Elements
of a Financial Plan
Entrepreneurship
ENT-301
Mark
M. Glenn, MBA
March
11th, 2019
Elements
of a Financial Plan
Introduction
While
considered by some as complicated or confusing, financial statements can and
should be structured in a simple manner with information easy to derive not
only for investors, but for the organization itself. An organization’s
financial statements and plans offer insights into the overall health of a
company and allow the organization to more accurately forecast and predict the venture’s
future. This paper will discuss the important elements of a financial statement
and provide the basic information for beginners to input relevant figures into
these elements.
There are four main financial statements. They are:
(1) balance sheets; (2) income statements; (3) cash flow
statements; and (4) statements of shareholders’ equity. Balance sheets
show what a company owns and what it owes at a fixed point in time. Income statements
show how much money a company made and spent over a period of time. Cash flow
statements show the exchange of money between a company and the outside world
also over a period of time. The fourth financial statement, called a “statement
of shareholders’ equity,” shows changes in the interests of the company’s
shareholders over time. For the purpose of this course, the focus will be on
the first three financial statements.
The
Balance Sheet
A balance sheet provides
detailed information about a company’s assets and liabilities. The
balance sheet states what is owned and what is owed. The balance sheet is the
first statement regarding organizational homeostasis.
Assets are things
that a company owns that have value. This typically means they can either be
sold or used by the company to make products or provide services that can be
sold. Assets include physical property, such as plants, trucks, equipment and
inventory. It also includes things that can’t be touched but nevertheless exist
and have value, such as trademarks and patents. And cash itself is an asset. So
are investments a company makes (U. S. Securities and
Exchange Commission, 2007).
Liabilities are
amounts of money that a company owes to others. This can include all kinds of
obligations, like money borrowed from a bank to launch a new product, rent for
use of a building, money owed to suppliers for materials, payroll a company
owes to its employees, environmental cleanup costs, or taxes owed to the
government. Liabilities also include obligations to provide goods or services
to customers in the future (U. S. Securities and Exchange
Commission, 2007).
A company’s balance
sheet is set up like the basic accounting equation shown above. On the left
side of the balance sheet, companies list their assets. On the right side, they
list their liabilities and shareholders’ equity. Sometimes balance sheets show
assets at the top, followed by liabilities, with shareholders’ equity at the
bottom (U.
S. Securities and Exchange Commission, 2007).
Assets are generally
listed based on how quickly they will be converted into cash. Current assets
are things a company expects to convert to cash within one year. A good example
is inventory. Most companies expect to sell their inventory for cash within one
year. Noncurrent assets are things a company does not expect to
convert to cash within one year or that would take longer than one year to
sell. Noncurrent assets include fixed assets. Fixed assets are those
assets used to operate the business but that are not available for sale, such
as trucks, office furniture and other property (U. S. Securities
and Exchange Commission, 2007).
Liabilities are
generally listed based on their due dates. Liabilities are said to be
either current or long-term. Current liabilities are
obligations a company expects to pay off within the year. Long-term liabilities
are obligations due more than one year away (U. S. Securities
and Exchange Commission, 2007).
A balance sheet shows a snapshot of a company’s
assets and liabilities at the end of the reporting period. It does not show the
flows into and out of the accounts during the period (U.
S. Securities and Exchange Commission, 2007).
Income
Statement
An income statement is a report that shows how
much revenue a company earned over a specific time period (usually for a year
or some portion of a year). An income statement also shows the costs and
expenses associated with earning that revenue. The literal “bottom line” of the
statement usually shows the company’s net earnings or losses. This tells you
how much the company earned or lost over the period (U. S. Securities
and Exchange Commission, 2007).
Income statements also report earnings per share (or
“EPS”). This calculation tells you how much money shareholders would receive if
the company decided to distribute all of the net earnings for the period.
Companies almost never distribute all of their earnings. Usually they reinvest
them in the business (U. S. Securities and Exchange Commission, 2007).
To understand how income statements are set up, think of
them as a set of stairs. You start at the top with the total amount of sales
made during the accounting period. Then you go down, one step at a time. At
each step, you make a deduction for certain costs or other operating expenses
associated with earning the revenue. At the bottom of the stairs, after
deducting all of the expenses, you learn how much the company actually earned
or lost during the accounting period. People often call this “the bottom line (U.
S. Securities and Exchange Commission, 2007).”
At the top of the income statement is the total amount of
money brought in from sales of products or services. This top line is often
referred to as gross revenues or sales. It’s called “gross” because expenses
have not been deducted from it yet. So the number is “gross” or unrefined (U.
