Chapter 14
Filling Out the Financial Statements for Business Managers
In This Chapter
Recognizing the managerial limits of external financial statements
Examining the additional information needed for managing assets and liabilities
Identifying the in-depth information required for managing profit
Providing additional information for managing operating cash flow
If you’re a business manager, I strongly suggest that you read Chapter 13 before continuing with this one. Chapter 13 discusses how a business’s lenders and investors read their external financial reports. These stakeholders are entitled to regular financial reports so they can determine whether the business is making good use of their money. The chapter explains key ratios that the external stakeholders can use for interpreting the financial condition and profit performance of a business — which are equally relevant for the managers of the business.
But as important as they are, the external financial statements do not provide all the accounting information that managers need to plan and control the financial affairs of a business. Managers need additional information. Managers who look no further than the external financial statements are being very shortsighted — they don’t have all the information they need to do their jobs. The accounts reported in external financial statements are like the table of contents of a book; each account is like a chapter title. Managers need to do more than skim chapter titles. They need to read the chapters.
This chapter looks behind the accounts reported in the external financial statements. I explain the types of additional accounting information that managers need in order to control financial condition and performance, and to plan the financial future of their business.
Building on the Foundation of the External Financial Statements
Seeking out problems and opportunities
Business managers need more accounting information than what’s disclosed in external financial statements for two basic purposes:
To alert them to problems that exist or may be emerging that threaten the profit performance, cash flow, and financial condition of the business
To suggest opportunities for improving the financial performance and health of the business
A popular expression these days is “mining the data.” The accounting system of a business is a rich mother lode of management information, but you have to dig that information out of the accounting database. Working with the controller (chief accountant), a manager should decide what information she needs beyond what is reported in the external financial statements.
Avoiding information overload
Business managers are very busy people. Nothing is more frustrating than getting reams of information that you have no use for. For that reason, the controller should guard carefully against information overload. While some types of accounting information should stream to business managers on a regular basis, other types should be provided only on an as-needed basis.
Ideally, the controller reads the mind of every manager and provides exactly the accounting information that each manager needs. In practice, that can’t always happen, of course. A manager may not be certain about which information she needs and which she doesn’t. The flow of information has to be worked out over time.
Furthermore, how to communicate the information is open to debate and individual preferences. Some of the additional management information can be put in the main body of an accounting report, but most is communicated in supplemental schedules, graphs, and commentary. The information may be delivered to the manager’s computer, or the manager may be given the option to call up selected information from the accounting database of the business.
My point is simply this: Managers and controllers must communicate — early and often — to make sure managers get the information nuggets they need without being swamped with unnecessary data. No one wants to waste precious time compiling reports that are never read. So before a controller begins the process of compiling accounting information for managers’ eyes only, be sure there’s ample communication about what each manager needs.
Gathering Financial Condition Information
The balance sheet — one of three primary financial statements included in a financial report — summarizes the financial condition of the business. Figure 14-1 lists the basic accounts in a balance sheet, without dollar amounts for the accounts and without subtotals and totals. Just 12 accounts are given in Figure 14-1: five assets (counting fixed assets and accumulated depreciation as only one account), five liabilities, and two owners’ equity accounts. A business may report more than just these 12 accounts. For instance, a business may invest in marketable securities, or have receivables from loans made to officers of the business. A business may own intangible assets. A business corporation may issue more than one class of capital stock and would report a separate account for each class. And so on. The idea of Figure 14-1 is to focus on the core assets and liabilities of a typical business.
Figure 14-1: Hardcore accounts reported in a balance sheet.
Cash
The external balance sheet reports just one cash account. But many businesses keep several bank checking and deposit accounts, and some (such as gambling casinos and food supermarkets) keep a fair amount of currency on hand. A business may have foreign bank deposits in euros, English pounds, or other currencies. Most businesses set up separate checking accounts for payroll; only payroll checks are written against these accounts.
Managers should ask these questions regarding cash:
Is the ending balance of cash the actual amount at the balance sheet date, or did the business engage in window dressing in order to inflate its ending cash balance? Window dressing refers to holding the books open after the ending balance sheet date in order to record additional cash inflow as if the cash was received on the last day of the period. Window dressing is not uncommon. (For more details, see Chapter 12.) If window dressing has gone on, the manager should know the true, actual ending cash balance of the business.
