Financial Statements Basics: Part 1, with Jason Pereira | E083
The Basics of Balance Sheets & Income Statements.
On today’s episode, Jason Pereira will review financial statements, how to read them properly, and what different terminologies mean. There are all kinds of rules about how depreciation impacts different types of business, and it’s also known as capital cost allowance in Canada.Today, Jason will discuss income statements, balance sheets, cash flow statements, and ratios.
Episode Highlights:
01.26: The balance sheet is a document that summarizes everything you own and owe and where the equity came from in the company.
01.52: Current assets are liquid assets meant to have a turnover period of less than a year. All assets on balance sheets start with the current assets.
03.20: Fixed assets are the things that are physical products or physical assets. We can have long-term investments in fixed assets things.
04.10: Equipment, vehicles, land, and buildings show up as the net number, which is the cost of acquisition minus the depreciation.
06.47: Current liabilities are the things that are due within the next year. Any of your debt service, any of the principal needs to be paid over the course of the next 12 months, makes up your current debt.
08.38: Retained earnings are not a number you can draw out of the business unless the assets exist.
09.42: Subtracting current assets from current liabilities gives you the net working capital. Net working capital is the amount of money you have invested in the business to keep it going.
10.53: The income statement tells you how profitable your business was for the year, and this is where all your sales transactions get summarized.
12:51: Subtracting the cost of goods sold or services rendered from the gross revenue gives you what is known as the net revenue or net after your direct expenses.
13.10 Fixed expenses are not directly tied to one thing, but it’s paying for the general apparatus of the build of the business to enable you to allow for incremental sales.
15.06 Interest is a funding cost based on your capital allocation strategy, and taxes are solely based on your net profit.
17.23: Working capital is current assets minus current liabilities, and that is an investment in a firm because you have to have that money in the company. Reducing your need for networking capital increases the amount you can pull out of the business or reinvest in the business.
3 Key Points:
Capitalizing on the purchase will reduce the amount that is going to get deducted, it will be reduced to a set amount per year based on one of a couple of schedules.
EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) allows you to compare business operations in terms of essentially what their top line is and how much they can convert to their bottom line.
Reducing your need for networking capital, increases the amount you can pull out of the business or reinvest in the business.
Tweetable Quotes:-
A cash flow is like water. It’s the life of the business, too much cash flow will make you drown, and too little will make you die first.
Anything that gets spent on the business directly not attributable to unit sales is a general fixed overhead expense.
Just because you spend the cash doesn’t mean it’s an expense for tax purposes and is a good thing or bad thing that’s debatable.
Resources Mentioned
Full Transcript:
Producer: Welcome to the Financial Planning for Canadian Business Owners Podcast. You will hear about industry insights with award-winning financial planner and entrepreneur, Jason Pereira. Through the interviews with different experts, with their stories and advice, you will learn how you can navigate the challenges of being an entrepreneur, plan for success and make the most of your business in life. And now your host, Jason Pereira.
Jason Pereira: Well, welcome to today's episode. Something a little different today. No guest, yet again. This was a suggestion that was given to me, my colleague of mine, when I threw out ideas for what I could be doing as an episode on this podcast. And they suggested, well, why don't you do some sort of review of financial statements and essentially how to read them properly and what things actually mean because more often than not people get involved in business to basically be business owners and do something, not specifically to be accountants and review that sort of stuff. So I put together the following series next couple episodes to kind of take you through the basic rudimentary stuff. Now, this might be old news to many of you. This might be a simple refresher for others, and this might be useless for others, but nevertheless, we're going to start off.
Jason Pereira: Today, I'm going to start off with income statements and balance sheets, and then move to cashflow statements, ratios, and a little bit of information on cashflow coaching. So let's start off with the first one. The balance sheet simply put the balance sheet is a document that summarizes everything you own and owe and where the equity came from in the company. So on one hand, on the left hand column, you have your assets on the right hand column, you have your liabilities and owner's equity or shareholders equity. Basically the way to look at it is all the assets are in one side and what paid for it is on the other side. So first off all balance sheets on all assets on balance sheet start off with the current assets. Current assets are basically liquid assets, things that are basically meant to have a turnover period of less than a year, meaning that you have less than a year to collect them and expect money to actually hit your cash balance, plus your cash balance.
Jason Pereira: So these are always ordered in priority of liquidity meaning how fast can you potentially get ahold of them? So the most common one that shows up at top as it always should is cash. What do you actually have in the bank? That's the first one, simple enough. The second is typically accounts receivable. So things that you are basically money owed to you, that should be collectible in less than a year. Then we can move on to inventory. So assets on hand that are basically currently ready for sale in your business and prepaid expenses. So things that you pay for in advance, that you are slowly going to realize the benefit over time. So examples of that include things like software licenses. If I pay for a software license that is basically on for the full year, one shot every month, I am using some of that benefit.
