and result in an inflow of cash into the business.
- The business now needs to invest in fixed (long-term) assets such as property, motor vehicles, machinery and computers. These are known as investing activities and result in an outflow of cash from the business.
- Next we need some product to sell so we purchase stock. An increase in stock results in an outflow of cash from the business, while a decrease results in an inflow. Stock, together with debtors and creditors, make up the working capital and are short-term.
- Assuming the above stock was purchased on credit, we now have creditors or accounts payable, that is, people or businesses to whom we owe money. An increase in creditors results in an outflow of cash from the business, while a decrease results in an inflow.
- We sell some stock and generate revenue, also known as sales or turnover. Revenue is units sold x selling price.
- The difference between the selling and the purchase price of units sold is gross profit.
- As the sales were on credit, we now have debtors or accounts receivable, that is, people or businesses who owe us money. An increase in debtors results in an outflow of cash, while a decrease results in an inflow.
- The business has various other expenses for administration, selling and marketing, which are deducted from the gross profit. The profit remaining is called earnings before interest, tax, depreciation and amortisation (EBITDA). Simplistically, EBITDA will be used in the cash flow statement as the proxy for the cash flow from operations.
- When we purchased the various fixed assets (point 2) only the balance sheet and cash flow statement were affected. However, we are allowed to deduct an annual expense called depreciation, which further reduces profitability. Depreciation is calculated by taking the purchase price and dividing it by the number of years of its useful life. For example, depreciation for machinery purchased for R100 with a useful life of five years will be R20 per annum charge. Amortisation would apply in the same way and refers to patents and goodwill. Depreciation and amortisation are both non-cash flow items, that is, they are book entries and do not affect the cash balance, only profitability.
- Lenders are paid interest on their loans next and we have earnings before interest and tax (EBIT), also known as operating income.
- Taxes are deducted next resulting in net profit after tax (NPAT), or net income.
- If the company decides to reward shareholders for their investment and the risks taken, they are paid dividends. There is no obligation to pay dividends. What is left of the profits after dividends are paid is called retained income and is retained in the business to help fund future growth, replacement or new assets, such as machinery and motor vehicles.