Understanding Financial Statements

Financial Statements

The idea of Financial Statements may put you to sleep, but the lack of Financial Statement knowledge may put you out of business.  This section is designed to provide you with a working knowledge of Financial Statement and Financial Analysis.

Financial Statements are tools used to evaluate the performance of a company. A number of financial analyses are then used to further evaluate business performance. As time progresses, financial statements can be compared from year to year to see whether the company’s performance is improving, declining or remaining stable. Having such knowledge, enables managers and business owners better establish goals, objectives and targets, to name a few.

The most popular financial statements and financial analysis include the income statement, balance sheet, cash flow statement, break-even analysis, sensitivity analysis, and ratio analysis. Below provides a brief discussion on each Financial Statement and Financial Analysis. For greater detail on each financial statement or financial analysis simply following the corresponding links as they appear in sequence below.

Chapter 1     The Income Statement
Chapter 2     The Balance Sheet
Chapter 3     The Cash Flow Statement
Chapter 4     Break-Even Analysis
Chapter 5     Ratio Analysis
Chapter 6     Sensitivity Analysis
Chapter 7     Notes to the Financial Statements

For your convenience, we have created a narrative describing the contents of each Financial Statement and Financial Analysis listed above.  Again, think of the narrative as a site map for humans opposed to search engines.  Let’s begin the narrative of Financial Statements and Financial Analysis with the first topic entitled, “Income Statement”.


The Income Statement:

The Income Statement, also known as profit and loss statement or statement of income, is a financial statement which tallies revenues, cost of goods sold, and operating expenses. When expenses and direct costs are subtracted from revenues, the resulting figure is known as net income or net earnings. As you’ll discover, net income and net earnings are also referred to as the bottom line.

In our discussion, we completely define the Income Statement and expand on its importance as it relates to an aspiring entrepreneur as well as an existing small business owner. An income statement example surrounding a factious company called Try Our Bikes is created for further discussion. We use this income statement example to discuss the six (6) components or sections of an income statement. You’ll learn the six components include the Heading, Revenues, Operating Expenses, Earnings before Tax (EBT), Income Taxes, and Net Income.

Related topics involve Inventory and Cost of Goods Sold on the Income Statement. We create another example to show you how to calculate cost of goods sold. Many individuals think inventory appears as an account on the income statement. Others think there is a category called balance sheet cost of goods sold. In this section, you’ll quickly learn, inventory appears on the Balance Sheet and Cost of Goods Sold appears on the Income Statement. In addition, you will discover how to calculate cost of goods sold for a manufacturer, cost of goods sold a retailer (also refered to as cost of merchandise sold. Should your company require an inventory, this financial statement section also touches on things to consider when selecting the right suppliers.

The Income Statement discussion continues by introducing you to a term known as Gross Margin. The term Gross Margin will apply to those of you who require inventory and need to calculate cost of goods sold. Gross Margin is a simple calculation which is the difference between the revenues and the cost of goods sold or cost of sales.  Gross Margin is the percentage value while Gross Profit represents the dollar amount of the calculation.

An Income Statement Summary concludes this financial statement section followed by four examples of an income statement. Below provides the income statement examples.

J&B Incorporated example of income statement
Scholarship Information Services example of income statement
The Internet Company example of income statement
The Maple Syrup Company example of an income statement


Balance Sheet:

The next financial statement to be discussed is the Balance Sheet. As mentioned earlier, the balance sheet and income statement are not the same. The balance sheet is a financial statement which shows the overall strength of a business. Under this section, you will learn the balance sheet consists of three main components known as Assets, Liabilities, and Equity. In our financial statement discussion, you will discover how Assets = Liabilities + Equity. In other words, the Assets of the company equally “balance” with a company's Liabilities and Equity.

A balance sheet example is created in order to fully discuss the four main components of this financial statement. The components include the Heading of a Balance Sheet, Assets of balance sheet, Liabilities of balance sheet, and Equity of the balance sheet. The heading of a balance sheet helps the reader of the financial statement identify the time frame involved. As you will discover, Assets are economic resources of a business. Two categories of assets are current assets and fixed assets. Examples of Current Assets include cash, accounts receivable, prepaid insurance, inventory, and marketable securities, to name but a few. Examples of Fixed Assets include computers, buildings, office furniture, proprietary items, land and other assets having a useful life of more than one year. The sum of current assets and fixed assets is known as Total Assets.

