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- Herausgeber: John Wiley & Sons
- Kategorie: Fachliteratur
- Sprache: Englisch
Gain a comprehensive understanding of how businesses produce, report, and utilize essential financial information! In this companion to How to Read a Financial Report, 9th Edition, bestselling financial author Tage Tracy delivers timeless knowledge on one of the most important functions of every business operating within the free market. Designed for managers, entrepreneurs, investors, and others who deal with vital financial information and the production of financial statements & reports "on the inside," Business Financial Information Secrets shows you how to produce, understand, and utilize financial information to the greatest effect for your business and the economy at large. This book guides you through the surprisingly clean and simple process of proper accounting and reporting, regardless of your organization's size or structure. Cash flow and business capital management are covered extensively throughout the book as without a thorough understanding of these all-important concepts, you could be lacking critical information about the lifeline of your business. To sharpen your business skills and avoid preventable losses, read Business Financial Information Secrets. You'll learn everything you need to know about Profit & Loss Statements, Balance Sheets, and Cash Flow Statements, along with externally produced reports, additional internal financial information, and all the ins and outs of ensuring that reports are always 100% accurate. Topics include: * Producing best-in-class financial information by learning finance terms, calculations, and standard reports * Understanding where financial information originates and how it flows from one type of report to the next * Analyzing financial information so you can generate meaningful insights for internal and external stakeholders * Discovering why financial information is so critical and learning how to use it to your advantage * Expanding your knowledge of how a business generates and consumes cash including the secrets to successfully raising debt or equity capital * Deciphering how companies can "Engineer" financial results and when profits are real versus manufactured Use this book for cost-effective solutions to provide reliable and timely financial information to shareholders, investors, lenders, analysts, government agencies, and beyond.
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Seitenzahl: 371
Veröffentlichungsjahr: 2021
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Table of Contents
Cover
Title Page
Copyright
Preface
Acknowledgments and Dedication
About the Author
PART ONE: THE
WHAT
,
WHEN
, AND
WHERE
OF PRODUCING BEST‐IN‐CLASS FINANCIAL INFORMATION
CHAPTER 1: The Big Three Financial Statements
STARTING WITH A QUICK BACKSTORY
THE FINANCIAL REPORTING BEDROCK
THE INCOME STATEMENT, AKA PROFIT AND LOSS (P&L)
THE BALANCE SHEET
THE STATEMENT OF CASH FLOWS
CHAPTER 2: Externally Prepared Financial Statements and Reports
THE ROLE AND IMPORTANCE OF EXTERNAL FINANCIAL REPORTING
PRIMARY EXTERNAL REPORTING DRIVERS
THE FINANCIAL REPORT VERSUS FINANCIAL STATEMENTS
TYPES OF EXTERNALLY PREPARED FINANCIAL STATEMENTS
CHAPTER 3: Internally Generated Financial Information
THE SHOTGUN VERSUS THE RIFLE
THE BASICS OF GENERATING INTERNAL FINANCIAL INFORMATION
A DEEPER DIVE AND EXAMPLE OF INTERNAL FINANCIAL INFORMATION
IN SUMMARY – DON'T MAKE THESE ROOKIE MISTAKES!
CHAPTER 4: The Importance of Completeness
ESSENTIAL TO UNDERSTANDING THE BIG PICTURE
BARELY ACCEPTABLE (THE WORLD OF SMALL BUSINESSES)
BETTER AND APPROPRIATE FOR THE EXTERNAL AUDIENCE
LET'S TAKE IT UP A NOTCH TO BEST IN CLASS
COMPLETENESS REVISITED
CHAPTER 5: Accuracy versus Reliability, Not to Be Confused
DO NOT CONFUSE THESE TWO CRITICAL AND INTERCONNECTED CONCEPTS
A CRASH COURSE IN ACCOUNTING
KEY ACCOUNTING THEORIES, CONCEPTS, AND TRENDS
ROUNDING OUT OUR DISCUSSION
CHAPTER 6: Reliability and Timeliness, the Best of Friends
PRODUCING RELIABLE FINANCIAL INFORMATION
BETTER LATE THAN NEVER, OKAY FOR EXTERNAL PARTIES
BETTER LATE THAN NEVER DOES NOT FLY INTERNALLY!
