Welcome to the first installment of our blog series, “Engineer Your Finances.” In this series, we embark on a journey to demystify the world of financial management through the lens of an engineer. Our goal is to provide you with practical insights that will empower you to navigate the financial terrain with confidence.
Finance can be seen as a complex system much like the engineering projects you’re accustomed to. Understanding the principles of financial management is like deciphering the blueprint of a structure before construction. So, let’s dive into the foundational aspects of financial statements, the pillars of financial understanding.
Understanding Financial Statements – First Principles
Financial statements are the lifeblood of any business, reflecting its health, performance, and overall well-being. Think of these statements as the technical blueprints for your business, detailing its structure and functionality. In this post, we’ll dissect the basics, understanding the purpose, components, and significance of financial statements.
Imagine a civil engineer examining architectural drawings to ensure a building’s structural integrity. Similarly, we’ll guide you through the essential components of financial statements, allowing you to analyze the financial health of a business like a seasoned engineer inspecting a project’s blueprints.
1. The Dual Aspect Principle: Balancing Act for Engineers
The financial world operates on the dual aspect principle, a fundamental concept that every financial transaction has two sides – assets and equities/liabilities – and they must remain in equilibrium. This principle is akin to the delicate balance engineers strive for ensuring that forces balance – as Newton’s 3rd Law of Motion demands. We’d actually go as far as saying the dual aspect principle is to accounting what the right hand rule is to engineering!
The balance sheet, a fundamental accounting report, embodies the equation Assets = Equities + Liabilities, serving as a cornerstone for financial understanding. It meticulously records transactions, balancing assets against equities at specific points, exemplified by the year-end snapshot of ABC Pty (Ltd) in 2021 and 2022 below. More examples cane be found in Financial Decision Making for Engineers Following the dual aspect principle, assets on the left equate to claims on the right. In this balance sheet, assets and equities are classified into current assets, fixed assets, and other categories, offering a minimum detail overview.
The format aligns with the widely accepted practice of displaying assets on the left and equities on the right. Key categories include current liabilities and shareholders’ equity. The balance sheet’s illustrative example unveils the financial position, showcasing the intricate interplay between assets, equities, and liabilities for insightful analysis, crucial for engineers and technicians navigating financial landscapes.
Balance Sheet for ABC Engineers Pty (Ltd)
As of 31 December 2021
| ASSETS | AMOUNT (Thousands of Dollars) | CLAIMS ON ASSETS | AMOUNT (Thousands of Dollars) |
|---|---|---|---|
| CURRENT ASSETS | CURRENT LIABILITIES | ||
| Cash | $52 | Accounts payable | $87 |
| Accounts receivable | $250 | Notes payable | $110 |
| Marketable securities | $175 | Accruals | $10 |
| Stock | $355 | Provision for tax | $135 |
| Total Current Assets | $832 | Total Current Liabilities | $342 |
| FIXED ASSETS | LONG TERM LIABILITIES | ||
| Plant & equipment | $1610 | Mortgages | $520 |
| Depreciation | -$400 | Debentures | $200 |
| Net plant & equipment | $1210 | Total long term liabilities | $720 |
| EQUITY | |||
| Common stock | $600 | ||
| Retained earnings | $380 | ||
| Total equity (net worth) | $980 | ||
| TOTAL ASSETS | $2042 | TOTAL CLAIMS ON ASSETS | $2042 |
Balance Sheet for ABC Engineers Pty (Ltd)
As of 31 December 2022
| ASSETS | AMOUNT (Thousands of Dollars) | CLAIMS ON ASSETS | AMOUNT (Thousands of Dollars) |
|---|---|---|---|
| CURRENT ASSETS | CURRENT LIABILITIES | ||
| Cash | $50 | Accounts payable | $60 |
| Accounts receivable | $200 | Notes payable | $100 |
| Marketable securities | $150 | Accruals | $10 |
| Stock | $300 | Provision for tax | $130 |
| Total Current Assets | $700 | Total Current Liabilities | $300 |
| FIXED ASSETS | LONG TERM LIABILITIES | ||
| Plant & equipment | $1800 | Mortgages | $500 |
| Depreciation | -$500 | Debentures | $200 |
| Net plant & equipment | $1300 | Total long term liabilities | $700 |
| EQUITY | |||
| Common stock | $600 | ||
| Retained earnings | $400 | ||
| Total equity (net worth) | $1000 | ||
| TOTAL ASSETS | $2000 | TOTAL CLAIMS ON ASSETS | $2000 |
2. Mastering Profit and Loss: A Financial Diagnostic Tool for Your Income
In the realm of financial management, the income statement also known as the profit and loss (P&L) statement serves as a diagnostic tool, providing insights into your business’s fiscal health. Analogous to engineers troubleshooting and diagnosing issues in a complex system, the income statement shows the companies revenues and expenses during a particular period. It shows how the revenues are transformed into the net income or net profit.
