Table of Contents
| 1 | Starting with Cash Flows | 1 |
| 2 | Introducing the Balance Sheet and Income Statement | 7 |
| 3 | Profit Isn't Everything | 17 |
| 4 | Sales Revenue and Accounts Receivable | 27 |
| 5 | Cost of Goods Sold Expense and Inventory | 33 |
| 6 | Inventory and Accounts Payable | 39 |
| 7 | Operating Expenses and Accounts Payable | 43 |
| 8 | Operating Expenses and Prepaid Expenses | 47 |
| 9 | Long-Term Operating Assets: Depreciation and Amortization Expense | 51 |
| 10 | Accruing Unpaid Operating Expenses and Interest Expense | 61 |
| 11 | Income Tax Expense and Income Tax Payable | 67 |
| 12 | Net Income and Retained Earnings; Earnings per Share (EPS) | 71 |
| 13 | Cash Flow from Profit and Loss | 77 |
| 14 | Cash Flows from Investing and Financing Activities | 85 |
| 15 | Growth, Decline, and Cash Flow | 89 |
| 16 | Footnotes - The Fine Print in Financial Reports | 101 |
| 17 | CPAs, Audits, and Audit Failures | 109 |
| 18 | Choosing Accounting Methods and Quality of Earnings | 125 |
| 19 | Making and Changing Accounting Standards | 133 |
| 20 | Cost of Goods Sold Conundrum | 147 |
| 21 | Depreciation Dilemmas | 159 |
| 22 | Ratios for Creditors and Investors | 167 |
| 23 | A Look Inside Management Accounting | 181 |
| 24 | A Few Parting Comments | 191 |
| Index | 201 |
Read a Sample Chapter
How To Read A Financial Report: Wringing Vital Signs Out of the Numbers John A. Tracy
0-471-32706-9
(NOTE: The figures and/or tables mentioned in this sample chapter do not appear on the web version.)
STARTING WITH CASH FLOWS
Importance of Cash Flows: Cash Flows Summary for a Business
Business managers, lenders, and investors, quite rightly, focus on cash flows. Cash inflows and outflows are the heartbeat of every business. So, we'll start with cash flows. For our example we'll use a midsize company that has been operating many years. This established business makes a profit regularly and, equally important, it keeps in good financial condition. It has a good credit rating; banks are willing to lend money to the company on very competitive terms. If the business needed more money for expansion, new investors would be willing to supply fresh capital to the business. None of this comes easy! It takes good management to make profit, to raise capital, and to stay out of financial trouble.
Exhibit A on the next page presents a summary of the company's cash inflows and outflows for its most recent year. Two different groups of cash flows are shown. First are the cash flows of making profit-cash inflows from sales and cash outflows for expenses. Second are the other cash inflows and outflows of the business-raising capital, investing capital, and distributing profit to its owners.
I assume you're fairly familiar with the cash inflows and outflows listed in Exhibit A-so, I'll be brief in describing each cash flow at this early point in the book:
- In the first group of cash flows, the business received money from selling products to its customers. It should be no surprise that this is the largest source of cash inflow, amounting to $10,225,000 during the year. Cash inflow from sales revenue is needed for paying expenses. The company paid $7,130,000 for manufacturing products sold to its customers; and, it had sizable cash outflows for operating expenses, interest on its debt (borrowed money), and income tax. The net result of these profit-making cash flows was a positive $540,807 for the year-which is an extremely important number that managers, lenders, and investors watch closely.
- In the second group of cash flows, notice first of all that the company raised additional capital during the year. Notes payable increased $175,000 from borrowing during the year; and, $50,000 was invested by stockholders (the owners of a corporation). On the other side of the ledger the business spent $750,000 for building improvements, machines, equipment, vehicles, and computers. And, the business distributed $200,000 to its stockholders from profit it earned during the year. The net result of the second group of cash flows was a negative $725,000 for the year, which is more than the cash flow from its profit-making operations for the year.
What Does Cash Flows Summary NOT Tell You? In Exhibit A we see that cash, the all-important lubricant of business activity, decreased $184,193 during the year. In other words, all cash outflows exceeded all cash inflows by this amount for the year. Without a doubt this cash decrease and the reasons for the decrease are very important information. The cash flows summary tells a very important part of the story of a business. But, cash flows do not tell the whole story. Business managers, investors in business, business lenders, and many others need to know two other essential things about a business that are
not reported in its cash flows summary.
The two most important types of information that a summary of cash flows does not tell you are:
1. The
profit earned (or loss suffered) by the business for the period.
2. The
financial condition of the business at the end of the period.
