Business 101: Principles of Management

If the above player doesn't work, try this direct link.

This lesson explains the purpose of financial controls and introduce important vocabulary relating to financial controls including: financial statement, income statement, balance sheet, financial audits and financial ratio analysis (liquidity ratios, profitability ratios, debt ratios, operating performance ratio, cash flow indicator ratio and investment valuation ratio).

Financial Accounting

In order to understand financial controls, it is important to first understand the role of financial accounting in an organization.

Financial accounting keeps track of and reports an organization's financial transactions. There are standard guidelines used to record, summarize and present financial reports or statements. The GAAP, or generally accepted accounting principles, are one such set of guidelines accountants follow.

Financial accounting focuses on providing information for people outside the organization like shareholders, investors and creditors.

Financial Controls

Financial controls ask the question, 'So, how are we doing financially?' Financial controls are controls over financial activity to ensure that the desired return on investment will occur. There are several financial controls that are used to determine how well an organization controls its financial transactions:

• Income Statement
• Balance Sheet
• Financial Audit
• Financial Ratio Analyses
  • Liquidity Ratio
  • Profitability Ratio
  • Debt Ratio
  • Operating Performance Ratio
  • Cash Flow Indicator Ratio
  • Investment Valuation Ratio

Financial Statements

Financial statements are mainly used to understand current and future business conditions. It all begins with the accounting cycle. The accounting cycle involves tracking, organizing and recording financial transactions. These financial transactions are used to create different financial statements. Each financial statement serves a different purpose. Let's explore several different financial statements and examples to gain a better understanding of the purpose of each.

Income Statement

Income statement - also known as a profit and loss statement - is a financial report of an organization's revenues and expenses over a given period of time, generally a month, a quarter or a year. The income statement is calculated by using the formulas:

Revenue - Cost of Goods Sold = Gross Profit/Loss

Gross Profit - Expenses = Net Profit/Loss

Let's look at a working example of an income statement for P & L Pie Shoppe for the period of one year, starting January 1, 2011, and ending on December 31, 2011.

Sales: dollar amount of sales for a given period.

Cost of goods sold: how much it costs to make the above sales.

Beginning inventory: how much money is invested in the inventory or products needed to make the pies.

Add: purchases: the amount of money spent on additional inventory purchased.

Total: the total value of inventory.

Less: Ending inventory: the value of inventory left at the end of the recording period.

Cost of goods sold: total dollar amount it costs to make the sales after adding inventory and deducted what's left in inventory.

Gross profit: total profit before business expenses are deducted.

Expenses: fixed and variable expenses or costs to run the pie shop (for example, marketing, depreciation, insurance, taxes, rent and wages).

Total expenses: total amount of expenses to run the pie shop.

Net income: the bottom line or gross profit minus expenses.

In this example, P & L Pie Shoppe made a net income of $400 for the recording period. Simply stated, we started with revenue from total pie sales, deducted the costs involved in making the pies. This is the gross profit. Then, we deducted the fixed and variable expenses from the gross profit to reveal the net profit. This means, we took all expenses incurred in making the pies and subtracted it from the sales revenue from selling the pies. At the end of the year, $400 profit was made in the pie shop.

Balance Sheet

A balance sheet is a statement of the overall financial status of an organization at a fixed point in time. The balance sheet contains financial data as it relates to assets, liabilities and shareholders' equity. Assets are things an organization owns like equipment, inventory and cash, investments, money markets and government securities. Liabilities are what an organization owes like current short-term debt and long-term debt. Current short-term debt may be monies owed to vendors for supplies. Long-term debt may be a mortgage on a building or a loan on equipment. Shareholders' equity is a shareholder's claim to assets after debts have been paid. Shareholders' equity may be common stocks or preferred stocks. The balance sheet is calculated using the following formula:

Assets = Liabilities + Shareholders' Equity

The balance sheet lists everything the organization owns, owes and the value of the owners' stake in the company.