Jason Pereira: So technically 1/12th of that is accrued to the balance, sorry to the income statement. If you paid for something that is going to be used over multiple years, then only the current year's portion shows up there. So basically it might not be a cash asset. It's not something that's converted to cash, but it's an expense that will be eaten up over time and you're not going to have to pay cash. So it doesn't reduce cash, therefore it belongs there. So you add that all up and those are your current assets. So current again, meaning less than one year to collect. Then we move on to the fixed assets. Fixed assets are things that are basically physical products, physical assets. So we get into things like vehicles and equipment are basically property, plant and equipment as these are the term used, but essentially property things like vehicles, equipment, things like machinery, fax machines ... oh, fax machines, printers, computers, whatever else it is.
Jason Pereira: And then you get into land and building. You also have different long-term investments on this side. So, that's the other thing too. Short-term investments will show up in the current assets. So basically these are typically ranked more likely unusable life. How long are they going to be around? It's unlikely that the building is going to be flipped every year. Your equipment will typically have a usable life and your vehicles typically the shortest usable life. So you see them happen that regard. You'll also find patents and goodwill things that basically that are intangibles. We'll come back in a second, but let me go back to equipment vehicles and landed buildings. So what actually shows up here is a net number. And that net number is the cost of acquisition minus the depreciation that you basically have there.
Jason Pereira: Depreciation, basically what that is, in the accounting world, instead of letting you expense everything when you buy a new piece of equipment all at once, they don't want you to expense that in the first year on the income statement. In some cases they do, depending on the equipment, but big things like cars and equipment, stuff like that is a longer term asset. So what they want you to do is they want you to spread that cost over its usable life. Now, if you're going to spread the cost over its usable life, that means you're spreading the value of it over its usable life, which is why you will see what is known as the depreciated amount or basically you'll see everything at acquisition cost. And then you'll see depreciation either itemized for each of them or as a lump sum. Basically what they're trying to say is that you're eating up the useful life or value of that asset. And it's being reduced by that. So like I said, you'll either see vehicle listed for the acquisition costs, less depreciation, giving you a net or sometimes for whatever reason, you see all the depreciation lumped in one category, but typically you see them grouped together.
Jason Pereira: So eventually the depreciated amount will hit zero. Doesn't mean that the thing is useless or valueless. You will continue to use it, but you can eventually sell it for whatever it's worth and whether it be scrap value or if it's still valuable. So there's all kinds of rules about how that gets recognized, how depreciation impacts different types of business. It's also known as capital cost allowance in Canada, but in general, the idea is that you're using it over time. Things like intangible assets, patents, and goodwill. Those are much harder to basically quantify. Where you typically find Goodwill, where that comes from in most cases is when you overpay beyond a tangible value of a business.
Jason Pereira: So I should say overpay. So let's just say that I buy another business. Okay. And that business has assets totaling half a million dollars, but I pay $750,000. Well, that extra 250,000 is basically for the operations over and beyond the cost of the equipment itself that I could have replaced. So that is goodwill. I have paid for goodwill. And any time, you basically have an acquisition of something where it's beyond the value that is of the value of the tangible property, you will create goodwill. Patents, typically that is different. That's development costs that gets rounded up or wrapped up into that, I believe. I'm not a big expert on that, but that gives you your total fixed assets. So total current assets plus total fixed assets equals your total assets.
Jason Pereira: On the other side of the balance sheet. On the other side of the balance sheet, you have you start it off with your liabilities first. So what do you owe people? And just like what you saw previously in the asset section, we start with current liabilities, this time, things that are due within the next year. So you have your accounts payable, your vendors that you owe any credit card that you're carrying, any lines of credit that you're carrying, any kind of accrued expenses. So you've already used up something. You have a bill coming in 60 days. Essentially, it's basically, you've already utilized the asset or they utilize the service and you have an outstanding bill and current portion of long term debt. So any of your debt service, any of the principle needs to be paid over the course of the next 12 months, that makes up your current debt.
Jason Pereira: So that combined equals your current liabilities, current assets and current liabilities. Now those are two important numbers that I'm going to come back to why they're important. Then you get into the next section, which is longterm liabilities. This is just debts that are outstanding or going to be outstanding longer than a year. So anything that's going to go on longer than a year, this is where it gets lumped in. So you have mortgages. You have any other long term debt, but not the portion that is due this year. That gets moved up to current portion of longterm debt in the current liability section. And by the way, you can Google as an example, samples of these anytime and follow along. In fact, BDC, the Business Development Canada has a website that gives you some simple templates that can be where you used. So once you've done that, you have your total liabilities. Everything else is equity.
