discussion 12

12.4 - Financial Controls

L E A R N I N G O B J E C T I V E S

1. Understand the nature of financial controls.

2. Know how a balance sheet works.

3. Know how an income profit and loss statement works.

4. See the sources of cash flow.

As we discussed in the previous section, financial controls are a key element of

organizational success and survival. There are three basic financial reports that all

managers need to understand and interpret to manage their businesses successfully: (1)

the balance sheet, (2) the income/profit and loss (P&L) statement, and (3) the cash flow

statement. These three reports are often referred to collectively as “the financials.”

Banks often require a projection of these statements to obtain financing.

Financial controls provide the basis for sound management and allow managers to

establish guidelines and policies that enable the business to succeed and

grow. Budgeting, for instance, generally refers to a simple listing of all planned expenses

and revenues. On the basis of this listing, and a starting balance sheet, you can project a

future one. The overall budget you create is a monthly or quarterly projection of what

the balance sheet and income statement will look like but again based on your list of

planned expenses and revenues.

While you do not need to be an accountant to understand this section, good managers

have a good grasp of accounting fundamentals. You might want to open a window to

AccountingCoach.com or a similar site as you work through this section to begin to build

your accounting knowledge tool kit. Retrieved October 21, 2008, from http://www.accountingcoach.com.

The Nature of Financial Controls

Imagine that you are on the board of Success-R-Us, an organization whose financial

controls are managed in an excellent manner. Each year, after the organization has

outlined strategies to reach its goals and objectives, funds are budgeted for the

necessary resources and labor. As money is spent, statements are updated to reflect how

much was spent, how it was spent, and what it obtained. Managers, who report to the

board, use these financial statements, such as an income statement or balance sheet, to

monitor the progress of programs and plans. Financial statements provide management

with information to monitor financial resources and activities. The income statement

shows the results of the organization’s operations, such as revenues, expenses, and

profit or loss. The balance sheet shows what the organization is worth (assets) at a single

point in time, and the extent to which those assets were financed through debt

(liabilities) or owner’s investment (equity).

Success-R-Us conducts financial audits, or formal investigations, to ensure that

financial management practices follow generally accepted procedures, policies, laws,

and ethical guidelines. In Success-R-Us, audits are conducted both internally—by

members of the company’s accounting department—and externally by Green Eyeshade

Inc., an accounting firm hired for this purpose.

Financial ratio analysis examines the relationship between specific figures on the

financial statements and helps explain the significance of those figures: By analyzing

financial reports, the managers at Success-R-Us are able to determine how well the

business is doing and what may need to be done to improve its financial viability.

While actual financial performance is always historical, Success-R-Us’s proactive

managers plan ahead for the problems the business is likely to encounter and the

opportunities that may arise. To do this, they use pro forma financials, which are

projections; usually these are projected for three fiscal years. Being proactive requires

reading and analyzing the financial statements on a regular basis. Monthly, and

sometimes daily or weekly, financial analysis is preferred. (In the business world as a

whole, quarterly is more common, and some organizations do this only once a year,

which is not often enough.) The proactive manager has financial data available based on

actual results and compares them to the budget. This process points out weaknesses in

the business before they reach crisis proportion and allows the manager to make the

necessary changes and adjustments before major problems develop.

Years ago, Success-R-Us experienced problems because its management style was

insufficiently proactive. A reactive manager waits to react to problems and then solves

them by crisis management. This type of manager goes from crisis to crisis with little

time in between to notice opportunities that may become available. The reactive

manager’s business is seldom prepared to take advantage of new opportunities quickly.

Businesses that are managed proactively are more likely to be successful, and this is the

result that Success-R-Us is experiencing since it instituted a company-wide initiative to

promote proactive controls.

Like most organizations, Success-R-Us uses computer software programs to do record

keeping and develop financials. These programs provide a chart of accounts that can be

individualized to the business and the templates for each account ledger, the general

ledgers, and the financial reports. These programs are menu driven and user-friendly,

but knowing how to input the data correctly is not enough. A manager must also know

where to input each piece of data and how to analyze the reports compiled from the

data. Widely accepted accounting guidelines dictate that if you have not learned a

manual record-keeping system, you need to do this before attempting to use a

computerized system.

The Balance Sheet

The balance sheet is a snapshot of the business’s financial position at a certain point in

time. This can be any day of the year, but balance sheets are usually done at the end of

each month. With a budget in hand, you project forward and develop pro forma

statements to monitor actual progress against expectations.

As shown in the following table, this financial statement is a listing of total assets (what

the business owns—items of value) and total liabilities (what the business owes). The

total assets are broken down into subcategories of current assets, fixed assets, and other

assets. The total liabilities are broken down into subcategories of current liabilities,

long-term liabilities/debt, and owner’s equity.

Assets

Current assets are those assets that are cash or can be readily converted to cash in the

short term, such as accounts receivable or inventory. In the balance sheet shown for

Success-R-Us, the current assets are cash, petty cash, accounts receivable, inventory,

and supplies.

