Accounting: The Language of Business - Vol. 2 (Intermediate: Part 63)

When individual enterprise is free and unhampered, profit-and-loss calculations set precise limits to a businessman's temptations to expand his services... a government valuable they may be, have no market price and, therefore, cannot be subjected to profit-and-loss accounting.

Hans F. Sennholz

Statements of Financial Position and Cash Flows and the Annual Report (Part A)

by

Charles Lamson 

Introduction

The balance sheet or statement of financial position, summarizes an entity's economic resources (assets), obligations (liabilities), and stockholders' equity. Financial statement users rely on the balance sheet information to help determine an entity's ability to generate future cash flows and to evaluate its exposure to risk. A strong balance sheet generally indicates a firm with solid financial health.

What makes a balance sheet strong? In simple terms, a strong balance sheet has limited obligations so that a company can make timely debt payments. A company with significant levels of debt may be at risk of defaulting on payments or even filing for bankruptcy when the economy is faltering or when markets are weak. Declining sales and low cash flows make it difficult for a company to liquidate its debt when due.

Companies actively manage their levels of debt. To maximize shareholders' returns, companies seek to borrow at low interest rates and operate efficiently. Too much debt can drain a company's ability to grow when cash is used to make debt payments rather than to invest. Consider Zoe's Kitchen Inc., a fast, casual restaurant chain that raised over $80 million in its 2014 initial public offering (IPO), Zoe's Kitchen planned to use about $50 million to ”clean up” its balance sheet by paying off debt and allocating the remaining $30 million to support growth plans. With the cash raised from the IPO, Zoe's Kitchen was able to both lower its debt and find fund future growth. The lower debt also frees up cash for investment that would have otherwise been used to pay principal and interest on the debt.

A healthy balance sheet, then, provides adequate cash and other assets for managing day-to-day operations, making timely debt payments, stimulating future growth, and funding any unexpected needs. The importance of cash management necessitates a separate financial statement, the statement of cash flows, to explain changes in cash.

In the next several parts of this volume, we complete our look at the four basic financial statements by examining the statement of financial position and the statement of cash flows. We addressed the statements of net income and comprehensive income and the statement of stockholders' equity in Parts 43, 57, 58, and 59. The discussion begins with an overview of the balance sheet, followed by an examination of the presentation of current and non-current assets and liabilities on the statement of financial position. Then, the statement of cash flows is introduced. We also discuss the differences between U.S. GAAP and IFRS regarding the form and content of the statement of financial position and the statement of cash flows.

In the next few parts, we examine how the four basic financial statements interrelate, or articulate, to provide comprehensive information on a company's operating performance and financial position. Financial reports also include the notes that accompany the financial statements, a key source of essential information regarding a company's accounting policies and further explain the amounts reported. The financial statements are usually part of a company's annual report to shareholders, which also includes additional disclosures that supplement and enhance the financial statements. The components of the annual report will be outlined using the Johnson & Johnson 2016 annual report.

*GORDON, RAEDY, SANNELLA, 2019, INTERMEDIATE ACCOUNTING, 2ND ED., PP. 235-236*

end