Reading Financial Reports for Dummies (37 page)

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Master budget:
After everyone signs off on each of the department and section budgets, the accounting department prepares a master budget which the company uses as a road map to test how well each department is doing in meeting its budget expectations.

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Cash budget:
After all the budgets are completed and combined into a master budget, the accounting department develops a cash budget that estimates the monthly cash needs for each department. Based on this budget, the finance department determines whether enough cash will be generated by operations to meet the cash needs or whether other financing is needed to maintain the company’s cash flow.

When all the budget planning is complete, the accounting department develops a budgeted income statement (see Chapter 7 for more information on income statements) to test whether the budgeting process has created a budget that truly meets profit-planning goals. If the answer is no, the budget committee then has to decide where budget changes are needed to meet company goals. A lot of negotiating is often necessary between the budget committee and the company’s top managers to determine budget changes.

If the budget committee imposes unrealistic changes on the budget for a department, little budget compliance from that department is likely to happen, and financial difficulties could develop throughout the year. Budgets that department and section managers can live with have a better chance of producing expected results and meeting goals.

Providing Monthly Budget Reports

No matter how thoroughly prepared, a budget is useless if it’s not matched to actual revenue and expenses. So throughout the budget period, the accounting department prepares monthly
internal financial reports
(reports that summarize financial results) for the managers, who use these reports to identify where the budget is going right or wrong. Many of these internal financial reports have a system of red flags that identify areas where the actual results aren’t meeting budget expectations.

Each company has its own style for internal reports, but most reports include similar types of information. The report is usually broken into five columns:

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Red flag:
A symbol, such as an asterisk, is usually used in the first or last column to identify problem line items in a budget. Instead of a symbol, some companies add a column with an explanation of the variances between actual and budgeted numbers.

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Line item:
This column lists the budget categories as they appear on the section or department budget.

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Budget amount:
This column states the dollar amount allocated for the period of the internal financial report.

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Actual amount:
This column states how much the company spent during the period of the internal financial report.

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Difference:
This column shows how close (or far apart) the actual and budgeted numbers are.

Many companies also include a year-to-date section on the internal financial reports that shows the same information on a year-to-date basis in addition to the information specific to the month or quarter.

Figure 14-1 shows an internal report for March 2008 for a fictitious company called ABC Company. In this example, a flag appears automatically on the report if the difference is greater than $100,000, but each company determines its own designated levels for red flags. A small company may flag items for a difference of just $5,000, and a large corporation may flag items for differences at much higher levels.

Income Statement - ABC Company - March 2008

Confidential For Internal Use

Flag

Line Item

Budget

Actual

Difference

*

Sales

$1,400,000

$1,200,000

($200,000)

Cost of Goods Sold

(700,000)

(650,000)

50,000

*

Gross Margin

700,000

550,000

($150,000)

Figure 14-1:
Expenses

A sample

Advertising

(150,000)

(150,000)

—

income

Administrative

(300,000)

(275,000)

25,000

statement.

Interest

(25,000)

(35,000)

(10,000)

*

Net Income

$225,000

$90,000

($135,000)

Although Figure 14-1 uses an income statement format, internal reports have no required format, and each company develops its own report format depending on what works best for the company.

In Figure 14-1, you can see that flags have been marked next to Sales, Gross Margin, and Net Income. Flags were thrown because those line items show differences of more than $100,000, and therefore, management needs to investigate them.

A glance at Figure 14-1 shows that the key problem is lower-than-expected sales revenue. Sales were budgeted for $1.4 million, and the actual sales were $200,000 less, at $1.2 million. That difference is shown on the report’s first line. Management first needs to determine why sales are lower than
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forecasted and then develop strategies for correcting the problem. The fact that cost of goods sold and administrative expenses are lower than budgeted could be a sign that management recognized the problem after a previous month’s report and already initiated cost-cutting programs.

After looking at the report in Figure 14-1, executives have to determine what the problem is and what other changes may be needed to get the budget back in line. If external factors such as economic conditions are to blame, the best the company can do is revise the budget to meet current economic conditions so that further slippage in net income can be avoided.

Internal financial reports aren’t important just to find out about the bad news; good news can also require critical actions. For example, if sales are much higher than expected, a company may need to put plans in place to be sure it can meet the unexpected demand without losing sales. After all, customers don’t want to wait weeks or months to get their products, and they may seek out a competitor to fulfill their needs if products aren’t available when they’re ready to buy.

If conditions change from expectations, a company can more easily make a midyear correction if budgets have been accurately prepared. The company knows what was expected, and it can tweak its revenues or expenses to correct a problem long before the shortfall becomes disastrous.

In Chapter 17, I talk about strategies companies use to keep cash flowing when internal financial reports don’t meet expectations.

Using Internal Reports

Inside your company, you probably see much more detailed reports than the sample in Figure 14-1. A department head sees only the budget line items related to his or her department, and only the budget committee and departments responsible for developing budget reports have access to companywide internal reports.

