How Organisations use these Financial Records
Planning and Control For planning and budgeting purposes, organisations often prepare forecasts of the P&L and balance sheet, as well as the cash flow forecast. In large organisations the finance department will be involved in the detailed production, but they will often consult colleagues from outside the finance department to ensure that their forecasts are as far as possible an accurate reflection of the organisation’s activities. Managers will use these records to help them make key decisions.
In the same way that an organisation uses financial documents to plan, they will also use the P&L and balance sheet to report on their progress. Many organisations have a legal obligation to publicly publish their P&L and balance sheet at the end of their financial year. There are many technical guidelines, international standards and laws to try to ensure that outside parties (for example, banks, lenders and investors such as pension funds) can understand the figures and use the information sensibly.
This is intended to make the financial documents easier to read and interpret. It also ensures that the published financial documents of all organisations are consistent. This allows outside parties to compare the finances of one company against another.
Outside parties might want to do this, for example, in order to make investment decisions. When the financial documents are publicly published they are known as the statutory accounts. When the documents are produced for use only within the organisation, they are collectively referred to as the management accounts.
The Spiral of Money invested in an Enterprise
At the top of the picture, the proprietor who has decided to invest in the enterprise injects a certain amount of cash into the business. The enterprise then uses that money to put together a value proposition that is wanted by the market. The surplus is then either withdrawn or reinvested by the proprietor. The following section will explore each step in a bit more detail.
Stage 1. The diagram starts at the top with the injection of money into the business. There are many potential sources of such money for a start-up business, as follows: ~ Sole trader’s own money ~ Personal loan from the bank ~ Partnership investment ~ Business loan ~ Floating shares But whatever the source of that initial capital, or subsequent additions, these sums are then known as ‘liabilities’ for the business, because it owes that money back to the source of that investment. Furthermore, the investor will be expecting something in return (Returns).
Stage 2. Use the money to implement the brilliant idea you have come up with. The enterprise may start small, but as it grows it will probably need some land, buildings, equipment, specialist people, raw materials, bought in services and so on.
Stage 3. Put all these resources together to extract natural resources, or produce the product, or create the relevant service.
Stage 4. Then as you know all too well, the hardest part of the whole cycle is to sell the products and services for a price that will cover all those costs and make a profit.
Of course there are differing views of this business model: ~ Finance people will tell you to stage 1 is the hardest, ~ Buyers will say that stage 2 is more difficult, ~ Operations will tell you that stage 3 is the hardest, ~ and of course, Sales are certain that stage 4 is the most challenging. The spiral then loops around to start all over again. Hopefully, the proprietor has made a profit and can now choose either to withdraw some of that money from the
An Example of the Surplus Spiral As far as finance is concerned, size doesn’t matter. Finance doesn’t care if a business is turning over $50 dollars a day or trillions of euro’s each year. There is no change in the way we should look at finance once the numbers get to a certain size.
The only relevant concept is called ‘Materiality’ – usually expressed as a percentage of turnover, profits, or stock. Information is considered to be material if its omission (or misstatement), could influence the economic decision of people reading the financial statements.
In the following example, the concepts apply right across the spectrum of business activity from the smallest market stall in the world to the largest multi-national conglomerate. In our example, the proprietor is Nellie Madden who has studied the latest Mintel report on green living and sees that 35 percent of survey respondents said they would pay more for environmentally friendly products, despite any downturn in the economy.
Nellie therefore opens an organic salad stall in Great Homer Street Market. She puts $1,000 start-up capital into the business. For the moment, let’s ignore any rental charge or fees to cover electricity and so on. Let’s start with her
first day of trading, when her first task is to buy her initial stock and then hopefully sell all, or most of it, at a profit to her customers.
On Day-One, she buys $600 of organic salad and sells it all for $800 cash. Her position at the end of the day is as follows: It’s always a good tip to follow the cash. We can start to complicate things later, but for now let’s just work out what happens to the cash. First, we have the concept of an ‘Opening Balance’ of $1,000 in cash. Then there is an outflow of cash (a payment) of $600 leaving an interim $400 balance in cash; followed by an inflow (receipts) of $800 which boosts the ‘Closing Balance’ of cash to $1,200. But every financial transaction in the business accounts has two sides to it.
We’ve looked at the cash account; now let’s look at the others. When Nellie made the decision to limit her initial risk to $1,000 her business became a separate entity to her. In effect, the business owes Nellie that $1,000.
To make that clear, this transaction is recorded by creating an account called ‘Capital’ – and when Nellie’s $1,000 is debited to Cash, the corresponding entry is a $1,000 credit to Capital. That is what is meant by double entry bookkeeping. See, we have already covered debits and credits!
Confusion between Cash and Bank Statements
Surveys conducted of finance professionals asked them on what side of the cash account do ‘Receipts’ appear. Half of them got it wrong. There are a couple of reasons for this basic error. These days, the computers do most of the accounting entries, so finance people don’t get to see the old fashioned cash books and other physical account books that conceptually are still critically important to businesses.
But the most common confusion is that people look at their own personal bank account statements, many of which show receipts as Credits on the right and they think this is what a cash account looks like – when actually it’s the complete opposite.
The reason for this is that a personal bank statement is usually just a copy of a page out of the Bank’s accounts, not your accounts. So everything is back to front! Several banks changed this when they introduced on-line services, but many still produce the old-style bank statements that add to the beginner’s confusion. When the Bank gets a receipt (a deposit) intended for Nellie Madden, it creates a double entry as follows:
DEBIT – Cash CREDIT – Nellie Madden’s Personal Account
The easiest way for the bank to produce a bank statement for its customer, is to give them a copy of the bank’s personal account in the name of that customer.
So cheques often appear as debits on the left and deposits appear as credits on the right. This can be confusing – but just remember it’s all about the difference between YOUR accounts and the BANK’S accounts. Hopefully, as more banks update their on-line banking systems, they will adopt a more customer friendly presentation.