Balance sheet liabilities are also classified into two categories known as current liabilities and long-term liabilities. Examples of current liabilities are accounts payable, income tax payable, and short-term loan payable. Long-term liabilities generally are loans or financial obligations maturing beyond a 5 year period. An example of a long-term liability would be a mortgage on a corporate building. The sum of short term liabilities and long-term liabilities is known as total liabilities.

The final component of the balance sheet is Equity. As you will discover, equity is defined as simply the value of a business at any given time. Such information is important to investors, management, and business owners, to name a few. As a result, the balance sheet is considered one of the most important financial statement.

The legal business form of a venture will determine the accounts used in the balance sheet equity section (IE sole proprietor, partnership, corporation, etc). For example, sole proprietorships and partnerships use a capital account, owner’s drawings, and net income when calculating equity on the balance sheet. On the other hand, Corporations use common shares, preferred shares, retained earnings and dividends when calculating equity on the balance sheet.

After our discussion on the four components of the balance sheet, we conclude by providing various balance sheet examples.

J&B Incorporated balance sheet example
Scholarship Information Services balance sheet example
The Internet Company balance sheet example
The Maple Syrup Company balance sheet example

Cash Flow Statement:

The next financial statement discussed at Business Plan Hut is the Cash Flow Statement which is also referred to as the statement of cash flow. This financial statement is extremely important since it shows when cash is expected to come into the company in the form of sales, owner’s investments, grants, and from financing through banks, government organizations and other external providers of financing, for example.

The cash flow statement is a financial statement that also predicts when cash is expected to leave the company in the form of operating expenses, marketing expenses, administrative expenses, capital purchases, inventory purchases, loan payments, income taxes, dividends, and the like. In essence, the cash flow statement is a financial statement which tallies all transactions dealing with cash and cash balances (i.e. cash inflows and cash outflows).

The ultimate purpose of the cash flow statement is to determine when additional business financing or cash investment is required by the business. That said, it is crucial you know exactly when additional cash is needed to pay for purchases or when sales and other cash inflows will actually arrive in your bank account. For example, if the cost of a piece of equipment valued at $30,000 is to be paid in full upon purchase, then that has a material effect on cash flow compared to paying for the equipment on a monthly basis.

The most important thing to ask when you prepare a cash flow statement is this “when will cash actually come into the business in the form of a cash inflow” and “when will cash actually leave the bank account to pay for corporate purchases or cash outflows”.

In our discussion, we completely explain the Cash Flow Statement format which consists of the following financial statement categories. The Heading of a Cash Flow Statement, Cash Inflows of a Cash Flow Statement, Cash Outflow of a Cash Flow Statement, Excess Cash or Deficiency of Cash, Financing Required and Ending Cash Balance. To provide further information, you’ll discover a link showing you how to prepare a cash flow statement from scratch. The discussion ends with several samples of a cash flow satetment which are as followings:

J&B Incorporated sample cash flow statement
Scholarship Information Services sample cash flow statement
The Internet Company sample cash flow statement
The Maple Syrup Company sample cash flow


Break Even Analysis:

The next topic appearing under the Financial Statement section of Busienss Plan Hut is the Break-even Analysis. Many mistaken the break-even point as the break-even analysis. The break-even point is, however, only one component of the overall break even analysis. Furthermore, the breakeven point calculates the point at which sales must be in order to achieve a net income of $0.00. The break-even analysis, however, deals with several “what if” situations.

A "what if" example or question a manager or business owner might like to know would be this. How many unit sales would need to be sold in order to achieve a net income of $80,000? Another “what if” example or question a sole proprietor might have is this. How many unit sales would need to be sold in order to achieve net earnings of $40,000 and provide the owner with a “salary” of $60,000? These questions or “what if" scenarios can be answered using a break-even analysis.

To ensure you have a great understanding of breaking even and break-even analysis, the following six (6) topics have been developed and have been included in the main menu of Financial Statements under the category labelled, break even point.

1. The Break-even Point Formula. Here you will learn the simple formula for breaking even. We have created an example which shows you how many cigars a company will need to sell in order to break even; based on their selling price, their variable costs and fixed costs.

