There are three main financial statements:
- Cash flow statement
- Income statement or Profit and Loss statement (P&L)
- Balance sheet
Cash Flow Statement
The cash flow statement shows the inflows and outflows of funds—the “show me the money” of the business. It covers a period of time. It can be a year, a quarter, a month, etc. A cash flow statement can be historical or forward-looking, a projection or an estimate.
There are three distinct sections:
1. Operating activities —they are the business’s bread and butter. They are the regular business operations that generate revenue and expenses.
2. Investing activities— they are not normal (an adjective that becomes popular in Covid times) or part of the regular operations of a business. For example, selling machines or equipment.
3. Financing activities— these activities include both debt and equity for the business to support operations.
There are two ways or recipes to build the cash flow statement:
- Direct method—This is to start from scratch. The person preparing the cash flow statement gathers all the transactions for a specific period and categorizes the transactions into the 3 buckets: operating, investing, and financing activities.
- Indirect method— Without getting into details that only accountants find charming, the person building the cash flow statement starts with the P&L or income statement and makes some adjustments to reflect cash only without the need to start from the ground up.
A P&L can be historical or forward-looking, a projection or an estimate.
Both the P&L and cash flow statements are fundamental. Showing only one is like eating mac and cheese without either the macaroni or the cheese, a peanut butter and jelly sandwich without the peanut butter or the jelly.
The P&L shows income and expenses for a period of time and follows the accrual accounting method. This means that finance records the transactions based on receipts and deliveries, not payments or money ownership exchanges. The profits (or loss) are in the P&L. The P&L shows the performance of a company. It has a similar structure as that of the cash flow statement— operating, financial, and tax activities. Supply chain and procurement have a huge impact on revenue, COGS, gross profits, and all operating expenses.
Let’s take a look at its key components.
Revenue —This is the top line of the P&L. Traditionally, supply chain is a synonym for cost containment and optimization. While savings are a top priority, supply chain goes beyond cost reduction.
Supply chain plays an essential role in business’ growth, orchestrating the multiple moving parts from raw material acquisition until delivery to the customer we want to delight. Not considering the impact of supply chain on revenue is leaving money on the table.
Marketing may sell the sun, the moon, and the stars with delivery in the next 24 hours, but with no product available, there are no sales; instead, there are disappointed and angry customers, like angry birds kicking and screaming for worms. Nasty.
Cost of Goods Sold—All roads lead to Rome, so as to COGS.
COGS is all costs related to getting your products ready to sell to your customers. It includes the ingredients, raw materials, components, the packaging, freight-in cost, plant labor, and factory overhead.
Production or factory costs are split into direct and indirect. Direct costs are those connected with a specific product. An example of a direct cost is when the line runs to produce barbecue chips, as that cost can be assigned to these spicy sweet chips. An example of indirect cost is the salary of factory supervisors because they can’t be related to a particular product. Another example is the factory utilities that are included in the overhead cost.
Production or factory costs also split into variable and fixed costs. Variable costs increase or decrease in the same proportion as production does. If the company doubles production, the cost of ingredients, packaging, and assembly-line worker wages will double too.
With production increases or decreases, fixed costs do not change. For instance, such changes in production don’t have an effect on factory supervisor cost. Her salary remains the same, so there is no change in cost. There are some situations in which fixed costs change, but not in the same ratio as production. In the example, the plant supervisor may need to work overtime.
Gross profit is the difference between revenues and COGS. Companies also calculate the gross margin, the percentage of gross profit over revenue (gross profit divided by revenue).
Gross profit is not what the company gets. There are other costs businesses face. Remember that COGS covers production costs only.
Operating expenses (OPEX) include the costs to support operations such as general & administrative, marketing, rent, utilities, and services. Indirect purchasing or indirect procurement has a profound impact on OPEX when they negotiate service contracts on technology—examples are SAP S4 or JD Edwards—and professional services, among others.
The operating profit is the net earnings from the core business. The focus is on performance. Its calculation is as follows:
A positive operating profit means that the company is performing. A negative result from operations means that costs are higher than revenues. Not good.
E – earnings
B – before
I – interest
T – taxes
EBIT is not included in the income statement or P&L, but it is a widely used term. It is not the same as operating profit or operating income. While both consider revenues, COGS, OPEX, depreciation and amortization, EBIT also includes non-operating or other income like that coming from bonds and stocks.
The income listed in this line item of the income statement included in the EBIT calculation does not come from its core business. For instance, the proceeds from selling a packing machine are other income, if this is not the company’s main activity.
E – earnings
B – before
I – interest
T – taxes
D – depreciation
A – amortization
EBITDA is not included in the income statement either.