Jason Pereira: So where did it come? So let's talk about what kind of equity you have here. So first off you have the money you basically raised from issuing shares. Now for most entrepreneurs, this is typically some nominal amount. You acquired a hundred shares of your company at a dollar a piece. And therefore that is a hundred dollars. Unless you ever sell shares again, you are never going to see that price increase and that's fine. It doesn't mean it's what your shares are worth. That means it's what you paid for them. That's the capital you contributed to the business in exchange for them. And then the last one becomes retained earnings. This is basically where your after tax profit goes for the year and pretty much roughly said. Now here's the thing to know people get this confused all the time. Retained earnings is not a number you can draw out of the business unless the assets exist.
Jason Pereira: What I mean by that, I've had people say, "Well I'm going to sell the business. I'm going to pull the retained earnings out first." Well, okay. The only way that happens really is if you liquidate, if you have enough cash on hand to do that, or if you liquidate enough of the assets to pay up the retained earnings that could cripple the business. So is a balance sheet entry. It's not necessarily a cash account for your draw upon. Now it is very important because that is increased by income, but it's reduced by dividends. So when dividends get paid out, it reduces that number. Also in Canada, these things called a notional account. I'm going to talk about another day where retainers are a proxy for one of those, that's known as safe income, but we've talked about on the podcast before. We'll talk about those in greater depth in a later episode.
Jason Pereira: So basically liabilities plus owners equity or shareholders equity have to equal the same number as assets, otherwise known as balancing the balance sheet. They have to be identical. So a couple things to keep in mind for this and the most important one I could tell you, especially as a business owner in the near term, it comes down to your current assets and current liabilities. Subtracting one from the other gives you, what's known as your networking capital, the amount of money that you have to have invested in the business in order to keep it going day to day. What does that mean? Well, your current assets represent all the money that you currently have that's due in the next, basically it's coming to you the next 12 months and your current liabilities represent the liability side, what you owe. And basically if that number's, when you subtract it to, if that number's positive, that number is the amount of money that has to be essentially that had to be invested in the business just to make sure you never run out of cash throughout the course of the year.
Jason Pereira: If that number is negative and it is possible, that number is negative, then it's a different story. Then what happens is essentially that means that you are basically selling and collecting money faster than you have to pay your vendors. So technically you're using them as a credit card which is not a bad position to be in. Now, it's not easy to achieve by most. When we start talking about how to optimize cash flow, we're going to talk about optimize networking capital in a later episode. We're going to talk about optimize every one of those accounts. Okay. But for now, I just want you to understand what they are. The second piece of this is of course, the second most important statement or the next most important statement. If not, probably the more important statement is the income statement. So the income statement, what is it?
Jason Pereira: This is what tells you how profitable your business was for the year. This is where all your sales transactions get summarized. So how does it work? First off, we start it all off with your revenue. How much money do you bring in your different lines of business, or if it's just one line of business, one thing? So essentially this can be itemized based on different business lines as it should be. Or if you're selling one thing like lemonade stand, whatever it is, this one line, sales of lemonade as a service, sales and whatever it is you're doing and that number, all those add together, give you your total revenue. The next thing you're going to do now, that's what's known as your gross revenue, gross income. The next section should be a cost of good sold or services provided.
Jason Pereira: So what is this? These are costs that are directly associated with the unit sale of the product or service. And what that means is that there are certain expenses that are overhead. So a building that building the cost of basically of your rent for example, is shared by all of the expenses that were all of the revenue and you generate. So essentially you're not saying, "Okay, well, this is directly attributable to that sale." Whereas other things are completely directly attributable. So if I buy something that then basically gets sold and I saw that as a profit, then there's a definitive direct connection between those two things. So simple example, I buy as a telephone kiosk, I buy a bunch of iPhone cases. They are wholesale price at $50, and I retail them at 75.
Jason Pereira: So what would happen is my revenue number would basically include the $75 sale, but my cost of good sold would include the $50 sale. Now this applies to goods, materials, essentially your inventory cost essentially is what we're looking at here. And things like hours that are billable by third parties. So what you're doing is you're trying to get rid of the stuff that's directly attributable to the sale specifically to that unit of sale. When you are done and you subtract the cost of good sold or services rendered from the gross revenue you are left with what is known as the net revenue, net after your direct expenses. Then we get into the other expenses, right? These are typically what is known as fixed expenses. These are expenses that it's not directly tied to one thing, but it's basically paying for the general apparatus of the business to enable you to allow for that incremental sale.
