Posts Tagged ‘Financial Statements’
What Are Budgets and Forecasts?
They are predictions of future income and expenses and cash flow. They also predict future performance with financial forecasts and projections and with financial models.
Why Budget and Forecast?
Budgets and forecasts provide a feasibility analysis. They can help develop a business model, review your key assumptions, and identify resource and capital needs. Budgets and forecasts can be used to find funding. They demonstrate the potential of your business to investors and lenders. Budgets and forecasts can also be used as a management tool. They can help you establish milestones and require accountability for accomplishing the milestones. They can help identify risks and show benchmarks. This will help the small business owner make the necessary adjustments to avoid the risks, to reach the milestones, and to measure up to benchmarks.
Why Are Forecast Important?
A forecast can establish measurements to guide management, to facilitate planning, and to facilitate goal-setting.
What Areas Do You Need to Forecast?
It is critical that you forecast your start-up costs so that you know how much it will cost to open your doors. You need to prepare estimated start-up financial statements and estimated short and long-term revenue forecasts. As part of your forecasts, you will review key concepts and issues that will make a difference in your company’s survival. You also need to forecast the resources you will need and set up a schedule for using and replenishing your resources.
Do Investors Want to See Forecasts?
Yes, your forecasts will show investors that you know your business, that you are likely to succeed, and that you will make wise use of their money. You must have at least a five-year forecast that shows significant profit by year five, significant net income by year two, and that investors will earn approximately 10% return on their investment.
Do Lenders Want to See Forecasts?
Yes, your forecasts will show lenders that you know your business and the you will be able to repay the loan. Be sure you forecast for the entire period of the loan and use conservative financial ratios, because the lenders will. Also, you will need to collateralize and personally guarantee the loan.
The investors and lenders will want to see forecasts of your profit and loss and revenue. They will also want to see what drives income in your industry; for example, sales, distribution, advertising, internet search engines, referrals, location, price, or coupons or other discounts. You also must forecast the revenue cycle for your target customer. How much time will you need to start production, and how quickly will your product or service be accepted in the market?
What Other Forecasts Are Needed?
Another important forecast is the total personnel required to support your desired revenue. If your revenues result from sales, you should start with the desired revenue in year 5. From year 5 subtract 40% from each prior year. On the basis of your research, estimate the number of sales each sales person will make each year. From that you can calculate number of salespeople required.
After you make your forecasts, you should complete a sensitivity analysis by adjusting each major item estimated by 10% plus or minus. Examine the impact on revenues, profit, and cash needs. Remember that most operating expenses are roughly proportional to personnel headcount. These are your variable expenses such as salaries, benefits, employment taxes, furniture, computers, rent, supplies, utilities, training, travel, meals, training, and dues. Other non-variable expenses may or may not be proportional such as professional services, subcontractors, advertising, and trade shows.
Use your forecasts to compare yourself to others in your industry by such things as revenue per employee, revenue per salesperson, gross margin, expense categories as a percentage of revenues, financial ratios, and inventory control. It is critical that you know your industry’s benchmarks and metrics and that your business forecasts are within these benchmarks and metrics. You can find this information by researching your industry.
Should You Hire a Business Consultant to Prepare Your Forecasts and Research Your Industry?
Yes! Unless you have a very strong finance and accounting background, you cannot create financials that will be acceptable to investors and lenders. You cannot do an acceptable business plan with a spreadsheet, and it will be difficult for your to be objective in developing your business model. Also, you are the entrepreneur and your efforts are better spent building and developing your business which is what you do best.
Jo Ann Joy, CEO, Indigo Business Solutions
JoAnnJoy@IndigoBusinessSolutions.net, Phone: (602) 663-7007
The future of your business starts here.
For more information about these and other important topics and for legal consultation, please visit our website at http://IndigoBusinessSolutions.net Copyright 2006. Indigo Business Solutions is a registered trade name.
Information is data that is transformed into something that it meaningful and understandable to a human being. Financial statements are the result of the transformation of financial data to information that meets the objectives of users. Therefore, the users of the various statements must find the information meaningful and useful for their purpose(s). In financial accounting, qualitative characteristics of financial statements ensure that the information in them is useful.
