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Financial Controls in Organizations

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  • 0:03 Financial Controls
  • 0:47 Financial Statements
  • 1:49 Income Statement
  • 3:37 Balance Sheets
  • 4:56 Using Financial Statements
  • 6:45 Lesson Summary
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Lesson Transcript
Instructor: Christopher Muscato

Chris has a master's degree in history and teaches at the University of Northern Colorado.

Organizations have to deal with a lot of money. How do they keep it all straight? In this lesson, we're going to explore the concept of financial controls and see how these can be used to help organizations manage their resources.

Financial Controls

There are a lot of questions you have to deal with when running a business. One question, however, seems to pop up more than nearly any other. No, not that one! It's the question, how are we doing financially?

That's a big question, but you don't need a literal financial wizard to answer it. Instead, businesses and other organizations utilize things called financial controls. Financial controls are tools and techniques that let organizations direct and monitor their resources, protect against fraud, prevent errors or mismanagement, and ensure the best possible use of investments. So, how do you track your finances? That's an important question to ask!

Financial Statements

Now that we're asking the important questions, let's start looking for some actual answers. There are several ways to manage an organization's finances, but almost all of them begin with the accounting cycle, or the set of rules that an organization uses to methodically and consistently record and analyze financial information. In essence, the accounting cycle is how an organization balances its checkbook.

The accounting cycle begins with financial transactions, or the records of how resources enter or exit the organization. Those transactions are organized into appropriate categories or sent to the correct departments, recorded according to the organization's rules and procedures, and finally entered into a financial statement, which is a formal record of financial activities. It's these financial statements that are generally used as financial controls. There are many, many kinds of financial statements that organizations use, but let's focus on two of the most important: income statements and balance sheets.

Income Statements

So, how much money did we make? If that sounds like an important question to you, then congratulations, you have what it takes to be a financial wizard! No, not that wizard! To answer this important question, organizations use something called an income statement, also called a profit and loss statement, which accounts for all expenses and sources of income over a set period of time. Basically, income statements show you how much money has come into the organization and how much is going out.

To generate an income statement, we go through the appropriate financial transactions and organize all the numbers into two simple formulas:

Revenue - Cost of Goods Sold = Gross Profit/Loss

Gross Profit/Loss - Expenses = Net Profit/Loss

That's not so bad, right? Ready to see these formulas in action? We just so happen to have an income statement from P&L Pie Shoppe for the year of 2011. If we look at it, we see that the company made $10,000 for the 2011 year, which is a lot of pie to sell. So, good for them! We can plug that into the revenue slot of our first formula. If we look further down the income statement, we can find that the cost of goods sold was $7,000. When we plug that into our formula, we see that the gross profit was $3,000.

The income statement already has this number calculated for us, but it's important to see how we got there. If we do the same thing for the second formula, we find that gross profit/loss - expenses = net profit/loss becomes $3,000 - $2,600 = $400. So, that's our net profit: $400. Not bad!

Balance Sheets

The second kind of financial statement that you'll see often is a balance sheet, which describes the overall financial status of an organization at a specific moment. If the income statement helps answer the question, 'how'd we do last quarter?,' the balance sheet answers the question, 'what are our finances like at this exact minute?' We can answer this question by comparing the value of everything we own to the value of shareholders' stakes. Here's the formula for that:

Shareholders' Equity + Liabilities = Assets

So, what's that mean? Let's break it down. Shareholders' equity is a shareholder's claim to assets. We generally identify this in terms of stocks, which represent a portion of the company that the shareholder has rights to. We take the total equity of the shareholders, and then add the liabilities, or debts. This includes short-term debts, like money owed to a vendor, as well as long-term debts, like mortgages or major loans.

By subtracting the liabilities from the shareholders' equity, we arrive at the assets, which is the value of all the available resources of the organization. This includes property, equipment, investments, securities, inventory, and, of course, all the cash in our accounts. So, our total assets are equal to the value of shareholders' equities and liabilities.

Using Financial Statements

Finally, we've got to talk about some of the ways that financial statements can actually be used for financial control. One very common technique is to do a financial ratio analysis. A financial ratio analysis compares different financial statements to reveal a relationship between them. For example, we could compare financial statements from the same department over different years or compare financial statements from different departments during the same year.

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