Were there any cash out days during the year? In other words, did the company’s cash balance actually fall to zero (or near zero) during the year? How often did this happen? Is there a seasonal fluctuation in cash flow that causes “low tide” for cash, or are the cash out days due to running the business with too little cash?
Are there any limitations on the uses of cash imposed by loan covenants by the company’s lenders? Do any of the loans require compensatory balances that require that the business keep a minimum balance relative to the loan balance? In this situation the cash balance is not fully available for general operating purposes.
Are there any out-of-the-ordinary demands on cash? For example, a business may have entered into buyout agreements with a key shareholder or with a vendor to escape the terms of an unfavorable contract. Any looming demands on cash should be reported to managers.
Accounts receivable
A business that makes sales on credit has the accounts receivable asset — unless it has collected all its customers’ receivables by the end of the period, which is not very likely. To be more correct, the business has hundreds or thousands of individual accounts receivable from its credit customers. In its external balance sheet, a business reports just one summary amount for all its accounts receivable. However, this total amount is not nearly enough information for the business manager.
Here are some key questions a manager should ask about accounts receivable:
Of the total amount of accounts receivable, how much is current (within the normal credit terms offered to customers), slightly past due, and seriously past due? A past due receivable causes a delay in cash flow and increases the risk of it becoming a bad debt (a receivable that ends up being partially or wholly uncollectible).
Has an adequate amount been recorded for bad debts? Is the company’s method for determining its bad debts expense consistent year to year? Was the estimate of bad debts this period tweaked in order to boost or dampen profit for the period? Has the IRS raised any questions about the company’s method for writing off bad debts? (Chapter 7 discusses bad debts expense.)
Who owes the most money to the business? (The manager should receive a schedule of customers that shows this information.) Which customers are the slowest payers? Do the sales prices to these customers take into account that they typically do not pay on time?
It’s also useful to know which customers pay quickly to take advantage of prompt payment discounts. In short, the payment profiles of credit customers are important information for managers.
Are there “stray” receivables buried in the accounts receivable total? A business may loan money to its managers and employees or to other businesses. There may be good business reasons for such loans. In any case, these receivables should not be included with accounts receivable, which should be reserved for receivables from credit sales to customers. Other receivables should be listed in a separate schedule.
Inventory
For businesses that sell products, inventory is typically a major asset. It’s also typically the most problematic asset from both the management and accounting points of view. First off, the manager should understand the accounting method being used to determine the cost of inventory and the cost of goods sold expense. (You may want to quickly review the section in Chapter 7 that covers this topic.) In particular, the manager should have a good feel regarding whether the accounting method results in conservative or liberal profit measures.
Managers should ask these questions regarding inventory:
How long, on average, do products remain in storage before they are sold? The manager should receive a turnover analysis of inventory that clearly exposes the holding periods of products. Slow-moving products cause nothing but problems. The manager should ferret out products that have been held in inventory too long. The cost of these sluggish products may have to be written down or written off, and the manager has to authorize these accounting entries. The manager should review the sales demand for slow-moving products, of course.
If the business uses the LIFO method (last-in, first-out), was there a LIFO liquidation gain during the period that caused an artificial and one-time boost in profit for the year? (I explain this aspect of the LIFO method in Chapter 7.)
The manager should also request these reports:
Inventory reports that include side-by-side comparison of the costs and the sales prices of products (or at least the major products sold by the business). It’s helpful to include the mark-up percent for each product, which allows the manager to focus on mark-up percent differences from product to product.
Regular reports summarizing major product cost changes during the period, and forecasts of near-term changes. It may be useful to report the current replacement cost of inventory assuming it’s feasible to determine this amount.
Prepaid expenses
Generally, the business manager doesn’t need much additional information on this asset. However, there may be a major decrease or increase in this asset from a year ago that is not consistent with the growth or decline in sales from year to year. The manager should pay attention to an abnormal change in the asset. Perhaps a new type of cost has to be prepaid now, such as insurance coverage for employee safety triggered by an OSHA audit of the employee working conditions in the business. A brief schedule of the major types of prepaid expenses is useful.
Fixed assets less accumulated depreciation
Most businesses adopt a cost limit below which minor fixed assets (a screwdriver, stapler, or wastebasket, for example) are recorded to expense instead of being depreciated over some number of years. The controller should alert the manager if an unusually high amount of these small cost fixed assets were charged off to expense during the year, which could have a significant impact on the bottom line.
