variations in the income statement format depending on industry, company size, and disclosure needs. They will still follow the gen- eral sequence resolving debits and credits. Note also that this example classifies the income as it related first to production, the Gross Margin, also called “income from continuing operations.”
Many consider this number the most important predictor of future business health. If it’s high, your business generates enough cash to support the activity that’s actually making money.
From the Gross Margin, subtract all the expenses incurred in
“keeping the doors open” to yield Operating Income. This sub- division of the income statement is not a GAAP requirement, but it gives an idea of the strength and profitability of the core business operation. Then both expenses and income not related to operations are calculated. Often these are single-event items that will not recur—the tornado that took the roof or the obscure patent sold for big bucks. That brings us to Income Before Tax.
We subtract the income tax and finally reach the bottom line, Net Income. This is how much we made. To know how well GW did as a company, you would have to compare this 7% return with others in the widget industry. It could be great, fair, or downright anemic.
collected. Creditors prefer steak to paper, but will take potatoes if that’s all you have left.
The information in the income statement and the balance sheet comes from end-state accounts. The statement of cash flows (Table 3-3) is the only report that uses “flow” information.
Changes in the cash flow can often explain why balance sheet accounts changed. The statement is also useful in projecting the liquidity of a business over time. One clear thing it will show is how a business uses the profits that it generates.
The first section of the statement is for operating activities.
Operating activities are those things that generate cash income. These include sales receipts as well as inventory or manufacturer purchase. Cash from operations can be negative, and often is, especially in growing companies. At the start, operating losses rise as cash is spent for expenses. As you add business, you start to book some revenue. A lot of that rev- enue is in the form of accounts receivable, so your cash collec- tion rate is a bit slow. Not for nothing is it called cash burn.
Without loans or personal capital coming in to feed the fire, a company can be reduced to cinders.
Know Your Audience
Who are the customers for these financial statements and what uses will they make of them? That’s a very broad question. Managers use them internally to gauge and guide management decisions. Interested external parties could include the following:
• Current or potential investors evaluating the firm’s prospects
• Creditors deciding whether or not to lend money
• Investment advisors and economists forecasting the future prospects for the company or the industry
• Customers evaluating you for your ability to complete long-term assignments
• Tax authorities monitoring compliance
• News media reporting on business and the economy
• Competitors wanting to know your strategies
Public financial statements generate a lot of interest and scrutiny.
People invest a lot of time and treasure in the results. Is there any wonder people get upset when they get bogus information?
A lot of that cash is going to investing activities.
Investments are the power tools, shop buildings, and office equipment needed to get things started. It doesn’t matter if you are buying them outright or financing them, you’ll have to account for them. How you chose to pay for your assets will affect your cash flow. Which path you choose will depend on several variables—amount, interest rate, expected payback time, and forecast of future cash flows.
If you chose to use debt financing, the financingactivities section is where you’ll record the loan proceeds. This section also shows the gozintas and gozoutas of cash to the owners through stock purchases, dividend payments, or shareholder loans.
Many companies are woefully undercapitalized, sometimes by owner intent, often through ignorance of the need. To be competitive, business owners and managers must continually plan to keep the cash flowing into the company. The U. S. Small Business Administration names ineffective cash flow manage- ment as one of the top reasons why firms fail.
There are two methods used to present statement of cash flows information, the indirectmethod (as in Table 3-3) and the directmethod. The methods are different in their treatment of operating activities only. Most companies use the indirect method, because it’s easier. Most banks prefer the direct method, as it provides more information.
The indirect method does not report the operating cash flows. Instead, the operating activities section reconciles net income and net operating cash flows. You start with the net income from your income statement. You then adjust this accrual amount for items that do not affect cash flows. There are three basic types of adjustments in the operating activities section. The first involves non-cash outlays, such as deprecia- tion or amortization. Then, adjust for gains and loses on trans- actions reported in other sections of the statement of cash flows. Finally, convert all current operating assets and liabilities from the accrual to the cash basis.
A way to visualize the cash coming in is with a corollary of the accounting equation (Table 3-4).
In the direct method, the net cash flow from operations is computed directly as the net sum of the operating cash flows.
Your firm will do one or the other. Ask about why the particular Indirect Method
Operating Activities Sales Receipts
Payments for Products Payments for Operations Payments for Interest Payments for Taxes Unusual Items Net Cash (Used) by Operating Activities
3,500,000 (1,750,000) (1,500,000) (75,000) (119,000
150,000 206,000 General Widget, Inc.
Statement of Cash Flows For the Year Ended December 31, 200_
Investing Activities Purchase of Property, Plant, and Equipment
Sales of Property, Plant, and Equipment
Interest and Dividend Income Net Cash (Used) by Investing Activities
(1,850,000
75,000 (1,775,000) Financing Activities
Short-Term Debt Long-Term Debt Capital Stock Issued Cash Dividends
Net Cash (Used) by Financing Activities
580,000 1,000,000 450,000
2,030,000 Net (Decrease) in Cash
Cash at Beginning of Year Cash at End of Year
461,000 (111,000)
350,000 Table 3-3. Statement of cash flows
statement form was chosen and just learn it.