The last topic of our PBL session was closely related to the previous one. After getting familiar with the basics of starting a company, forms of entrepreneurship, ways of financing and required documentation we got more into the life cycle of a start-up. The main purpose of every business is to gain profit and thus understanding and maintaining accounting is crucial to reach a smoothly working business. Our trigger described a case of start-up of two friends, who started struggling with their financial statements. After reading and discussing the topic we have agreed that our main problem is understanding financial analysis of a business, more specifically the business of Ken and Jimmy (two friends from our example). We are going to cover this question with the following learning objectives:
1. Understanding a balance sheet and an income statement
2. How do you know a business is profitable
3. How to use financial analysis to achieve future business goals
1. How to read a balance sheet and income statement
When I look at our trigger I see a very clear and luckily not that long income statement first. A lot of websites go too much in depth and their explanations made the whole thing even more complicated for me. Finally I found a really good article on the Dummies webpage, which helped to make the whole problem much easier (http://www.dummies.com/business/accounting/how-to-read-an-income-statement/).
So first we have the heading, which shows us the title and the time period of the income statement. In this case, we can see that the income statement is written for two years (2014 and 2015). This can help to further analyze the results since we can compare with previous year. Additionally, there should also be the name of the institution, which we do not see in this case.
The body part starts with sales revenue, in our case called net sales and ends with a net income, which has a double underlining to emphasis and draw readers' attention. Even though we generally call it profit, we would not find this term in income statements, other terms might be net earnings or simply earnings.
The problem with the net sales is that we only see a total number but it doesn't tell us, which products/services were the most profitable.
In a regular income statement, there shouldn't be minus signs. It it obvious that if we have a column called expenses, we will have to deduct these numbers from the net sales. I suppose that since we are just getting familiar with the idea of accounting, it is easier for us to see the minus signs.
Even though on the first sight, it might seem that there are lot of different expenses, many of them are actually not even mentioned. For example the term other operating expenses cover a large variety of costs, such as energy expenses, advertising or legal costs.
The operating expenses cover things that are directly related to production. They create the core of the statement. In our case, we can see that the operating expenses take almost the whole amount of the net income (2015). The largest item is salaries, so Ken and Jimmy should really think about the number of employees they have and the salaries they pay them. The amount of salaries paid has more than doubled since the previous year.
In our income statement we can also see financial expenses. I was not entirely sure, what does this item cover. I found help on the Office ToDo website (http://www.officetodo.com/public/financial-expenses-and-income-on-the-income-statement/). According to this website, financial income and expenses mostly mean taking and paying back loans, currency translations (when dealing with foreign currencies) or loss/return on investment. Important thing is that financial income does NOT cover paying taxes even though we might consider that as financial expense.
After deducing financial expenses and taxes we can see that the net income only makes up 2,5% of the net sales. The previous year it was 7,1% so it seems that despite the net sales have doubled, the net income is much lower.
For me the Balance sheet is much easier to read and the items seem more logical. However, there were few things I wasn't that sure about. I was for example not familiar with the term Intangible assets. After looking it up at Investopedia (https://www.investopedia.com/terms/i/intangibleasset.asp), I understand that it means not physical assets. As an example there are given trademarks, licences, value of a brand, or intellectual property. In today's business, for most big companies the intangible assets makes up much higher value that the physical assets. Since we have a case of a small start-up (a bakery), which does not use any special licences or trademarks, we can see that this item is 0 in both years.
The next thing I had problem to understand was what are cash equivalents. on the website Investing Answers (http://www.investinganswers.com/financial-dictionary/financial-statement-analysis/cash-and-cash-equivalents-cce-2464) I found a nicely put together article. It says that cash equivalents are assets in such form that is easily converted to cash (so for example treasury bills or checks)
With the term equity I had again look at the Investopedia to understand. This term actually has more meanings depending on where it is used. In the case of balance sheet, equity is the amount of funds contributed by the owners (share capital) and retained earnings (or losses).
It is important to differentiate the income statement from the balance sheet. According to the eCommerce Fuel website (http://www.ecommercefuel.com/how-to-read-a-balance-sheet/), the income statement shows, how a company performed over a certain period of time, while the balance sheet shows 'financial health' at a single point. Also, the important word is BALANCE, it means that the two sides (in our case columns)- assets and equity+liabilities have to be always equal. Otherwise the balance sheet is done wrong.
