Revenues represent the money received or billed for services or products sold. Revenues may also result from sources other than sales, such as returns on investments (interest earned), franchising fees, or even rental income from a property. When revenues are recorded in the income statement will depend on the accounting method chosen, as discussed previously.
Expenses
Expenses represent a cost associated with the selling of services and products. Expenses are composed of the cost of goods sold (COGS), operating expenses, financing expenses, and tax expenses. Again, expenses are recorded in the income statement depending on the accounting method chosen.
Cost of Goods Sold (COGS). The cost of goods sold (COGS) includes everything directly connected with the purchasing or production of the services or products that are ultimately sold. These expenses include the wages of the direct labor involved in the production of the product or service, the materials used, parts or components purchased, and repairs made to the equipment of the facility used for production of the product or service. These are expenses directly related to the venture's production of goods or services. If we subtract these expenses from revenue, the resulting sum is gross profit. Gross profit (when gross profit is measured as a percent of sales, it's called gross margin) is defined as the difference between sales of the company's goods and services and the cost of goods sold.
Operating Expenses. The operating expenses, also known as OPEX, represent a category of expenditure directly connected with operating the venture and not directly connected with the production of the product or service. This category includes accounting and legal services, advertising and marketing costs, insurance coverage, office equipment and supplies, office rent (factory rent for production may or may not be included in the COGS depending on the accountant), salaries not directly tied to the production process, utility bills (could also be classified in the COGS depending on the type of business), depreciation (allocation of the cost of a tangible asset spread throughout its economic life), and amortization (allocation of an intangible asset's cost over that asset's useful life).
Other Expenses. Other expenses cover financing expenses (interest paid on loans) and tax expenses associated with the company's profit.
The Statement of Cash Flow
The statement of cash flow describes the venture's cash flow. It analyzes cash flow, calculating cash flow attributed to three different activities: operations, investment activities, and financing activities. Questions include how much cash the company spent or where the cash came from. A simplified cash flow statement is shown in Table 3.5.
Table 3.5
Cash flow from operations is defined as the cash generated or used by virtue of the day-to-day operations of the venture. Collected accounts receivable and cash from cash sales represent positive cash flow. Paid expenses related to generating those sales represent outflows of cash. The sum of these two flows is referred to as cash flow from operations, and this normally represents the bulk of the cash inflows and outflows that pass through the company.
Cash flow from investments includes cash generated or consumed by the purchase or sale of buildings, equipment, and marketable securities (stocks or bonds). It may also include loans advanced to suppliers or customers as well as payments related to acquisitions of parts of another venture.
Cash flow from financing activities includes cash generated or consumed by investments, investors, loans from banks, dividend payments, stock repurchases, and repayment of debt principal.
The firm's net cash flow is the cumulative sum of the above three subclasses of cash sources and uses. In short, the net cash flow equals cash sources minus cash uses. This computation is used to describe how the venture generates cash to fund operations, pay off liabilities, or pay dividends to investors. By analyzing the cash flow of a venture, it is possible to make conclusions about management's capabilities and the firm's overall efficiency. For example, if external financing from investors is the main source of cash for a large period of time, without significant inflows from operations, it is an alert that the firm could face upcoming financial challenges or is already experiencing difficulty in making and selling its product.
Summary
In this chapter, the three basic financial statements were presented and explained. Each of these statements provides information about the status and health of the venture. Later chapters will provide more tools for a deeper understanding of how to analyze and interpret each of the reports covered. The balance sheet is a comparison tool where the performance of the firm is assessed at a certain point in time. The income statement gives an overview of how much the company made and spent in a specific period of time. The statement of cash flow defines how much cash is generated and how it is used over a period of time.
Chapter 4 Financial Ratio Analysis
Learning Objectives
To explain the use of financial ratios
To learn where to source information to calculate and compare ratios
To distinguish between the different types of ratios and their purposes
To understand the limitations of financial ratio analysis
Case: Old Pueblo Lithographers
Old Pueblo Lithographers, the largest lithographer in New Mexico and headquartered in Santa Fe, is a family firm that dates back to the 1950s. The company specializes in high-quality, fine art, book, and commercial printing for customers in New Mexico and the southwestern United States, with some commercial customers in Mexico. The firm is managed by James Logan, a third-generation printer who is approaching retirement. The issue at the firm is what to do about choosing the next leader of the company.
James has one child, a daughter, Sydney, who works in the business. By all accounts she is very good at her job. She is excellent with clients, is well respected by her peers, and knows the production process inside and out. She had a meeting with her father and has asked him to consider appointing her the new president of the corporation. James turned her down. She took offense at what she perceived as a slight; hurt and dejected, she stalked out of her father's office, slamming the door.
Later when she had calmed down, she approached her father and asked why he had turned her down in her bid to lead the company. His answer was simple and direct: “You cannot read financial statements.” He went on to say, “Without this ability, you will not be able to manage the company well enough to keep it on track with the requirements of its banks, nor will you be able to assure that the customers would pay their bills appropriately and that the company would pay its bills in the most efficient manner. You would not have any idea about how to give credit terms or take advantage of terms offered by the firm's suppliers. You would not know what the impact of production scheduling changes or capital purchases would have on the firm and would thus not know the impact of any decisions you made in these areas. In short, if you can't read the financial statements, you won't know how to manage the firm's cash flow and, ultimately, you would not be able to keep the company on an even financial keel.”