RELIABILITY, TIMELINESS, AND THE FINANCIAL STORY
CHAPTER 7: Business Cycles and Financial Connections
OUR COMPANION BOOK –
HOW TO READ A FINANCIAL REPORT
THE SALES CYCLE
THE PURCHASING CYCLE
THE OPERATING EXPENSE CYCLE
THE INVESTMENT AND FINANCING CYCLES
PART TWO:
HOW
TO ANALYZE FINANCIAL INFORMATION AND ITS MEANING
CHAPTER 8: Basic Financial Ratio Analysis and Terminology
PURPOSE AND STANDARD TERMINOLOGY
A BIT MORE DEPTH ON OUR CASE STUDY BUSINESS
BENCHMARK FINANCIAL RATIOS – FINANCIAL STRENGTH AND SOLVENCY
BENCHMARK FINANCIAL RATIOS – FINANCIAL PERFORMANCE
CHAPTER 9: Advanced Financial Ratio Analysis and Terminology
PURPOSE AND ADVANCED TERMINOLOGY
ADVANCED BENCHMARK FINANCIAL RATIOS AND CONCEPTS
A FINAL PIECE OF ADVICE
CHAPTER 10: Projections and Forecasts – Living, Rolling, and Breathing
THE IMPORTANCE OF BUSINESS FORECAST MODELS
MANAGING THE FORECASTING PROCESS
INCREASING THE POWER AND VALUE OF YOUR FORECAST
FORECAST EXAMPLES
FORECAST SECRETS AND THE BIG PICTURE
CHAPTER 11: Flash Reports and Key Performance Indicators
I FEEL THE NEED FOR SPEED
PRIMARY FLASH REPORT CHARACTERISTICS
KEY PERFORMANCE INDICATORS
A FEW PARTING THOUGHTS
CHAPTER 12: Wall Street's Latest Trick – Financial Engineering
WHAT FINANCIAL ENGINEERING IS NOT
WHAT FINANCIAL ENGINEERING IS
PART THREE:
WHY
FINANCIAL INFORMATION IS SO CRITICAL AND HOW TO USE IT TO YOUR ADVANTAGE
CHAPTER 13: Capitalizing a Business
THE NEED FOR FINANCIAL CAPITAL AND A BUSINESS PLAN
THE BUSINESS PLAN
TYPES OF AVAILABLE CAPITAL
THE NATURE OF DEBT CAPITAL
OUR SAMPLE COMPANY'S FIRST YEAR PERFORMANCE – EYES OF THE LENDER
CHAPTER 14: Net Profits and Cash Flow – Real or Imaginary?
LET'S START WITH THE OBVIOUS
FIXED, VARIABLE, AND SEMI‐VARIABLE EXPENSES
GENERATING REAL PROFITS
MANUFACTURING IMAGINARY PROFITS
CASH FLOW AS OUR VALIDATION
CHAPTER 15: Business Valuations – Why and How?
WHY VALUE A BUSINESS?
HOW TO VALUE A BUSINESS?
CLOSING COMMENTS AND A CAUTIONARY WORD ABOUT THE FED!
CHAPTER 16: Business Acquisitions – The Basics
TYPES OF BUSINESS ACQUISITIONS
BUSINESS VALUATION ADJUSTMENTS
TYPES OF CONSIDERATION RECEIVED
ADDITIONAL BUSINESS ACQUISITION TIPS AND TIDBITS
CHAPTER 17: Deciphering the Cap Table
CRITICAL KNOWLEDGE TO HELP MAINTAIN CONTROL OF YOUR BUSINESS
EQUITY DISGUISED AS DEBT
PREFERRED EQUITY AND THE REAL CONTROL
COMMON EQUITY, OPTIONS, AND WARRANTS
OUR FINAL RAISING CAPITAL TIPS, TIDBITS, AND TRAPS
Index
End User License Agreement
List of Illustrations
Chapter 1
EXHIBIT 1.1 Audited Income Statement
EXHIBIT 1.2 Audited Balance Sheet
EXHIBIT 1.3 Audited Statement of Cash Flows
Chapter 3
EXHIBIT 3.1 Unaudited Internal Income Statement
EXHIBIT 3.2 Unaudited Operating Division Income Statement
EXHIBIT 3.3 Unaudited Company Sales Report by Primary Software/SaaS Product Line
Chapter 4
EXHIBIT 4.1 Example Small Company Unaudited Balance Sheet
EXHIBIT 4.2 Example Small Company Unaudited Income Statement
Chapter 7
EXHIBIT 7.1 Sales Cycle Financial Transaction Flows
EXHIBIT 7.2 Purchasing Cycle Financial Transaction Flows
EXHIBIT 7.3 The Investment and Financing Financial Transaction Flows
Chapter 10
EXHIBIT 10.1 Unaudited Income Statement Forecast – High, Medium, and Low
EXHIBIT 10.2 Unaudited Balance Sheet Forecast – High, Medium, and Low
EXHIBIT 10.3 Unaudited Statement of Cash Flows Forecast – High, Medium, and Low
Chapter 11
EXHIBIT 11.1 DTC Business Unaudited Sales Flash Report
EXHIBIT 11.2 DTC Business Audited Mini‐P&L Flash Report
Chapter 13
EXHIBIT 13.1 Unaudited Debt Covenant Analysis and Summary Income Statement
Guide
Cover
Table of Contents
Begin Reading
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Business Financial Information Secrets
How a Business Produces and Utilizes Critical Financial Information
Tage C. Tracy
Copyright © 2021 by John Wiley & Sons, Inc. All rights reserved.