2. Profitability of a business
As mentioned, to read a performance of a business, we use the income statement. We can see that the business generates a profit, but that doesn't necessarily mean that the business generally is profitable. We can see that the operating income is only a fraction of the net sales, so in other words, there is almost nothing left after deducing the costs. Also, we can see that the net income is lower compare to the previous year, which means that the business is not growing.
Again on the Dummies website, I found a good article that advises how to use an income statement to read profitability (http://www.dummies.com/business/accounting/using-an-income-statement-to-test-a-businesss-profitability/). The article suggests to use so called ROS (Return on sales) as one way. It means that we have to dividing net income before taxes by sales. We can see that the net income only makes up 2,5% of the net sales. In other words, each euro of sales gives us 2,5 cent of profit. The previous year it was 7,1% so it seems that despite the net sales have doubled, the net income is much lower.
The problem is that we don't know what is Ken and Jimmy's goal, what they consider as success. The website suggests to check the ROS of a similar business (with the local chamber of commerce).
Another common test is return on assets (ROA). That tells us, how well the company's assets is being used. We calculate this by dividing net income by total assets. In our case (2015) we get 9,6% and we have to use both the income statement and the balance sheet. It shows that the company made 9,6% on each dollar of assets that we hold. ROA depends strongly on the branch of industry. Since Jimmy's and Kens startup does not require expensive equipment, its ROA should be higher.
ROA usually ranges from 5% for manufacturing companies and 20% for service companies.
The last common measure is Return on equity (ROE). We can use it to measure how well the company is earning money from owners and investors. This measurement is more commonly used for larger companies with many owners and employees.
According to these measurements, but also just from simple looking at the income statement I don't think the business is doing well and if it continues the same way, it might get into troubles and generate loss. Of course it depends on these two guys what they would consider as success/profit.
3. Achieving business goals with the use of financial analysis
First we have to think about what are even good business goals. On a website called Chron Small Business I found a brief article about what are good goals a small business should set (http://smallbusiness.chron.com/examples-business-goals-objectives-4698.html).
On the first place there is of course profitability: minimizing expenses while maximizing revenue. This is also connected to regular checking and analyzing the 'financial health' of a business and act accordingly with the results.
Secondly, there is customer service, which is in case of a café very crucial. Most of us choose our favourite café not only based on the quality of coffee and food but also how well we feel there and how friendly the stuff is. A business should also strive for feedback to know what the customers know. Happy customers= more customers = more revenue.
Employees are also very important in a business. In cafés, retention might become a problem and also the fact that working closely with people can be for some very overwhelming and exhausting. Keeping employees motivated and passionate for the philosophy of a business automatically means happier customers.
Another thing that especially small businesses might struggle with is efficiency. Start-ups, especially at the early stage are usually quite disorganized without clear structure and specifications of who does what. Lean management, which we talked about earlier in this course can be a great help in this.
Another goal mentioned in the article is growth but I think that in case of a small coffee shop/bakery there is probably not that big strive for growth and it could actually be harmful and hard to maintain. The possibility can be that in the future a chain of similar coffee shops could exist if the business and concept are doing really well.
Even though there are many different goals they usually all concern mainly the profit and how to maximize it. No matter how passionate the owners are, if they can't turn it into stable profit, they might lose their business.
Sources
Chron Small Business. Examples of business goals and objectives. Available from: http://smallbusiness.chron.com/examples-business-goals-objectives-4698.html. Accessed 13.11.2017.
Dummies. How to read an income statement. Available from: http://www.dummies.com/business/accounting/how-to-read-an-income-statement/. Accessed: 12.11.2017.
Dummies. Using an income statement to test a businesses' profitability. Available from: http://www.dummies.com/business/accounting/using-an-income-statement-to-test-a-businesss-profitability/. Accessed 13.11.2017.
eCommerce Fuel. How to read a balance sheet (The non-boring version). Available from: http://www.ecommercefuel.com/how-to-read-a-balance-sheet/. Accessed: 13.11.2017.
Investing Answers. Cash Equivalents. Available from: http://www.investinganswers.com/financial-dictionary/businesses-corporations/cash-equivalents-5012. Accessed: 12.11.2017.
Investopedia. Equity. Available from: https://www.investopedia.com/terms/e/equity.asp. Accessed: 13.11.2017.
