Question

It is easy to see how financial statements provide a platform for informed decisions. What are some examples of decisions you might make relative to daily operations? What decisions might you make relative to long term planning based on financial statements?

Answer 1

The three financial reports that are usually used to make a business decision are the Balance Sheet, Income Statement, and Cash Flow statement. Your financial reports must be accurate and GAAP (Generally Accepted Accounting Principles) compliant. It would be very difficult to make good decisions based on inaccurate information.

The Balance Sheet:

The balance sheet is a summary of the financial balances i.e. assets, liabilities, and equity of a company at any GIVEN time. It depicts a picture of the strength of the company and days of working capital i.e. how easily can a company handle changes in revenue while staying afloat. Balance sheets can also identify other trends, such as how the receivables cycle works, how net profits are being used, and how often equipment is replaced.

The Income Statement:

The Income Statement, also known as Profit and Loss Statement (P&L), reflects the company’s revenue and expenses DURING a particular period of time. The purpose of an income statement is to show how the company has performed, by listing sales and expenses, and the resulting profit or loss.

The Cash Flow Statement:

The Cash Flow Statement simply states the inflows and outflows of cash during a finite period of time. These movements of money will account for the financial products from operation, investment, and financing activities. Although often overlooked, the income statement is an important indicator as being able to internally generate sufficient cash is key to maintaining a healthy business.

By providing a steady and up-to-date financial reporting, a business is able to make appropriate decisions to:

• Reduce costs
• Increase sales
• Raise profitability
• Purchase new capital assets
• Best sources of financing, duration, etc.

Owners and managers can now make informed choices to:

• Allocate human resources
• Continue or discontinue certain activities of the business
• Purchase or rent certain equipment used for the production of goods/services
• And much more

A decision should never be based on information found on one lone financial statement, because one financial report will not provide the complete information needed to make the best decision possible. It would not provide the decision-maker a view of the entire financial condition of its business.

All financial statements are based on historic financial data. Therefore, it is important to understand that any decision made will be based off trends that may never occur in the future. Henceforth, anyone making a decision with the use of financial statements should be aware it is merely guide and business happens in real-time and other economic conditions could cause businesses to miss their mark. A company’s goals, sales or earnings forecasts, and measuring business performance are all things that can be determined with information from financial statements along with an understanding of best business practices and market trends.

In addition to assist you with better decision-making, financial statements are key to:

Investors: Prospective investors use financial statements to perform financial analysis, which is the basis of their decision to invest or not in your business.

Lenders: A lending institution will examine the financial health of your company and use the financial statement to confirm if it has the capacity to service the debt.

Creditors: Vendors who extend credit may use financial statements to assess the credit-worthiness of your business.

Irrespective of the size of your organization, finances are regarded as the life blood of the business. One of the unavoidable responsibilities for the Owner /CEO is to ensure the company has sufficient funding. A robust familiarity with your financial statements will always be advantageous. Ultimately, it’s about your readiness to make proactive business decisions on the basis of what really matters most in your specific situation.

Types of decisions that come under short-term and long-term:

Short-term decisions could include whether to resolve staff shortages by using agency staff, to make something in-house or buy it in, to offer special packages/ reduce prices to boost short-term sales or to accept a booking/one-off contract.

The following are few of the short term and long term decisions with respect to specific areas:

Production Decisions

• Short run: Quantity of labor is variable but the quantity of capital and production processes are fixed (i.e. taken as a given).
• Long run: Quantity of labor, the quantity of capital, and production processes are all variable (i.e. changeable).

Measuring Costs

• Short run: Fixed costs are already paid and are unrecoverable (i.e. “sunk”).
• Long run: Fixed costs have yet to be decided on and paid, and thus are not truly “fixed.”

Market Entry and Exit

• Short run: The number of firms in an industry is fixed (even though firms can “shut down” and produce a quantity of zero).
• Long run: The number of firms in an industry is variable since firms can enter and exit the marketplace.

Microeconomic Implications

The Short Run:

• Firms will produce if the market price at least covers variable costs, since fixed costs have already been paid and, as such, don’t enter the decision-making process.
• Firms’ profits can be positive, negative, or zero.

The Long Run:

• Firms will enter a market if the market price is high enough to result in positive profit.
• Firms will exit a market if the market price is low enough to result in negative profit.
• If all firms have the same costs, firm profits will be zero in the long run in a competitive market. (Those firms that have lower costs can maintain positive profit even in the long run.)