Published by John Wiley & Sons, Inc., Hoboken, New Jersey.
Published simultaneously in Canada.
No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per‐copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750‐8400, fax (978) 750‐4470, or on the web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748‐6011, fax (201) 748‐6008, or online at http://www.wiley.com/go/permission.
Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages.
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Library of Congress Cataloging‐in‐Publication Data:
Names: Tracy, Tage C., author.
Title: Business financial information secrets : how a business produces and utilizes critical financial information / Tage C. Tracy.
Description: Hoboken, New Jersey : Wiley, [2021] | Includes index.
Identifiers: LCCN 2021014561 (print) | LCCN 2021014562 (ebook) | ISBN 9781119779001 (paperback) | ISBN 9781119779032 (adobe pdf) | ISBN 9781119779056 (epub)
Subjects: LCSH: Financial statements. | Business enterprises—Finance.
Classification: LCC HF5681.B2 T735 2021 (print) | LCC HF5681.B2 (ebook) | DDC 658.15/12—dc23
LC record available at https://lccn.loc.gov/2021014561
LC ebook record available at https://lccn.loc.gov/2021014562
Cover Design: Wiley
Cover Image: © mucahiddinsenturk/Shutterstock
Preface
When we first entertained the idea of writing Business Financial Information Secrets, we were a bit apprehensive about the idea – but not for the reasons you might think. There is no question that the financial, accounting, and strategic business content and concepts covered in this book represent essential knowledge that business owners, executives, board members, managers, external analysts, lenders, investors, and similar parties must know and understand how to utilize as a strategic weapon in today's rapidly evolving and changing global economy. In fact, we have never been more bullish on the material presented in this book, along with our companion book, How to Read a Financial Report, ninth edition, as it represents “evergreen” business knowledge covering the subjects of business accounting, financing, capital management, and planning.
Rather, our concerns lay more with the macroeconomic and political environments that have, since the start of 2020, gripped and consumed the world, which has seen an unprecedented response by governments and central banks across the globe. To drive home our point, think about this fact for a moment: Since the birth of the United States of America's Central Bank, known as the Federal Reserve System (or simply the Fed) in 1913, it took approximately 95 years to accumulate approximately $1 trillion in assets on its balance sheet (and basically the same amount of currency). Over the past 12 years, from 2008 through 2020, the Fed's balance sheet has grown from roughly $1 trillion to approximately $7 trillion (7x growth) to combat two major economic corrections, including the Great Recession from 2008 through 2010 and the COVID‐19 economic shock experienced starting in 2020. If this does not gain your attention (and concern), then layer on this fact as well: Total global debt was approximately $87 trillion at the end of the 2000 compared to a global GDP of roughly $50 trillion (representing a ratio of 174%). By the end of 2020, total global debt had risen to an unbelievable estimated figure of $277 trillion compared to an estimated global GDP of approximately $88 trillion for 2020 (representing a ratio of 315%). These trends are simply not sustainable, as the only real reason more and more debt can be absorbed is via historically low interest rates (now less than 1% for most of the world's public debt issued by developed countries) combined with ultra‐accommodative terms.
So why our apprehension, you may ask, as it would appear now more than ever that the material presented in this book represents critical knowledge? The answer lies in the fact that between Wall Street (via the Fed) and Washington (not to mention countries and their respective banks from around the world), the current mindset seems to be centered on giving away free money.
That is, if you believe the Fed and the federal government are on the right path by handing out free money via loans (if you can call them that) with no regard for whether a company, individual, public entity, and so on can repay the loan, then this book is not for you. There is no point in understanding critical financial information, reports, analyses, sources and uses of capital, cash flow, and so on, as with free money raining down like there is no tomorrow, why even bother? Just load up on debt, spend it rapidly in unproductive ventures, cry poor or blame someone else, and then request another loan (i.e., wash, rinse, repeat). Better yet, why even bother with having accountants, business analysts, financial officers, or even the IRS, as in this bizarre new world financial accountability is not required?
