Interpreting Financial Statements: The Income Statement

The Income Statement is a very useful tool for understanding a company's performance. It is the most recognised financial statement because it shows whether the company is making profits or losses in a particular period e.g. month, quarter or year. It is also known as the profit and loss account.

In this article, we took the common components of this financial statement and what a reader can decipher from them. Whereas an income statement in a particular period is useful, the apparent value is derived when it is compared against prior periods or against an expectation such as a budget. One is then able to understand whether the company is performing to expectation or whether profitability is declining.

1. Sales/ Revenue

This is the top line of the income statement, it records earnings from sale of goods or services to customers. But when is a sale made?

Some of the corporate scandals reported in the press have been on manipulation of sales figures by recording sales too soon or too late.

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Nairobi Stock Exchange Bear Run Persists

A stocks market bear run is a market condition in which the prices of securities are falling, and widespread pessimism causes the negative market trend to continue for a long while. In such a market, investors would anticipate losses and continue selling their securities at even lower prices, which contributes to further pessimism. A downturn of more than 20% in the market indexes for over two months, is considered a bear run in the stock market.

Investing in a bear market is usually very tricky as it's usually difficult to know when the market is bottoming out or just having a small hiccup. Unlike a market correction, which is a short-term negative trend that lasts less than a month and often presents a great opportunity for investors to find low entry points, bear markets rarely provide any entry points. In most cases, buying in a bear market will be a case of catching a falling knife with only painful results to follow. The only thing to do in such a market is keep a level head and seek as much information as you can.

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Managing Foreign Exchange Risk

The Kenya Shilling has depreciated by about 6% against all major currencies between April and last week with the exception of South African Rand and the Japanese Yen as tabulated below. The economic conditions responsible for this decline still prevail and one can only speculate when and where the exchange rates will eventually stabilise.

30-Apr-15 10-Jul-15 Movt %
US DOLLAR   94.60 100.74 6.5%
GBP   145.82 154.85 6.2%
EURO   104.87 111.68 6.5%
JAPANESE YEN  79.79 82.65 3.6%
INDIAN RUPEE 1.49 1.59 6.7%
SA RAND   8.00 8.09 1.1%
CHINESE YUAN  15.25 16.22 6.4%

A slump in domestic currency has the following effects which can adversely affect the profitability of the business:

  • Increase in costs for importers
  • Increase in cost of servicing foreign currency denominated debts
  • Increase in cost of capital investment where it involves importation of equipment

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Selecting a Capital Structure for your Business

Capital is a necessary requirement to start up a business, operate and generate profits. Lack of capital may lead to business failure. A business can raise capital from the following main sources; debt, profits and sale of equity. The following are pros and cons of these sources of capital.

1. Equity

The main advantage of using equity as a source of capital for business is that it does not have fixed payment requirements or interest charges. Therefore it does not increase payment burden so the business can focus on growth.

A major disadvantage of equity financing is that when equity/shares are sold, the investor has ownership interest in the business and gets part of the profits. Therefore equity capital reduces the primary owner's share of the profits and of the business as a whole.

Another disadvantage of equity capital is that equity investors demand a high rate of return on their investment. A business owner may end up giving up more stock for a lower price.

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Enhance Your Chances of Securing Business Financing

One common challenge perceived by SME's is general lack of support by banks. Business owners, as a result, tend to shun banks and go to great lengths to secure alternative financing for their businesses.

But given the aggressive marketing of loan products by financial institutions, one tends to wonder whether it is the banks that are reluctant to lend or it's the businesses that are not well prepared to borrow. Understanding what the banks look for when assessing loan applications can significantly increase the possibility of accessing funding.

Below are five issues you need to look into before approaching any lender.

1. Have well prepared historical Financial Statements.

The lender relies to a great extent on demonstrated financial performance of the business to assess your ability to repay the loan.

Apart from having 2-3 years' financial statements, take time to understand what they portray of your business. Has the company been making profits? Does the business generate sufficient cash flow to repay the loan? How strong is the company's balance sheet? Seek the help of your accountant or financial advisor if necessary.