Investopedia. Intangible Assets. Available: https://www.investopedia.com/terms/i/intangibleasset.asp. Accessed: 12.11.2017.
Office ToDo. Financial expenses and income on the income statement. Available: http://www.officetodo.com/public/financial-expenses-and-income-on-the-income-statement/. Accessed: 12.11.2017.
1. Understanding a balance sheet and an income statement
2. How do you know a business is profitable
3. How to use financial analysis to achieve future business goals
1. How to read a balance sheet and income statement
When I look at our trigger I see a very clear and luckily not that long income statement first. A lot of websites go too much in depth and their explanations made the whole thing even more complicated for me. Finally I found a really good article on the Dummies webpage, which helped to make the whole problem much easier (http://www.dummies.com/business/accounting/how-to-read-an-income-statement/).
So first we have the heading, which shows us the title and the time period of the income statement. In this case, we can see that the income statement is written for two years (2014 and 2015). This can help to further analyze the results since we can compare with previous year. Additionally, there should also be the name of the institution, which we do not see in this case.
The body part starts with sales revenue, in our case called net sales and ends with a net income, which has a double underlining to emphasis and draw readers' attention. Even though we generally call it profit, we would not find this term in income statements, other terms might be net earnings or simply earnings.
The problem with the net sales is that we only see a total number but it doesn't tell us, which products/services were the most profitable.
In a regular income statement, there shouldn't be minus signs. It it obvious that if we have a column called expenses, we will have to deduct these numbers from the net sales. I suppose that since we are just getting familiar with the idea of accounting, it is easier for us to see the minus signs.
Even though on the first sight, it might seem that there are lot of different expenses, many of them are actually not even mentioned. For example the term other operating expenses cover a large variety of costs, such as energy expenses, advertising or legal costs.
The operating expenses cover things that are directly related to production. They create the core of the statement. In our case, we can see that the operating expenses take almost the whole amount of the net income (2015). The largest item is salaries, so Ken and Jimmy should really think about the number of employees they have and the salaries they pay them. The amount of salaries paid has more than doubled since the previous year.
In our income statement we can also see financial expenses. I was not entirely sure, what does this item cover. I found help on the Office ToDo website (http://www.officetodo.com/public/financial-expenses-and-income-on-the-income-statement/). According to this website, financial income and expenses mostly mean taking and paying back loans, currency translations (when dealing with foreign currencies) or loss/return on investment. Important thing is that financial income does NOT cover paying taxes even though we might consider that as financial expense.
After deducing financial expenses and taxes we can see that the net income only makes up 2,5% of the net sales. The previous year it was 7,1% so it seems that despite the net sales have doubled, the net income is much lower.
For me the Balance sheet is much easier to read and the items seem more logical. However, there were few things I wasn't that sure about. I was for example not familiar with the term Intangible assets. After looking it up at Investopedia (https://www.investopedia.com/terms/i/intangibleasset.asp), I understand that it means not physical assets. As an example there are given trademarks, licences, value of a brand, or intellectual property. In today's business, for most big companies the intangible assets makes up much higher value that the physical assets. Since we have a case of a small start-up (a bakery), which does not use any special licences or trademarks, we can see that this item is 0 in both years.
The next thing I had problem to understand was what are cash equivalents. on the website Investing Answers (http://www.investinganswers.com/financial-dictionary/financial-statement-analysis/cash-and-cash-equivalents-cce-2464) I found a nicely put together article. It says that cash equivalents are assets in such form that is easily converted to cash (so for example treasury bills or checks)
With the term equity I had again look at the Investopedia to understand. This term actually has more meanings depending on where it is used. In the case of balance sheet, equity is the amount of funds contributed by the owners (share capital) and retained earnings (or losses).
It is important to differentiate the income statement from the balance sheet. According to the eCommerce Fuel website (http://www.ecommercefuel.com/how-to-read-a-balance-sheet/), the income statement shows, how a company performed over a certain period of time, while the balance sheet shows 'financial health' at a single point. Also, the important word is BALANCE, it means that the two sides (in our case columns)- assets and equity+liabilities have to be always equal. Otherwise the balance sheet is done wrong.
2. Profitability of a business
As mentioned, to read a performance of a business, we use the income statement. We can see that the business generates a profit, but that doesn't necessarily mean that the business generally is profitable. We can see that the operating income is only a fraction of the net sales, so in other words, there is almost nothing left after deducing the costs. Also, we can see that the net income is lower compare to the previous year, which means that the business is not growing.
