Financial Reporting Standards: What You Need to Know

How To Prepare Organized Financial Reporting

Written by Ben Robinson Position
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Learn how to prepare financial reporting in a standardized and organized way so you can gain the trust of potential investors and creditors.

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In this article:

  1. Financial Reporting: How to Prepare Financial Statements
    1. Income Statement
    2. Statement of Retained Earnings
    3. Balance Sheet
    4. Statement of Cash Flows
  2. The Credit Philosophy

Financial Reporting Standards: What You Need to Know

Financial Reporting: How to Prepare Financial Statements

To prepare the financial statements, you need to compile information from your general ledger and accounting journals into a standard financial report. The purpose of financial reporting is for investors, creditors, and lenders to be able to properly evaluate a company’s capacity.

Businesses distribute their financial statements to these parties so they can check their performance, cash flows, and liquidity. If the company passes the evaluation, they’ll be eligible to get investors’ funding or apply for loans.

When preparing the financial reporting requirements, it’s important to take into account the order of how you need to present your financial statements. In this way, whoever will receive the financial report can precisely analyze your business’ financial position in a faster way.

There are four types of financial statements we’ll talk about today:

  • Income Statement
  • Statement of Retained Earnings
  • Balance Sheet
  • Statement of Cash Flows

1. Income Statement (Profit and Loss)

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When you create your Income Statement, organize the items under it this way:

COST OF GOODS SOLD (COGS)EXPENSES
Used to determine the Gross ProfitUsed to determine the Net Profit
Predictable and based on salesSemi-predictable and based on the
manager’s discretion
Typically variableTypically fixed
DirectIndirect
Unallocated
OTHER INCOME AND EXPENSES
Amortization
Capital Gains / Losses
Depreciation
Extraordinary Items
Interest Expenses
Interest Income
Income Tax

Noteworthy Items Under the Income Statement

What Is Gross Profit? This refers to the company’s profit after deducting the costs they incurred in manufacturing and selling their products or providing their services. To calculate this, subtract the COGS from the revenue (sales).

What Is Net Profit? This refers to the company’s remaining profit after deducting the following from the total revenue: operating expenses, taxes, interest, and preferred stock dividends. To calculate this, subtract the Total Expenses from the Total Revenue.

What Is Gross Margin? This is the sales revenue retained by the company after incurring the COGS. To calculate this, subtract the COGS from the Net Sales Revenue.

It’s important to appropriately identify the Cost of Goods Sold (COGS) versus Operating Expenses (or simply “Expenses”). This will help you properly analyze the Gross Profit and Gross Margin.

The percentage of the Gross Margin is a good indicator of the business’ characteristics.

  • A low gross margin percentage (e.g. 5%) typically indicates that the business is focusing on volume-based sales. This means they may be selling commodities with lower quality and prices.
  • A high profit margin that reaches over 40% can indicate that the business offers both products and services. This also means they’re focused on products with higher quality and prices.

Investors, creditors, and lenders alike are all interested in the Net Profit a.k.a. “The Bottom Line.” This is where they’ll be able to determine how lucrative the business is or if they’ll be able to repay their loan.

Remember as well that you should properly identify your business’ Non-operating and Extraordinary Items. This is especially important if you incurred a big loss in the past but it isn’t expected to recur.

The bank, in particular, may consider not including that factor in the calculation of your Net Profit.

2. Statement of Retained Earnings

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The first step to prepare this part of the financial reporting is to calculate the Net Profit or Loss. This statement determines your company’s total retained earnings to date and the amount of dividends you’ll pay your investors.

What is retained earnings? Retained earnings are the profit your company keeps for growth. This is different from earnings distributed as dividends to stakeholders or distributed profit share to investors.

3. Balance Sheet

There are three buckets under the Balance Sheet, namely:

  • Assets — What you own
  • Liabilities — What you owe
  • Equity — What you owe

Through the Balance Sheet, investors, creditors, and lenders can determine a business’s financial position as a whole since inception. Unlike Profit and Loss Statement, Balance Sheet is a real account which means permanent, as opposed to a nominal account which is temporary in nature.

Here’s how you can organize these three buckets in your financial reporting:

Assets

CURRENT ASSETS
These are the assets in cash or those you can convert to cash within an operating cycle
FIXED ASSETS
This refers to the needed infrastructure to generate income like buildings and equipment
Cash on handProne to depreciation
Checking AccountMinimum threshold (typically > $500)
Marketable SecuritiesUseful life > 1 year
Accounts Receivable
Inventory
NON-CURRENT ASSETS
Goodwill
Long-term investments
Long-term loan receivables
Trademark
Deferred tax assets

If you’re applying for a bank loan, you should know that banks mostly focus on the liquidity of the business. They prefer businesses with a higher amount of Current Assets, or highly liquid assets, as they’ll have a better chance to get their funds back if the business fails to pay their loan.

What is liquidity? Liquidity is how quickly a business converts assets into cash like Marketable Securities and Accounts Receivable.

Meanwhile, Fixed Assets serve as collateral. Businesses can use their equipment or real estate assets to back their loans.

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Liabilities

CURRENT LIABILITIES
These refer to claims against your assets that are payable within an operating cycle.
NON-CURRENT LIABILITIES
Liabilities payable not due within one year
Credit card
Credit lines
Loans payable within one year

Lenders like banks aren’t open to lend to businesses that have high debt as they know they might have a tough time paying back all their loans. They’re well aware that businesses can file for bankruptcy.

During bankruptcy proceedings, shareholders aren’t held personally liable to pay the lenders back. That’s why having a high debt is a red flag.

Another issue that lenders watch out for is the blanket lien. This means that the potential lender is second in position for the collateral, as previous lenders are the priority.

The probability of collecting their loan payment is lower with the blanket lien in place. Lenders also know that if a single loan defaults, then all of the others do the same.

Equity

EQUITY – NET WORTH
Companies increase their Net Worth with Shareholder’s Equity and Net Income and/or Retained Earnings.

The business’ net worth is the Equity. If the business owners opt to retain their profit and let it circulate within the business, equity grows and maintains.

4. Statement of Cash Flows

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In this statement, you compare financial data from two time periods. Here you show how cash changed in the following areas:

  • Revenue
  • Expense
  • Asset
  • Liability
  • Equity

The Cash Flow Statement comes last because it needs data from the first three financial statements. Then you divide the cash flows into the following:

  • Operating cash flows
  • Investment cash flows
  • Financing cash flows

What you’ll determine is the net change in cash flows in a given period of time. This statement shows your company’s cash basis financial position or a record of the revenue you actually received in cash.

The Credit Philosophy

If you’re planning to use your financial reports to apply for a bank loan, it’s good to know the five C’s of Credit. This is how they measure risk prior to issuing credit to businesses:

  • Capacity of the business to pay the loan back
  • The capital that the owner, or borrower, invested into their business.
  • The sufficiency of the collateral to cover for the loan amount.
  • Industry and other external conditions that affect the borrower
  • The borrower’s character, which includes their credit history.

You can present a stronger case by including a narrative that’s similar to the “Notes to Financial Statements” that accountants prepare for audit. Do this in the form of a Business Plan and include the following details:

  • Why your business is applying for a loan
  • Where you will use the funds
  • How the loan can increase your business sales
  • How your current operation is affecting everything that’s in your financial statements

These are the standard contents you can expect to find in a business financial reporting. The highlights of the report may vary depending on the end-user, but all financial statements include the Income Statement and Balance Sheet.

Always keep in mind the objectives of financial reporting so you can present accurate and useful data.

Do you have other tips in preparing organized financial reporting? We’d love to read about them in the comments section below.

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