It doesn’t include depreciation and amortization. Depreciation is the loss of value of a fixed asset (machine, computers, etc.) over its useful life because of wear and tear. Amortization is the same concept applied to intangible assets like goodwill, patents, and trademarks.
A company finances its operations with a combination of debt and equity. This combination is the capital structure. When the company uses debt like bond issues or loans, the P&L shows interest expenses.
Before a business can take the earnings after considering the interest expense, there are expenses for federal and state income taxes (Yeah! A portion goes to the IRS).
The net profits or bottom line is the finished line. The moment of truth. The “To be, or not to be” of William Shakespeare’s play, Hamlet. Net profits ARE what the business makes after all costs, including taxes. If the result is positive, the business can distribute or reinvest. A negative result means that the company is not profitable; its costs are higher than its income.
The last core financial statement to cover is the balance sheet.
The balance sheet is like a snapshot—a Kodak moment—of a business’s finances. The balance sheet can be historical or forward-looking, a projection or an estimate.
These are the three big buckets.
- Shareholders’ equity
The balance sheet gets its name because of the fundamental equation:
It is the equilibrium between assets on the left side of the seesaw and liabilities and shareholders’ equity on the right side. Liabilities and shareholders’ equity finance assets.
Assets are resources that a business owns or controls. The business expects assets to provide current and future benefits, to generate sales.
There are two pockets: 1. current assets and 2. non-current assets
The most liquid assets go first in each of these pockets—current and non-current assets.
Current means that the assets can turn into cash sooner than in 12 months. Current assets include:
- cash and cash equivalents
- marketable securities
- accounts receivable (AR)
- supplier prepayments
- prepaid expenses
- Cash and cash equivalents: These are the most liquid of all assets. Available. Ready to use.
- Marketable securities: A company can convert these assets into cash with short notice. They have a maturity of three months or less.
- Accounts receivable (AR): Sales revenue on credit. When a company sells to retailers, the company doesn’t get paid until months later, after the delivery of the goods. The amount owed is in AR. When the company gets the payment, it reduces AR and increases cash and cash equivalents for the same amount.
- Inventory: Top priority for the supply chain and procurement.
- Supplier prepayments: These are payments in advance to suppliers before receiving the materials or products.
- Prepaid expenses: The company has made the payment in advance; for example, marketing campaigns and insurance.
Non-current means that the assets can turn into cash after 12 months.
Non-current assets include:
- Fixed assets like property, plant, and equipment (PP&E).
- Intangible assets such as intellectual property and goodwill.
A liability is money that the company owes to third parties, including suppliers, creditors, the government, and employees. Liabilities also show on the balance sheet based on their liquidity. As with assets, there are current and non-current liabilities. Current liabilities are the amount due in 12 months, while non-current liabilities are the amount due after 12 months.
Current liabilities include:
- Accounts payable: The amount that the company owes its suppliers is in AP. When the business makes a payment, it reduces AP and reduces cash and cash equivalents for the same amount.
- Wages payable: these are liabilities for wages earned but not yet paid. As such, the amount in wages payable is a short-term obligation, due within 12 months.
- Interest payable: this is the amount of interest owed.
- Dividends payable: this is the amount of dividends owed. This can happen when the company approves the dividend but needs to make the payment.
- Customer prepayments: These are payments in advance that the business receives from customers.
- Current portion of long-term debt: the amount due in 12 months or less.
Non-current liabilities include:
- Bonds payable: companies may issue bonds to get funds to finance their operations. This is the amortized (remaining) amount of the bonds.
- Long-term debt: the amount due after 12 months, based on the debt schedule. The debt schedule shows the outstanding debt, the interest expense, and the payments against the borrowed capital that the company needs to make in every period.
Equity—also known as shareholder’s equity or net worth—consists of what the owners or shareholders own. The equity calculation is as follows:
Equity=Total assets-Total liabilities
Equity has two main items:
- Paid-in capital—the dollar amount that the owners paid when the company started or, in the case of the shareholders, the dollar amount paid with the first stock issue.
- Retained earnings—the profits kept at the company for reinvestments.
The paid-in capital or contributed capital is the amount of cash or other assets that shareholders have given a company in exchange for stock at the initial issuance.
It can be common stock and preferred stock. There can also be additional paid-in capital or capital surplus. This is the amount that the shareholders have invested above that of common and preferred stock.
This is the generated profits or net income that the company does not distribute. It is like the umbilical cord with the P&L. The P&L shows the net profit on the bottom line. From there, the company may decide to distribute. That part goes to the pockets of the shareholders. What is left goes to retained earnings in the balance sheet.
We now have the three core financial statements covered. As a supply chain and procurement professional, you impact them in a massive way.