2. The Components of the Break-even Point Formula. In this section, we analyze each component of the break-even formula. Furthermore, we discuss how variable costs, fixed costs and selling prices are essential to the formula of breaking even. As you’ll discover, it is the disquisition between the two types of costs that is important to breaking even and the break even analysis.

3. Understanding the Break-even Formula. Under this section, we introduce you to a new term known as the Contribution Margin per unit. The Contribution Margin per unit is calculated by subtracting the variable cost per unit from the selling price per unit. In other words, the contribution margin per unit is the money left over after you produce and sell one unit of product. This money will then go towards paying down or “contributing” to the fixed costs. When all fixed costs are completely paid in any given year, the contribution margin per unit or left over money becomes complete profit. You will learn more about the relationship of contribution margins and income through various examples of break-even (as provided).

4. A Break-even Point example for Businesses Selling a Single Product. In this section, we continue to use the standard format to breaking even. All break-even examples, to date, deal with a single product and it continues under this category as well. Here, however, you will be introduced to more advanced areas of the break-even point and see the importance of the breakeven analysis. Furthermore, you will learn how to calculate the number of units you’ll need to sell in order to achieve a desired income level. To do this, we incorporate a new break-even example.

5. Break-even Point Example for Businesses Selling Multiple Products. Up onto this point, we dealt with determining the break-even point for only companies selling one product or service. Most businesses, however, have more than one revenue stream or sell more than one product or service. Please note, when we refer to the term product, we are also referring to a service. The two terms are interchangeable. That said, under this section, we will introduce you to a new term known as a Weighted Average. There are two types of weighted averages, in particular, that are important to Break Even. These include the weighted average selling price and weighted average cost. Below provides a brief definition of weighted average selling price and a definition of a weighted average cost.

The weighted average selling price considers all the selling prices of all the products a company sells and reduces them down into one single selling price. The weighted average cost considers all the variable costs of all the products a company sells and reduces them down into one single product cost. Working with one number opposed to 30 numbers, for instance, is more manageable and reduces the odds of making a mistake.

When reading this section entitled, Break-even Point for Businesses Selling Multiple Products, you’ll find the weighted average definition is fully explained and various examples are provided. Furthermore, we discuss in great lengths the process of the weighted average calculation. Below provides a step by step process of reducing all your selling prices and all your variable costs down to one weighted average selling price and one weighted average cost.


Step 1 Create a List of your Product Line
Step 2 Create a List of the Products in Your Product Line
Step 3 Forecast Sales Percentages for Your Product line
Step 4 Forecast Sales Percentages for each Product Line Item
Step 5 Determine your Cost(s) for Each Product
Step 6 Determine your Selling Prices for each Product
Step 7 Determine Your Weighted Average Cost
Step 8 Determine Your Weighted Average Selling Price

As you can see, 8 steps are involved in the weighted average for multiple products calculation. After you calculate the weighted average selling pricing and the weighted average cost, you’ll be able to input those numbers into the following break-even formula for multiple products. Please note: WA means Weighted Average.


Break Even for multiple products   =        _                    Fixed Costs                           
                                                                 WA Selling PriceWeighted Average Cost


Several examples are provided throughout our discussion which will guide you through the entire process of calculating a weighted average price and calculating a weighted average cost.

6. We end the break-even analysis section of the financial statements with a topic entitled, the Break-even Point Using a Questions & Answers Approach. Here you will find a number of answers to frequently asked questions relating to breaking even and the Break Even Analysis. Again, a number of break even examples and samples are used to ensure you have a full understanding of the difference between breaking even and the break-even analysis. Links to additional calculations and break even examples are provided below.

Examples of the Break-even Point:

J&B Incorporated break even point example
Scholarship Information Service break even point example


Ratio Analysis:

The next topic under the Financial Statements section at www.businessplanhut.com is Ratio Analysis. In its simplest form, a ratio analysis helps determine how a business is currently performing, how the business performed in the past, and how it’s performing compared to other players in the industry.

We have organized the ratio analysis section into three categories which are as follows.

1. Calculating Ratios
2. Ratio Trend Analysis
3. Comparing Ratios to the Industry.

Below briefly discusses each of the three categories.

1. Calculating Ratios:

Here you will learn a number of ratio calculations and ratio definitions. You’ll discover the four types of ratios include Liquidity Ratios, Activity Ratios, Leverage Ratios, and Profitability ratios. Each class or category of ratios has subsections which are summarized below.