Now, just a minute. Didn't we just see in Exhibit A that the net cash increase from sales revenue less expenses was $540,807 for the year? You may well ask: "Doesn't this cash increase equal the amount of profit earned for the year?" No, it doesn't.
The net cash flow from profit-making operations during the year does not equal profit for the year. In fact, it's not unusual for these two numbers to be very different.
Profit is an
accounting-determined number that requires much more than simply keeping track of cash flows. The differences between using a checkbook to measure profit and using accounting methods to measure profit are explained in the following section. Hardly ever are cash flows during a period the correct amounts for measuring a company's sales revenue and expenses for that period. Summing up, profit cannot be determined from cash flows.
Also, a summary of cash flows reveals virtually nothing about the
financial condition of a business. Financial condition refers to the assets of the business matched against its liabilities at the end of the period. For example: How much cash does the company have in its checking account( s) at the end of the year? We can see that over the course of the year the business decreased its cash balance $184,193. But we can't tell from Exhibit A the company's ending cash balance. A cash flows summary does not report the amounts of assets and liabilities of the business at the end of the period.
Profit Cannot Be Measured by Cash Flows
The company in this example sells its products on credit. In other words, the business offers its customers a short period of time to pay for their purchases. Most of the company's sales are to other businesses, which demand credit. (In contrast, most retailers selling to individuals accept credit cards instead of extending credit to their customers.) In this example the company collected $10,225,000 from its customers during the year. However, some of this money was received from sales made in the previous year. And, some sales made on credit in the year just ended were not collected by the end of the year.
At year-end the company had receivables from sales made to its customers during the latter part of the year. These receivable will be collected early next year. Because some cash was collected from last year's sales and some cash was not collected from sales made in the year just ended, the total cash collected during the year does not equal the amount of sales revenue for the year.
Cash disbursements (payments) during the year are not the correct amounts for measuring expenses. Like sales revenue, the cash flow during the year is not the whole story. The company paid out $7,130,000 for manufacturing costs during the year (see Exhibit A). At year-end, however, many products were still on hand in inventory. These products had not yet been sold by year-end. Only the cost of products sold and delivered to customers during the year should be deducted as expense from sales revenue to measure profit. Don't you agree?
Furthermore, some of its manufacturing costs had not yet been paid by the end of the year. The company buys on credit the raw materials used in manufacturing its products and takes several weeks to pay its bills. The company has liabilities at year-end for recent raw material purchases and for other manufacturing costs as well.
There's more. Its cash payments during the year for operating expenses, as well as for interest and income tax expenses, are not the correct amounts to measure profit for the year. The company has liabilities at the end of the year for unpaid expenses. The cash outflow amounts shown in Exhibit A do not include these additional amounts of unpaid expenses at the end of the year.
In short, cash flows from sales revenue and for expenses are not the correct amounts for measuring profit for a period of time. Cash flows take place too late or too early for correctly measuring profit for a period. Correct timing is needed to record sales revenue and expenses in the right period.
The correct timing of recording sales revenue and expenses is called accrual-basis accounting. Accrual-basis accounting recognizes receivables from making sales on credit and recognizes liabilities for unpaid expenses in order to determine the correct profit measure for the period. Accrual-basis accounting also is necessary to determine the financial condition of a business-to record the assets and liabilities of the business.
Cash Flows Do Not Reveal Financial Condition
The cash flows summary for the year (Exhibit A) does not reveal the financial condition of the company. Managers certainly need to know which assets the business owns and the amounts of each asset, including cash, receivables, inventory, and all other assets. Also, they need to know which liabilities the company owes and the amounts of each.
Business managers have the responsibility for keeping the company in a position to pay its liabilities when they come due to keep the business solvent (able to pay its liabilities on time). Furthermore, managers have to know whether assets are too large (or too small) relative to the sales volume of the business. Its lenders and investors want to know the same things about a business.
In brief, both the managers inside the business and lenders and investors outside the business need a summary of a company's financial condition (its assets and liabilities). Of course, they need a profit performance report as well, which summarizes the company's sales revenue and expenses and its profit for the year.
A cash flow summary is very useful. In fact, a slightly different version of Exhibit A is one of the three primary financial statements reported by every business. But in no sense does the cash flows report take the place of the profit performance report and the financial condition report. The next chapter introduces these two financial statements, or "sheets," as some people call them.
A Final Note before Moving On: Over the past century an entire profession has developed based on the preparation and reporting of business financial statements-the accounting profession. In measuring their profit and in reporting their financial affairs, all businesses have to follow established rules and standards, which are called generally accepted accounting principles or GAAP for short. I'll say a lot more about GAAP and the accounting profession in later chapters.
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