Financial controls

Overview

Financial reports

Financial reports are your financial controls. Explanations of the three major financial reports used for financial management are given below.

The balance sheet

The balance sheet shows the financial position of a business at a specific point in time, for example, the last day of the month or the year.

This financial statement shows total assets (what the business owns — items of value) and total liabilities (what the business owes).

Total assets are broken down into subcategories of current, assets and other assets. The total liabilities are broken down into subcategories of current liabilities, long-term liabilities/debt and owner’s equity. The total assets must equal the total liabilities plus owner’s equity.

The accounting equation

Assets = liabilities + owner’s equity

is a simple formula to describe the balance sheet.

The profit and loss statement

The profit and loss statement shows revenues, minus the cost of goods sold, minus operating expenses, plus other revenues and expenses and the net income/loss before taxes.

The cash flow statement

The cash flow statement is the detail of cash received and cash expended for each month of the year. A projected cash flow statement helps you determine if the company has positive cash flow. If your company’s projections show a negative cash flow, you must revisit your business plan and solve this problem.

Summary

Accurate and timely financial reports show the progress and current condition of the business. You can compare performance during one period of time (month, quarter or year) with another period, calculate trends and plan for the business’s future.

Comprehensive overview — financial controls

Introduction

By analyzing your business’s financial reports, you are able to determine how well your business is doing and what you may need to do to improve its financial viability. There are three basic financial reports that all business owners need to understand and interpret in order to manage their businesses successfully — the balance sheet, the profit and loss and the cash flow statement.

These are often referred to as the financials. Pro forma financials are projections, usually projected for three fiscal years. Financial controls provide the basis for sound management and allow you to establish guidelines and policies that enable the business to succeed and grow.

Proactive vs. reactive financial management

The proactive financial manager uses pro forma or projections to plan ahead for the problems the business is likely to encounter and the opportunities that may arise. To be proactive you must read and analyze your financial statements on a regular basis. Monthly financial analysis is preferred, quarterly is more common, and yearly is not often enough. The proactive manager has financial data available based on actual results and compares them to the budget. This process points out weaknesses in the business before they reach crisis proportion and allows the manager to make the necessary changes and adjustments before major problems develop.

A reactive manager waits to react to problems, and then solves them by crisis management. This type of manager goes from crisis to crisis with little time in between to notice opportunities. The reactive manager’s business is seldom prepared to take advantage of new opportunities quickly. Businesses that are managed proactively are more likely to be successful.

Assistance in developing financial controls

You may need an accountant or business consultant to assist you in setting up your chart of accounts. Accountants use a standard numbering system for the business accounts in the chart, but each business may have a different chart of accounts depending on the operational plan. The accountant or business consultant also will assist you in setting up the financial reports you need to manage the operation of your business.

Many business owners purchase software to do recordkeeping and develop financials. These programs provide a chart of accounts that can be individualized to your business and the templates for each account ledger, the general ledgers, etc. and the financial reports. These programs are menu-driven and user-friendly, but knowing how to input your data correctly is not enough. You must know where to input each piece of data and how to analyze the reports compiled from the data. If you have not learned a manual recordkeeping system, you need to do this before attempting to use a computerized system.

Financial — definitions and classifications

The balance sheet

The balance sheet is a snapshot of the business’s financial position at a certain point in time. This can be any day of the year, but balance sheets are usually done at the end of each month.

This financial statement is a listing of total assets (what the business owns — items of value) and total liabilities (what the business owes). The total assets are broken down into subcategories of current, fixed and other assets. The total liabilities are broken down into subcategories of current liabilities, long-term liabilities/debt and owner’s equity.

Assets

Current assets

Current assets are those assets that are cash or can be readily converted to cash within the next 12 months, such as accounts receivable or inventory. In the balance sheet shown for Sterling Retail, the current assets are cash, petty cash, accounts receivable and inventory.

Some business people define current assets as those the business expects to use or consume within the coming fiscal year. Thus, a business’s noncurrent assets would be those that have a useful life of more than one year. These include fixed assets and intangible assets.

Fixed assets

Fixed assets are those assets that are not easily converted to cash in the short term; i.e., they are assets that only change over the long term. Land, buildings, equipment, vehicles, furniture and fixtures are some examples of fixed assets. In the balance sheet for Sterling Retail (below), the fixed assets shown are furniture and fixtures and equipment. Note that these fixed assets are shown less accumulated depreciation.

Intangible assets (net)

Intangible assets also may be shown on a balance sheet. These may be goodwill, trademarks, patents, licenses, copyrights, formulas, franchises, etc. In this instance, net means the value of intangible assets minus amortization.

Liabilities

Current liabilities

Current liabilities are those liabilities coming due in the short term, usually within the next 12 months. These are accounts payable; employment, income and sales taxes; salaries payable; federal and state unemployment insurance; and the current year’s portion of multi-year debt. (See the sample balance sheet below.)

  • A comparison of your current assets and your current liabilities reveals your working capital. (See cash flow worksheet below.)
  • Many managers use an accounts receivable aging report and a current inventory listing to help them manage the current asset structure. (See also current assets above.)