Okay, we know this is a certainly a reach and yes, we are being sarcastic, but given the current policies being implemented at both the monetary and fiscal levels, the question does have to be asked about the financial viability not just of businesses but, even more importantly, at the governmental and country levels as well. This is where we became enthralled with writing this book, as the concepts and material presented are even more important and relevant today than ever before for individuals, businesses, governments, and countries alike. Our position is simple in that proper accounting and financial reporting will always be an essential and critical function of every business operating in free markets and economies around the globe.
This book, along with How to Read a Financial Report, have been written to assist the reader in gaining the most complete and comprehensive understanding of how businesses produce, report, distribute, analyze, and use financial information. While How to Read a Financial Report is focused on external users and readers looking in (from the outside in), Business Financial Information Secrets is focused on internal producers and users of financial statements/information (from the inside out). A wide range of topics will be covered, specifically focused on the difference between externally prepared financial reports and statements and internally generated financial information, with additional attention placed on raising capital, managing cash and liquidity, and understanding how a business generates and consumes cash.
In summary, the material presented in this book does not represent a luxury (i.e., it is nice to understand this content), as for internal and external users of the financial information to succeed in today's business world, this book offers must‐have knowledge. Further, and a concept that we harp on time and time again throughout this book, if you do not understand a business's cash flows and financial capital resources, you will most likely fail to understand its very bloodline that keeps it alive, in good times or bad. So fail here, and you are possibly placing the very existence of your business at risk.
And to leave you with one final thought before you dive headfirst into the book, a simple reference to a quote from a movie might help explain the current economic environment and risks present. In the movie Jurassic Park, Dr. Allan Grant realized that the power of life (in the form of dinosaurs finding a way to reproduce) was far greater than the control over “unauthorized” breeding trying to be administered by the fictitious corporation known as InGen. As he so eloquently noted (by confirming that Dr. Ian Malcom was also correct in his assessment), “life found a way.” In the same respect, free markets will eventually find a way to function in an economically viable manner and be allowed to correct, adjust, and survive, as the central control being administered over the markets (by both the Fed and the federal government) will eventually give way to what will most likely be an extremely violent and painful correction – all in the name of Adam Smith's theory on markets and the invisible hand.
That is, invisible forces will act in such a powerful way that the laws of supply, demand, and individual pressures will result in the natural flow of resources, capital, and price discovery (beyond anything the central planners can control).
We absolutely believe that this will be the case as, with most of the world's global economy now based on some form of capitalism, it will only be a matter of time before natural economic market forces find a way to not only survive but thrive moving forward. This book is designed to make sure you have at least a fundamental understanding of the basic principles of business financial information, what is needed, where it comes from, when it is needed, how it is used, and why it is so important!
Note: We have prepared all of the exhibits in this book as Excel worksheets, which can be requested via email, free of charge, by reaching out [email protected].
Acknowledgments and Dedication
We would like to express our utmost thanks to John Wiley & Sons, Inc., (commonly referred to as Wiley) for their continued support of our quest to produce and distribute relevant, timely, and critical accounting, financial, and business planning content to assist readers around the globe. Wiley has been a trusted partner to me and my father for over 30 years, during which time 15 books (including updated editions and this current title) have been published in over a dozen different languages. Wiley's current team, led by Kevin Harreld and Susan Cerra, have been a pleasure to work with as their level of professionalism, experience, and knowledge in this space is unmatched. This rings especially true at the time of this publication given the significant economic, political, social, environmental, and global health challenges facing basically all businesses throughout the world.
Taking the lead role in authoring this book, I would like to dedicate this project to, first, my parents: my dad, who turned a spry 86 years old in late 2020, and my mom, who passed away in 2017. I cannot tell you how much invaluable guidance my dad has provided on the topic of writing books as he encouraged me to take over the family business a decade or so ago, and how many thanks I owe my mom for saving my ass by editing numerous college papers drafted decades past (a job thankfully taken over by Wiley's editing department). But the real thanks to my parents resides in providing me with the proper moral compass and ethics on which I have operated my own business for the past 25+ years and coauthored numerous books. In an era when economic, business, and political trust is in such short supply, I can only look back to the foundation my parents laid for me with profound gratitude.
And second, it would be extremely selfish of me not to offer my sincere and deepest thanks and love to my immediate family, including my wife and partner in crime Kristin, our eldest son Mitchel (next in line to take over the family business), our daughter Katrina (and her new husband Nicolas Small), and our youngest son Tanner (and his new wife Meredith Cahill). Their impact on my career and understanding of the importance of effectively discussing and communicating subjects of extreme importance in a clear, concise, and easy‐to‐understand manner is a lesson they have taught me every day of my life, and which I will never forget.