The manager should be aware of the general accounting policies of the business regarding estimating useful lives of fixed assets and whether the straight-line or accelerated methods of allocation are used. Indeed, the manager should have a major voice in deciding these policies, and not simply defer to the controller. In Chapter 7, I explain these accounting issues.
Using accelerated depreciation methods may result in certain fixed assets that are fully depreciated but are still in active use. These assets should be reported to the manager — even though they have a zero book value — so the manager is aware that these fixed assets are still being used but no depreciation expense is being recorded for their use.
The manager needs an insurance summary report for all fixed assets that are (or should be) insured for fire and other casualty losses, which lists the types of coverage on each major fixed asset, deductibles, claims during the year, and so on. Also, the manager needs a list of the various liability risks of owning and using the fixed assets. The manager has to decide whether the risks should be insured.
Accounts payable
As you know, individuals have credit scores that affect their ability to borrow money and the interest rates they have to pay. Likewise, businesses have credit scores. If a business has a really bad credit rating, it may not be able to buy on credit and may have to pay exorbitant interest rates. I don’t have space here to go into the details of how credit rankings are developed for businesses. Suffice it to say that a business should pay its bills on time. If a business consistently pays its accounts payable late, this behavior gets reported to a credit rating agency (such as Dun & Bradstreet).
The manager needs a schedule of accounts payable that are past due (beyond the credit terms given by the vendors and suppliers). Of course, the manager should know the reasons that the accounts have become overdue. The manager may have to personally contact these creditors and convince them to continue offering credit to the business.
Accrued expenses payable
The controller should prepare a schedule for the manager that lists the major items making up the balance of the accrued expenses payable liability account. Many operating liabilities accumulate or, as accountants prefer to say, accrue during the course of the year that are not paid until sometime later. One main example is employee vacation and sick pay; an employee may work for almost a year before being entitled to take two weeks vacation with pay. The accountant records an expense each payroll period for this employee benefit, and it accumulates in the liability account until the liability is paid (the employee takes his vacation). Another payroll-based expense that accrues is the cost of federal and state unemployment taxes on the employer.
Many businesses guarantee the products they sell for a certain period of time, such as 90 days or one year. The customer has the right to return the product for repair (or replacement) during the guarantee period. For example, when I returned my iPad for repair, Apple should have already recorded in a liability account the estimated cost of repairing iPads that are returned after the point of sale. Businesses have more “creeping” liabilities than you might imagine. With a little work, I could list 20 or 30 of them, but I’ll spare you the details. My point is that the manager should know what’s in the accrued expenses payable liability account, and what’s not. Also, the manager should have a good fix on when these liabilities will be paid.
Income tax payable
The controller should explain to the manager the reasons for a relatively large balance in this liability account at the end of the year. In a normal situation, a business should have paid 90 percent or more of its annual income tax by the end of the year. However, there are legitimate reasons that the ending balance of the income tax liability could be relatively large compared with the annual income tax expense — say 20 or 30 percent of the annual expense. It behooves the manager to know the reasons for a large ending balance in the income tax liability. The controller should report these reasons to the chief financial officer and perhaps the treasurer of the business.
The manager should also know how the business stands with the IRS, and whether the IRS has raised objections to the business’s tax returns. The business may be in the middle of legal proceedings with the IRS, which the manager should be briefed on, of course. The CEO (and perhaps other top-level managers) should be given a frank appraisal of how things may turn out and whether the business is facing any additional tax payments and penalties. Needless to say, this is very sensitive information, and the controller may prefer that none of it be documented in a written report.
Interest-bearing debt
In Figure 14-1, the balance sheet reports two interest-bearing liabilities: one for short-term debts (those due in one year or less) and one for long-term debt. The reason is that financial reporting standards require that external balance sheets report the amount of current liabilities so the reader can compare this amount of short-term liabilities against the total of current assets (cash and assets that will be converted into cash in the short term). Interest-bearing debt that is due in one year or less is included in the current liabilities section of the balance sheet. (See Chapter 5 for more details.)
Recall that debt is one of the two sources of capital to a business (the other being owners’ equity, which I get to next). The sustainability of a business depends on the sustainability of its sources of capital. The more a business depends on debt capital, the more important it is to manage its debt well and maintain excellent relations with its lenders.
