Ag
Ec Home Course
Description 
Best if printed in landscape.
Financial Goals and Financial Statements
Several common business goals have been suggested. These include
- earn a profit,
- increase owner equity,
- pay bills on time, and
- do not assume unreasonable risk.
A quick review of basic financial statements reveal a relationship between these common business goals and the information provided by the financial statements, for example
- an income statement reports the business profit,
- a series of balance sheets reveals whether the owner equity in the business is increasing,
- a cash flow statement summarizes whether creditors were paid on time, and
- a balance sheet reveals whether the business has capacity to assume risk.
This page reviews some fundamental features of each of these financial statements. The discussion does not explain how to prepare the financial statements, that is taught in accounting courses, or performed by accounting experts. The focus of this page is on how a manager can use these financial statements in decision making.
Several introductory points:
- each of these financial statements can be prepared to report the past or project the future, and
- no one type of financial statement reports all the information needed to manage a business; each type of financial statement is needed because each provides the information to answer a specific question(s).
Financial statements contain information based on the business' internal financial records.
The following points briefly review the key points of financial statements frequently used by businesses. The assumption is that these financial statements have been introduced and studied in detail in other courses.
Balance sheet or net worth statement
- Summarizes the business' assets, liabilities, and net worth or equity
- A balance sheet is prepared as of a particular point in time, such as December 31, 20XX.
- All owned assets and their values are listed. All debts owed also are listed. The difference between the total value of the assets and the total liabilities is the owners' equity.
- An inventory of the business assets and their values; and a list of the business debts are needed to prepare a balance sheet.
- Why is it important to know the assets, liabilities, and equity of the business?
- How does equity in the business relate to the owner's capacity to assume risk?
- Review -- What is the difference between capacity/ability to assume risk and willingness to assume risk? How does one's capacity to assume risk change over time and how does one's willingness to assume risk change over time? What is the practical implication of these two trends?
- Review -- what is the relationship between ability to assume risk as revealed by a balance sheet and a common business goal of accepting a reasonable level of risk exposure?
Another balance sheet could be prepared at another time, maybe three months later, maybe a year later. The values on the two balance sheets will likely be different. For example, a comparison of equity calculated on balance sheet 1 and the equity calculated on balance sheet 2 reveals how the owners' equity changed during the time between the dates the two balance sheets were prepared.
- Review -- what is the relationship between change in equity as revealed by a series of balance sheets and the common business goal of increasing equity or net worth?
What transactions impact the balance sheet? What are some simple examples?
- Sale of inventory for cash would decrease the quantity of inventory (an asset) and increase the amount of cash (another type of asset). Total assets should not change, nor should total liabilities or equity. This transaction primarily changes the form of the business assets; that is, from physical items in inventory to cash.
- Cash used to pay principal on a loan decreases the amount of cash (an asset) a business has; liabilities should decrease (by the same amount); equity should remain unchanged.
- Purchase a piece of equipment by borrowing the purchase price. Total assets and total liabilities should increase; equity should remain unchanged.
- Purchase a piece of equipment by using cash to pay the purchase price. Cash (an asset) should decrease), equipment (an asset should increase), total assets, total liabilities and equity should remain unchanged. The transaction changed the form of the asset -- cash to equipment.
- How should warranties and growing crops be treated in preparing a balance sheet?
- If a warranty (such as a warranty that the manufacturer will repair a tractor engine should it fail) is not listed on the balance sheet, should it at least be included as a footnote as an indicator that the risk of an engine failure is not borne by the business at this time? Is this consistent with the idea of using a balance sheet to assess risk?
- How might the payment of an interest expense or operating expense impact a balance sheet?
Resource: Kay, et al. Farm Management, McGraw Hill, 6th Ed. 2008, chapter 5.
Resource: Edwards, W. Your Net Worth Statement, Iowa State U. File C3-20.
Simple example: see page 1 of Basic Financial Statements
Income statement
- Summarizes the business' revenue, cost and profit
- Be careful to appropriately use these terms; for example, it is easy to interchange revenue and profit, but they are different concepts.
- "Preparing an income statement" is a process to calculate the profit of an entire business; an income statement is a document that summarizes the data and information used to calculate the business' profit.
- Review -- It is assumed that earning a profit is a goal for the business owners, but it may not be the only goal.
What is the relationship between the common business goal of earning a profit and an income statement?
- An income statement covers a period of time; for example, January 1, 20XX to December 31, 20XX.
- An income statement can be prepared to 1) "report the past:" that is, what profit was generated during a past period, and 2) "project the future;" that is, what profit is expected to be generated during a future period.
