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living in the world. Despite all this, it™s no secret that many in
government, the church, and society at large have a deep-
seated distrust of our profit-motivated, free enterprise, and
open market system”and not entirely without reason.
It would be naive to ignore the abuses and failings of the
profit system and not to take notice of the ruthless profit-at-
any-cost behavior of some unscrupulous business managers.
Unfortunately, you don™t have to look very far to find examples
of dishonest advertising, unsafe products, employees being
cheated out of their pensions, dangerous working conditions,
or deliberate violation of laws and regulations.
Too many companies travel the low moral and ethical road.
A form of Gresham™s law* seems to be at work. Dirty practices
tend to drive out clean practices, the result being a sinking to
the lowest level of tolerable behavior. Which is very sad. No
wonder profit is a dirty word to so many. No wonder business
gets bad press. Ethical standards should be above and ahead
of what the law requires.
Many businesses have adopted a formal code of ethics for
all employees in the organization. It goes without saying that
managers should set the example for full-faith compliance
with the code of ethics. If managers cut corners, what do they
expect employees to do? If managers pay only lip service to
the code of ethics, employees will not take the code seriously.




*You may recall that Sir Thomas Gresham was a sixteenth-century econo-
mist who is generally credited with the important observation that, given
two types of money circulating in the economy, the one perceived as more
dear or of higher quality will be kept back and spent last; the cheaper or
lower-quality money will be offered first in economic exchange. Thus, the
cheaper money will drive out the higher-quality money. Even though we
have only one currency in the American economy, you may have noticed
that most of us tend to pass the currency that is in the worst shape first and
hold back the bills that are in better condition.

10
2
CHAPTER




Introducing Financial
Statements



T
This chapter introduces the financial statements that are
included in periodic financial reports from a business to its
shareowners and lenders. They are called external financial
statements to emphasize that the information is released out-
side the business. Let me stress the word introducing in the
chapter title. One brief chapter cannot possibly cover the
waterfront and deal in a comprehensive manner with all
aspects of external financial statements. This chapter™s objec-
tive is more modest and more focused.

My main purpose is to explain the basic content and structure
of each financial statement in order to provide stepping-
stones to later chapters, which develop models of profit, cash
flow, and financial condition for management decision-making
analysis. External financial statements are not designed for
management use; they are designed for outside investors and
lenders who do not manage the business. External financial
statements report results, but not how and why the results
happened.


THREE FINANCIAL IMPERATIVES,
THREE FINANCIAL STATEMENTS
Without a doubt, managers should understand the external
financial statements of their business that are reported to

11
FINANCIAL REPORTING


shareowners and lenders, whether the managers own shares
in the business or not. Financial statements are the basic
touchstone of every business. A separate, distinct financial
statement is prepared for each of the three financial impera-
tives of every business:
• Make profit. The income statement (also called the profit
and loss statement) summarizes the revenue and expenses
of the business and the profit or loss result for a period of
time such as one year.
• Generate cash flows. The statement of cash flows summa-
rizes the various sources and uses of cash of the business
for the same period as the income statement.
• Control financial condition. The balance sheet (also called
the statement of financial condition) summarizes the vari-
ous assets and liabilities of the business at the end of the
income statement period, as well as how much of the
excess of assets over liabilities was invested by the share-
owners in the business and how much is attributable to the
cumulative profit over the life of the business that was not
distributed to its shareowners.
A business is profit-motivated, so its income statement (the
financial statement that reports the profit or loss of the busi-
ness for the period) occupies center stage. The market value
of the ownership shares in the business depends heavily on
the profit performance of the business. A business has to earn
enough operating profit to pay the interest on its debt, so its
lenders also keep sharp eye on profit performance.


A Business Example
I use a realistic business example to illustrate and explain the
three external financial statements. This business manufac-
tures and sells products to other businesses. It sells products
from stock; in other words, the business carries an inventory
of products from which it makes immediate delivery to cus-
tomers. The business sells and buys on credit. It has invested
in many long-life operating resources”buildings, machines,
equipment, tools, vehicles, and computers. The business was
started many years ago when several persons invested the ini-
tial ownership capital in the venture.
The business borrows money from banks on the basis of

