You should read these financial reports carefully, but if you don’t — or if you do but don’t understand what you’re reading — this Cheat Sheet can help you understand the language and necessity of accounting.
Financial statements Q&A
In a financial report, accounting information is presented in the form of financial statements packaged with other information, such as explanatory footnotes and a letter from top management.
Financial statements are prepared at the end of each accounting period, which may be one month, one quarter (three calendar months), or one year. Read on for info on what you find in these documents.
Q: Who is the target audience of financial statements?
A: Believe it or not, financial statements are for nonaccountants — in particular, the lenders, investors, and analysts who follow the business, as well as its managers. These users need to know how to read financial statements, which can be a challenge.
Q: What information is reported in financial statements?
A: Oh, not much . . . the profit or loss of the business, whether its financial condition is sound or precarious, and whether its cash flow is strong or weak. Just these little financial odds and ends about the business.
Q: Where do I find the top-line sales and bottom-line profit or loss of a business?
A: The very first line in the income statement should report total sales revenue (commonly referred to as the top line). The bottom-line profit or loss is the last line in its income statement, which summarizes the sales revenue, income, expenses, and losses of the business for the period. Public companies also report earnings per share in their income statements. Private companies don’t have to.
Q: Where do I find the summary of assets and liabilities of a business?
A: In its balance sheet, which also reports the sources of its owners’ equity. The sales and expense activities of a business propel or drive its assets and liabilities (not all, but most). The asset values reported in a balance sheet reflect past transactions and may differ from their current replacement or market values.
Q: Where do I find the good or bad news about cash flow of a business?
A: Read the business’s statement of cash flows. Cash flow generated from making profit is disclosed in the first section of this financial statement. A business could report a decent profit but still have cash flow problems.
Q: Are standard financial statements adequate for managing a business?
A: No, not by a long shot. Financial statements are a good starting point, but managers need more detailed information, which is confidential and not circulated outside the business, to do their jobs. Accountants who don’t understand this should be fired on the spot.
Accounting tips for business managers
Business managers should get the most out of their accounting information — to know how the business is doing and how to do better, and whether or not it’s on the verge of serious cash flow and financial problems. You wouldn’t pilot a plane without knowing how to read the flight map.
A business manager should know how to read the financial map of the business provided by accounting information. Here are some useful tips to keep in mind:
- Take charge in choosing the accounting methods for your business and the design of your accounting reports. All too often, business managers adopt the policy that accounting is best left to the accountants. Unfortunately, this may result in your not fully understanding your own financial information.
Make sure you have a smartly designed profit and loss (P&L) report that serves as a hands-on tool for managing profit. A good P&L report highlights the key variables that drive performance for each major profit center of your business. It should serve like a well-used guide that directs you to the right destinations. You may need different formats for different profit centers in your business. A P&L report generally should focus on key margins (gross margin or profit, operating margins, and contribution margins), sales volume, variable expenses, and fixed expenses.
Margin per unit equals sales price minus product cost and minus the variable expenses of making the sale. Your business must sell enough volume to earn total margin equal to fixed expenses before breaking into the profit zone. After sales reach the breakeven point, the margin from additional sales goes entirely to profit (before income tax).
- Remember that relatively small changes in profit factors can yield dramatic results. A small slippage in margin per unit can have a devastating impact because unit margin is multiplied by total sales volume. On the other hand, even a slight boost in sales price — or a little more sales volume — yields lots more profit.
- Make sure you clearly understand every cost figure you use. Product costs depend on which accounting method is used, such as the choice between the weighted average and the first-in, first-out (FIFO) methods, or they depend on rather arbitrary allocation methods. Know how your costs are calculated! Press your accountant to explain if you aren’t clear about costs.
Establish and enforce strong internal controls, especially in the technology digital age. More companies are storing their data in the cloud, and more employees are handling confidential data on their home devices; some use public Wi-Fi that isn’t secure. Businesses process a large amount of data, confidential information, financial transactions, and money, which present countless opportunities for errors, theft, embezzlement, and fraud.
Make sure bulletproof internal controls are in place and working well, and actively involve the technology team to implement best-in-class security firewalls. When your internal controls are weak, you can be sure that some of your hard-earned profit will go down a rat hole.
