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Financial Reporting

Create Financial Statements… Properly

Being able to create accurate balance sheets, income statements and cash flow statements could be the difference between business success and failure.

Steven Delport

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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.

  1. 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.
  2. 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.
  3. 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.
  4. 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.
  5. We sell some stock and generate revenue, also known as sales or turnover. Revenue is units sold x selling price.
  6. The difference between the selling and the purchase price of units sold is gross profit.
  7. 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.
  8. 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.
  9. 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.
  10. Lenders are paid interest on their loans next and we have earnings before interest and tax (EBIT), also known as operating income.
  11. Taxes are deducted next resulting in net profit after tax (NPAT), or net income.
  12. 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.

Steven Delport is the founder of Integer Consulting Solutions (Pty) Ltd. Integer Consulting Solutions helps: • Improve business performance and strategic direction, • Understand finance and business acumen, and • Develop individual’s knowledge of self. This three pronged approach helps improve profitability and cash flow while integrating strategy, operations and finance. Steven holds both a MBA and a Certificate Programme in Leadership Coaching from Wits Business School. He has extensive business experience having worked in the banking and consulting industries for more than 20 years and works with a number of business schools in the areas of strategy, finance, leadership development and coaching. For more information, please visit www.integerconsultingsolutions.com and find him on Google+.

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1 Comment

1 Comment

  1. Ife Uma

    Sep 15, 2012 at 15:24

    An often overlooked but very important aspect of any startup business. Thanks for the post.

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Entrepreneur Today

Small Business Has A Critical Role To Play In The Economy – But Entrepreneurs Need Better Financial Skills

While government is stepping up to support small business more than ever before, the sector will not thrive unless entrepreneurs are also equipped with the financial tools to optimise their organisations – UCT Associate Professor Mark Graham.

Entrepreneur

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The role of small business in promoting growth and development has shot to the top of the agenda this year with both President Ramaphosa in his inaugural SONA and Minister Malusi Gigaba in his budget speech highlighting the critical role of this sector of the economy.

Globally, SMMEs are recognised as one of the key drivers of economic growth and job creation – and it is clear that the small business sector has led the world out of several global recessions – but in South Africa, the sector is under-performing.

Entrepreneurs need help to become sustainable

Recent data from the Global Entrepreneurship Monitor shows that South African entrepreneurship lags behind that in similar economies. And for every 1.5 people who were engaged in early-stage entrepreneurial activity in SA in 2016, one was exiting a business.

According to Mark Graham Associate Professor in Accounting at the University of Cape Town, typical reasons for business failure include: insufficient start-up funding, incorrect pricing for products or services, growing too quickly or prematurely, and inadequate cash flow.

Related: How to Improve Your Company’s Financial Management

“We need entrepreneurs to run their businesses successfully so that they can be sustainable,” he says. “Most of these issues can be addressed through a proper understanding of financial and accounting principles and concepts to help entrepreneurs run their businesses better.”

A growing understanding of financial principles

Graham, who runs the Finance for Non-Financial Managers programme at the UCT Graduate School of Business (GSB), emphasises that finance and accounting terms are really just a language that uses numbers to tell a story about a business.

“If you understand the fundamentals of financial principles you will be able to analyse what is happening in any organisation,” says Graham.

“Concepts like profit and cash flow are basic to business. However, people are often surprised to find that while a business can be extremely profitable, there may be a cash flow problem that will soon bring it to its knees.

Most people don’t know the basics of financial reports, what the right capital structure (i.e. the mix of debt and equity) might be. By getting to grips with concepts like working capital management and cash flow vs profit, business owners and managers can give themselves the best chance of success.”

Financial literacy is key to entrepreneurial success

Jannie Rossouw, head of Sanlam’s Business Market, agrees that financial literacy is key to entrepreneurial success and has argued that it should be integrated into the school curriculum so that future business owners can understand critical concepts like the time value of money.

“It is imperative that SA starts to spend significant time and resources to address the need for access to quality education aimed at those who want to pursue entrepreneurship and business ownership. We shouldn’t only start teaching these skills at the tertiary level,” says Rossouw.

And it is not just entrepreneurs that would benefit from a better grasp of the basics of finances, says Graham. All businesses should invest in developing the financial skills of their people – especially those in managerial roles.

Related: Create Financial Statements… Properly

“It is important for everyone working in business to understand the basic language of business and demystify the jargon – which is one of the things that the course I run at the GSB seeks to do,” he says.

“Feedback from previous course participants shows that people really appreciate being able to see how the numbers are telling a story about the health – or lack thereof – of a business and that this helped them make better business choices.”

Financial tools are needed to optimise businesses

“Sustainable small businesses have big potential to make a significant contribution to the SA economy and put a dent in the unemployment figures. So when Gigaba said that by enabling new businesses with new ideas to emerge and thrive, ‘we are radically transforming patterns of production in the economy’ he is not wrong.

But unless serious steps are also taken to equip owners and managers with the financial tools to optimise their companies, we will find that despite more proactive government policies and funding, the small business sector will still not thrive.”

Related: Want To Know Your Numbers? 3 ACCA Accounting Online Courses Your Can Take For Free

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Financial Reporting

Build A Financial Model

Start-ups often struggle to develop a suitable financial model for their new businesses. Here are some of the most important financial modelling considerations.

Jason Sive

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All budding entrepreneurs spend long hours typing up a well versed strategy document for their new entity, as expected. However, very often there is insufficient time allocated to the crux of the business, the numbers.


