Establishing Financial Controls & Securing Operating Funds

Instructor: Sandra Judge

Sandra is a CPA, CA with a graduate diploma in public accounting.

Financial controls are important to monitor the financial health of companies. In this lesson, we will introduce different financial controls and learn how firms secure operating funding.

Financial Controls

Just like you need to go to the doctor for an annual check-up, companies must also have periodic check-ups. Financial controls are used to see how a company is doing. Financial controls include financial statements, ratio analyses, and break-even analyses. Let's take a look at some of these financial controls, beginning with a financial statement.

Financial Statements

Financial statements show a company's transactions throughout the year. Financial statements include an income statement, which contains all of a company's revenues and expenses for the period resulting in net income.

Happy Farm: Income Statement and Balance Sheet
Happy Farm

These are the formulas used on an income statement:

  • Gross profit = sales revenue less cost of goods sold
  • Net income = gross profit less operating expenses and taxes

Key terms usually found on income statements include:

  • Sales revenue: proceeds from sales
  • Cost of goods sold: total cost of all products sold during the year, such as direct materials and direct wages
  • Operating expenses: costs used to run a company that cannot be directly attributed to products, like administrative and rent expenses

Financial statements also include a balance sheet, which is a picture of all of a company's assets, liabilities, and shareholder's equity at the year's end. The balance sheet follows the accounting equation:

Assets = liabilities + shareholder's equity

Key terms found on balance sheets include:

  • Assets: company-controlled resources that can be converted to cash and benefit or increase the value of a company
  • Current assets: cash, accounts receivable, and inventory expected to be used within one year
  • Long-term assets: property, plant, equipment, and long-term investments expected to be used beyond one year
  • Liabilities: company debts and obligations
  • Current and long-term liabilities: similar to assets, they are due within one year and over a year respectively

On a financial statement, you'll also find a cash flow statement, which reveals a company's sources of cash and what it spent cash on. Cash flow can be divided into three categories:

  • Operating activities: all the activities used to generate operating revenue for a company, like selling products and services
  • Investing activities: purchase and sale of long-term assets, such as equipment used in a business
  • Financing activities: all the activities carried out, which provide long-term funds to a company, such as the purchase of shares

On a financial statement, you'll also find a statement of retained earnings, which is made up of beginning retained earnings, net income, dividends, and ending retained earnings. It shows all the transactions relating to a shareholder's property.

Ratio Analysis

Ratio analysis quantifies the financial health of the company. These include quick ratios, current ratios, and fixed asset turnovers. The quick ratio measures if a company is able to pay its short-term liabilities quickly; it compares the most readily available current assets with current liabilities:

Quick ratio = (cash + accounts receivable + marketable securities) / current liabilities

As you can see on the Happy Farm statement:

  • Cash: $5,000
  • Accounts receivable: $7,280
  • Marketable securities: $87,360
  • Current liabilities are the accounts payable ($41,000) and current portion of loan payable ($33,000)

When we plug these figures into the quick ratio, we see that: (5,000 + 7,280 + 87,360) / (41,000 + 33,000) = 1.3. This means that the farm is able to pay its short-term liabilities as they come due.

Now let's look at the current ratio, which measures a company's ability to pay short-term debts as they become due:

Current ratio = current assets / current liabilities

Happy Farm's current ratio is: 132,840 / 124,000 = 1.1. The current ratio is positive; this is a good sign because the farm has enough current assets to pay off its current liabilities.

To calculate the fixed asset turnover for Happy Farm, we can use this formula:

Fixed asset turnover = net sales / net property, plant, and equipment

  • Net sales: sales less discounts, returns, and allowances
  • Net property, plant, and equipment: property, plant, and equipment less depreciation
  • Fixed asset turnover ratio: measures how many sales dollars are generated per dollar of property, plant, and equipment

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