Along this same line, I would like to extend an extra‐special thanks to my wife of 35+ years, who has somehow put up with an old bean counter and business professional like myself, always willing to lend an ear and pretend to enjoy learning more about such lively and entertaining topics as accounting and finance. Maybe she was actually interested (doubtful) or maybe she just needed a bit of conversation to help her fall asleep at night (probably, as this is a running joke between the two of us), but whatever the case, she has always supported my endeavors, no matter how challenging, time‐consuming, or “out there,” with zero doubt and 100% confidence. Could anyone ask for a better wife, partner, or friend?
Tage C. Tracy
About the Author
Tage C. Tracy (pronounced “Tog”/Scandinavian descent) has, over the past 25+ years, operated a financial consulting firm focused on offering CFO/executive‐level support and planning services to private companies on a fractional basis. These services include providing guidance and support with raising debt and equity capital, completing complex financial analysis, supporting risk management assessments, guiding accounting system designs and structuring, and being an integral part of the strategic business planning management functions. Tage specializes in providing these services to businesses operating at four distinct stages: (1) startups and business launches, (2) rapid growth, ramp, and expansion management, (3) strategic exit and acquisition preparedness and management, and (4) turnarounds, challenged environments, and survival techniques.
Tage is also an active author and has been the lead or coauthor with a total of seven books, including this most recent title, Business Financial Information Secrets. The other books Tage has coauthored (with his father, John A. Tracy) include How to Read a Financial Report, ninth edition, How to Read a Financial Report – Comprehensive Version, Cash Flow for Dummies, Small Business Financial Management Kit for Dummies, previous editions of How to Read a Financial Report, and How to Manage Profit and Cash Flow.
Tage received his baccalaureate in accounting in 1985 from the University of Colorado at Boulder with honors. Tage began his career with Coopers & Lybrand (today PricewaterhouseCoopers) and obtained his CPA certificate in the state of Colorado in 1987 (now inactive). Tage can be reached on his website http://financemakescents.com/ or directly at [email protected].
PART ONEThe What, When, and Where of Producing Best‐in‐Class Financial Information
CHAPTER 1The Big Three Financial Statements
STARTING WITH A QUICK BACKSTORY
As we launch into the content and concepts presented throughout this book, I would like to begin by referring to a book my father and I coauthored, titled How to Read a Financial Report (now in its ninth edition). This book, first written by my father and published by Wiley over 30 years ago, has stood the test of time and represents one of the top “go‐to” technical accounting and financial references used by businesses, colleges, and organizations around the world. The book has so much useful information that you will find several overlaps and references to key financial and accounting concepts discussed in this book. However, there are also significant differences between these books that at heart are centered in the following two items:
First, our book
How to Read a Financial Report
is centered on the premise of an external party (e.g., an investor, lender, etc.) evaluating or analyzing an organization from the outside looking in. That is, all the financial and accounting information produced has been done with the understanding that the audience will be external, independent third parties who are not privy to the organization's internal operations and related financial information and data. This represents a critical difference between this book and
How to Read a Financial Report
that will become evident moving through the material. The content of this book has been structured to look at financial and accounting information from the inside out with a heavy emphasis on business management (as opposed to adhering to guidelines, rules, and regulations established by external bodies or organizations such as the SEC).
Second,
How to Read a Financial Report
is presented from more of a technical/accounting perspective or, for lack of a better term, a bit more black‐and‐white (as it relates to providing an understanding of accounting and financial concepts and how the big three financial statements are interconnected). This book is based on more of an internal business approach where, while it adheres to general or standard accounting rules and guidelines, its primary purpose is to assist with socializing accounting concepts, financial analyses and reporting strategies, and business planning from an internal operating or strategic perspective. Or, as I told my dad (a retired professor emeritus from the University of Colorado), “That is how you teach it in the classroom, but this is how it is done on the street.”
So, with this said, let's launch into our first topic on the big three financial statements, as there is no better place to start, making sure you have a clear understanding of the role and importance of the balance sheet, income statement (aka profit‐and‐loss, or P&L), and statement of cash flows. Large or small, for‐profit or non‐profit, corporations, LLCs, partnerships, or sole proprietorships, governments, or private businesses, legal or illegal, it doesn't really matter, as this basic concept is always present. That is, all operating entities need to produce complete, accurate, reliable, and timely financial statements on which to base sound business decision‐making.
THE FINANCIAL REPORTING BEDROCK
It should go without saying that business managers, company lenders and investors, regulatory agencies, and countless other parties need to clearly and concisely understand an organization's financial performance and results in a timely manner. This is common sense, no doubt, but you would be absolutely amazed at how often this basic concept is overlooked or, for lack of a better term, neglected, by even the senior‐most executive management teams. Maybe it is a result of ignorance, not having enough time, or just being lazy, but as we start our discussion on the big three financial statements, it should become abundantly clear just how important all three primary financial statements are and the key role each one plays.