12
I N T R O D U C I N G F I N A N C I A L S TAT E M E N T S


short-term notes (having maturity dates less than one year)
and long-term notes (having maturity dates three years or
longer). The business has made a profit most years, but suf-
fered losses in several years. To grow the business the share-
owners invested additional capital from time to time. But the
main reason for the increase in owners™ equity is that the
business has retained most of its annual profits in order to
build up the capital base of the company instead of distribut-
ing 100 percent of its annual profits to shareowners.
For the year just ended, the business recorded $26 million
sales revenue; this amount is net of discounts given customers
from list or billed prices. The company™s bottom-line profit
after deducting all expenses for the year from sales revenue is
$2.2 million. Bottom-line profit is called variously net income,
net earnings, or just earnings. (The example assumes that the
business did not have any nonrecurring, unusual, or extraor-
dinary gains or losses during the year.) Profit equals 8.5 per-
cent of sales revenue, which is typical for this industry ($2.2
million profit · $26 million sales revenue = 8.5%).


The business uses accrual-basis accounting to meas-
ure profit and to prepare its balance sheet (state-
ment of financial condition). All businesses of any size that sell
products and have inventories and that own long-lived operat-
ing resources use accrual-basis accounting. Accrual-basis
accounting is required by financial reporting standards and by
the federal income tax law (with some exceptions for smaller
businesses). Business managers should have a good grip on
accrual-basis accounting, and they should understand how
accrual-basis accounting differs from cash flows.


ACCRUAL-BASIS ACCOUNTING
Before introducing the financial statements for the business
example, I present Figure 2.1, in which cash flows are sepa-
rated from the accrual-basis components for sales and
expenses. (I culled this information from the accounts of the
business.) Figure 2.1 is not a financial statement. Rather, I
present this information to lay the groundwork for the busi-
ness™s financial statements. This figure presents the basic build-
ing blocks for sales revenue and expenses and for cash flows

13
FINANCIAL REPORTING




Note: Amounts are in millions of dollars.

Revenue and expense cash flows
Note: Cash flows include amounts related to last year™s
and next year™s revenue and expenses.

Accrual-basis sales revenue and expenses
Note: Revenue and expenses are of this and only this
year; only one year is involved.

$3.2 $22.5 $3.5
Cash collections during Cash collections during Sales made during the
the year from sales year from sales made year but no cash col-
Y
$25.7 during the year. $26.0 lected during the year;
made last year or for
sales to be made next cash will be collected
FL
year. next year or was
already collected last
year.
AM


less less
TE




$7.5 $14.9 $8.9
Cash payments during Expenses recorded dur-
Cash payments during
the year for expenses of $22.4 the year for expenses of $23.8 ing the year but not
the year. paid during the year;
last year or next year.
cash was paid either in
previous year or will be
paid next year.

$3.3 $2.2
Net cash flow during year Net profit for year according
from operating, or profit- to accrual-basis profit
making activities. accounting methods.

FIGURE 2.1 Cash flow and accrual components of sales revenue and
expenses for the year just ended for the business example.




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I N T R O D U C I N G F I N A N C I A L S TAT E M E N T S


during the year. This information also is very helpful to under-
stand the balance sheet, which is explained later in the chapter.


Sales Revenue and Cash Flow from Sales Revenue
The revenue from most of the sales during the year was col-
lected during the year”neither before the year started nor
after the year ended. In Figure 2.1, observe that the company
collected $22.5 million cash during the year from sales made
during the year.* To complete the accrual-basis sales revenue
picture for the year you have to consider sales made during
the year for which cash was not collected during the year. To
complete the cash flow picture you have to consider other
sales-driven cash flows during the year, which are either from
sales made last year or from sales that will be made next year.
In summary (see Figure 2.1 for data):
• Accrual-basis sales revenue for year: $22.5 million cash
collections during the year from sales made during the year
+ $3.5 million sales made during the year but cash not col-
lected during year = $26 million sales revenue for year
• Sales revenue“driven cash flows during year: $22.5 mil-
lion cash collections during the year from sales made dur-
ing the year + $3.2 million cash collections during year
from last year™s sales or for next year™s sales = $25.7 million
cash flow from sales revenue


Expenses and Cash Flow for Expenses
Many expenses recorded in the year were paid in cash during
the year”neither before the year started nor after the year
ended. In Figure 2.1, note that the company recorded $14.9
million total expenses during the year for which it paid out
$14.9 million cash during the year. Many expenses are paid
weeks after the expense is originally recorded; the business
first records a liability on its books for the expense, and the
liability account is decreased when it is paid. To complete the

*The business makes many sales on credit, so cash collections from sales
occur a few weeks after the sales are recorded. In contrast, some customers

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