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Understanding
Financial Statements
MANAGINGan agribusiness requires a good under-
standing of financial matters. Knowing when to buy new assets, sell old assets, borrow money, invest in the business, or buy a new business requires the ability to understand financial statements. What can they tell us? How are they used as tools to assess the financial "health" of a business?Objective:
?Identify the purposes of three common financial statements and explain how to develop the statements.Key Terms:
Financial Statements inBusiness Management
Financial management is important to the success of a business. With an understanding of where you are, where you have been, and where you are going financially, you can make man agement decisions that maximize the profitability of the business.E-unit: Understanding Financial Statements
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Copyright © by CAERT, Inc. - Reproduction by subscription only.020097 accrual accounting method balance sheet cash accounting method cash-flow statement current ratiodebt-to-asset ratio debt-to-equity ratio liquidity profit-and-loss statement profitabilityreturn-on-assets ratio return-on-equity ratio solvency working capital The "Big Three" financial statements most often used in business are the balance sheet (also called the net worth statement), the profit-and-loss statement (also called the income state ment), and the cash-flow statement. These three statements, along with the financial ratios that can be calculated from them, provide information to managers and other interested persons about the ability of a business to pay off debts, operate effectively, and return a profit. Business owners must be consistent in the way they track their financial activity. There are two methods of accounting that businesses use to document their income and expenses. Thecash accounting methodrecords income and expenses when the money is received or payment is made. For example, if Weber Florists bought and paid for greenhouse plants in September, sold them in December, and received payment from its customers in Jan uary, the expense would be recorded in September and the income would be recorded in Janu ary. The cash method is very simple to use and understand but may be misleading. If Weber Florists uses January 1 through December 31 as its tax year, the business would show expenses for this transaction in one year, with no income from the transaction to offset those expenses. Similarly, records for the next tax year would show income with no offsetting expenses in that tax year for this particular transaction. Theaccrual accounting methodrecords income and expenses when a sale is made or an expense is incurred regardless of when the money is received or payment is made. Using accrual accounting in our Weber Florists example, the expense would be recorded in Septem- ber, and the income would be recorded in December even though the money itself was not received until January. Once a method of accounting is chosen, sticking with that method is important. Frequently switching methods or following a method inconsistently can create an inaccurate financial pic- ture of the business and may result in tax consequences.THE PURPOSE OF FINANCIAL STATEMENTS
The purpose of financial statements is to determine the financial standing of a business and to measure three main objectives: profitability, liquidity, and solvency. Profitabilityis the ability of a business to make a profit. After all the revenue is in and all the expenses are paid, is there a profit? Liquidityis the ability of a business to pay current obligations without disrupting normal operations. It is the ability to pay regular bills without having to sell off assets needed to operate the business. In short, being liquid means having enough cash to pay the bills. Solvencyis the ability of a business to pay all its debts if the business were liquidated, or sold out. A solvent business must have more assets than it has debt. Financial statements can measure these objectives by showing the revenue a business is gen erating (profit-and-loss statement), the amount of cash it has available to pay current obliga tions (cash-flow statement), and the net worth of the business (balance sheet). With some fairly simply calculations, financial ratios can be computed that allow a business to compare itsE-unit: Understanding Financial Statements
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Copyright © by CAERT, Inc. - Reproduction by subscription only.020097 financial situation with that of the average business in its industry or with its own performance in previous years.Cash-Flow Statement
Acash-flow statementshows all sources of cash for the year, as well as all uses of cash. Sources of cash may include products or services sold, cash on hand or balances of checking accounts, equipment sold, money borrowed, and any miscellaneous sources of cash. Uses of cash may include operating expenses, purchase of assets, principal payments on loans, and any other expenses paid for by the business. The cash-flow statement shows where the money went for a business. It can demonstrate the need for borrowing money and the ability to repay the lending institution.Balance Sheet
Abalance sheet, also known as a net worth statement, identifies all assets and liabilities of a business. The balance sheet is really a checkup on the financial standing of the business. Balance sheets are prepared annually. They show how financial progress is being made over previous years. As liabilities get paid off and a business owns a larger percentage of the assets, net worth should increase.Precision Lawn Care
Balance Sheet
December 31, 20--*
Assets(owned or have value)
Current Assets(converted to cash easily, can be used without disrupting business operations)Cash $1,200
Checking Account Balance 3,500
Accounts Receivable(payments due the business)300
Total Current Assets $5,000
Noncurrent Assets(needed to run the business on an ongoing basis)Truck & Trailer $21,500
Lawnmowers 12,500
Blowers, Trimmers & Other Equipment 2,200
Total Noncurrent Assets 36,200
Total Assets$41,200
E-unit: Understanding Financial Statements
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Copyright © by CAERT, Inc. - Reproduction by subscription only.020097Liabilities(owed)
Current Liabilities(owed this year)
This Year's Portion of Equipment Loan $900
Accounts Payable(payments due suppliers)200
Total Current Liabilities $1,100
Noncurrent Liabilities(owed after this year)
Remaining Equipment Loan(mowers, truck)$10,500
Total Noncurrent Liabilities 10,500
Total Liabilities11,600
Net Worth(also called Owner Equity)29,600
Total Liabilities and Net Worth$41,200
*The purpose of the balance sheet is to organize everything owned and owed by the business at a specific time.
