One of the most important things for a business to understand is its profitability—literally, its ability to make a profit from the products it creates or sells. There are two key factors in determining profitability: (1) how much revenue the sales of the products generate; and (2) how much it costs to make and deliver those products. The simplest way to think about the income statement is with the simple equation below:
Total Revenues – Total Expenses = Profit(or Loss)
In essence, subtract the amount everything cost the business from the amount of revenue (or income) the business earned to see the profit. If things cost the business more than it earned in revenue, the company will see a loss.
Of course, it’s not really that simple. There are different ways a business can make money, such as selling equipment. And there are also many expenses a business might incur during that same period of time. The income statement goes one step further, adding more detail so that people can understand where the key sources of income and expenses are.
To help us better understand this statement, let’s look at an example from SunsTruck. Note that when a number is negative, it appears in parentheses.
At the top of the statement, you’ll see that it clearly identifies three things: (1) the name of the company, (2) the title of the financial statement, and (3) the period of time the statement is summarizing. For this example, we’re looking at the income statement for SunsTruck for the Third Quarter (“Q3”), or the three months ending September 30, 2016.
The first category of numbers at the top is called revenues. This is the total amount of income that the company earned during this time period. You can see that there are two main sources of revenue, or income for SunsTruck: (1) sales revenue, which is the money the business earned from selling its main product, sunglasses; and (2) other revenue, which is the money the business made from other sources, such as selling old equipment. For this quarter, SunsTruck made $80,000, which is shown as total revenues.
The second area of revenue is related to the cost of earning that revenue. If you are in the service industry like a hospital or software design, this is called cost of revenues. In our example, SunsTruck sells a physical product, sunglasses, so it is called cost of goods sold (COGS). This number represents the direct cost of either making the products or purchasing them from the supplier. In the case of SunsTruck, this number is the amount of money the company spent to buy the sunglasses from brands like Oakley or RayBan that were then sold in their truck. In the third quarter, SunsTruck spent $40,000 on sunglasses to sell in their truck.
The third area of revenue shows gross profit-—total revenue minus the cost of goods sold. The amount of gross profit that SunsTruck earned this quarter is $40,000. It is the total revenue minus the total COGS ($80,000 revenue – $40,000 COGS = $40,000 gross profit). Gross profit is a very important number to know, because it is what’s left over to cover all of the business’s other expenses. If gross profit is not high enough, the company is losing money and (eventually) will go out of business. In our SunsTruck example, the business has $40,000 in gross profit to cover its remaining expenses.
Our second category on the income statement includes all of the other types of expenses that a business has. You can see two expense groupings: (1) selling, general and administrative expenses and (2) marketing and advertising. Remember, expenses are the costs it takes to keep a business going. Each group includes a number of different but related costs. Selling, general, and administrative expenses often refer to costs associated with selling a product, such as sales commissions and shipping costs, and/or administrative needs such as rent or office supplies. Marketing and advertising expenses refers to the spend on promotional activities for the product. While there are many other expense categories that businesses use, these are two of the most common.
The next area of expenses is income from operations. In this line, all expenses are subtracted from the gross profit ($40,000 gross profit – $10,000 expenses = $30,000 income from operations). This, too, is an important figure to watch because it tells us whether or not a company’s core business is profitable. For SunsTruck, its expenses were less than its gross profit so there is a positive amount of income from its operations of selling sunglasses.
The next area of expenses is other expenses. You’ll see interest expense under this category, which refers to the total amount of money spent on interest for outstanding loans the company owes. During the third quarter, SunsTruck had $500 in interest expense on its outstanding loans.
Our third category is pretax income. In this line we subtract other expenses from the income from operations to get our pretax income ($30,000 income from operations – $500 other expenses = $29,500 pretax income). We then need to account for the amount of taxes paid on this income, which in our SunsTruck example was $7,000.
Our final category in the income statement is net income. Net income shows how much money a business makes after all expenses are paid. To calculate net income, we subtract the income tax expense from the pretax income ($29,500 pretax income – $7,000 income tax expense = $22,500 net income). In the case of SunsTruck, net income is $22,500! It’s important to know that net income can be positive (a profit) if revenues are higher than the total of all expenses, or negative (a loss) if all of the expenses are higher than revenues. But watch out! Net income does not mean that you have this much in your checking account. Remember, some revenues were done on credit and the business has to wait to see its cash. Likewise, some expenses have not yet been paid, only recorded.
WHEN TO USE THE INCOME STATEMENT
The income statement is useful when you want to understand how profitable a business is. Generally speaking, a sign of a successful and growing company is a steady increase in revenue, with the difference between income and expenses getting wider and wider. This indicates that the business is making more money while controlling or even decreasing expenses.