Raising and using debt and equity capital, referred to as financial management or corporate finance, is a broad subject that extends beyond the scope of this book. For more information, look at Small Business Financial Management Kit For Dummies (Wiley) — coauthored by my son, Tage, and me, which explains the financial management function in more detail.
Owners’ equity
Broadly speaking, the manager faces three basic issues regarding the owners’ equity of the business:
Is more capital needed from the owners?
Should some capital be returned to the owners?
Can and should the business make a cash distribution from profit to the owners and, if so, how much?
These questions belong in the field of financial management and extend beyond the scope of this book. However, I should mention that the external financial statements are very useful in deciding these key financial management issues. For example, the manager needs to know how much total capital is needed to support the sales level of the business. For every $100 of sales revenue, how much total assets does the business need? The asset turnover ratio equals annual sales revenue divided by total assets. This ratio provides a good touchstone for the amount of capital being used for sales.
Culling Profit Information
Chapter 9 explains internal profit reports to managers, which are called P&L (profit and loss) reports. P&L reports should be designed to help managers in their profit analysis and decision making. Chapter 9 is the logical take-off point for this section, in which I discuss the types of profit information managers need.
Now here’s a question that might strike you as rather odd: What is the specific profit motive of the business? For large public companies, it’s abundantly clear that their main profit attention is on earnings per share (EPS). (I explain EPS in Chapter 13.) Of course, the company has to earn enough total net income and control the total number of its stock shares in order to hit their EPS targets. The profit objective of public businesses centers on EPS, because EPS plays such a dominant role in determining the market value of its stock shares.
In contrast, the specific profit focus of a private business is not EPS but . . . well, but what? The main objective could be simply the bottom line, which is total net income. A private business may also put heavy importance on its return on equity (ROE), which is the measure of profit compared with the equity capital being used to earn that profit. (I introduce ROE in Chapter 13.)
Digging deeper into the return on equity (ROE) measure of profit
Return on equity (ROE) is computed as follows:
Profit/Owners’ Equity = ROE
Profit is the bottom-line net income and all components (invested capital and retained earnings) are included in owners’ equity. The calculation of ROE is expanded in the DuPont model, which has its origins years ago in the company of the same name. The DuPont model computes return on equity (ROE) in three parts, as follows:
ROE = Profit Ratio × Asset Turnover Ratio× Leverage Ratio
The three ratios in this equation are defined as follows:
ROE = Profit/Sales × Sales/Assets × Assets/Equity
Suppose, for example, that a business earns $50 profit on $1,000 sales, has $500 assets, and $250 owners’ equity (meaning that it has $250 liabilities, the other source of total assets). Its ROE is computed as follows using the DuPont model:
ROE = $50/$1,000 × $1,000/$500 × $500/$250
20% ROE = 5% profit ratio × 2.0 asset turnover ratio × 2.0 leverage ratio
In other words, the company earned 5 percent on its sales revenue, turned its assets twice (its sales were two times its assets), and liabilities supply half its total assets so the business has a leverage factor of 2 times the owners’ equity capital invested in the business. This is a rough-and-ready model, which has to be refined in the actual context of a business. But it does provide a good overview of the three key factors that determine ROE.
Margin: The catalyst of profit
Figure 14-2 presents a skeleton of the P&L report. No dollar amounts are given because I focus on the kinds of information that managers need in order to analyze and control profit. Note that operating expenses below the gross margin line are classified between variable and fixed. Therefore, the P&L report includes margin (profit before fixed operating expenses). Income statements in external financial reports do not classify the behavior of operating expenses.
The P&L report stops at the operating profit line, or earnings before interest and income tax expenses. (Interest is in the hands of the chief financial officer of the business, and income tax is best left to tax professionals.)
Figure 14-2: Skeleton of a P&L (profit and loss) report.
For example, consider a hardware store in Boulder, Colorado that sells more than 100,000 different products (including different sizes of the same products). Suppose it has ten key managers with sales and profit responsibility. This means that each manager would be responsible for 10,000 different sources of sales. It would be possible to report every specific sale to the manager, but this would be absurd! The same is true for a high-volume retailer like Target or Costco. For a Honda or Toyota auto dealer, on the other hand, reporting each new car sale to the manager would be practical.