The balance sheet should be done each year at the same time to identify changes in net worth. Both assets and liabilities can be identified as either current or noncurrent. Current assets are readily available to meet cash needs within one year's time. They may include cash, check- ing accounts, accounts receivable (money owed the company by clients), and inventory ready for sale. Current liabilities are debts owed within the next year. They may include accounts payable, such as bills owed to suppliers, and loan balances due within a year's time. Noncurrent assets and liabilities are those items that will remain on the company ledger longer than one year. Noncurrent assets may be machinery that will be used within a business for several years and other assets that, if sold, would interrupt the ability to operate the busi ness. Noncurrent liabilities are those that will be paid more than a year into the future.Profit-and-Loss Statement
Aprofit-and-loss statement(also known as an income or operating statement) shows all a company's revenue and expenses for a specific period, usually a year. Revenue includes all money coming into the company. Expenses are calculated as variable or fixed. Profit-and-loss statements are different from year to year depending on the revenue and expenses involved.E-unit: Understanding Financial Statements
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Copyright © by CAERT, Inc. - Reproduction by subscription only.020097Precision Lawn Care
Profit-and-Loss Statement
for Year Ending December 31, 20--*Revenue
Lawn Services $92,500
Other Cash Income 500
Gross Income$93,000
Expenses
Variable Cash Expenses
Hired Labor $28,500
Gasoline, Fuel & Oil 7,500
Repair & Maintenance 2,500
Advertising 500
Grass Seed, Fertilizer & Herbicide** 3,500
Miscellaneous Cash Expenses 300
Total Variable Cash Expenses $42,800
Fixed Cash Expenses
Depreciation of Equipment $3,200
Insurance 3,000
Interest on Debt 800
Total Fixed Cash Expenses 7,000
Total Expenses49,800
Net Income(Gross Income Minus Total Expenses) $43,200*The profit-and-loss statement, also referred to as the income or operating statement, shows the earnings of a
business for a period, usually one year. It shows all revenue and all expenses and calculates net income.
**Includes any year-to-year adjustments to inventory.CALCULATING FINANCIAL RATIOS
There are several ways to measure the financial situation of an agribusiness. These tools study the profitability, liquidity, and solvency of the business.E-unit: Understanding Financial Statements
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Copyright © by CAERT, Inc. - Reproduction by subscription only.020097Measures of Profitability
Profit is extremely important to a business. Without profit, a business will cease to operate once its money is gone! Two ratios are particularly valuable in measuring the profitability of a business. They are the return-on-assets ratio and the return-on-equity ratio. Thereturn-on-assets ratioassesses the rate of return on the assets used in a business. An asset is anything of value the owner has invested in. To calculate the return-on-assets ratio, a profit-and-loss statement and a balance sheet are needed. Use the sample statements of Pre cision Lawn Care included in this E-unit. The owner of Precision Lawn Care has a net income of $43,200. The owner does not pay himself anything but figures his wages to be $30,000. The balance sheet for the business lists total assets of $41,200.Net Income: $43,200
minus Value of Unpaid Labor: - $30,000Net Income less Value of Unpaid Labor: $13,200
divided by Total Assets: ÷ $41,200 = 0.32Return-on-assets ratio: 0.32:1
The lawn-service business returns $0.32 for every $1.00 in assets. The higher the ratio, the more profitable the business. Owners prefer to have few assets that generate a lot of dollars. Each type of business will be different for the type of return-on-assets ratio it has. Service- based businesses without many tangible assets have much higher ratios because instead of hav- ing physical assets, they perform services. Equity is the bottom line on a balance sheet. Equity is the value of all assets after all liabili- ties have been subtracted. Thereturn-on-equity ratioassesses the rate of return on the equity of a business. Again using our example of Precision Lawn Care, the return-on-equity ratio is calculated as follows:Net Income: $43,200
minus Value of Unpaid Labor: - $30,000Net Income less Value of Unpaid Labor: $13,200
divided by Equity (Net Worth): ÷ $29,600 = 0.45Return-on-equity ratio: 0.45:1
For a comparison of profitability, both types of ratios can be compared with those of similar businesses or with those of the same business in past years.E-unit: Understanding Financial Statements
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Copyright © by CAERT, Inc. - Reproduction by subscription only.020097Measures of Liquidity
Liquidity is the ability of a business to meet expenses or debt without interrupting normalbusiness operations. It is essentially the ability to pay the bills without having to sell assets to do
so. Working capital and current ratio are the two measures of liquidity used in agribusinesses. Working capitalis calculated from the balance sheet by subtracting current liabilities from current assets. Since liquidity is a measure of being able to pay debts immediately, only assets and liabilities that will be realized within the current year are used. Using the Precision Lawn Care example, the current assets were $5,000, while the current liabilities were $1,100.