Category Archives: Finance

Bean Counting for Dummies: Part 2

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In my last blog, I highlighted what I call the Big Five in Accounting: Assets, Liabilities, Equity (or Shareholders’ Funds for incorporated companies), Income and Expenses.  In this blog, I will highlight the key financial statements for all organisations, and show how they link up with the Big Five.

Financial statements are a formal record of the financial activities of an organisation or person.  They are typically presented in a fairly standardised and user-friendly manner.  For larger organisations, they will be accompanied by a detailed set of footnotes which describe each item in those statements.

Two key financial statements are as follows:

1.  Income Statement: this summarises the organisation’s income, expenses and net profit over a given period (e.g. one year).  This is often called Profit & Loss Statement (especially for companies).  For councils, they used to be known as Statement of Financial Performance. This actually indicates what it is – a summary of how the organisation performed financially during a given accounting period.  Councils now usually call them Income Statements, and call the bottom line Net Surplus (or Deficit) rather than Net Profit (or Loss).

A simplistic example for a company that sells products (hence Cost of Goods Sold) is as follows:

Income Statement for ABC Company for Year ended 30 June 2015

Income                                                                                           $1,200,000

Less Cost of Goods Sold                                                       b   $620,000

Gross Profit                                                                                $580,000

Less Expenses

Salaries and wages                                                                      $295,000

Contractors                                                                                       $82,000

Printing and stationery                                                                    $8900

Utilities                                                                                                   $1400

Depreciation                                                                                     $11,500

Interest paid                                                                                           $950

Total Expenses                                                                        $399,750

Net profit before tax                                                            $180,250

Income tax                                                                                  $54,075

Net profit after tax                                                               $126,175

2.  Balance Sheet: This summarises the assets, liabilities and equity (or shareholders’ funds) of an organisation as at a particular date (e.g. 30 June 2015).  For councils, this used to be known as Statement of Financial Position.  A simple example of a Balance Sheet is as follows:

Balance Sheet for ABC Company as at 30 June 2015

                                                                                  $

ASSETS

Current Assets

Bank                                                                     85,400

Debtors                                                              11,850

Inventory                                                           47,900

Short-term investments                             45,000

 Non-Current Assets

Land and Buildings                                   125,000

Motor vehicles                                               51,250

Plant and machinery                                  43,100

 Less accumulated depreciation         (39,300)

 TOTAL ASSETS                                       370,200

 LIABILITIES

Current Liabilities

Bank overdraft                                                8750

Provision for leave                                        4500

Provision for bad debts                              2800

 Non-Current Liabilities

Long-term Loan                                        40,000

Provision for long-service leave        17,500

 TOTAL LIABILITIES                             73,550

 NET ASSETS                                        296,650

 EQUITY                                                 296,650

 A few points about the items on the Balance Sheet:

  1. Current Assets are those assets that are either cash or are normally and readily converted to cash within a 12 month period.  So while you could sell motor vehicles, land, buildings, etc. within short notice, this is not normally what we purchase them for, so they are usually shown as non-current assets.
  2. Accumulated Depreciation: this is the sum total of depreciation of an asset(s) that has accumulated over time. It is important to show non-current assets at their current value.
  3. Current Liabilities are those debts that need to be paid within a twelve month period.
  4. Provisions for long-service leave, etc.: are liabilities because they are debts that will ultimately need to be paid.
  5. Net Assets and Equity: are always the same, and are calculated by subtracting an organisation’s liabilities from its assets, as shown.

The Cash Flow Statement is the third key financial statement which I shall mention in passing.  This is concerned with the flow of cash in and out of the business, and analyses this flow in terms of its operating, investing, and financing activities.  As an analytical tool, it is useful in determining the short-term viability of a company, particularly its ability to pay bills.  As you may know, an organisation can be asset-rich and cash-poor, lacking the ability to pay debts and forthcoming expenses.

The Current Ratio is one useful ratio, which demonstrates the ability of an organisation to meet its short-term debts. This expresses current assets as a proportion of current liabilities, and a benchmark figure for this is usually 2:1.  In other words, there are twice as many available current assets as there are current liabilities.

Hopefully this has all made sense!  There is only so much one can explain in a blog, of course.  We should be mindful that the above financial statements don’t tell the full story, and there is much other information and many other ratios and statistics that will give a fuller picture of the financial health and longer-term viability of an organisation.

Happy reading!

Narayan van de Graaff

 

Bean Counting for Dummies

Now that I have your attention, I’ll explain the point of this article!  Finance for Non-Finance Managers would have been a more boring title, but that is essentially what I will be covering.

Bean Counting for Dummies

I have run well over 100 one-day Finance for Non-FinanceManagers workshops in the past twelve years, and many participants decide at the end of the workshop that they made the right decision by not pursuing a career in accounting!  However, they are also pleased that they now have a sufficient grasp of accounting jargon, processes, and budgeting to have meaningful discussions with the finance department.

In this blog I shall discuss what I call the Big Five.  I’ve coined this term and you won’t find it in any accounting textbooks.  It refers to the fact that there are five key accounting elements: equity, assets, liabilities, income and expenses.  Any financial transaction will impact on one or more of these elements.  Workshop participants often become confused about the difference between assets and income, between expenses and liabilities, and with what equity actually means.  Let me explain.

Assets: are items of value owned by an organisation.  Examples include motor vehicles, computers, cash, investment, land and buildings, plant and machinery.  In the case of councils (for whom I have run about 80 workshops), assets include the enormous value of the infrastructure, such as roads, footpaths, bridges, water, sewerage works, etc.

Various managers in the workshops have argued that these are not necessarily assets because (a) they’re more of a liability because they cost so much to maintain, and (b) they are not able/allowed to sell most of them anyway.  My response is that they are still assets because they are owned by councils and enable them to charge the community for services provided as a consequence of their using these assets.  The costs of maintaining them are expenses, and assets don’t become liabilities because of these significant costs.

Liabilities: are amounts owed by an organisation to individuals or other organisations.  Examples are creditors, overdrafts, short-term and long-term loans, accrued salaries and wages (wages owing but not yet paid), and provisions for long-service leave and other leave – leave that is owing but has not yet been taken.

Equity: is the residual interest or new ownership in an organisation after liabilities are deducted from assets.  With incorporated companies, we normally use the term ‘shareholders’ funds’ and with sole traders the term ‘proprietorship’ is used.   The Accounting Equation shows the relationship between equity, assets and liabilities, and states: Equity = Assets – Liabilities.  A net profit or surplus in any one year (shown in the Income Statement) will increase Equity, and a net loss or deficit will decrease it.

Income: is often interchanged with ‘revenue’ and is the amount earned from sales, professional fees, interest, etc.  For councils, their main forms of income are: rates, fees and charges, grants, and interest on investments.  For private sector companies, income is earned through selling goods and/or services to the community.

Expenses: are the costs incurred by an organisation in the process of carrying out its operations.  These vary according to the nature of an organisation, but there are typical expenses such as: employee expenses, materials and contracts, utilities, supplies, interest on loans, and so many more. Depreciation (the reduction in value of an asset) is also an expense.  People sometimes confuse expenses with liabilities, which are debts, such as those just mentioned.

In my next blog, I’ll discuss the key financial statements linked to these elements.