There are nine basic qualitative characteristics of financial statements. Four of these are of paramount importance:
i) Understandability
ii) Relevance
iii) Reliability
iv) Comparability
In addition to the four main characteristics, other elements add to the quality and usefulness of financial reports. These are:
a) Completeness
b) Prudence
c) Substance over form
d) Neutrality
e) Faithful representation
Financial statements are supposed to be understandable to users who have a working knowledge of economics, business and accounting. It is natural that some statements may be more complex than others are, because of the nature of certain transactions or intricacy of certain entities. However, once information is relevant, it must be included. Any information that may not be clear to a knowledgeable user should be clarified in the notes to the relevant statements.
Irrelevant information, in a particular context, is not useful. Since the purpose of financial statements is to provide information about the entity’s performance, financial position, cash flows and changes in equity, it follows that only information pertinent to those should be included in the financial statements. Determination of relevance is also affected by the nature of information and its materiality (whether it can influence the economic decisions of users).
Reliability, in the context of financial reports, refers to information being free from material error and bias. Material errors refer to those that can influence the economic decisions of information users. The characteristic of neutrality also dictates that information is financial statements should be free from bias. Presenting information in a manner that is designed to contrive an outcome or influence users in a certain way is no longer neutral, regardless of whether it is verified by an external party or not.
Financial statements must be presented in such a manner that a user can compare the statements over time and with those of other entities (Comparability). There must be a degree of consistency in the treatment of like items within the entity and across entities. The statement should also disclose any use of particular accounting policies or methods.
Since most financial accounts are created based on accruals and not cash, there is a degree of uncertainty in anticipating transactions. Prudence, one of the fundamental assumptions of financial accounting, ensures that assets are not overstated and liabilities understated. However, you must note that prudence does not permit understatement of assets and overstatement of liabilities either.
Completeness complements the reliability of financial statements. Omission of material information can mislead users. However, information should only be complete once it is relevant and within the restrictions of materiality, timeliness and cost. Faithful representation states that where there are difficulties or uncertainty in identifying transactions or measuring certain elements, an entity should avoid identifying it in the financial statement. Another characteristic, substance over form, dictates that an entity should account for a transaction according to economic reality as opposed to legal form. Substance over form supports fair presentation.
One of the main objectives of financial reporting is to satisfy the information needs of a range of users. In so doing, financial statements and reports must have a framework. Financial accounting is not just about getting your ledgers in order or creating financial reports, but involves a theoretical aspect that governs the production of information for economic users. In the same way that good accounting information has certain characteristics, financial reports are bound to possess certain qualitative characteristics.
The four main qualitative characteristics of financial statements are:
i) Understandability
ii) Relevance
iii) Reliability
iv) Comparability
There are other qualitative characteristics of financial statements, but those four are the most important, especially as they rely on fundamental assumptions like consistency and fair presentation. These characteristics define what makes financial statements useful to the users-whoever the users may be.
1. Understandability
While you can argue that financial information is somewhat complicated for the uninitiated to understand, users must be able to understand the information provided. This applies to the format/ layout of the statement, to the terms used in the statement and the policies, methods and assumptions utilized in preparing the statement. Users of financial accounts are assumed to have sufficient knowledge to study the information properly. Understandability ensures that a user equipped with the basic knowledge can discern information pertaining to the performance and financial position of the enterprise.
2. Relevance
Since financial accounts are for users to make economic decisions, the information must be relevant to the decisions that those users have to make. By definition, irrelevant information cannot be useful. Once all items in a financial statement helps users to assess historic or future events, the information in the statement relevant to the users. Whether the information affects the economic decisions of users (materiality) and the nature of information affect relevance as well. Materiality is one of the assumptions used in financial reporting, but it merely contributes to relevance.
3. Reliability
The word “reliable” is easily understood, but its manifestation differs according to context. In the context of accounting, reliable information is free from material error (errors that affect the economic decisions of users) and bias. In other words, a reliable financial statement must fairly and consistently present information about the performance and financial position of an entity. Users must have confidence in the financial statement, without it being misleading or deliberately constructed in a manner that presents the entity in a favourable light.
4. Comparability
Imagine if you saw a financial statement from one company and they prepared it differently from other companies in the industry or even different from how they prepared it in previous years. It is likely that the users would not be able to compare the statements among companies and over time. Comparability adds a degree of transparency to financial statements by allowing comparisons over time and among entities.