Before we dive into a more detailed analysis of each of the big three financial statements, a quick overview of each financial statement and the related purpose is warranted:
The balance sheet:
The financial condition of a business is communicated in an accounting report called the
balance sheet
. In its simplest form, the balance sheet reports the assets owned by a business, the liabilities owed by the business (to third parties), and the net ownership equity (assets minus liabilities), all at a point in time.
The income statement (AKA the Profit & Loss or just the P&L):
The financial performance of a business that reports and measures its profit‐ or loss‐making activities is presented in an accounting report called the
income statement
. In its simplest form, the income statement reports sales, costs of goods sold, operating expenses, other expenses or income, and finally, whether a net profit or loss was generated and covers a period of time (e.g., 12‐month period of 1/1/20 through 12/31/20).
The statement of cash flows:
Finally, the last of the big three financial statements, and often the most important (but least understood), is the
statement of cash flows
. In its simplest form, this financial statement reports a business's sources (i.e., how a business generates cash), uses (i.e., how a company consumes cash), and net change in cash. Similar to the income statement, the statement of cash flows covers a time period which is almost always consistent with the time period reported in the income statement.
It should be noted that alternative titles for these financial statements are common. For the balance sheet, alternatives include “statement of financial condition” or “statement of financial position.” An income statement may be titled “statement of operations” or “earnings statement” as well as the profit & loss or, more simply, the P&L. For ease of presentation, we stick with the names balance sheet and income statement to be consistent throughout the book. The statement of cash flows is almost always called just that (but sometimes referred to as just a cash flow statement).
Finally, as you work your way through the book, please remember these definitions for frequently used terms and concepts:
Financial information:
The term
financial information
is used throughout the entire book and in its broadest sense includes basically all types of financial reports, financial statements, data, analyses, evaluations, assessments, and so on. For ease of reference and consistency, we simply use the term
financial information
in an all‐encompassing meaning, apart from
Chapter 2
, where we present a discussion on the role and importance of preparing external financial reports and statements (which represent a selection or fraction of internally generated financial information).
Businesses:
As previously noted, all types of businesses, organizations, not‐for‐profits, government entities, and so on should produce financial statements on a periodic basis. Again, for ease of reference and consistency, when we refer to a
business
throughout the book, it is assumed to include any one of the entities identified.
Financial statements:
The term
financial statements
, in the plural, generally refers to a complete set that includes a balance sheet, an income statement, and a statement of cash flows as well as often implying that multiple years of financial statements will be presented. Informally, financial statements are called just “financials.” In almost all cases the financial statements need to be supplemented with additional information, which is presented in
footnotes
and
supporting schedules
. One supporting schedule is very common – the
statement of changes in stockholders' (owners') equity
.
THE INCOME STATEMENT, AKA PROFIT AND LOSS (P&L)
First up, we will begin with the income statement, as, for most parties, this is the financial statement that is not only looked to first to quickly assess total sales generated (which is a common measurement of the “size” of a business) and whether a business made any money (i.e., a profit), but, maybe more importantly, is the financial statement that tends to be the most easily understood. Exhibit 1.1 provides an example of a standard externally presented income statement.
The income statement is read in a step‐down manner, like walking down a set of stairs. At the top of the staircase, sales revenue is reported first. Then, as you proceed down each step, a deduction of one or more expenses is reported. The first step deducts the cost of goods (products) sold from the sales revenue of goods sold, which gives gross profit (also called gross margin – one of the few places you see the term profit in income statements). This measure of profit is called gross because many other expenses are not yet deducted.
EXHIBIT 1.1 Audited Income Statement
Next, a broad category of general business expenses, often referred to as operating expenses or selling, general, and administrative expenses, are reported in the P&L. In our income statement example (Exhibit 1.1) you see four different operating expenses presented, including selling, marketing, and promotional; corporate general and administrative; followed by research, development, and design; and finally depreciation and amortization expense. When preparing external income statements, there is no set rule as to how many expenses must be presented but generally speaking, you will find that most external income statements attempt to avoid providing too much detail and limit the list to eight or less (unless the business had a very unusual year and elects to provide additional disclosures).
In our example, the reason we have chosen to disclose three specific expense “buckets” separately is for their importance.
First, in today's hyper‐technology‐driven economy, investors are keenly focused on just how much a business spends on research, development, and design (an extremely important function). Since our sample company is a technology‐based business, this expense bucket makes sense to report separately.