The internal financial report you receive as a manager is usually based on the budget you develop. The line items listed are those directly related to your department functions. Any line item whose difference exceeds the difference allowed by the company is flagged, and you’ll need to find out why.

Sometimes, the answer is clear. For example, if you know sales were higher or lower than expected, you simply need to report why, and what you’re doing to correct any problems. Other times, the answer will require some digging on your part.

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After a report arrives at your office door, you don’t have much time to figure out what the differences are and what they mean for your department. If the differences are big, you can probably expect a call from your manager as soon as he sees his copy. When I was managing the finances for five departments, I knew I could expect a call from my manager even before I got my copy of the report. An entire day’s activities could be changed if a major difference showed up on an internal financial report, and I had to find out why.

Your best bet is to keep a good working relationship with someone in the accounting department who can help you sort through the details. Hopefully, you’ll find that the difference was based solely on a coding error, and the revenue or expense was just put in the wrong place. When that’s not the case, you’ll likely have to come up with some solution to correct the problem rather quickly.

Chapter 15

Turning Up Clues in

Turnover and Assets

In This Chapter

▶ Comparing inventory valuation systems

▶ Counting inventory turnover

▶ Measuring fixed assets turnover

▶ Assessing total asset turnover

Testing how well a company manages its assets is a critical step in measuring how effectively it uses its resources. Inventory is the most important asset for generating cash for any company that sells a product.

Many factors directly impact the cost of selling a product, including producing the product, purchasing the products or materials not produced in-house, storing the product until it’s sold, and shipping the product to the customer or store where it’s sold. And if a company doesn’t sell its product fast enough, the product may become obsolete or damaged before it’s sold.

In this chapter, I review the measures you can use to gauge how well a company manages its assets, especially its inventory, and how quickly the company sells the inventory.

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Tracking inventory

Inventory tracking methods for large corpo-

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Perpetual inventory system:
Using this

rations can be a highly honed science that

system, a company gets an updated inven-

involves extensive computer programming and

tory count after each sale. If you get a

management, or they can be as simple as taking

receipt that lists a long string of numbers

a count of what’s in stock. Companies use one

next to each product’s name, the company

of the following two systems to keep track of

most likely uses a perpetual inventory

their goods on hand:

system. The long string of numbers is the

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tracking number assigned to the inventory

Periodic inventory tracking:
A company

in the computer system.

periodically counts inventory on hand to

verify how many of the products are left

You’ve probably been the victim of a company’s

on the shelves (if the company has retail

perpetual inventory system if you’ve tried to buy

outlets) and how many are left to be sold in

something at a store when the cash register is

the warehouse (or in cartons in the back of

down. I’ve actually been in stores that couldn’t

a store, if the company has retail outlets).

make a sale because the cash register was

Most companies that use periodic inven-

down, and the store had no way to manually

tory tracking do a physical count at least

handle the sale.

monthly, and possibly as often as daily,

depending on the company’s sales volume.

Exploring Inventory Valuation Methods

A company must know the value of its inventory in order to complete its balance sheet. In addition, the company must set a value for the items it sells in order to include a
cost-of-goods-sold number
on its income statement (see Chapter 7). How that value is calculated depends on the accounting method the company uses. Five different methods are acceptable for determining the value of inventory, and each one can result in a different
net income.
These methods include

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Last In, First Out (LIFO) inventory system:
This system assumes that the last item put onto the shelf is the first item sold. Each time a product is purchased or manufactured to be put on the shelves, it costs a different amount. Most times, the cost goes up, so the last item put on the shelf likely costs more than the first item. Therefore, the goods sold first in the LIFO system are the highest-priced goods, which raises the cost-of-goods-sold number and lowers the net income. Stocking a shelf by leaving the older items in place and just adding the newly received products in front of them is a lot quicker. For example, hardware stores often use this method when restocking products that rarely change, like hammers and wrenches. Be aware that a company must use the same method for all its inventory.

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First In, First Out (FIFO) inventory system:
This system assumes that the first item put on the shelf is the first item sold. Just as for LIFO, the cost of goods purchased or manufactured differs each time they’re bought or made. Usually, prices increase, so in the case of FIFO, the first item put on the shelf likely has a lower cost than the last item. Because the first item is the one sold first, the cost of goods sold will likely be lower than in a company that uses the LIFO method. Therefore, the cost-of-goods-sold number will be lower, and the net income will be higher.

For example, grocery stores must worry about spoilage, so they put the newly received products behind the older ones to be sure that the older products sell first before they spoil.

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Average-costing inventory system:
This system doesn’t try to specify which items sell first or last but instead calculates the average cost of each unit sold. This method gives a company the best picture of its inventory cost trends because the ups and downs of prices don’t impact the company’s inventory. Instead, the inventory value levels out through the year. The net income will actually fall somewhere between the net income figures based on LIFO and FIFO.