Definition: Financial modelling is the process by which a firm constructs a financial representation of some, or all, aspects of its business.


Related: Financial Focus For Your Business In Different Growth Stages

For any new start-up entity the initial necessity for assessing potential returns on new investment or seeking external funding can be a daunting process. Whether you are soliciting funds from an institution, or a high net worth individual investor, the financial projections could make or break your deal.

Although you as the founder are naturally optimistic about the new venture, be mindful that most investors would rather see the worst case scenario. This allows the potential investor/banker to take a realistic view on the maximum potential losses, should the business fold in the first 12 – 24 months. As such, it is recommended to produce a low, middle and high road model, for a three to five year period.

Inputs and outputs

financial-inputs-and-outputs

Most importantly, always keep in mind that your financial model is nothing more than certain inputs producing certain outputs. By designing the model correctly, a user should be able to change certain inputs to assess the impact of these changes on the related outputs (commonly referred to as a ‘what if analysis’ or ‘stress testing’ a model).

By way of a simple example, your sales revenue line for any specific month should be a function of the number of products sold, at a specific sales price.

For ease of use, both you and a potential investor should be able to adjust either of these variables in order to see how resilient the business model is, should your assumptions be incorrect.

Related: 3 Ways Emerging Entrepreneurs Run Financially Sound Businesses

Other basic recommendations when building your model:

  • Create an assumption page, clearly defining any assumptions on which the model is built. By linking certain variables to the assumption page the model becomes robust and user-friendly.
  • Be as transparent as possible, showing all formulae that lie behind calculations. This allows the user to easily follow logic through the model.
  • Aim for simplicity and ease of understanding. Over-complicating a financial model with unnecessary worksheets can confuse and overload the reader.
  • When inputting projected overheads, deal with each line item separately, without consolidating. This demonstrates detailed thinking, and allows discussion around each expense if necessary.
  • The model should evolve with the business. You should be looking to check the assumptions made at the inception of the business, with the reality of what is achievable, after having the benefit of hindsight. By tweaking the numbers accordingly, the model becomes a more accurate prediction of the business in the future. This should be an ongoing process.
  • Beware of attempting to use a generic template that may not apply to your business. Trying to customise these generic models could complicate a would-be simple model. Building your own bespoke model from scratch is the cleanest approach, even if assistance is necessary. This forces you to learn the intricacies of your model, which will hopefully stand you in good stead.
  • Many books and websites recommend a myriad of options when it comes to building financial models. As a principle, lean towards the concept of simplicity, provided you are able to integrate your model into regular projected income statement, balance sheet and cash flow statements.

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Financial Reporting

Are You Crunching The Right Numbers?

Measure what matters and you will find hidden money in your business.

Monique Sharland

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Abacus

Defining true profits

Just because you sell at a profit, is that enough to be profitable? A mistake that many business owners make is that they don’t factor in net profit when calculating selling price.

The natural tendency of business owners is to focus on sales growth rather than net profit. So, what is net profit? Profit is on paper — it is not in the bank. It is the money left over each month after deducting all the cost of sales and expenses it generates and subtract them from all the revenue it creates. Net profit is also calculated after paying a market-related salary to the business owners.

Related: Trends In Investing For Entrepreneurs In South Africa

Identifying the winners

What are your profitable products or services, and which aren’t? Gross margin is the most important component of any business as it enables your business to pay its overheads, pay you and make a net profit to continue to grow and be protected from adverse economic times.

Gross margin is calculated by taking the gross profit, that is, the selling price less the cost of the product or service, expressed as a percentage over sales. Most business owners make the mistake of just measuring gross margins, and if they are being achieved, cannot understand why there is no money in the bank. To find hidden money, gross margins cannot be calculated alone.

Measuring cash flow together with gross margins for each and every product you sell or service you provide will determine which products or services make you money, and which don’t. For example, if product X has a gross margin of 33,3% and takes six months to sell, you have effectively lost your margin as money has been used to finance the product instead of being utilised to purchase more of the same products at a far higher turnaround.

Profitable relationships

Abacus-counting

Which customers make you money, and which don’t? You need to know how much of each product or service each customer has purchased from you and the gross margin earned on each of those products or services sold and how much money each one owed your business at any given time.

This analysis will determine the profitability of each customer. If your marketing efforts are directed only at those customers that give you a higher gross margin without also measuring the cash flow of that customer, you’ll be making the unwitting mistake of selling to some of the least profitable customers.

Unlike products and services, customers are people, some very nice, others either hostile or simply undesirable. If you have any hope of building a business that maximises profit, fun, and your free time, you should focus on attracting customers that respect you and your team, who allow you to use your full talents, are respectful of your time and have reasonable expectations and demands of your business.

If a customer does not resonate with you and your business, don’t deal with them, as they will invariably take a chunk of profit from your business, and that’s not a good thing, is it?

Related: Understanding Total Return of Investment

Return on investment

Your business cannot make money for you if your investment in assets increases at a faster rate than your net profit. The two assets we are concerned about are inventory and accounts receivable.

Let’s say your inventory and accounts receivable increases by R58 000 and your net profit was only R35 000 for the same year, you will not see money in your bank. Don’t fall into the trap of increasing net profit and ignoring your business’s overall investment in assets.

By measuring what matters, you’ll be amazed how you can find hidden money lying in your business.

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