The most popular Liquidity Ratios consist of the current ratio formula and the quick ratio formula.

The most analyzed Activity Ratios consist of the average collection period ratio and the inventory turnover ratio calculation.

The most calculated Leverage Ratios include the debt ratio and the debt-to-equity ratio formula.

The most popular Profitability Ratios consist of the gross profit margin ratio calculation, net profit margin ratio, return on total assets ratio, and return on equity ratio formula.

Ratio examples are included throughout our financial statement and financial analysis discussion so that you understand how to do a ratio and what each ratio means in terms of a percentage and as a dollar amount. We get a lot of individuals asking the question “where do I get the numbers to calculate a ratio?” Simply put, all numbers come from the financial statements such as the balance sheet and income statement.


2. Ratio Trend Analysis:

Under our discussion of calculating ratios, you learn how a business is presently performing. Under Trend Analysis, however, you will learn how a business preformed throughout the years. In essence, trend analysis enables you to compare financial statement components of a business over a number of years.

In our trend analysis example, you will learn how to do a ratio calculation and compare the result to the same ratios from a previous fiscal period. The example takes you though the entire ratio trending process and clearly explains the meaning of each ratio calculation.

3. Comparing Ratios to the Industry:

In the final financial statement and financial analysis section, you’ll discover how to compare the ratios of one company to the ratios of an entire industry. After reading this section, you will know whether the company is outperforming or underperforming, relative to the industry as a whole. Futhermore, ratio calculations will be developed which will enable you to clearly pinpoint the company’s strengths and weaknesses; relative to the entire indusrty. You can use the knowledge learned here to uncover possible strengths and weaknesses you may have within your own industry. As usual, a complete example of ratios and Ratio Analysis is used throughout the discussion. 

Sensitivity Analysis:

The next section to be addressed under the financial statements is Sensitivity Analysis. The Sensitivity Analysis can be used by an existing business owner or an aspiring entrepreneur. The existing business owner uses it when reviewing upcoming budgets or preparing an income statement for the upcoming year. An aspiring entrepreneur, on the other hand, would include a sensitivity analysis in their business plan to show a lending institution, for example, how projections might appear at various sales levels.

Essentially, the Sensitive Analysis is a “what if” tool which can provide the answers to important questions such as.

- "What if" sales were actually 10% lower than envisioned?
- "What if" sales increased by 25% above sales projections?
- "What if" sales were actually 20% lower than the sales projections?
- And so on…

This section starts with a definition of a sensitivity analysis. Then we discuss the three components of the sensitivity analysis which are as follows:

1. The Heading of Sensitivity Analysis
2. Sales Percentage Factors of Sensitivity Analysis

3. The Body of Sensitivity Analsysis

The Body of a sensitivity analysis is the most detailed part of our discussion. Here, you will discover Sales, Variable Costs and Fixed Costs all are the key components when creating a sensitivity analysis. Examples and Samples are used throughout so you'll acquire a solid understanding of the importance of this “what if” financial analysis. Visitors are encouraged to dive deeper into the topic as we provide a complete sensitivity analysis example. This example starts from scratch to produce a professional sensitivity analysis.

Notes to Financial Statements:

The Notes to Financial Statements is the final section appearing under the Financial Statements main menu. Notes are basically the assumptions made when preparing financial statements. Consider notes to financial statements as a way to show the reader how you arrived at the numbers appearing in the financial statements. It’s similar to grade school when the teacher would tell you to “show your work”.

Not all accounts, however, require an explanation or a note to the financial statement. Only the significant revenue, expense, asset, liability, and equity accounts require further explaination. The insignificant accounts are considered immaterial and can be omitted under the notes to the financial statements.

In our discussion, you will find examples of several Notes to the Financial Statements. When creating financial projections or budgets, generally the most popular financial notes include sales, collection of sales, cash invested by owner, external financing, cost of sales, inventory levels, fixed asset purchases, accounts receivable, accounts payable, investments, loan payment/terms, dividends (corporation), share structure, and so on. Generally, larger priced assets, liabilities, equity components, operating expenses and other items that have a material effect require a note to the financial statements.

This concludes our narrative relating to Financial Statements and financial analysis.

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