Jason Pereira: So this includes things like wages for employees, unless they're on commission. Commission can be attributable to unit sales because it is based on the unit sale, things like your rent or mortgage payments, at least the interest portion, for sure interest paid transportation, utilities, signage, basically anything that gets spent on the business that is directly not attributable to a unit sale is a general kind of fixed overhead expense. And that stuff basically all shows up here. Now, keep in mind what I said earlier about depreciation. Okay? If I buy a car in this given year, I cannot deduct the full expense of that car in a given year. If I did, I would get a mass deduction today. And then as long as I held that car, I would get no deduction. Instead, the way the system works is that we have to capitalize the purchase.
Jason Pereira: And essentially what happens is that we reduce the amount that we get to deduct is reduced to a set amount per year, based on one of a couple of schedules. There's different ones where it's the same number every year. There's ones where decreasing and increasing value. There's all kinds of regulations around this bottom line is just because you spent the cash, doesn't mean it's an expense for tax purposes. And is that a good thing or bad thing? Well, it's debatable. It would be nice to get rid of it all in the first year because you get the immediate tax savings, however it better reflects the value of the business to depreciate that over time. So once you're done, all of that minus a couple things. So what you want to say minus a couple things. There's a couple things you want to hold back.
Jason Pereira: First off, you want to arrive at all the stuff that is not depreciation interest or taxes, and you get basically all those direct costs of labor, overhead, all that other stuff. That gives you your gross income. Okay. Gross income. Why? Because the other stuff is a little bit different. So from there you would basically, that's also known as your EBITDA, Earnings Before Interest Taxes Depreciation Amortization. Why this number? Well, look at the other stuff. So interest taxes depreciation amortization. Interest is a funding cost that is based off of your capital allocation strategy. So essentially, how did you fund the business? Was it primary limit debt? Well, that numbers could be bigger or smaller. That's not really how you fund it. It's not really a metric of how the business is operating. So that's why it's separate.
Jason Pereira: Depreciation, I just went through it. The schedules can vary, but we know that essentially it's actually not a cash expenditure. It can be something for cash that was spent previously and then depreciation amortization, same thing. And then taxes. Taxes are solely based off of what your net profit was. So that's where they come back later. So EBITDA, EBITDA's a powerful number because it allows you to compare business operations in terms of how essentially what their top line is and how much they can convert to their bottom line. What is their gross profit margin? So once you arrive at that, we then start taking the other stuff away. And typically the order is depreciation and amortization first, which leaves you with EBIT, earnings before interest and taxes. Now that's a reflection of basically all the costs of the business with the exception of a financing cost, your interest.
Jason Pereira: Subtract out interest and now you're left with interest earnings before taxes or EBT. That reflects the profitability of the firm before you cut into government. And then you basically subtract that taxes and you are left with your net profit. Now your net profit, if at the end of the year, it gets rolled into your retained earnings. So that is the basics of the income statement, different accounts that are there. Now, one other one that we're going to cover not today, but later is going to be the shareholders. So let me tell you about what's going to happen in the upcoming episodes. This was a short one. Next I'm going to cover the cash flow statement. The cash flow statement is the most important statement that you probably will need, especially early on as a business owner that unfortunately accountants by default do not include because it's not required for tax purposes, but I'm going to go through what's in it, how it works and why it's important to you.
Jason Pereira: Then we're going to talk about optimization and optimization, look, I'm not going to tell you how to run your business. End of the day with an income statement, it's relatively straightforward. Bottom line is you want to sell for as much as possible and you want distribution and cost to be as little as possible. You have to manage all those, but there are some other optimizations I can give you in particular around cash flow. So we're going to talk about that. We're going to talk about optimizing cashflow and optimizing what is specifically optimizing around working capital. Again, working capital is current assets minus current liabilities. That is your networking capital. That is a investment in the firm because you have to have that money in the company. If you can reduce your need for networking capital, that increases the amount you can pull out of the business or reinvest in the business.
Jason Pereira: So optimizing around that can be a very valuable exercise because often I find a lot of business owners out of fear, end up holding onto too much. However, if you don't have enough, it will basically kill you. I'd like to say cash flow is like water. It's the life line of the business, but too much and you'll drown. Well, it's not a bad thing in this case, you're not going to fully drown, but it can be problematic and too little and you will die of thirst. So that was the first episode of my series on financial statement analysis. Again, this was meant as a brief introduction. Hope you come back for the next two, they will be basically over the next two episodes. Until next time, take care.
Producer: This podcast was brought to you by Woodgate Financial, an award-winning financial planning firm catering to high net worth individuals, business owners, and their families. To learn more, go to woodgate.com. You could subscribe to this podcast on Apple podcast, Stitcher, Google Play and Spotify, or find more episodes at jasonperrera.ca. You can even ask Siri, Alexa or Google Home to subscribe for you.