Sales revenue and expenses
In this section, I offer examples of sales revenue and expense information that managers need that is not reported in the external income statement of a business. Given the very broad range of different businesses and different circumstances, I can’t offer much detail.
Here’s a sampling of the kinds of accounting information that business managers need either in their P&L reports or in supplementary schedules and analyses:
Sales volumes (quantities sold) for all sources of sales revenue.
List sales prices and discounts, allowances, and rebates against list sales prices. For many businesses sales pricing is a two-sided affair that starts with list prices (such as manufacturer’s suggested retail price) and includes deductions of all sorts from the list prices.
Sales returns — products that were bought but later returned by customers.
Special incentives offer by suppliers that effectively reduce the purchase cost of products.
Abnormal charges for embezzlement and pilfer age losses.
Significant variations in discretionary expenses from year to year, such as repair and maintenance, employee training costs, and advertising.
Illegal payments to secure business, including bribes, kickbacks, and other under-the-table payments. Keep in mind that businesses are not willing to admit to making such payments, much less report them in internal communications. Therefore, the manager should know how these payments are disguised in the accounts of the business.
Sales revenue and margin for new products.
Significant changes in fixed costs and reasons for the changes.
Expenses that surged much more than increases in sales volume or sales revenue.
New expenses that show up for the first time.
Accounting changes (if any) regarding when sales revenue and expenses are recorded.
Digging into Cash Flow Information
Chapter 6 explains the statement of cash flows included in a business’s external financial report. Cash flows fall into three types:
Cash flows from operating activities (“operating” refers to making sales and incurring expenses in the process of earning profit)
Cash flows from investing activities (outlays for new long-term assets and proceeds from disposals of these assets)
Cash flows from financing activities (borrowing and repaying debt; raising capital from and returning capital to owners; and cash distributions from profit to owners)
Distinguishing investing and financing cash flows from operating cash flows
The field of financial management — raising capital for a business and deploying its capital — is beyond the scope of this book. For more information, you can refer to the book I coauthored with my son, Tage, Small Business Financial Management Kit For Dummies (John Wiley & Sons).
This section concentrates on cash flow from operating activities. These cash flows are affected by managers with operating responsibilities — managers who have responsibilities for sales and the expenses that are directly connected with making sales. These managers should understand the cash flow impacts of their sales and expenses. (See the sidebar “Cash flow characteristics of sales and expenses.”) Their sales and expense decisions drive the operating activity cash flows of the business.
Managing operating cash flows
The net cash flow during the period from carrying on profit-making operations depends on the changes in the operating assets and liabilities directly connected with sales revenue and expenses. Figure 14-3 highlights these assets and liabilities, and also retained earnings. Changes in these accounts during the year determine the cash flow from operating activities. In other words, changes in these accounts boost or crimp cash flow.
Figure 14-3: Assets and liabilities affecting cash flow from operating activities.
Note that retained earnings is highlighted in Figure 14-3. Profit increases this owners’ equity account. Profit is the starting point for determining cash flow from operating activities. (Alternatively, a business may use the direct method for determining and reporting cash flow from operating activities, which I explain in Chapter 6.)
The cash flow from profit is determined as follows:
1. Start with the accounting profit number, usually labeled net income.
2. Add depreciation expense (and amortization expense, if any) because there is no cash outlay for the expense during the period.
3. Deduct increases or add decreases in operating assets because
• An increase requires additional cash outlay to build up the asset.
• A decrease means amount invested in the asset is reduced and thus provides cash.
4. Add increases or deduct decreases in operating liabilities because
• An increase means less cash is paid out than the expense.
• A decrease means more cash is paid out to reduce the liability.
The manager should closely monitor the changes in operating assets and liabilities (see Figure 14-3). A good general rule is that each operating asset and liability should change about the same percent as the percent change in the sales activity of the business. If sales revenue increases, say, 10 percent, then operating assets and liabilities should increase about 10 percent. The percents of increases in the operating assets and liabilities (in particular, accounts receivable, inventory, accounts payable, and accrued expenses payable) should be emphasized in the cash flow report to the manager. The manager should not have to take out his calculator and do these calculations.
Controlling cash flow from profit (operating activities) means controlling changes in the operating assets and liabilities of making sales and incurring expenses: There’s no getting around this fact of business life. There’s no doubt that cash flow is king. You can be making good profit, but if you don’t turn the profit into cash flow quickly, you are headed for big trouble.