Understanding Financial Statements

2.1 Introduction
Knowing the financial conditions of your business enterprise is very important. Such
knowledge can help you allocate resources and identifies areas requiring
development and problems that needs correction. The finance manager should
know how the business enterprise is doing financially. Is it growing contracting? Will
it be around for a long time? How profitable is each department, and what can be
done to improve the profitable picture? These question and others can be answered
if the finance managers understand corporate financial statement. On the
enterprises is doing financially, he cannot provide the needed financial leadership
and directions.
This chapter looks at the key financial statements from an external viewpoint.
Financial statements are they financial information outsider are very interested to
see.

2.2 WHAT AND WHY OF FINANCIAL STATEMENTS

Financial decisions typically based on data generated from accounting system.
Financial management, shareholders, potential investors, and creditors are
concerned with how well the business enterprise is doing. The three reports
generated by accounting systems included in the business enterprises annual
reports are the statement of financial position, income statement and statement of
cash flow. Although the form of these financial statements may vary among
different businesses or other economic units, their basic purposes do not change.
The statement of financial positions reveal the financial conditions of the
organization at the particular point in time. It tells what you own (assets), how much
you owe to vendors and lender (liabilities), and what is left (assets minus liabilities,
known as equity or net worth). A statements of financial position freezes the action,
giving the business enterprises financial conditions as of a certain data. The
statement of financial position equation is: Assets Liabilities = Shareholders
Equity. The third financial statement is the statement of cash flows. This statements
provides useful information about inflows and outflows of cash that cannot be found
in the statement of financial position and the income statement.

2.3 The Income Statement

The income statement (profit and loss statement) reveal the revenue, expenses and
net income (or net loss) for a period of time. A definition of each statement follows.
Revenue is the increase in the capital arising from the sales of goods or the
performance of the services. When revenue is earned, its result in an increase in
either cash (money received) or accounts receivable (amount owed to you by the
customers).

Expenses decrease capital and result from performing activities necessary to

generate revenue. The expenses is either equal to the cost of the goods sold or the
expenditures necessary to conduct business operations (e.g., rent expense, salary
expense, depreciation expense) during the period. (Depreciation is discussed in
other chapter of this book).
Net Income is the amount by which total revenue exceeds total expenses. The
resulting profit is added to the retained earnings account (accumulated earnings of
a business enterprise since its inception less dividends). If total expense are greater
than total revenue, a net loss results, decreasing retained earnings.
Revenue does not necessarily mean of receipt of cash, and expenses does not
automatically imply a cash payment. Net income and net cash flow (cash receipt
less cash payments) are different. For example, taking out a bank loan generate
cash, but this cash is not revenue since no merchandise has been sold and no
services have been provided. Further, capital has not been altered by the loan
because the laon represent a liability, rather than a shareholders investment, and
must be repaid.
Every item of revenue and expense has its own account. Such a systems enables
you to evaluate and control revenue and expense source better and to examine the
relationships among amount classification.
Classified income statement
While companies differ in nature therefore the specific transactions and accounts
differ fom business to business. It is useful to classify the entries in the financial
statements into major categories. Financial statements organized such a function
called classified financial statements.
In a classified income statement, every major revenue and expense function is
listed separately to facilitate analysis. The entries in an income statement are
classified into four major functions: revenue, cost of goods sold (cost of inventory
sold), operating expense and other revenue or expenses. The entries in classified
income statement covering different time periods are easily compared; the
comparison over time revenue sources, expense items, and relationship between
them can reveal areas that require attention and corrective action. For example, if
revenue from services has been sharply declining over the past several months, you
will want to know why and take action to reverse the trend.
Revenue compromises the gross income generated by selling goods (sales) or
performing services (professional fees, commission income). To determine net sales,
gross sales are reduced by sales return, allowances (discounts given for defective
merchandise) and sales discounts.
Cost of goods sold is the cost of merchandise or service sold. In a retail business. It
is the cost of buying good from the manufacturer; in a services business, it is the
cost of the employee services rendered for a manufacturing business enterprise,
cost of goods sold is the beginning finished goods inventory plus the cost of goods
manufactured minus the ending finished goods inventory.

Operating expense are expenses incurred or resource used in generating revenue.

Two types of operating expense are selling expenses and general and administrative
expenses. Selling expense are cost incurred in obtaining the sales of goods or
services (e.g. advertising salespersons salaries) and in distributing the merchandise
(e.g. fright paid on shipments); they relate solely to the selling function, if a sales
manager is responsible for generating sales, his or her performance is judge on the
relationship between promotion cost and sales obtained. General and administrative
expenses are the cost of running the business as the whole. The salaries of the
office clerical staff, administrative executives salaries, and depreciation on office
equipment are example of general and administrative expenses.
Other revenue (expenses) covers incidental sources of revenue and expenses that
are non operating in nature and that do not relate to the major purpose of the
business. Example are the interest income, dividend income, interest expense.
Figure 2.2 shows a classified income statement
2.4 THE STATEMENTS OF FINANCIAL POSITION
The statement of financial position (balance sheet) is classified into groups of assets
and liabilities. An assets is something owned, such as land and automobile; a
liability is something owned, such as loans payable and mortgage payable.

ASSETS
A classified statement of financial position is generally break down assets into two
categories: current assets and non-current assets. Non-current assets are further
classified into long-term investments, property, plant, and equipment (plant assets),
intangible assets, and deferred charges. This breakdown aids in analysing the types
and liquidity of the assets held.
Current assets are assets expected to be converted into cash or used up within one
year or normal operating cycle of business, whichever is greater. (the operating
cycle is the time period between the purchase of inventory merchandise for resale
and the transfer