The Balance Sheet
It’s often helpful to have a quick summary of where things stand, especially for your personal finances. Knowing what you own compared to what you owe to other people gives you a helpful snapshot of your current financial health. The balance sheet, also known as the statement of financial position, is unique because instead of looking at a business over a period of time, it shows where the business stands at that moment.
The balance sheet gets its name from the fact that both sides of the balance sheet have to be equal. There is a common equation that summarizes the balance sheet:
Assets = Liabilities + Shareholders’ Equity
If you think about it, this makes sense. If assets are the items a business owns or controls, the business has to have the money to pay for those things either by borrowing money (liabilities) or getting money from investors or from retained earnings (shareholder’s equity).
One thing to note about this statement is that individual accounts are shown on the left and the summary accounts are shown in the column on the right. Let’s look at a sample balance sheet from SunsTruck:
The first category of the balance sheet is assets, which includes all of the things the business owns or controls. You’ll notice there are two groups of assets: current and long-term. Current assets are expected to be used up and replaced over and over during the current twelve months. Long-term assets are items expected to last longer than one year. There can be many types in both groups, but we’ll just focus on a few of the most common ones.
In the current assets category, you have cash, accounts receivable, and merchandise inventory.
- Cash is pretty simple—it’s the amount of money a business currently has in the bank.
- Accounts receivable is the money that the business is owed from customers who have already purchased products on credit.
- Merchandise inventories is the value of all of the merchandise products the company has on hand but has not yet sold.
In the long-term assets category, you have SunsTruck’s truck and equipment, the total value of vehicles or other large equipment that the business owns. Many businesses also have other long-term assets like land, buildings, machinery, and patents.
Adding together a business’s current assets and long-term assets gives us our total assets ($32,000 total current assets + $68,000 long-term assets = $100,000 total assets). As you can see, the total of all of SunsTruck’s assets as of September 30, 2016 is $100,000.
The next section of the balance sheet is liabilities. This is the money that the business owes to other parties. Like assets, liabilities are divided into current and long-term groups. This lets everyone know what has to be paid over the upcoming twelve months versus what’s not due for more than a year from now.
In the current liabilities group, the first item is accounts payable. This is the total of all of the money the business owes for things it has purchased on credit from suppliers related to the creation of its products. For example, SunsTruck may purchase all the sunglasses it expects to sell in the next month from a sunglasses supplier with an agreement to pay the supplier back in 30 or 60 days.
In the long-term liabilities group , you’ll find loan categories:
- Truck Loan (the money SunsTruck owes for its mobile store) and
- Operating Loan (the money SunsTruck borrowed from a lender to provide cash for expenses, such as meeting payroll).
Between current and long-term liabilities, the total of all the money the business owes as of the given date is shown as total liabilities ($10,000 current liabilities + $60,000 long-term liabilities = $70,000 total liabilities).
Finally, in addition to loan liabilities, a business can get money from investors. This money is shown in the shareholders’ equitysection. Contributed capital shows the total amount of money given by outside investors. Retained earnings is the amount of profit that the business has kept to use to grow the company instead of giving it back to the owners of the business.
As of September 30, 2016, SunsTruck had total shareholders’ equity of $30,000.
Remember how we said both sides of the balance sheet have to equal? To see that the SunsTruck balance sheet is “in balance” at this moment of time, you can compare the total assets of the business ($100,000) to the sum of total liabilities plus shareholders’ equity ($70,000 total liabilities + $30,000 total shareholders’ equity = $100,000 total liabilities and shareholders’ equity), the last line of the balance sheet. As of September 30, 2016, SunsTruck had $100,000 for both “sides”—demonstrating that the balance sheet is balanced.
WHEN TO USE THE BALANCE SHEET
The balance sheet is useful to see how healthy a business is at any particular time. It’s important to ensure that the business’s debt, its liabilities, is a reasonable size relative to assets and shareholders’ equity. If debt is growing, it may be a sign that the business is not effectively converting its investments into profits for the company’s owners.
Statement of Cash Flows
Many business leaders will tell you that the statement of cash flows is the most important statement of them all—and that may very well be true. In reality, if the business doesn’t have cash on hand to purchase products or pay employees, it can’t keep its doors open. Cash is the lifeblood of a business, and knowing how much of it is available is vital for success.
As we’ve learned multiple times in this course, you can pick up a lot about business from your personal life. Creating a statement of cash flows is almost identical to balancing a checkbook. You start off with a certain amount of cash and, during a period of time, money comes in and money goes out. Then, at the end of the time period, you have an ending cash balance that is either higher, lower, or the same as the cash you had when you started.