Comparability is affected by consistency of presentation and disclosure of accounting policies-particularly when comparing items among entities that might use different (but equally valid) methods like straight-line/ reducing balance depreciation or FIFO/average cost method. This indicates that comparable financial statements are not necessarily uniform, but merely allow comparisons.
== Conclusion ==
Besides understand ability, reliability, relevance and comparability, other qualitative characteristics of information include completeness, prudence, neutrality, faithful representation and substance over form. Sometimes, there exists a trade-off between or among qualitative characteristics. The financial accountant usually exercises discretion where any conflict might occur.
Accounting is a way of recording, analyzing, and summarizing transactions of a business.
o The transactions are recorded in “books of prime entry”
o The transactions are than analyzed and posted to the ledger
o Finally the transactions are summarized in the financial statements
The need of Accounts
If business runs efficiently, why it have to go through all the bother of accounting procedures in order to produce financial information?
A business should produce information about its activities because there are various groups of people who want or need to know that information. This sounds rather vague, to make it clearer, we should look more closely at the classes of people who might need information about a business. We need also to think about what information in particular is of interest to the members of each class.
Users of financial statements and accounting information
The people who might be interested in financial information about a large public company may be classified as follows,
o Managers of the company.
o Shareholders of company.
o Trade contacts.
o Providers of finance to the company.
o The Inland Revenue.
o Employees of the company.
o Financial analysts and advisers.
o Government and their agencies.
o The public.
Accounting information is organized into financial statements to satisfy the information needs of these different groups,
Not-commercial undertakings
It is not only businesses that need to prepare accounts, Charities and Clubs also prepare financial statements every year. Accounts also need to be prepared for public sector organization.
The Main Accounting Statements
Transactions are summarized in the financial statements. The two main financial statements are the Balance sheet and the Profit and loss account. Both of the balance sheet and the profit and loss account are summaries of accumulated data.
The balance sheet – is simply a list of all the assets owned and all the liabilities owned by a business as at a particular date. It shows the financial position of the business at a particular moment.
A profit and loss account – is a record of income generated and expenditure incurred over a given period.
The period chosen will depend on the purpose for which the statement is produced, that time called finance year.
Every business has several stakeholders. All stakeholders depend on the financial statements to provide them appropriate information for their needs. They will assume in most cases, that the financial statements are prepared in accordance with generally accepted accounting principles and that the same have been followed consistently from year to year. The Financial statements should address the information requirements of the user. Financial statement users are generally interested in the following three financial statements. The Income statement provides a picture of the profitability during a given period. The Balance sheet provides a snapshot of the financial position, assets and liabilities at a certain date. The cash flow statement shows the movement of cash in the business between any two given dates. Financial statements are the primary source of information about the company’s profitability, financial position and cash flow.
Let us now look at how the various users use the financial information. Investors need to look at profitability over time as well as comparison with industry, solvency as evidenced by the financial position and stability and continuity as evidenced by a strong cash flow. They will also be interested in the capital structure and what would contribute to the value of their holdings. The Lenders would be interested in knowing whether the company would be able to meet its cash obligations as they mature security of their loans and the company’s capacity to pay interest and repay the loan. They would also be interested in knowing whether the company is using working capital to finance long term projects? Suppliers rely on the information in the Balance sheet to determine whether to sell on credit to the company and what would be the dangers if any; Pension fund managers would look at the profitability and long term survival of the business and their stake. The Business managers are the immediate users of financial information. They have to understand how the business is doing on the financial front, spot problems that may be coming up on the horizon. An example could be inventory build-up or a receivable build-up that may lead to cash problems down the line.
Understanding financial statements and how it can fulfill specific information needs is critical for every stakeholder in the business.
In continuing in our series of fundamental concepts of financial modeling, and after taking a quick break to discuss the cash conversion cycle, I will now turn to another initial step of understanding how to forecast financial information. It is important that the reader has some familiarity of the three major financial statements (income statement, balance sheet and cash flow statement) that I covered in the prior three articles. If not, please read those first prior to continuing.