A few key accounting terms
Knowing the correct accounting terms and what they mean can make a world of difference when you’re deciphering financial statements and reports and determining profits and losses.
It’s easy to get debits and credits confused, and it’s a must to know which documents make up a complete financial report. A ton of cash could depend on your understanding of the following basic accounting terms:
Accounting: The methods and procedures for identifying, analyzing, recording, accumulating, and storing information and data about the activities of an entity that has financial results and for preparing summary reports of these activities internally for managers and externally for those entitled to receive financial reports about the entity.
A business’s managers, investors, and lenders depend on accounting reports called financial statements to make informed decisions. Accounting also encompasses preparing tax returns that the entity must file with government tax authorities and facilitating day-to-day operating functions.
Balance sheet: A financial statement that summarizes the assets, liabilities, and owners’ equity of a business at a moment in time. It’s prepared at the end of every profit period (and whenever else it’s needed). The main elements of a balance sheet are called accounts — such as cash, inventory, notes payable, and share capital.
Each account has a dollar amount, which is called its balance. But be careful: The fact that the accounts have balances is not the reason this financial statement is called a balance sheet; rather, the name refers to the equality (or balance) of assets with the total of liabilities and owners’ equity. This financial statement is also called the statement of financial position.
- Cash flow: An ambiguous term that can refer to several different sources of or uses of cash. This term is often shorthand for cash flow from earning profit or from operating activities. Some friendly advice: When using this term, always make clear the particular source or use of cash you have in mind!
Debits and credits: Accounting jargon for decreases and increases recorded in accounts according to the centuries-old scheme based on the accounting equation (Assets = Liabilities + Owners’ equity). An increase in an asset is a debit, and the ingenious twist of the scheme is that a decrease in a liability or an owners’ equity is also a debit.
Conversely, a decrease in an asset is a credit, and an increase in a liability or an owners’ equity is a credit. Revenue is recorded as a credit, and expenses are recorded as debits. In recording transactions, the debit or sum of debits must equal the credit or sum of credits. The phrase “the books are in balance” means that the total of accounts with debit balances equals the total of accounts with credit balances.
Financial reports: The periodic financial communications from a business (and other types of organizations) to those entitled to know about the financial performance and position of the entity. Financial reports of businesses include three primary financial statements (the balance sheet, income statement, and statement of cash flows) as well as notes and other information relevant to the owners of the business.
Public companies must file several types of financial reports and forms with the Canadian Securities Administrators (CSA), which are open to the public. The financial reports of a private business are generally sent only to its owners and lenders.
- Financial statement: Generally refers to one of the three primary accounting reports of a business: the balance sheet, statement of cash flows, and income statement. Sometimes financial statements are simply called financials. Internal financial statements and other accounting reports to managers contain considerably more detail, which is needed for decision-making and control.
- Fixed or capital assets: The shorthand term for the variety of long-life physical resources used by a business in conducting its operations, which include land, buildings, machinery, equipment, furnishings, tools, and vehicles. These resources are held for use, not for sale. Please note that fixed assets is an informal term; the more formal term used in a balance sheet is property, plant, and equipment.
- Generally accepted accounting principles (GAAP): The authoritative standards and approved accounting methods that should be used by profit-motivated businesses and private not-for-profit organizations domiciled in Canada to measure and report their revenue and expenses; to present their assets, liabilities, and owners’ equity; and to report their cash flows in their financial statements. GAAP are not a straitjacket; these official standards are loose enough to permit alternative interpretations.
- Income statement (also known as the P&L or profit & loss statement): A financial statement that summarizes sales revenue (and other income) and expenses (and losses) for a period and reports one or more different profit lines. The income statement is one of the three primary financial statements of a business included in its financial report and is also called the earnings statement, operating statement, simply the P&L, or similar titles.
- Profit: A very general term that is used with different meanings. It may mean gains minus losses or other kinds of increases minus decreases. In business, the term means sales revenue (and other sources of income) minus expenses (and losses) for a period of time, such as one year. In an income statement, the preferred term for final or bottom-line profit is net income. For public companies, net income is put on a per-share basis, called earnings per share.