- Revenue is the value of all production during the period of time. It includes items produced but not sold; it does not include items sold from inventory that had been produced during an earlier period.
- Cost is the expense associated with the items produced during the time period.
- As will be emphasized throughout these materials: a cost MAY NOT require a cash outflow and revenue MAY NOT provide a cash inflow. This point is often confusing.
- In a closely-held business, it is important to distinguish between a business expense and a non-business (family) expense. For example, the insurance premium paid to protect against the risk that a business building might be damaged by a storm is a business expense, whereas the insurance premium paid to protect the family residence is not a business expense.
The question an income statement answers is whether the business generated a profit by producing its product during the time period. Restated, was the value of the product produced during this period greater than or less than the cost of producing the products?
- Recognize that income tax law may allow a business owner to treat some expenditures differently for income tax purposes than it would be treated for calculating the business profit. In this course, the emphasis is NOT on income tax practices.
The information needed to prepare an income statement is the quantity and value of all products produced during the period of time and the cost of all inputs used to produce those products during that period of time.
- Each business needs a record keeping system that records production and the inputs used in the production process.
- With our modern information technology, agricultural producers should be able to devise a record keeping system that is based on quantity and value of production and cost of inputs used. 21st century operators should be able to begin shifting away from "cash accounting with adjustments" to "accrual accounting" when assembling the data needed to prepare an income statement.
All revenue may not provide a cash inflow; some production may have been added to inventory.
- A farmer harvested feed grain in the fall of the year and placed it in farm storage (inventory). The value of the grain would be revenue for the period in which the grain was harvested.
All expenses may not require a cash payment; e.g., the use of inventory to produce output this period. For example, the farmer using stored grain to feed livestock -- the grain was an inventory item and its use was NOT a cash expense.
- Continuing the previous example: the next year, the farmer uses the grain to feed livestock; that is, the farmer uses some inventory (grain) to produce a product (livestock). The value of the grain removed from inventory and fed would be a cost for the period when the grain is fed.
Another example of a cost without a cash outflow would be depreciation of equipment is not a cash expense, but it is an expense or cost.
- Depreciation is a cost, but what is depreciation? Depreciation is discussed on another page.
All expenses are not recognized on an income statement. For example, the value of the owners' time is an opportunity cost (recognized by the managers), but is not a cost that accountants include as an expense when preparing an income statement. That is a difference between how managers analyze a business and how accountants analyze a business. This discussion focuses on how managers analyze a business. More on opportunity cost on another page.
- How does a manager determine whether the business generated an adequate profit?
- Review -- what is the relationship between profit as calculated with an income statement and the common business goal of earning a profit?
Resource: Kay, et al. Farm Management, McGraw Hill, 6th Ed. 2008, chapter 6.
Resource: Edwards, W. Your Farm Income Statement, Iowa State U. File C3-25
Simple example: see page 1 of Basic Financial Statements
Cash flow statement
A cash flow statement documents the business' cash inflows and cash outflows
- What is the relationship between a cash flow statement and the common business goal of wanting to pay the business' obligations when they are due?
Like an income statement, a cash flow statement covers a period of time; for example, January 1, 20XX to December 31, 20XX.
A cash flow statement can be prepared to 1) "report the past," that is, what cash inflows and outflows occurred during a past period, or 2) "project the future," that is, what cash inflows and outflows are expected to occurred during a future period.
- Projected cash flow is sometimes referred to as "a cashflow budget".
A cash flow statement includes all cash flowing into the business and all cash flowing out of the business. It includes cash flowing into the business from the sale of produce and cash flowing out of the business for the purchase of production inputs or operating expenses. But it also includes cash the owners' contribute to the business in an attempt to expand the business; as well as the cash the owners remove from the business to compensate themselves for being invested in the business.
- For example, in many closely-held businesses, the owners may try to withdraw enough cash to pay all or part of the owners' family living expenses.
The information needed to prepare a cash flow statement is a record of all transactions that brought cash into the business and that removed cash from the business.
- For example, a business that uses a checking account as the vehicle for handling its cash may find that most of the information needed to prepare a cash flow statement can be collected from a well-documented checking account.
The purchase of a long-term asset, such as a piece of equipment, requires cash, and thus appears as a cash outflow on the cash flow statement. However, the cost of the equipment does not appear as an expense on the income statement. Only the amount that the equipment is depreciated during this first time period will appear as an expense on the current income statement. The difference between cash flow and revenue/expenses is addressed in more detail in a subsequent section.
Borrowing cash is a cash inflow on the cash flow statement, but is not revenue on an income statement. Again, the difference between cash flow and revenue/expenses is addressed in more detail in a subsequent section.
