Financial Reports for Managers - The 10 minute MBA

All managers should have a basic understanding of how the finances of a company work.  Accountants have a way of making the financial reports complicated, but if a manager sticks to the basics, they can understand how a company uses these reports to stay healthy.  I know there are a million sources for this information, but it should be in every manager's toolbox so I am including it as a post.
What are the most important financial reports for a manager to understand? 
There are many reports that a company uses to understand their finances, but there are three main reports that will tell whether a company is healthy.  They are:

1. The Profit and Loss statement, also called the Income Statement - This is basically a list of all the expenses of a company in any defined period subtracted from the revenue for that period.  A positive number means a profit and a negative number is a loss.
2. The Balance Sheet - This is a list of assets, which is what the company owns and a list of liabilities, which is what the company owes.  The difference between these two things is the value of the company, or the equity of the owners.  This doesn't mean you can buy a company for this amount, but gives a basis for what is called "book value".  The amount needed to buy a company (another way to "value" it) is either determined by the amount someone will pay for a private company, or is represented by the market capitalization (total value of all outstanding stock) of a public company.
3. The Cash Flow Statement - A company can make a profit and have lots of assets, and still go out of business if they don't manage their cash carefully.  It is like a house.  Let's say a person purchased the house for $500,000 and after 5 years it would sell for $1million.  That means the person who owns the house has made $500,000 profit.  The problem is that if the person can't make the monthly mortgage payments, the bank will force the person to sell the house.  That's great if the objective is to get the money out of the house - it is bad if the objective was to live in the house.

Let's look at each of these reports in more detail.

Profit and Loss Statement
 Image source: tutorsonnet.com
Costs - There are two basic ways that costs are categorized, fixed and variable.  Added together they are called Total Costs.

1. Fixed costs - expenses that are needed to keep the business running whether or not anything is produced.
1. Salaries
2. Rent/Mortgage
3. Depreciation
4. Equipment Leases
5. Property Taxes
6. Debt Payments
7. Insurance
2. Variable costs  - expenses that vary with the amount of goods or services produced.  Theoretically, if nothing is produced, there will be no variable costs incurred.
1. Labor Wages
2. Overtime
3. Materials
4. Utilities
5. Commissions
6. Freight In/Out
7. Packaging Supplies
8. Sales Taxes
9. Scrap
10. Tooling and repairs
3. Total cost  - the sum of all fixed and variable costs, TC=FC+VC, and can be represented in the following way:

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Revenue - The amount of money a company brings in through sales.  There are other ways companies can bring in money, but let's just stick with sales for this illustration.

Now let's add two more important concepts, Contribution Margin and Break Even Point.

Contribution Margin - the amount of money left over after the variable costs have been covered for a product or service.  Basically this amount "contributes" to paying for the fixed costs.
Break Even Point - The point at which enough goods have been sold to pay for all of the fixed costs. 


Image source: fao.org

The concept of Contribution Margin is especially important because after the break even point has been reached, the contribution margin represents the profit that will be realized with each additional sale.  Let's use an example to illustrate why this is important.
Contribution Margin ExampleLet's say the break even point for a product that sells for $100, with a contribution margin of $25, is 900 units.  If the monthly sales are 1,000 units, the revenue will be $100,000 and the profit will be $2,500 (all the CM after BE).  If an additional 100 units could be sold, the Revenue would be $110,000, but the profit will now be $5,000.  This shows how a 10% increase in sales can produce a 50% increase in profit.  That's why it is important to understand the connection between Break Even and Contribution Margin.


Balance Sheet

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Assets - Here is a very simplified list of asset accounts

1. Cash
2. Investments
3. Accounts Receivable
4. Inventory
5. Prepaid Expenses
6. Property, Plants, Equipment (PP&E)
7. Goodwill - The amount paid for a company purchased above that company's book value

Liabilities - Here is a very simplified list of liability accounts

1. Accounts Payable
2. Reserves
1. Unpaid Benefits
2. Unpaid Taxes
3. Notes
1. Loans
2. Line of Credit
3. Notes for equipment

Equity

1. Paid in capital - Money that the owners put into the company.
2. Retained Earnings - All the earnings not distributed to owners from previous years.
3. YTD Income - This year's earnings

Cash Flow Statement
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From Operations

1. Sales (+)
2. Materials (-)
3. Labor (-)
4. Expenses (-)

From Financing

1. Loan Service (-)
2. Dividends from investments (+)
3. Dividends paid to shareholders (-)
4. Taxes (-)

From Investments

1. Capital equipment (-)

How are the Balance Sheet and the Profit and Loss Statement (Income Statement) connected?

Any change to the balance sheet that is not balanced by another account on the balance sheet must "flow through the income statement". For instance, if a loan is paid off, the liability can be cleared by reducing the cash assets, which means the accounts remain in balance and would not have an impact to the Profit and Loss Statement. However, if it is determined that a valuable piece of equipment was stolen, this can not be balanced through a liability adjustment, so it must be reflected as a loss on the income statement.

That's what I think.  Tell me what you think.