Again on the Dummies website, I found a good article that advises how to use an income statement to read profitability (http://www.dummies.com/business/accounting/using-an-income-statement-to-test-a-businesss-profitability/). The article suggests to use so called ROS (Return on sales) as one way. It means that we have to dividing net income before taxes by sales. We can see that the net income only makes up 2,5% of the net sales. In other words, each euro of sales gives us 2,5 cent of profit. The previous year it was 7,1% so it seems that despite the net sales have doubled, the net income is much lower.
The problem is that we don't know what is Ken and Jimmy's goal, what they consider as success. The website suggests to check the ROS of a similar business (with the local chamber of commerce).
Another common test is return on assets (ROA). That tells us, how well the company's assets is being used. We calculate this by dividing net income by total assets. In our case (2015) we get 9,6% and we have to use both the income statement and the balance sheet. It shows that the company made 9,6% on each dollar of assets that we hold. ROA depends strongly on the branch of industry. Since Jimmy's and Kens startup does not require expensive equipment, its ROA should be higher.
ROA usually ranges from 5% for manufacturing companies and 20% for service companies.
The last common measure is Return on equity (ROE). We can use it to measure how well the company is earning money from owners and investors. This measurement is more commonly used for larger companies with many owners and employees.
According to these measurements, but also just from simple looking at the income statement I don't think the business is doing well and if it continues the same way, it might get into troubles and generate loss. Of course it depends on these two guys what they would consider as success/profit.
3. Achieving business goals with the use of financial analysis
First we have to think about what are even good business goals. On a website called Chron Small Business I found a brief article about what are good goals a small business should set (http://smallbusiness.chron.com/examples-business-goals-objectives-4698.html).
On the first place there is of course profitability: minimizing expenses while maximizing revenue. This is also connected to regular checking and analyzing the 'financial health' of a business and act accordingly with the results.
Secondly, there is customer service, which is in case of a café very crucial. Most of us choose our favourite café not only based on the quality of coffee and food but also how well we feel there and how friendly the stuff is. A business should also strive for feedback to know what the customers know. Happy customers= more customers = more revenue.
Employees are also very important in a business. In cafés, retention might become a problem and also the fact that working closely with people can be for some very overwhelming and exhausting. Keeping employees motivated and passionate for the philosophy of a business automatically means happier customers.
Another thing that especially small businesses might struggle with is efficiency. Start-ups, especially at the early stage are usually quite disorganized without clear structure and specifications of who does what. Lean management, which we talked about earlier in this course can be a great help in this.
Another goal mentioned in the article is growth but I think that in case of a small coffee shop/bakery there is probably not that big strive for growth and it could actually be harmful and hard to maintain. The possibility can be that in the future a chain of similar coffee shops could exist if the business and concept are doing really well.
Even though there are many different goals they usually all concern mainly the profit and how to maximize it. No matter how passionate the owners are, if they can't turn it into stable profit, they might lose their business.
Sources
Chron Small Business. Examples of business goals and objectives. Available from: http://smallbusiness.chron.com/examples-business-goals-objectives-4698.html. Accessed 13.11.2017.
Dummies. How to read an income statement. Available from: http://www.dummies.com/business/accounting/how-to-read-an-income-statement/. Accessed: 12.11.2017.
Dummies. Using an income statement to test a businesses' profitability. Available from: http://www.dummies.com/business/accounting/using-an-income-statement-to-test-a-businesss-profitability/. Accessed 13.11.2017.
eCommerce Fuel. How to read a balance sheet (The non-boring version). Available from: http://www.ecommercefuel.com/how-to-read-a-balance-sheet/. Accessed: 13.11.2017.
Investing Answers. Cash Equivalents. Available from: http://www.investinganswers.com/financial-dictionary/businesses-corporations/cash-equivalents-5012. Accessed: 12.11.2017.
Investopedia. Equity. Available from: https://www.investopedia.com/terms/e/equity.asp. Accessed: 13.11.2017.
Investopedia. Intangible Assets. Available: https://www.investopedia.com/terms/i/intangibleasset.asp. Accessed: 12.11.2017.
Office ToDo. Financial expenses and income on the income statement. Available: http://www.officetodo.com/public/financial-expenses-and-income-on-the-income-statement/. Accessed: 12.11.2017.
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