Second, selling, marketing, and promotional expense is also highlighted to reflect the importance of just how much a business must spend to secure or capture customers and, ultimately, drive sales revenue. Marketing, promotional, and selling expenses often are separated from general and administration expenses, given their significance (from a dollar perspective) and importance in driving sales revenue.
Third, you will notice that in our income statement example, we have elected to report depreciation and amortization expense (unique noncash expenses) as a separate line item. The reason for this is that as we move through the book and highlight the importance of understanding the statement of cash flows, it is very convenient to segregate noncash expenses such as depreciation and amortization expense as a separate line item in the income statement. It should be noted that businesses may or may not report depreciation or amortization expense on a separate line in their income statements based on the concept of materiality (discussed in
Chapter 5
). We have elected to report depreciation and amortization as a unique expense to better help our readers understand its impact on earnings, cash flow, and the balance sheet.
The level of detail for expenses in income statements is flexible and is really dependent on the desires of the company's management team to report what they believe is the right balance of providing too much detail versus not enough. From a financial reporting standards perspective, the guidelines are somewhat loose on this point and left open for different levels of opinions.
Finally, we reach the bottom portion of the income statement where other expenses and income are reported. Interest expense on debt is deducted as well as other non‐recurring‐type expenses (e.g., in this case, a large loss was incurred for a discontinued operation), which generates earnings before income tax. The last step is to deduct income tax expense, which gives net income, the bottom line in the income statement. Undoubtedly, you have heard the term bottom line (but this slang is not used in financial statements), as well as top line, which refers to total sales revenue. Other terminology you should be aware of includes being in the “black” (generating a profit) or the “red” (incurring a loss).
Note: Publicly owned businesses are required to report earnings per share (EPS), which basically is annual net income divided by the number of capital stock shares or similar investment units. Privately owned businesses don't have to report EPS, but this figure may be useful to their stockholders.
To conclude our introduction with the income statement, three items should be kept in mind.
First, the income statement presented in
Exhibit 1.1
has been structured for external presentation (as opposed to internal business analysis). We dive into the key differences and importance of income statements prepared for external versus internal parties in
Chapter 2
.
Second, it is important to note that of the big three financial statements, the income statement is the one that tends to be the most easily and often manipulated or subject to misstatement. The reason for this is that many parties tend to focus first (and only) on this financial statement (making it the main attraction), as well as that these same parties are often not nearly as well versed in understanding the balance sheet and statement of cash flows.
Third, you will see multiple references to this all‐important advice (throughout the book) which simply states – Understand the income statement, trust the balance sheet, but most importantly, rely on the statement of cash flows. As you work through the financial statements and this book, the importance of the state of cash flows will become increasingly clear.
THE BALANCE SHEET
The financial statement that is second in line is the balance sheet, which in its simplest form presents the financial condition of a business at a point in time (e.g., as of the fiscal year ending 12/31/20). Unlike the income statement, which presents a business's financial performance over a period of time, the balance sheet reports and summarizes a business's assets and liabilities, as well as the ownership interests in the residual of assets in excess of liabilities (referred to as owners' equity).
EXHIBIT 1.2 Audited Balance Sheet
The balance sheet shown in Exhibit 1.2 follows the standardized format regarding the classification and ordering of assets, liabilities, and ownership interests in the business. It should be noted that financial institutions, public utilities, railroads, and other specialized businesses use somewhat different balance sheet layouts but for the purpose of this book, we will use the standard format presented in Exhibit 1.2 for our overview. This format is generally used by technology companies, manufacturers, distributors, professional service companies, and retailers, as well as the large majority of other business types.
The assets, liabilities, and owners' equity reported in the balance sheet follow generally accepted conventions, which we briefly summarize here. According to long‐standing rules, balance sheet accounts are subdivided into the following classes, or basic groups, in the following order of presentation:
Left Side (or Top Section)
Right Side (or Bottom Section)
Current assets
Current liabilities
Long‐term operating assets
Long‐term liabilities
Other assets
Owners' equity
Balance sheets are often presented in a horizontal format, with assets presented or listed on the left side, liabilities on the upper half of the right side, and net owners' equity on the lower half of the right side below the liabilities, to emphasize that the owners or equity holders in a business (the stockholders of a business corporation) have a secondary and lower‐order claim on the assets – after its liabilities are satisfied. Balance sheets can also be presented in a vertical format with assets listed at the top or first, liabilities listed in the middle or second, and net owners' equity presented at the bottom or third. For ease of presentation, we used the vertical format in Exhibit 1.2.