S. Securities and Exchange Commission, 2007).
The next line is money the company doesn’t expect to
collect on certain sales. This could be due, for example, to sales discounts or
merchandise returns. When you subtract the returns and allowances from the
gross revenues, you arrive at the company’s net revenues. It’s called “net”
because, if you can imagine a net, these revenues are left in the net after the
deductions for returns and allowances have come out (U. S. Securities
and Exchange Commission, 2007).
Moving down the stairs from the net revenue line, there are
several lines that represent various kinds of operating expenses. Although
these lines can be reported in various orders, the next line after net revenues
typically shows the costs of the sales. This number tells you the amount of
money the company spent to produce the goods or services it sold during the
accounting period (U. S. Securities and Exchange Commission, 2007).
The next line subtracts the costs of sales from the net
revenues to arrive at a subtotal called “gross profit” or sometimes “gross
margin.” It’s considered “gross” because there are certain expenses that
haven’t been deducted from it yet (U. S. Securities and Exchange Commission,
2007).
The next section deals with operating expenses. These are
expenses that go toward supporting a company’s operations for a given period –
for example, salaries of administrative personnel and costs of researching new
products. Marketing expenses are another example. Operating expenses are
different from “costs of sales,” which were deducted above, because operating
expenses cannot be linked directly to the production of the products or
services being sold (U. S. Securities and Exchange Commission, 2007).
Depreciation is also deducted from gross profit.
Depreciation takes into account the wear and tear on some assets, such as
machinery, tools and furniture, which are used over the long term. Companies
spread the cost of these assets over the periods they are used. This process of
spreading these costs is called depreciation or amortization. The “charge” for
using these assets during the period is a fraction of the original cost of the
assets (U. S. Securities and Exchange Commission, 2007).
After all operating expenses are deducted from gross
profit, you arrive at operating profit before interest and income tax expenses.
This is often called “income from operations (U. S. Securities and
Exchange Commission, 2007).”
Next,
companies must account for interest income and interest expense. Interest
income is the money companies make from keeping their cash in interest-bearing
savings accounts, money market funds and the like. On the other hand, interest
expense is the money companies paid in interest for money they borrow. Some
income statements show interest income and interest expense separately. Some
income statements combine the two numbers. The interest income and expense are
then added or subtracted from the operating profits to arrive at operating
profit before income tax (U. S. Securities and Exchange Commission,
2007).
Finally, income tax is deducted and you arrive at the
bottom line: net profit or net losses. (Net profit is also called net income or
net earnings.) This tells you how much the company actually earned or lost
during the accounting period. Did the company make a profit or did it lose
money (U. S. Securities and Exchange Commission, 2007)?
Cash Flow Statements
Cash flow statements report a company’s inflows and outflows of cash. This is important because a company needs to have enough cash on hand to pay its expenses and purchase assets. While an income statement can tell you whether a company made a profit, a cash flow statement can tell you whether the company generated cash (U. S. Securities and Exchange Commission, 2007).
A cash flow statement shows changes over time rather than absolute dollar amounts at a point in time. It uses and reorders the information from a company’s balance sheet and income statement. The bottom line of the cash flow statement shows the net increase or decrease in cash for the period. Generally, cash flow statements are divided into three main parts. Each part reviews the cash flow from one of three types of activities: (1) operating activities; (2) investing activities; and (3) financing activities (U. S. Securities and Exchange Commission, 2007).
The first part of a cash flow statement analyzes a company’s cash flow from net income or losses. For most companies, this section of the cash flow statement reconciles the net income (as shown on the income statement) to the actual cash the company received from or used in its operating activities. To do this, it adjusts net income for any non-cash items (such as adding back depreciation expenses) and adjusts for any cash that was used or provided by other operating assets and liabilities (U. S. Securities and Exchange Commission, 2007).
The second part of a cash flow statement shows the cash flow from all investing activities, which generally include purchases or sales of long-term assets, such as property, plant and equipment, as well as investment securities. If a company buys a piece of machinery, the cash flow statement would reflect this activity as a cash outflow from investing activities because it used cash. If the company decided to sell off some investments from an investment portfolio, the proceeds from the sales would show up as a cash inflow from investing activities because it provided cash (U. S. Securities and Exchange Commission, 2007).
The third part of a cash flow statement shows the cash flow from all financing activities. Typical sources of cash flow include cash raised by selling stocks and bonds or borrowing from banks. Likewise, paying back a bank loan would show up as a use of cash flow (U. S. Securities and Exchange Commission, 2007).
Conclusion
Research is essential when developing and reproducing the figures for financial statement practice. When learning the elements of a financial statement and plan and the inputting of figures, remember to keep numbers conservative. This will allow the preparer to better understand the information as it is more manageable. This will also keep the preparation exercise of the balance sheet, the income statement and the cash flow statement easier to understand.
References