Long-term debt

Long-term debt/liabilities may be bank notes or loans made to purchase your business’s fixed asset structure. Long-term debt/liabilities come due in a time period of more than one year. The portion of a bank note that is not payable in the coming year is long-term debt/liability.

For example, a business owner may take out a bank note to buy land and a building. If the land is valued at $50,000 and the building is valued at $50,000, the business’s total fixed assets are $100,000. If $20,000 is made as a down payment and $80,000 is financed with a bank note for 15 years, the $80,000 is the long-term debt.

Owner’s equity

Owner’s equity refers to the amount of money the owner has invested in the firm. This amount is determined by subtracting current liabilities and long-term debt from total assets. The remaining capital/owner’s equity is what the owner would have left in the event of liquidation, or the dollar amount of the total assets that the owner can claim after all creditors are paid.

Projected balance sheet — Sterling Retail
Year ended 2014

Assets

Current assets
Cash $11,250
Accounts receivable 6,500
Inventory 30,000
Deposits
Utilities 75
Telephone 75
Sales tax bond 960
Rent deposit 2,000
Total current assets $50,885
Fixed assets
Equipment $25,000
(less accumulated depreciation) (5,000)
Furniture & fixtures 12,500
(less accumulated depreciation) (4,500)
Total fixed assets $28,000
Total assets $78,885

Liabilities

Current liabilities
Accounts payable $5,080
Current portion, long-term debt 10,100
Total current liabilities $15,180
Long-term liabilities
Note payable $36,400
Total long-term liabilities $36,400
Total liabilities $51,580
Owner’s equity $27,305
Total owner’s equity $27,305
Total liabilities & owner’s equity $78,885

The profit and loss statement

The profit and loss statement represents the relation of income and expenses for a specific time interval. This statement is expressed in a one-month format, January 1 through January 31, or a quarterly year-to-date format, January 1 through March 31. This financial statement is cumulative for a 12-month fiscal period, at which time it is closed out. A new cumulative record is started at the beginning of the new 12-month fiscal period.

The profit and loss statement is divided into five major categories:

  • Sales or revenue
  • Cost of goods sold/cost of sales
  • Gross profit
  • Operating expenses
  • Net income

Sales or revenue

The sales or revenue portion of the income statement is the retail price of the product expressed as dollars times the number of units sold. This can be product units or service units. Sales can be expressed in one category as total sales or can be broken out into more than one type of sales category: car sales, part sales and service sales, for example.

Cost of goods sold/cost of sales

The cost of goods sold/sales portion of the income statement is where you show the cost of products purchased for resale, or show the direct labor cost (service person wages) for service businesses. Cost of goods sold/sales also may include additional categories, such as freight charges cost or sub-contract labor costs. These costs also may be expressed in one category as total cost of goods sold/sales or can be broken out to match the sales categories: car purchases, parts, purchases and service salaries, for example.

Breaking out sales and cost of goods sold/sales into separate categories can have an advantage over combining all sales and costs into one category. When you break out sales, you can see how much each product you have sold cost and the gross profit for each product. This type of analysis enables you to make inventory and sales decisions about each product individually.

Gross profit

The gross profit portion of the profit and loss statement tells you the difference between what you sold the product or service for and what the product or service cost you. The goal of any business is to sell enough units of product or service to be able to subtract the cost and have a high enough gross profit to cover operating expenses, plus yield a net income that is a reasonable return on your investment. The key to operating a profitable business is to maximize gross profit.

If you increase the retail price of your product too much above the competition, you might lose units of sales to the competition and not yield a high enough gross profit to cover your expenses. On the other hand, if you decrease the retail price of your product too much below the competition, you might gain additional units of sales but not make enough gross profit per unit sold to cover your expenses.

A carefully thought out pricing strategy maximizes gross profit to cover expenses and yield a positive net income.

Operating expenses

The operating expense section of the profit and loss statement is a measurement of all the operating expenses of the business. There are two types of expenses, fixed and variable. Fixed expenses do not vary with the level of sales, thus you will have to cover these expenses even if your sales are less than the expenses. The entrepreneur has little control over these expenses once they are set. Examples of fixed expenses are rent (contractual agreement), interest expense (note agreement), an accounting or law firm retainer for legal services of X amount per month for 12 months, local phone charges, etc.

Variable expenses vary with the level of sales. Examples of variable expenses are bonuses, employee wages (hours per week worked), long-distance telephone expense, etc. (Note: categorization of these may differ from business to business.) Expense control is an area where the entrepreneur can maximize net income by holding expenses to a minimum.

Net income

The net income portion of the profit and loss statement is the bottom line. This is the measure of a firm’s ability to operate at a profit. Many factors affect the outcome of the bottom line. Level of sales, pricing strategy, inventory control, accounts receivable control, ordering procedures, marketing of the business and product, expense control, customer service and productivity of employees are just a few of these factors. The net income should be enough to allow growth in the business through reinvestment of profits and to give the owner a reasonable return on investment.