Table 15.2 Sample Balance Sheet

Success-R-Us Balance Sheet

December 31, 2009

Assets Liabilities

Current Assets Current Liabilities

Cash $12,300 Notes Payable $5,000

Petty Cash 100 Accounts Payable 35,900

Wages Payable 14,600

Accounts Receivable 40,500 Interest Payable 2,900

Inventory 31,000 Warranty Liability 1,100

Supplies 5,300

Total Current Assets 89,000 Total Current Liabilities 61,000

Investments 36,000 Long-term Liabilities

Notes Payable 20,000

Property, Plant and Equipment Bonds Payable 400,000

Land 5,500 Total Long-term Liabilities 420,000

Land Improvements 6,500

Buildings 180,000

Equipment 201,000 Total Liabilities 481,000

Less Accum. Depreciation (56,000)

Prop., Plant, and Equipment net 337,000

Intangible Assets Stockholders’ Equity

Goodwill 105,000 Common Stocks 110,000

Trade Names 200,000 Retained Earnings 229,000

Total Intangible Assets 305,000 Less Treasury Stock (50,000)

Other Assets 3,000

Total Assets $770,000 Total Liability and Stockholder Equity $770,000

Some business people define current assets as those the business expects to use or

consume within the coming fiscal year. Thus, a business’s noncurrent assets would be

those that have a useful life of more than 1 year. These include fixed assets and

intangible assets.

Fixed assets are those assets that are not easily converted to cash in the short term; that

is, they are assets that only change over the long term. Land, buildings, equipment,

vehicles, furniture, and fixtures are some examples of fixed assets. In the balance sheet

for Success-R-Us, the fixed assets shown are furniture and fixtures and equipment.

These fixed assets are shown as less accumulated depreciation.

Intangible assets (net) may also be shown on a balance sheet. These may be goodwill,

trademarks, patents, licenses, copyrights, formulas, and franchises. In this instance, net

means the value of intangible assets minus amortization.

Liabilities

Current liabilities are those coming due in the short term, usually the coming year.

These are accounts payable; employment, income and sales taxes; salaries payable;

federal and state unemployment insurance; and the current year’s portion of multiyear

debt. A comparison of the company’s current assets and its current liabilities reveals its

working capital. Many managers use an accounts receivable aging report and a current

inventory listing as tools to help them in management of the current asset structure.

Long-term debt, or liabilities, may be bank notes or loans made to purchase the

business’s fixed asset structure. Long-term debt/liabilities come due in a period of more

than 1 year. The portion of a bank note that is not payable in the coming year is long-

term debt/liability.

For example, Success-R-Us’s owner may take out a bank note to buy land and a

building. If the land is valued at $50,000 and the building is valued at $50,000, the

business’s total fixed assets are $100,000. If $20,000 is made as a down payment and

$80,000 is financed with a bank note for 15 years, the $80,000 is the long-term debt.

Owner’s Equity

Owner’s equity refers to the amount of money the owner has invested in the firm. This

amount is determined by subtracting current liabilities and long-term debt from total

assets. The remaining capital/owner’s equity is what the owner would have left in the

event of liquidation, or the dollar amount of the total assets that the owner can claim

after all creditors are paid.”

The Income Profit and Loss Statement (P&L)

The profit and loss statement (P&L) shows the relation of income and expenses for a

specific time interval. The income/P&L statement is expressed in a 1-month format,

January 1 through January 31, or a quarterly year-to-date format, January 1 through

March 31. This financial statement is cumulative for a 12-month fiscal period, at which

time it is closed out. A new cumulative record is started at the beginning of the new 12-

month fiscal period.

The P&L statement is divided into five major categories: (1) sales or revenue, (2) cost of

goods sold/cost of sales, (3) gross profit, (4) operating expenses, and (5) net income.

Let’s look at each category in turn.

Table 15.3 Sample Income Statement

Success-R-Us Income Statement

For the year ended December 31, 2009

Sales/Revenues (all on credit) $500,000

Cost of Goods Sold 380,000

Gross Profit 120,000

Operating Expenses

Selling Expenses 35,000

Administrative Expenses 45,000

Total Operating Expenses 80,000

Operating Income 40,000

Interest Expense 12,000

Income before Taxes 28,000

Income Tax Expense 5,000

Net Income after Taxes 23,000

Sales or Revenue

The sales or revenue portion of the income statement is where the retail price of the

product is expressed in terms of dollars times the number of units sold. This can be

product units or service units. Sales can be expressed in one category as total sales or

can be broken out into more than one type of sales category: car sales, part sales, and

service sales, for instance. In our Success-R-Us example, the company sold 20,000

books at a retail price of $25 each, for total revenues of $500,000. Because Success-R-

Us sells all of its books on credit (i.e., you can charge them on your credit card), the

company does not collect cash for these sales until the end of the month, or whenever

the credit card company settles up with Success-R-Us.

