4 Connections in the financial reports that every manager should know

Every business manager should use his / her income statement to evaluate profit performance and to ask profit-oriented questions like:

  • Did sales revenue meet the goals and objectives for the period?
  • Why did sales revenue increase compared with latest period?
  • Which expenses increased more or less than expected? And many similar questions…

PROFIT ISN’T EVERYTHING

A good manager can’t stop at the end of the above questions!

Beyond profit analysis, business managers should move on to financial condition analysis and cash flow analysis. They should have a close look at the three basic financial reports, income statement, balance sheet and cash flows statement, and see how they interlock with one another.

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SALES REVENUE & ACCOUNTS RECEIVABLE

How Sales Revenue Drives Accounts Receivable?

Every company has a mix of quick, regular, and slow-paying customers. Extending credit to customers will lead to creating a cash inflow lag. The accounts receivable balance is the amount of this lag. At year-end the amount the balance in this asset account is the amount of uncollected sales revenue.

Let’s have a look at the following example:

  • Sales Revenue for the year (Income Statement) = $52,000,000
  • Accounts Receivable at End of Year (Balance Sheet) = $5,000,000

 The relationship between annual sales revenue and the ending balance of accounts receivable, can be expressed through the average sales credit period – determines the size of accounts receivable. The longer the average sale credit period, the larger the accounts receivable amount.

In order to determine the average sales credit period we should first calculate the following ratio:

$52,000,000 Sales Revenue / $ 5,000,000 Accounts receivable = 10.4 Times

This calculation gives the accounts receivable turnover ratio. If we want to know the average sales credit period (in weeks) we should divide the ratio in 52 weeks:

52 Weeks / 10.4 Accounts Receivable Turnover Ratio = 5 Weeks

Time is the essence of the mater. What interests the business manager, and the company’s creditors and investors as well, is how long it takes on average to turn accounts receivable ratio into cash. (In our example the company needs 5 Weeks, on average).

The manager in charge has to decide whether the average credit period is getting out of hand. The manager can shorten credit terms, shut off credit to slow payers, or step up collection efforts.

To make an important point here assume that without losing any sales the company’s average sales credit period has been shortened to 4 weeks, instead of 5 weeks. In this scenario, the company’s ending accounts receivable balance would have been $1,000,000 less, or $4,000,000 in total. In this way the company would have collected $1,000,000 more cash during the year!

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COST OF GOODS SOLD EXPENSE AND INVENTORY

Holding products in Inventory before they are sold

Cost of goods sold expense means just that- the cost of all products sold to customers during the year. For manufacturing companies, this is by far the largest expense in the company’s income statement.

To sell products, most companies must keep a stock of products on hand, which is called inventory. The inventory asset is reported at cost in the balance sheet, not at its sales value. The inventory asset account accumulates the cost of the products purchased or manufactured. Acquisition cost stays in an inventory asset account until the products are sold to customers. At this time, the cost of the products is removed from inventory and charged out to cost of goods sold expense.

The size of the inventory is determined by the average inventory holding period. Suppose we did not know the company’s average inventory holding period, we can determine it using the following information from its financial statements:

  • Cost of Goods Sold Expense (Income Statement) = $33,800,000
  • Inventory (Balance Sheet) = $8,450,000

The longer the manufacturing and warehouse holding period, the larger is the inventory amount. Business managers prefer to operate with the lowest level of inventory possible, without causing lost sales due to products being out of stock when customers want to buy them.

In order to determine the average inventory holding period we should first calculate the inventory turnover ratio:

$33,800,000 Cost of Goods Sold Expense / $8,450,000 Inventory = 4 Times

Dividing this ration into 52 weeks gives the average inventory holding period expressed in number of weeks:

52 Weeks / 4 Inventory Turnover Ratio = 13 Weeks

What interests the managers, as well as the company’s creditors and investors, is how long the company holds inventory before products are sold. If the holding period is longer than necessary, too much capital is being tied up in inventory. Or, the company may be cash poor because it keeps too much money in inventory and not enough in the bank.

In summary, if inventory holding period is too long, capital is being wasted, if too short profit opportunities are being missed.

 

INVENTORY AND ACCOUNTS PAYABLE

The company’s inventory holding period is much longer than its purchase credit period (which is typical for most businesses). In other words, accounts payable are paid much sooner than inventory is sold.

Based on its experience and policies, a business knows the average purchase credit period for its production-related purchases, and can easily calculate the average inventory holding period. From here we can easily calculate the year-end balance of accounts payable for inventory-related purchases.

Accounts Payable for inventory-related purchases:

[Average purchase credit period for production-related purchases / Average inventory holding period] x Inventory

OPERATING EXPENSES AND ACCOUNTS PAYABLE

Operating expenses (Selling, General and Administrative Expenses) include all business expenses except: cost of goods sold, interest, depreciation and income tax expenses.

Based on its experience, a business should know the average time it takes to pay its short term accounts payable arising from unpaid operating expenses.

Account Payable (for operating expenses):

[Average credit period (in Weeks) / 52 Weeks] x Operating Expenses for Year

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References: How to read financial report, John A. Tracy

4 Connections in the financial reports that every manager should know
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