HR professionals should become familiar with key financial statements that the organization and its stakeholders use to measure the organization's health and to plan actions-the balance sheet, the income statement, and the cash flow statement. These statements are integrated. Information from one is used in creating the other statements.
Understanding the financial statements helps the HR professional:
Understand the perspectives of internal and external stakeholders. HR professionals can better understand the economic issues driving management decisions (for example, poor profit margins relative to industry, inadequate cash flow to cover wages, large deductions from gross sales caused by returns). Investors analyze financial statements to gauge growth opportunities and identify risks, such as too much debt.
Identify opportunities for HR to improve the organization's financial performance (for example, developing new competencies aligned with financial goals). The HR function can better fulfill its consultation role to organizational leadership.
Understand factors that may affect HR strategies. For example, weak revenue may affect executive compensation. Poor cash flow or ability to incur debt may limit internal investments in a new HR information system.
A good way to gain financial
perspective and understanding is to consult with colleagues in finance. Meeting
regularly with a financial officer will increase an HR professional's
understanding of the financial values driving strategy and operations. It is
also an opportunity to learn about the challenges facing the financial managers
and consider ways HR activities might help. These discussions may create an
influential ally and advisor when crafting HR initiatives.
Balance Sheet
The balance sheet is one indicator of the organization's financial
health. It is a statement of the organization's financial position- its assets,
liabilities, and equity- at a particular time. Exhibit 39 displays the balance
sheets of a fictional company on December 31 of two consecutive years. We will
refer to this sample throughout the following description of the balance sheet.
The key word in the term "balance sheet" is "balance." In accounting, all transactions should be balanced: Any money entered as an asset is balanced by offsetting liabilities. To illustrate this, consider that, in our example, ABC's factory buildings and land are valued in year 2 at $59,600,000. This asset is balanced by a note to a bank for, let's say, 60% of its value, or $35,760,000. The remainder of the asset's value, $23,840,000, is considered equity value held by ABC's owners and shareholders.
This relationship between assets,
liabilities, and equity is represented by the balance sheet equation, which may
be shown as:
Assets =
Liabilities + Equity or Equity = Assets - Liabilities
In our example, the top part of
the balance sheet lists assets, which are balanced by the items in the bottom
half of the sheet, liabilities.
Assets are what an organization
owns. They can be tangible (for example, cash or cash equivalents, inventory of
finished product or materials, property, and equipment) or intangible (for
example, copyrights and patents, proprietary knowledge). (Although human
capital is an important asset for organizations, finance and accounting do not
list it as an asset because it cannot be monetized with absolute agreement.)
Assets also include investments
the company has made (for example, purchase of income-bearing instruments) and
what is owed to the organization (for example, as-yet unpaid invoices). In
accounting terms, these are accounts receivable, the money an organization's
customers owe the organization. It is in the financial interest of the
organization to collect all of its accounts receivable. If a balance sheet
regularly shows a high level of doubtful accounts, this might indicate that customers'
financial strength should be considered when making sales. Doubtful accounts-probably
long overdue and uncollectible-are deducted from accounts receivable.
In this example of a balance
sheet for a small manufacturer, current assets include items that can be easily
liquidated or converted into cash, such as cash deposits, inventory of finished
and in-process products, and accounts receivable. Fixed assets (for example,
buildings, land, factory and office equipment, furnishings) have tangible value
but are long-term investments not intended for quick liquidation.
Liabilities are what an
organization owes. Liabilities can include items such as rent, loans or notes,
wages and benefits that have been earned but not paid, reserves set aside to
cover potential liabilities, unpaid fines or legal judgments, tax debts, and
accounts payable. Accounts payable is the money an organization owes its
vendors and suppliers.
In our example, ABC Manufacturing
has rather simple liabilities:
·
Accounts payable (probably for items such as
materials, utilities, servicing of equipment, and advertising)
·
Short-term notes (perhaps for equipment
purchases)
·
Long-term debt (perhaps for factory
construction)
·
Shareholder equity
Equity is combined with liabilities in the balance
sheet because it represents what a company owes to either its owner(s) or its
shareholders. Equity is what is left of a company's assets after its
liabilities have been discharged. Stockholder equity is the value of all stock
held by investors. In this case, it also includes profits that have not been
distributed to investors as dividends but have been retained by the company,
probably for reinvestment to grow the company, for example, the purchase of
robotic equipment to increase productivity.
Important points to remember
concerning balance sheets are:
·
The basic form of the sheet is Assets =
Liabilities + Equity.
·
Balance sheets provide a snapshot of the
company's financial position at a given moment in time. Balance sheets change
as new transactions are recorded.
·
Every financial transaction is an exchange, and
both sides of the transaction are entered on the balance sheet to reflect
assets, liabilities, or equity.
·
Only transactions measurable in money are
recorded. Transactions without a definite monetary amount are not placed on a
balance sheet.