Long-Term Assets
The most common long-term asset for many industrial or manufacturing companies is property, plant and equipment (“PP&E”), also referred to in certain cases as fixtures, furniture, fixtures and equipment. PP&E is a category on the balance sheet that typically captures large pieces of equipment used to generate products. For example, a car manufacture would include all of the assembly line equipment like conveyor belts, robotic arms, power drills and lifts, etc., in this category. Also computers, desks, chairs, leasehold improvements, land and buildings would be included in PP&E. In most financial statements, a company lists both gross PP&E and net PP&E. The gross amount is the actual totally dollar amount a company paid for all of its equipment and the net amount represents the book value of those same items after depreciation is included.
What is depreciation? Depreciation is a means to try to establish useful lives for various assets based on both accounting standards and the tax code, which have different approaches. For example, a computer may have a five-year asset life for both accounting and tax purposes, but a company car might be depreciated over 10 years for accounting and five years for tax purposes. It is not uncommon to have assets classes with disparate timeframes between GAAP and tax methods. The Financial Accounting Standards Board regulates GAAP, which constitutes the rules for accounting methods and the IRS is the regulatory agency behind the tax code. These two entities have different rules for governing depreciation methods and a general understanding of the differences is important prior to developing a financial model. Further, some analyses may get into very complex tax code understanding, so if your project calls for a deep dive into the tax impact of decisions, you should have a resource to address those questions. In many instances of simple financial modeling, however, the book method and the tax method are left the same and much of the aforementioned differences become moot.
To keep everything simple, financial modelers will take the entire net PP&E amount and use what is called “straight line” depreciation, or subtract the same depreciation amount from PP&E each year. For example, if the beginning total was $100,000,000 and accounting rules dictate that the assets are depreciable over a 20-year period, the depreciation would be $5,000,000 per year, if there is no “residual value” (residual value, or salvage value, refers to the amount one thinks an asset would be worth at the end of the useful life to a company and this value does not exist for tax purposes). If there is a residual value of $20,000,000, you would depreciate $80,000,000 over a 20-year period, or $4,000,000 depreciation expense per year. From a modeling perspective, it is easy to do an explicit depreciation calculation based on the accounting timeframes.
Companies build up the PP&E category through capital expenditures (“CapEx”). CapEx can either be improvements to existing equipment or new equipment purchases. To determine the amount of forecasted CapEx, there are two methods: explicit time horizon or ratio. Under the explicit time horizon, the financial modeler would have specific information on the spending needs of a company. For example, assume that the management team must spend $30 million equally over the next three years to upgrade existing equipment. In this case, you know that $10 million per year will be spent. If you do not know the exact amount, you would use a ratio to determine total CapEx, like a percentage of revenue. Let’s assume that over the past few years a company has spend 5% of total sales in CapEx. Barring some specific news of the future, you might assume that the 5% ratio would hold for the foreseeable future. Another way some financial modelers will forecast CapEx, particularly for a company in the mature stage of business, is to have CapEx equal depreciation. This way, the net PP&E will stay the same over the forecasted horizon. Whichever method you choose to use should just make sense from an historical performance analysis as well as incorporating future expectations.
Another common long-term asset is goodwill, which is an intangible asset. Goodwill arises when one company buys another company for a value that is in excess of the net asset value. This “extra” value is, presumably, related to the positive intangible aspects of running a successful business, and the amount is placed on the balance sheet at goodwill. The current accounting rules for goodwill dictate that the total amount be evaluated periodically for potential decreases in value. If there is a determination that the goodwill account is higher than it should be, the goodwill is considered impaired and a write-down is required. For financial models with a short forecast horizon (three to five years), the goodwill is rarely adjusted. Other intangible assets include patents, trademarks, copyrights, etc. and there are specific time periods by which these categories are amortized (amortization is depreciation but for intangible assets). Patents are generally amortized over their legal life, trademarks, while technically indefinite, are amortized over their useful lives, and copyrights are amortized over a time period reflective of the costs to obtain such copyright. From a financial modeling perspective, there accounts are very straightforward and require little to no adjustment over the forecast horizon.
There are other long-term assets, like deferred taxes, long-term investments and various prepaid rights. The category most spend time getting right, however, is PP&E. It is of paramount importance that you have a basic understanding of depreciation methodologies and CapEx rationale in order to correctly forecast PP&E. The vast majority of the other long-term assets are much easier to model and once the PP&E calculations are conquered, the rest of the long-term assets will seem like child’s play.