Let's look at a working example of a balance sheet for P & L Pie Shoppe for the period of one month, starting on December 1, 2011, and ending on December 31, 2011.

Assets:

• Non-current assets: things the organization owns or long term investments (land and building, equipment, investments).
• Current assets: assets that can be converted to cash, like accounts receivable and inventory (inventory, accounts receivable - monies owed to the organization - cash).

Total assets: Non-current assets plus current assets

Equity and Liabilities:

• Shareholders' equity
  • Capital
• Non-current liabilities: like a loan with 5% interest.
  • Bank loan
• Current liabilities: monies owed to creditors by the organization.
  • Accounts payable

Total equity and liabilities: shareholders' equity, non-current liabilities, current liabilities.

Financial Audits

A financial audit is a verification of the financial statements of an organization. An audit is an opinion by an auditor that expresses whether the organization is accurately reporting its financial data in accordance with financial reporting procedures.

The financial audit is done in four steps:

1. Planning and risk assessment
2. Testing of internal controls
3. Substantive procedures
4. Finalization

Planning and risk assessment is done during the fiscal year, or a 12-month business period, and involves the auditors gathering data. The more data the auditor has in the industry and regulations governing the accounting practices of the organization, the more thorough the audit will be.

Testing of internal controls involves analyzing the internal controls an organization has in place. This means the auditor will investigate the process for all transactions like deposits, posting of financial information, accounts receivable and payable. This step is used to track the activity within the organization's accounting department. The best way to do this is to take a random sampling of the various documents for analyses.

Substantive procedures involves verifying the actual financial transactions by verifying the actual documents. This step takes the most time because it requires the auditor to review large amounts of documents of all types.

Finalization involves creating a report for management that includes the auditing procedures, the audit process and the support for the findings.

Financial Findings

Financial ratios compare financial statement items with other financial statement items to reveal a relationship between the two. There are several financial ratios. We will focus on the following six categories of ratios.

• Liquidity measurement ratio
• Profitability ratio
• Debt ratio
• Operating performance ratio
• Cash flow indicator ratio
• Investment valuation ratio

Liquidity measurement ratio is the measurement of an organization's ability to pay off short-term debt. It measures whether an organization has enough liquid assets to pay for the debts it incurred.

Profitability ratio is the measurement of how well an organization utilizes its resources to turn a profit and return shareholders equity. It measures how profitable an organization is when all resources are factored in.

Debt ratio is the measurement of the amount of debt an organization has compared to its assets. It measures how much money an organization has as it relates to its profits. This is very much like a debt to income ratio in personal finance.

Operating performance ratio is the measurement of how an organization turns its assets into revenue. It measures how efficiently an organization's systems are in turning what they have to use into a profit like converting sales to cash.

Cash flow indicator ratio is the measurement of how much cash flows through an organization and the origin of the cash. It measures how much cash is generated from different areas of the business. This ratio provides insight into the financial health of the organization.

Investment valuation ratio is the measurement of the value of an organization to a potential shareholder or stock buyer. It measures stock performance and earnings. This information is important to an investor who wants to invest in the organization.

Lesson Summary

In summary, financial controls are controls over financial activity to ensure that the desired return on investment will occur. There are several financial controls managers use to analyze an organization's financial health.

The income statement is a financial report of an organization's revenues and expenses over a given period of time, generally a month, a quarter or a year. Its purpose is to show how revenue is converted into a net profit or a bottom line. The balance sheet is a statement of the overall financial status of an organization at a fixed point in time. Its purpose is to provide a clear snapshot of an organization's financial health as it relates to assets and liabilities.

The financial audit verifies the accuracy of all financial reporting in an organization as it relates to regulations and shareholder equity. Its purpose is to analyze and verify all financial data.

The financial ratios compare financial statement items with other financial statement items to reveal a relationship between the two. Its purpose is to determine whether information being compared has an interrelationship. Financial controls are important and must always be in check. By always keeping financial controls in check through continual evaluation, the financial health of the organization will always be strong.