The foundation for any financial analysis is the financial statements. So how much do we know about financial statements?
The Business dictionary defines financial statement as “summary report that shows how a company has used the funds entrusted to it by its shareholders (stockholders) and lenders, and what is its current financial position”.
Show me where the money is? A question everyone wants to know the answer to when presented with a business proposal. That question is exactly what financial statements answer. It answers your basic questions about the money; where the company’s money came from, where it went, and where it is now.
There are four types of financial statements which are reported by companies, but one of them, the statement of shareholder’s equity is not widely discussed. The statement of shareholder’s equity shows the changes in the interests of the company’s shareholders over time.
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We will leave out this fourth statement and focus only on the three other statements that shows us where the money used in the business is.
Every business is involved in economics activities, the size and scope may vary, but it is the same for all. Whether it is the shop in the village selling fresh vegetables, or the giant supermarkets in the city selling a variety of items, the community bank or the international bank, the cement seller or the cement manufacturer, it doesn’t really matter. The activities they are all engaged in are all the same.
We introduce to you, our entrepreneurs; Obi and Ada that will be our guide in this lesson. Obi and Ada are cousins, during the last Christmas holidays they spent in the village, they decided to start a business together. The business idea was to buy farm produce from the village market, package them and sell in the city.
There are three kinds of economic activities that Obi and Ada, and any other person in business will carry out. These activities will be captured in the three types of financial statements.
The starting point for the two would be to establish a company, with an agreement on the terms of the business partnership.
The next cause of action for the two entrepreneurs will be to fund the business. This can be in form of putting in their own money or getting someone else to put in theirs, or taking a loan from the bank or private individuals.
This activity is called financing activity.
When the money needed for the business is in the bag, they will go out spending this money on their business. They will set up a shop in the city, buy packaging tools in accordance with their requirement, get a means of transporting the goods from the village to the city like a pick-up truck if they want to, and may even set up a warehouse in the village.
This activity is called the investing activity.
Next will be to start buying the produce from the village, packaging materials to package them, and then selling to customers, and finally collecting payments everyday.
This activity is called the operating activity.
All businesses go through this cycle of economic activities; operating activity, investing activity and financing activity. This can be broadly called the business cycle, and it applies to all businesses, no matter the size or the number of transactions done in a day.
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Having used the money from financing activity to execute the investing activity, Ada and Obi would carry out the operating activity which ends with the sell of the product to earn money or revenue, which is their ultimate business goal. They as well as any other business will constantly repeat this cycle.
Now, at any point in the business cycle, to be able to describe that particular cycle, what information do we need?
The purpose of the business is to make a profit, so you must want to know whether you have made a profit or not.
However, a basic requirement for Obi and Ada to continue in business is for them not to lose the principal of their investment. It is therefore important that they ask a question to know if the principal of their investment is still there.
The principal invested in the form of cash is no longer cash, it has become all kinds of things. You therefore need to understand what your initial cash investment has become and how much it is still worth.
Hence, you need a financial statement to tell you the status of the principle of your investment and such a financial statement is called the Balance sheet or the Statement of Financial Position.
When you have established what your business capital is worth, then you can turn your attention to answering the next question; which is how much profit your business is making.
The basics of every trade being profitable or not is in the values of the total revenue and the total expenses. So, where do you get the information to answer the question about profit?
The financial statement known as Profit and Loss statement or Income statement provides the answer over a defined period of time usually monthly.
How are our friends, Obi and Ada doing in their business? After a year of doing business, they have decided to open another shop and start buying farm produce from another village, making it their second source of produce.
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They are embarking on what we already know as business expansion. Do you remember the three economic activities? Obi and Ada will have to embark on a new investment activity. But, where will the cash to do this come from?
Recall that one cycle ends when Obi and Ada sells their products to their customers and earn revenue, and if they made a profit, there is some new cash generated in the business. If they made loses, they will need some new cash to make up their capital to continue operating the business at the same level.
It is therefore a legitimate question to ask; from where does the cash used in running the business on a day to day basis come from, and where does the cash generated as revenue go to?
Once again, the financial statement provides the answer in the third type of statement called Cash Flow Statement.
Next week, we will introduce you to the Balance Sheet. What has become of your initial investment, and how much is it still worth?