Cost of Goods Sold/Cost of Sales

The cost of goods sold/sales portion of the income statement shows the cost of products

purchased for resale, or the direct labor cost (service person wages) for service

businesses. Cost of goods sold/sales also may include additional categories, such as

freight charges cost or subcontract labor costs. These costs also may be expressed in one

category as total cost of goods sold/sales or can be broken out to match the sales

categories: car purchases, parts, purchases, and service salaries, for example.

Breaking out sales and cost of goods sold/sales into separate categories can have an

advantage over combining all sales and costs into one category. When you break out

sales, you can see how much each product you have sold costs and the gross profit for

each product. This type of analysis enables you to make inventory and sales decisions

about each product individually.

Gross Profit

The gross profit portion of the income/P&L statement tells the difference between what

you sold the product or service for and what the product or service cost you. The goal of

any business is to sell enough units of product or service to be able to subtract the cost

and have a high enough gross profit to cover operating expenses, plus yield a net income

that is a reasonable return on investment. The key to operating a profitable business is

to maximize gross profit.

If you increase the retail price of your product too much above the competition, you

might lose units of sales to the competition and not yield a high enough gross profit to

cover your expenses. However, if you decrease the retail price of your product too much

below the competition, you might gain additional units of sales but not make enough

gross profit per unit sold to cover your expenses.

While this may sound obvious, a carefully thought out pricing strategy maximizes gross

profit to cover expenses and yield a positive net income. At a very basic level, this means

that prices are set at a level where marginal and operating costs are covered. Beyond

this, pricing should carefully be set to reflect the image you want portrayed and, if

desired, promote repeat business.

Operating Expenses

The operating expense section of the income/P&L statement is a measurement of all the

operating expenses of the business. There are two types of expenses, fixed and variable.

Fixed expenses are those expenses that do not vary with the level of sales; thus, you will

have to cover these expenses even if your sales are less than the expenses. The

entrepreneur has little control over these expenses once they are set. Some examples of

fixed expenses are rent (contractual agreement), interest expense (note agreement), an

accounting or law firm retainer for legal services of X amount per month for 12 months,

and monthly charges for electricity, phone, and Internet connections.

Variable expenses are those expenses that vary with the level of sales. Examples of

variable expenses include bonuses, employee wages (hours per week worked), travel and

entertainment expenses, and purchases of supplies. (Note: categorization of these may

differ from business to business.) Expense control is an area where the entrepreneur can

maximize net income by holding expenses to a minimum.

Net Income

The net income portion of the income/P&L statement is the bottom line. This is the

measure of a firm’s ability to operate at a profit. Many factors affect the outcome of the

bottom line. Level of sales, pricing strategy, inventory control, accounts receivable

control, ordering procedures, marketing of the business and product, expense control,

customer service, and productivity of employees are just a few of these factors. The net

income should be enough to allow growth in the business through reinvestment of

profits and to give the owner a reasonable return on investment.

The Cash Flow Statement

The cash flow statement is the detail of cash received and cash expended for each month

of the year. A projected cash flow statement helps managers determine whether the

company has positive cash flow. Cash flow is probably the most immediate indicator of

an impending problem, since negative cash flow will bankrupt the company if it

continues for a long enough period. If company’s projections show a negative cash flow,

managers might need to revisit the business plan and solve this problem.

You may have heard the joke: “How can I be broke if I still have checks in my check book

(or if I still have a debit/credit card, etc.)?” While perhaps poor humor, many new

managers similarly think that the only financial statement they need to manage their

business effectively is an income/P&L statement; that a cash flow statement is excess

detail. They mistakenly believe that the bottom-line profit is all they need to know and

that if the company is showing a profit, it is going to be successful. In the long run,

profitability and cash flow have a direct relationship, but profit and cash flow do not

mean the same thing in the short run. A business can be operating at a loss and have a

strong cash flow position. Conversely, a business can be showing an excellent profit but

not have enough cash flow to sustain its sales growth.

The process of reconciling cash flow is similar to the process you follow in reconciling

your bank checking account. The cash flow statement is composed of: (1) beginning cash

on hand, (2) cash receipts/deposits for the month, (3) cash paid out for the month, and

(4) ending cash position.

K E Y T A K E A W A Y

The financial controls provide a blueprint to compare against the actual results once the

business is in operation. A comparison and analysis of the business plan against the

actual results can tell you whether the business is on target. Corrections, or revisions, to

policies and strategies may be necessary to achieve the business’s goals. The three most

important financial controls are: (1) the balance sheet, (2) the income statement

(sometimes called a profit and loss statement), and (3) the cash flow statement. Each

gives the manager a different perspective on and insight into how well the business is

operating toward its goals. Analyzing monthly financial statements is a must since most

organizations need to be able to pay their bills to stay in business.

R E F L E C T I O N S

1. What are financial controls? In your answer, describe how you would go about building a

budget for an organization.

2. What is the difference between an asset and a liability?

3. What is the difference between the balance sheet and an income statement? How are

the balance sheet and income statement related?

4. Why is it important to monitor an organization’s cash flow?

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