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Taxation in Kenya

One of the first things you need to find out when you're starting any kind of business, be it a sole proprietor, Limited company, Partnership etc are the tax laws that apply to your business. It is important to consult a tax professional to help you with all the requirements that you must comply with, such Pay As You Earn (PAYE) tax, Corporate tax, Value Added Tax (VAT) etc.

In Kenya some of the basic tax compliance requirements according to the income tax laws relating to businesses are:

  •  Keeping of up to date books of account by businessmen,
  •  Acquiring of Personal Identification Numbers (PIN) by all potential taxpayers,
  •  Determining the taxable income according to the stipulated rules and regulation,
  •  Accurate determination of tax liability,
  •  Filing of returns on income by the prescribed date,
  •  Paying of tax dues by the prescribed date, payment of fines and penalties for overdue taxes and
  •  Allowing of audit by tax collectors if deemed necessary.

Below is an outline of some of the taxes that apply to the most business entities;

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Managing Cash Flow - Forecast

One tool that is very useful in effectively managing cash flow is a Cash Flow Forecast. A good forecast encourages you to think ahead and plan for ways to finance cash shortages or deploy surpluses before they occur. A cash flow forecast also helps in assessing the actual performance of the business against expectations.

The forecast is usually for a year or a quarter in advance broken down by week or month. Shorter term forecasts are likely to be more accurate than longer term forecasts. So how do you go about preparing a cash flow forecast?

STEP 1 – OPENING CASH POSITION
Establish your current cash position. This is the money in the bank or in short-term deposits and forms the opening balance

STEP 2 – CASH INFLOWS
Estimate the money you expect to receive during the period. This includes payments from customers, money from cash sales, funds from disposal of assets, funds from shareholders and other cash inflows. It is important to note that the focus is on collections not sales. Historical customer payment trends are a good starting point in making the estimates.

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Successfully Convert your Credit Sales into Cash

Many businesses sell on credit to their customers. The sales cycle is never complete until the customer pays for the goods or services supplied. The business needs to be aware of and establish mechanisms for managing the arising credit risk. Credit risk is the risk that the customer defaults and fails to make payment. Below are some useful, practical considerations which can help you successfully collect on all credit sales and hence improve business cash flow while avoiding loss.

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Managing Cash Flow

'Cash is King', is an old saying which describes the importance of cash in running a business. It basically means that cash flow is at the heart of a business and is a vital element for success of any business.

Good cash flow management entails ensuring that you have more incoming cash than outgoing. Positive cash flow arises when the cash coming into your business from capital, sales and other revenue sources is more than the cash going out through expenses, salaries, etc. Negative cash flow arises when cash outflow is greater than cash received. This generally is a problem for the business that management must grapple with. It is evidenced by:

  • Late or non-payment of suppliers, salaries, taxes and other essential business related expenditure.
  • Inability to fulfill customer demands in a timely manner.
  • Threatened or real legal action by suppliers at the extreme.
  • High stress levels across the business.

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Can lessons from personal cash flow management apply in a business?

Whether it's by scribbling on the back of an envelope or through elaborate worksheets, the fact is each one of us plans for their personal cash. Spending is determined by personal goals (short and long-term) of the individual, disposable cash available and priority of expenditure. Note that whether consciously or not, goals come first and these consequently inform the priority in which cash is allocated.

If the aim is to take a loan in the next six months, for example, and a cash collateral of X amount is required, then setting aside some funds towards this will be among the cash allocations. This cannot happen without having that goal in mind, in the first place, and hence the importance of goal setting. And this simple approach can apply to your business as well.

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How Often Should Business Accounts be Monitored?

Joshua Kamau* has operated a mid-sized internet service providing business in Nairobi since 2007. “I had an accountant in charge of making collections from clients. The same worker also ensured clients had internet and was in charge of disconnections in case of payment default,” he says. Everything went on smoothly until the accountant tendered his resignation.

“He cleared following the right procedure but as soon as he was gone, we realized some clients enjoyed internet services but nowhere in the records were their payments indicated,” he recalls. “The clients themselves had paid cash amounts of over Ksh 700,000 to the accountant over a period spanning four months,” says the businessman who also runs a stockbrokerage firm.

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