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How Financial Statements Are Used in Decision Making

written by: •edited by: Linda Richter•updated: 5/18/2011

Within all types of businesses, there are certain financial statements including income statements, balance sheets and the ever-important trial balance. What about financial statements and the decision making process? Which financials offer up the company owner or investor the most information?

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    Types of Financial Statements

    Why So Many Financial Statements In most business, especially those that use some sort of financial accounting software, financial statements include:

    Balance Sheet – This is really a snapshot of your business status at any time and shows assets, liabilities, capital and owner’s equity.

    Income Statement or Profit & Loss – The income statement can be complex based on the size of the business or very small if there is only one department. It breaks downs total revenues, less fixed and variable expenses to show a final profit (or loss).

    Trial Balance – The trial balance is created through journal entries made to various journals and schedules and an accurate trial balance must balance or adjustments may be needed.

    Journals & Schedules – These show more detailed postings based on type, date, and amount and offer up running totals for the accounting period.

    Detail General Ledger – The detail general ledger offers up every journal entry (debits and credits) along with all account activity for the accounting period posted into your chart of accounts.

    Cash Flow Analysis – These can be forecasted or actual and are a great comparison tool. They show revenues and all expenses in an easy-to-view format that shows a profit (or loss) at the end of each accounting period.

    EBTIDA - Also known as earnings before taxes, interest, depreciation, and amortization, an EBTIDA report is often favored by investors.

    So with these types of reports, why are financial statements and the decision making process important when it comes to analyzing your business?

    In the following sections, we’ll look at each one to see its importance level when it comes to the business owner, lender or investor.

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    The Balance Sheet

    As mentioned above, your balance sheet is a snapshot of your business. A quick look by a business owner or investor and one should be able to see summary account balances of all assets like cash in bank, inventories, and accounts receivables along with fixed assets such as land, buildings, vehicles, etc. On the liability side, a glance will offer up all short- and long-term liabilities, accounts payables, payroll and sales tax payables, etc. Finally, the amount of owner’s equity or capital stock is shown based on the type of business structure you have. To learn more about the balance sheet, you can download a copy from our Media Gallery.

    As a business owner and investor for many years, there are often times when the balance sheet doesn’t reveal everything it should. As far as financial statements and decision making go, the balance sheet only shows summary accounts and although a popular report to view, most serious investors or lenders will want to see what makes up those summary accounts—usually found in journals, schedules or the general ledger.

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    Income Statement

    A sample income statement can also be downloaded from our Media Gallery and is often the best way to analyze how your company is really doing. Because the income statement shows your revenues and both fixed and variable expenses, a business owner can see where his money is most being spent via department or fixed (overhead) operations.

    If a business owner finds most of its outgoing expenses are in overhead, a revisit to those expenses may be needed. On the other hand, if the business owner realizes a consistent profit, he’s probably handling expenses well. Your income statement is also important to investors as they want to know where you’re spending money, on what, and why to better evaluate your business. If you constantly have losses, you may have to explain them.

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    Trial Balance

    The Trial Balance Most tax professionals and CPAs utilize the trial balance. It is their favorite financial report when it comes to financial statements and decision making. Because a trial balance for any accounting period, month or year end, must balance, meaning all debits and credits are equal, CPAs can easily view if there are profits, losses, identify types of expenses and owner’s equity or stock. It’s imperative that you stay on top of your trial balance and learn how to make adjustments when needed.

    Because the trial balance is the favored report to use for your annual tax returns, a good CPA or tax professional can tell you right off where you're losing money or where most of your income is going.

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    Schedules & Journals

    Often, from the summary accounts of the balance sheet, a business owner or investor will want to delve into what’s in those summary accounts. An accounts receivable journal or schedule will show who owes the company what and the amount of dollars that are past due and for how long. If you have many overdue accounts receivables that are all 120+ days past due, anyone viewing this journal can instantly see you’re not practicing accounts receivable best practices.

    When it comes to other types of journals and schedules such as inventory, one will be able to evaluate aging inventory, inventory on hand, etc. Schedules and journals are also financial statements used in decision making when it comes to keeping track of owner disbursements and investment accounts. They also offer great insight on who you owe and what you are or aren’t able to pay on a consistent basis.

    Within each journal, most accounts are scheduled, meaning they show accurate detail from journal entries.

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    Detail General Ledger

    If your trial balance doesn’t balance, your detail general ledger is the place to review to ensure adequate journal entries. Because the detail general ledger shows every journal entry in great detail, inaccurate posting mistakes can often be found here. A review of the detail general ledge is key to a balanced trial balance—one of your most important financial statements.

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    Cash Flow Analysis

    Again, feel free to download a copy of a cash flow analysis (or proforma) from our Media Gallery. This easy to view financial report allows a quick way to view revenues, all expenses and the profit (or loss) of a business. Lenders love the cash flow analysis and cash flow analysis comparisons from forecasted to actual to see how well a business is really doing. They are also great analytical tools for business owners.

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    EBTIDA Reports

    Some investors choose to review an EBTIDA, earnings before taxes, interest, depreciation, and amortization. There are certain cautions for investors when using this financial statement and the decision making process as it emphasizes a company's sales, expenses and profits or losses only. Find out here why an EBTIDA may not be the best financial statement to determine the value of a business.

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    Financial Statements and Decision Making

    Believe it or not, many business owners never look at financial statements of any kind to gain insight into their business. They rely on cash in bank, cash going out and in, and if they made a profit. Unfortunately, this isn’t the best route to go if you want to stay in business and be profitable.

    Understand all of your financial statements and how they work in the decision-making process to determine the value of your business. Failure to do so may cause your business to fail due to oversights, or when tax return time comes around, you could be scrambling to obtain accurate data for your tax professional.

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    References

    Jean Scheid has been a business investor and owner for over 16 years.

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