Income Statement
Unlike the balance sheet, the
income statement compares revenues, expenses, and profits over a specified
period of time-usually a year or a quarter. The income statement is also known
as the profit and loss statement or P&L.
The income statement indicates an
organization's net income, which is often referred to as the "bottom
line" and provides key information about the organization's performance.
The equation for net income is: Net income = Revenues – Expenses
Exhibit 40 shows a sample income
statement for ABC Manufacturing. This is a consolidated statement, which means
that it includes multiple reporting periods (FY [Fiscal Year] 1 and FY 2 in
this case). A consolidated statement enables comparisons of key financial data
over time and thus can show trends in growth or decline.
In the example, ABC's revenue or
net sales for FY 1 and FY 2-$271,200 and $ 296,400 consists of its total sales
minus items such as repayments to customers for faulty products or discounts
granted for buying products in larger quantities. The cost of goods sold (for
example, raw materials, purchased equipment and supplies, direct labor) is
subtracted from revenue to show ABC's gross profit ($103,800 for FY 1 and
$114,200 for FY 2).
To arrive at net income, we have
to make a series of deductions. First, total operating expenses (also referred
to as total expenses or total costs) must be deducted from gross profit. Total
operating expenses include items such as selling expenses (for example,
advertising), salaries that are not directly related to producing goods (for
example, administrative salaries), and continuing lease payments (for example,
for large equipment or facilities). The total operating expenses are $59,600
for FY 1 and $65,200 for FY 2. We should note that the increase in total
operating expenses from FY 1 to FY 2 makes sense, since total sales have
increased as well.
If we also subtract depreciation
(loss in value of assets as they are held over time) from gross profit, we
arrive at earnings before interest and taxes, or EBIT.
If we subtract interest and
taxes, we finally arrive at net income: for FY 1 $24,500 and for FY 2 $19,500.
The drop in net income, despite increased gross income, probably derives from
the sharp increase in taxes that ABC paid in FY 2.
Financial data in the income
statement is used to create metrics for an organization's financial health. Two
key metrics from the income statement, for example, are gross and net profit
margin.
·
Remember that gross profit is net sales minus
the costs of producing what is sold. The gross profit margin compares gross
profit with sales. It is calculated in the following way:
Gross profit +
Net sales = Gross profit margin
For FY 1, gross
profit margin will be $103,800 $271,200, or 38%.
For FY 2, gross
profit margin will be $114,200 $296,400, or 39% (rounding up).
·
Net income is what is available for reinvestment
or for distribution to owners and stockholders. The net profit margin is
calculated in the following manner.
Net income
+ Net sales = Net profit margin
For FY 1, net
profit margin will be $24,500$271,200, or 9%.
For FY 2, net
profit margin will be $19,500 + $296,400, or 7% (rounding up).
The downward direction of net
profit margin could be a problem for ABC if it continues to decline or if it is
unique to ABC (if its competitors are not experiencing a similar decline).
These metrics are important because an organization with a healthy profit
margin (for its industry) can obtain financing and reinvest for growth.
The following are important
points to remember concerning income statements:
·
The basic form is Revenues - Expenses = Net
income.
·
Income statements reflect performance over a
specific time period, usually a quarter or a year.
·
Some expenses are never cash outflows
(depreciation, for example) but are only accounting items, and some expenses
may be paid in cash partly in this period and partly in the next period (cost
of goods sold, for example).
·
Owner withdrawals are not an operating expense
but are a distribution out of net income.
Cash Flow Statement
The cash flow statement
illustrates the effect of all organizational activities- activities that both
consume value (for example, production, administration) and produce value (for
example, sales, investments)-on how much cash or cash equivalents the
organization has on hand.
In other words, the cash flow
statement shows how money is flowing into and out of the organization through
operations, investing, and financing over a defined period of time. Financial
data for the cash flow statement comes from the income statement and the
balance sheet.
The combined cash flow from these
three areas is subtracted from the cash balance available to ABC at the
beginning of year 2. This is the same as the ending balance for year 1, which
was carried over into year 2. For year 2, ABC showed a negative cash flow. This
could be problematic if the trend continues.
The balance, trends, and
relationships in the areas of the cash flow statement are often interpreted by
outside financial experts (such as banks or investors) as signs of sound or
weak management. A negative cash flow in operations could indicate that sales
are too low and/or the cost of production is too high for the organization to
sustain existence. Positive cash flow indicates the ability to repay debt and
meet expenses. Negative cash flow in investing could suggest that the
organization is not continuing to invest in itself to develop new skills and
products. The cash flow in financing, compared to operations and investing,
could show when an organization is relying too heavily on borrowing.
For an HR professional, poor cash
flow may mean that fewer resources will be available for HR programs, but there
may also be opportunities for HR to use its expertise to improve the cash flow
situation, which will make the company more attractive to investors. HR might,
for example, work with operations to introduce a leaner manufacturing process
(which will decrease inventory) or with sales and marketing to create an
incentive system (which will increase net income).
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