Financial Reports – Net Worth

A company's financial statements indicate the amount of resources (assets) it has at its disposal and also any claims against those precious resources at a particular point in time, the difference between the two is the company's Net Worth.

Claims upon the company's assets can also be referred as liabilities or equities. So, a company can be known as a combination of economic resources and equities.

Regardless of what structure your business takes (sole trader, partnership or corporation), every company or business has two different types of equities. They are creditor liabilities and owner's equity.

The main way to communicate information on how a business is performing financially, to those who have an interest in the business, is through financial statements. However, care must be taken when interpreting these as no set of financial statements is perfect and all have their flaws, the main one being they represent the position of an enterprise at a given point in time and may not reflect major changes in the financial position since that time.

There are three main financial statements:-

1. Statement of financial performance (the profit and loss statement). Reports, in summary form the revenue, expenses and profit (or loss) that has been made over a given period. The statement shows where an entity's revenue was obtained and what expenses were incurred. This report also allows investors to evaluate the past performance of an enterprise and assess its prospects for the future, many consider this to be the most important financial report as it makes it clear whether a business has met its profitability goal.

2. Statement of financial position (balance sheet). This report is a statement of the book value (net worth) of a business at a particular point in time, listing the assets or resources controlled by the enterprise, its debts, and the owner's claim on the equity. The key elements in the statement of financial position are assets, liabilities, net assets, shareholders' equity, and retained earnings.

3. Statement of cash flows. Reports the effects of transactions, over a specified accounting period, that involve a flow of cash into or out of the entity and whether those transactions are of an operational, financial or investment nature.

Operating activities involve the receipts and payments for production, sale and delivery of goods and services.

Financing activities relate to the composition of the financial structure of the entity, for example borrowings and shareholding movements.

Investing activities relate to the acquisition and disposal of non-current assets such as plant and equipment or investments in other companies.

The accounting equation: Economic Resources (Assets) = Liabilities + Owners Equity.

As in all algebraic equations, both sides of the equation have to be equal. The importance of this equation becomes apparent when analyzing the financial effects of your everyday business activities.

Assets are known as the economic resources that are available to a business that are expected to generate income for the entity in the future.
Such as: real estate, buildings or other property that a business can rent, lease or use in the manufacture of goods for sale.
Stock on Hand - finished goods and components which are used in the manufacture of finished goods.
Monies owed to the business for goods or services already supplied (known as accounts receivable).
There are also some assets that are not of a physical nature, though still extremely valuable to a business, some examples are: copyrights, trademarks, patents and good will.

Liabilities are the payment obligations that a business has, such as: taxes, payroll obligations, utilities, amounts owing to other businesses for the supply of goods or services received.  These are the debts or accounts payable of a business, the monies that it will have to pay out in the near future. The law gives creditors (people that money is owed to) the right to push for the sale (liquidation) of a company's assets if it is unable to pay its debts on time.  Creditors have greater rights over the assets of a business than owners as they have to be paid before the owners receive anything.

Owner's equity refers to the claim that owners of a business have over the assets of the business. It is the residual interest or the remaining assets of a company after deducting the liabilities of the business. Here is the equation for owner's equity. Owner equity = Assets - Liabilities. The owner's equity within a particular corporation is referred as stockholders or shareholders equity.

This is made up of two distinct parts, contributed capital and retained earnings.  (Owner's Equity = Contributed Capital + Retained Earnings). The amount that individual shareholders put into a business is known as contributed capital. Retained earnings is the amount of equity (profit) that has been earned by shareholders from the income generating activities of a business that has been kept for future uses by the business. Retained earnings are affected by three types of transactions which are revenues, expenses, and dividends.

When revenues exceed expenses it is known as net income this results in an increase in assets and hence the owner's equity. On the other hand where expenses are greater than revenues it is known as a net loss this results in a decrease in assets and hence the owner's equity (which means that you are losing business or your business costs more to operate than what you earn).

Dividends are the distribution of assets (income) to shareholders relating to the past earnings of the business. It is important not to confuse expenses with dividends as both reduce the retained earnings amount. Retained earnings are the collected net income or revenues minus expenses.