Roughly speaking, a balance sheet lists assets in their order of “nearness to cash.” Cash is listed first at the top of the assets stack. Next, receivables that will be collected in the short run are listed, and so on down the line. In later chapters, we say much more about the cash characteristics of different assets. In like manner, liabilities are presented in the sequence of their “nearness to payment.” We discuss this point as we go along in later chapters.
Each separate asset, liability, and stockholders' equity reported in a balance sheet is called an account. Every account has a name (title) and a dollar amount, which is called its balance. For instance, from Exhibit 1.2, at the end of the most recent year ending 12/31/20 the inventory account had a balance of $1.841 million. It should be noted that the inventory account is most likely made up of multiple sub‐accounts, including raw material, work‐in‐process, finished goods, and other inventory accounts, which for external reporting purposes are consolidated to reflect just one value in inventory. This generally holds for most other balances (presented in the balance sheet); also, in almost all cases, the dollar figure represents a summation of multiple individual accounts (that are summed together given their similarities in purpose).
A balance sheet is prepared at the close of business on the last day of the income statement period. For example, if the income statement is for the year ending December 31, 2020, the balance sheet is prepared at midnight December 31, 2020. The amounts reported in the balance sheet are the balances of the accounts at that precise moment in time. The financial condition of the business is frozen for one split second. A business should be careful to make a precise and accurate cutoff to separate transactions between the period just ended and the next period.
A balance sheet does not report the flows of activities in the company's assets, liabilities, and shareowners' equity accounts during the period. Only the ending balances at the moment the balance sheet is prepared are reported for the accounts. For example, the company reports an ending cash balance of $9.441 million at the end of its most recent year (see again Exhibit 1.2). Can you tell the total cash inflows and outflows for the year? No, not from the balance sheet; you can't even get a clue from the balance sheet alone, as when understanding the flow of cash over a period of time, this represents the purpose of the statement of cash flows.
Some part of the total assets of a business comes not from liabilities but from its owners investing capital in the business and from retaining some or all of the profit the business earns that is not distributed to its owners. In this example the business is organized legally as a corporation. Its stockholders' equity accounts in the balance sheet reveal the sources of the company's total assets in excess of its total liabilities. Notice in Exhibit 1.2 the three stockholders' (owners') equity sources, which are called capital stock – common, capital stock – preferred, and retained earnings. The reason we have separated different forms of capital stock between common and preferred is extremely important to understand and will be covered in more depth in Chapter 17 in our discussion on sources of capital.
When owners (stockholders of a business corporation) invest capital in the business, the capital stock account is increased. Net income earned by a business less the amount distributed to owners increases the retained earnings account. The nature of retained earnings can be confusing; therefore, we explain this account in depth at the appropriate places in the book. Just a quick word of advice here: Retained earnings is not—we repeat, is not—an asset. Get such a notion out of your head.
A final word or two with the balance sheet. First, when reviewing the balance sheet, keep these thoughts in your head: Are your assets lying to you? and Are your liabilities telling you the truth? For example, in our balance sheet presented in Exhibit 1.2, the value in inventory as of the fiscal year‐end 12/31/19 is stated at $4.331 million, yet this decreases to $1.841 million as of the fiscal year‐end 12/31/20 (a substantial drop). The value of inventory was in fact written down in 2020 (as you will discover later in this book), but it begs the question, did management “massage” the inventory value to be a bit higher as of the fiscal year end 12/31/19 to protect net income?
Second, it is recommended that you become familiar with the term balance sheet dressing. No, this is not some special type of side dish served with your seasonal Thanksgiving Day turkey but rather represents the efforts by company executives to manage certain transactions as of the end of a period to present the performance of a business in the best light possible. When we dive into various company performance ratios and analyses covered in Chapters 8 and 9, this will become more apparent.
THE STATEMENT OF CASH FLOWS
Finally, we reach the third and final financial statement of the big three, which I like to think of in terms of the Disney movie Cinderella. If you recall, the two attention‐starved stepsisters (i.e., the balance sheet and income statement) demand all the attention and relegate Cinderella to performing demeaning tasks. However, as the story moves forward, Cinderella blossoms into the most beautiful sister of all as her true, deep, and rich value comes to light. You might think of the statement of cash flows in this same light as, once you truly understand its importance and meaning, you will find that it really shines an amazing light on the operating performance of a business.
Okay, so this might be a bit of an overreach, but this analogy drives home a critical concept associated with the big three financial statements. That is, the income statement and, to a lesser extent, the balance sheet, tend to get most of the attention from financial experts, as in today's “time is of the essence” business mindset, the questions that generally first come to mind are: (a) What are top line sales (and how much did they grow)?, (b) What's the company's bottom‐line profit?, and (c) How financially strong is the company? All