- Likewise, paying part of the principal portion of a debt is a cash outflow on the cash flow statement, but not an expense on the income statement.
- The interest portion of a debt payment is a cash outflow on the cash flow statement AND an expense on the income statement.
- Even though lenders often review a borrower's balance sheet in assessing whether to extend a loan, would there be any reason for the lender (as well as the borrower) to assess the borrower's projected cash flow in deciding whether the loan should be made?
- Review -- what is the relationship between projected cash flow as revealed by a cash flow budget and the common business goal of paying obligations on time?
Net cash flow (the difference between cash inflows and cash outflows during a specified period) is NOT the same as profit (the difference between revenue and costs during the specified period). Again, see Cost v. Cash Outflow.
Resource: Kay, et al. Farm Management, McGraw Hill, 6th Ed. 2008, chapter 13.
Resource: Edwards, W. Twelve Steps to Cash Flow Budgeting, Iowa State U. File C3-15.
Simple example: see page 1 of Basic Financial Statements
Understanding the Relationship Among the Three Statements
Even though the three financial statements provide different information, they need to be considered collectively.
- Example of financial statements following a series of business transactions. This example is intended to illustrate how individual transactions impact each financial statement.
- Swenson, Andrew L.
Financial Characteristics of North Dakota Farms 2007-2008, November 2009.
- Review the "DEFINITION OF FINANCIAL MEASURES" in the appendix on pp. 27-29 of the publication.
- A collective review of the financial statements. This brief document suggests what a manager might learn about the business by reviewing the financial statements as a single portrayal of the business.
Does each of the three basic financial statements have a role in assessing the business' ability or capacity to assume risk?
- The balance sheet reveals assets v. liabilities; this is probably of greatest interest to a lender -- "can I get my money back immediately by forcing the business to sell assets to pay its debts?"
- The cash flow budget or projected cash flow is probably of interest to the borrowing business manager -- "will I have enough cash to pay the debt when it is due?".
- Of equal interest for the borrowing manager is the question "will borrowing this money and using it in the business generate enough profit to justify the risk of making the investment, especially if making the investment requires borrowing?"
- The profitability of assuming a risk can be analyzed by projecting profit without assuming the risk and projecting profit if the risk is assumed. The difference between the two projected profits is the profit attributable to the assuming the risk. Two enterprise analysis (one based on assuming the risk and one based on not assuming the risk) should reveal the same outcome. Likewise, a partial budget analysis could also be used to complete the analysis.
- All three of these analytical techniques (two projected income statements, two projected enterprise analyses, or a partial budget analysis) should reveal the same outcome if all are properly prepared.
What the Financial Statements do NOT Reveal
It is important to understand what information the three basic financial statements reveal to the business manager. It is equally important to understand what information these statements do NOT reveal. For example, these statements do not reveal whether it is profitable to update equipment. That question is most likely best analyzed with an enterprise analysis or a partial budget analysis which are explained on other web pages.
These statements do not reveal whether a manager is "spending too much money." The problem with such a statement is it does not indicate whether the manager is "spending too much" relative to the revenue being generated (thus the investment is not reaching the profit goal) or is "spending too much" and the business does not have enough cash to meet its obligations (thus a cash flow problem). To be able to use these financial statements, the manager needs to ask precise questions.
- A balance sheet will not reveal whether assuming risk is profitable.
- An income statement will reveal the amount of profit, but it will not reveal whether the amount of profit is adequate.
- Paying bills on time not only helps maintain credit-worthiness, but it keeps unpaid creditors from shutting down the business.
Summary of Key Points
This web page addressed several critical management topics.
- A balance sheet summarizes the business assets and their values, the business debts, and the owner's equity in the business. This information provides some insight into the business ability or capacity to assume risk.
- An income statement calculates the profitability of the business.
- A cash flow statement (especially a projected cash flow) helps the manager identify whether there will be enough cash to pay obligations when they are due. A cash flow statement also provides an indication of when and how much cash may need to be borrowed, or when and how much cash the business may have available.
- Revenue and expenses are different from cash inflow and cash outflow.
- Financial goals provides the manager a basis for establishing opportunity costs; that is, how much profit must the business return to the owner to keep the owner invested in the business.
The next page reviews the definition of accounting profit, depreciation from a manager's perspective, and assessing the adequacy of business' accounting profit.
Last Updated September 23, 2010
Email: David.Saxowsky@ndsu.edu
This material is intended for educational purposes only. It is not a substitute for competent professional advice. Seek appropriate advice for answers to your specific questions.
Phone
Book Campus
Map NDSU
Search College
of Agriculture