Income statement — Sterling Retail
Year ended 2014

2014 % Sales
Sales
Revenues $305,000 100.00%
(less) returns & allowances 5,000
Total sales 300,000 $100.00%
Cost of goods sold
Beginning inventory 5,760 1.92%
+ Purchases 101,760 33.92%
- ending inventory (11,520) -3.84%
= Cost of goods sold 96,000 32.00%
Gross profit 204,000 68.00%
Expenses
Gross wages 48,000 16.00%
Payroll expenses 5,280 1.76%
Supplies 6,000 2.00%
Maintenance 6,000 2.00%
Advertising 2,400 .80%
Accounting and legal 2,400 .80%
Rent 48,000 16.00%
Telephone 3,600 1.30%
Utilities 7,200 2.40%
Insurance 6,400 2.13%
Interest 21,492 7.16%
Bank charges 480 0.16%
Depreciation 20,000 6.67%
Miscellaneous expenses 1,296 0.43%
Total expenses $178,548 59.52%
Net profit $25,452 8.48%

The cash flow statement

The cash flow statement is the most important financial tool you have. The cash flow statement is the detail of cash received and cash expended for each month of the year. By closely monitoring cash flow, the entrepreneur can manage the business’s most important asset effectively.

Many entrepreneurs think that the only financial statement they need to manage their business effectively is a profit and loss statement, and that a cash flow statement is excess detail. They mistakenly believe that the bottom line profit is all they need to know and that if the company is showing a profit, it is going to be successful. In the long run profitability and cash flow have a direct relationship, but profit and cash flow do not mean the same thing in the short run. A business can be operating at a loss and have a strong cash flow position. Conversely, a business can be showing an excellent profit but not have enough cash flow to sustain its sales growth.

The cash flow statement is composed of:

  • Beginning cash on hand
  • Cash receipts for the month
  • Cash paid out for the month
  • Ending cash position

Cash on hand

Cash on hand is the starting cash position of the business on the first day of the month. It usually represents the business’s checkbook balance.

Cash receipts

Cash receipts is the total of cash inflows — cash sales, collections from accounts receivable, monies received from loans, etc. The cash flow statement considers only cash. It does not take into account any uncollected portion of a credit sale.

Cash expense

Cash expense represents the total cash paid out of the business account. Purchases, wages, taxes, expenses, capital equipment purchases, loan repayments and owner’s withdrawals represent most cash expenses. The cash flow statement measures and takes into account all of these cash expenditures as they are paid.

Ending cash position

Total cash available minus total cash paid out equals the end of month cash position. The ending cash position should equal the balance of the checkbook account at the end of the month of business activity.

Monthly cash flow projection worksheet — Sterling Retail
Year ended 2014

Item Pre-startup Month 1 Month 2 Month 3
1. Cash on hand $20,000 $24,280 $17,733 $12,896
2. Cash receipts
a. Cash sales 10,520 15,200 20,000
b. Collections
c. Loans 50,000
3. Total receipts 50,000 10,520 15,200 20,000
4. Cash available 70,000 34,800 32,933 32,896
5. Cash paid out
a. Purchases 20,000 6,150 9,120 12,000
b. Gross wages 4,000 4,000 4,000
c. Payroll expenses 512 512 512
d. Services 100 100 100
e. Supplies 2,800 200 200 200
f. Maintenance 200 200 200
g. Advertising 1,200 150 150 150
h. Car and travel 200 80 80 80
i. Accounting and legal 500 120 120 120
j. Rent 1,200 4,000 4,000 4,000
k. Telephone 320 80 80 80
l. Utilities 1,000 600 600 600
m. Insurance 2,500
n. Taxes
o. Interest 375 375 375
p. Other expenses 1,000
1. Profit share
2. License
q. Miscellaneous
r. Subtotal 30,720 16,567 19,537 22,417
s. Loan payment 500 500 500
t. Capital purchase 15,000
u. Initial expense
v. Owner’s fee
6. Total paid 45,720 17,067 20,037 22,917
7. Cash position $24,280 $17,733 $12,896 $9,979

Summary

Financial controls enable you to take a proactive management position in your business. The three most important financial controls are:

  1. The balance sheet,
  2. The profit and loss statement and
  3. The cash flow statement.

Each gives the entrepreneur a different perspective on and insight into how well the business is operating toward its goals. The business plan requires a projection of these statements to obtain financing. The financial controls provide a blueprint to compare against the actual results once the business is in operation. A comparison and analysis of the business plan against the actual results can tell the entrepreneur whether or not the business is on target. Corrections or revisions to policies and strategies may be necessary to achieve the business’s goals. Analyzing monthly financial statements is a must if you want to successfully manage your new business.

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NOTE: These materials are designed to provide accurate and authoritative information in regard to the subject matter covered. They are provided with the understanding that the authors are not engaged in rendering legal, accounting or other professional service. If legal advice or other expert assistance is required, the services of a competent professional person should be sought. Completion of these materials does not ensure success in business.