The statement of cash flows shows all of the cash entering and leaving a company during a given period of time. It’s important to know that cash is different from revenue! The revenue number from the income statement includes both sales paid with cash and sales made on credit. This second type of sale, where the business has not yet received its cash, shows up indirectly on the statement of cash flows as either an increase or decrease in accounts receivable. A decrease in accounts receivable indicates that more cash has been received than new sales made on credit. An increase in accounts receivable indicates more new sales were made on credit than cash received.
Let’s walk through a sample statement of cash flows for SunsTruck. Note that when a number is negative, it appears in parentheses.
The statement of cash flows focuses on three main types of cash activities: (1) cash flows from operating activities, (2) cash flows from investing activities, and (3) cash flows from financing activities. Let’s look at each category in turn.
The first category, cash flows from operating activities, shows all the money coming in and going out from day-to-day business operations. This includes sales, expenses, taxes paid, employees’ salaries and more.
The next category is cash flows from investing activities, which includes money coming in and money going out that is related to investments in things such as equipment or manufacturing tools. Typically, there is cash going out to pay for these investments. In this SunsTruck example, the business only spent money to pay back their investment in the truck for their mobile store.
Finally, cash flows from financing activities summarizes all of the money that is tied to activities like borrowing and repaying money or getting funds from investors by selling stock or issuing bonds. This will be a cash-coming-in category if it shows new loans or investments increasing a business’s bank account. Sometimes, however, this will be a cash-going-out category if the business is repaying loans or paying investors back by paying out stock dividends or interest on bonds.
At the bottom of the statement of cash flows there are three key numbers. The net increase (or decrease) in cash shows how much money was gained or lost in total during the time period. The amount of cash at the beginning of the period shows how much money was in the bank at the beginning of the time period. Lastly, cash at the end of the period shows how much money is in the bank at the end of the time period. This figure ties back to the cash balance reported on the balance sheet.
WHEN TO USE THE STATEMENT OF CASH FLOWS
The statement of the cash flows should be regularly checked and updated to ensure that a business has the money on hand that it needs to operate. It shows how effectively a business is using its cash to grow the business and make it more profitable.
Financial statements are an essential part of knowing how well a business is doing and how it can be improved. While there is a lot to learn about these statements, like many things, they will become easier to read and understand over time. By familiarizing yourself with these statements and understanding what they mean, you’ll be better able to support decision-making within your company based on the information that these accounting processes provide.
FINANCE & ACCOUNTING – SENIOR ACCOUNTANT ANALYSIS
Note: While representative of possible situations faced by SunsTruck Sunglasses, all scenarios in this assignment are fictional.
Large discount retailers like Target and Walmart employ large teams of Finance and Accounting professionals to help measure and understand the financial health of the business. Financial and accounting information helps these businesses make educated financial decisions, such as whether or not to continue partnering with a retail supplier. While often smaller businesses, it is equally important for these retail suppliers to use financial and accounting data to make educated decisions, such as the best approach to gaining additional funding.
This week, you’ll assume the role of Senior Accountant with SunsTruck Sunglasses.
Senior accountants take ownership of reporting costs, profitability, margins and expenditures for a given business. They use the principles of accounting to analyze sales information, create financial reports, make recommendations about the financial health of the company, and more. They are also responsible for training junior accounting staff.
For the last six months, SunsTruck has partnered with the discount retail store to run a pop-up sunglasses stand in their stores for a big summer promotion. Due to the high customer purchase rate, the store has requested stock for five additional stores. SunsTruck needs to increase its capacity to meet the additional demand. In order to do so, SunsTruck needs additional money.
In this assignment, you will need to help determine which type of financing option is best for your company and train your junior accountants on the accounting cycle and financial statements.
Step 1: Financing
The junior accounting team has assembled a Financing Report that (a) offers three options for securing the additional funds required to meet the new order; and (b) details the criteria Shaun, the owner of SunsTruck, would like you to consider when choosing one of the three options. Based on this report:
- Identify which financing option you think is the best option for SunsTruck to pursue given Shaun’s constraints. Please explain the rationale for your decision.
Note: You should complete Steps 2 & 3 after reading the material in Week 5.
Step 2: Accounting Cycle
A junior accountant is working to get everything in order for the new financing and has come to you with a question about what do next in the accounting cycle.
- Read the email the junior accountant sent you and identify the best next step to take in the accounting cycle. Please explain your reasoning.
Step 3: Financial Statements
A potential investor has been identified, but before it is willing to commit, it has requested information about SunsTruck’s current debt from the junior accountants.
- Identify the correct financial statement for your junior accountants that will provide the investor with the information it has requested. Please explain to your junior accountants why you are giving them this financial statement and where the debt information is located.