From revenue and expenses to net profit, uncover the story these numbers tell and how they can guide strategic decisions. By the end, you’ll view your P&L as a powerful diagnostic instrument in your financial toolkit, much like the analytical tools an engineer uses to assess the performance of intricate systems.
ABC Pty (Ltd) Income Statement
For the Year Ended December 31, 2021
| Revenues | Amount (Thousands of Dollars) |
|---|---|
| Sales | 1,200 |
| Other Income | 50 |
| Total Revenues | 1,250 |
| Expenses | |
|---|---|
| Cost of Goods Sold | 800 |
| Operating Expenses | 300 |
| Depreciation | 50 |
| Interest Expenses | 30 |
| Total Expenses | 1,180 |
| Net Income | 70 |
ABC Pty (Ltd) Income Statement
For the Year Ended December 31, 2022
RevenuesAmount (Thousands of Dollars)Sales1,500Other Income75Total Revenues1,575
| Expenses | |
|---|---|
| Cost of Goods Sold | 950 |
| Operating Expenses | 400 |
| Depreciation | 60 |
| Interest Expenses | 100 |
| Total Expenses | 1,510 |
| Net Income | 65 |
3. Fluid Dynamics of Money – Cash Flow Statements
As someone which understands the intricacies of fluid dynamics or hydraulics you would be in a good position to under liquidity. Liquidity refers to the ease with which an asset, or security, can be converted into ready cash without affecting its market price. Cash is the most liquid of assets, while tangible items are less liquid and Cash Flow Statements(CFS) are used to guage a companies liquidity. Also known as the statement of cash flows, the CFS helps its creditors determine how much cash is available (referred to as liquidity) for the company to fund its operating expenses and pay down its debts.
In the ABC Pty (Ltd) cash flow statement below, the left-hand column represents all sources of funds during the 2021 financial year, while the right-hand column illustrates how these funds were utilised. The positioning (left/right) of individual items is variable and depends on whether they contributed to or consumed funds. Here are the main things you need to look out for and understand in the cash flow statement:
Sources of funds:
- Net profit after tax ($120,000): This amount, the final item in the income statement, contributes to the overall funds.
- Depreciation ($100,000): Obtained from the income statement as well.
- Decreases in working capital led to additional sources of funds, including:
- Cash: A reduction from $52,000 to $50,000 indicates a withdrawal of $2,000, serving as a source of funds.
- Marketable securities: A decrease from $175,000 to $150,000, representing a $25,000 source of funds from the sale of securities.
- Accounts receivable: A reduction from $250,000 to $200,000 results in a $50,000 transfer from debtors to the company.
- Stock: Inventory decreased from $355,000 to $300,000, freeing up cash for other uses.
The total source of funds equals net profit after tax + depreciation + total decreases in working capital, totaling $352,000.
Uses of funds:
- Increases in working capital led to fund disbursement, including:
- Accounts payable: A reduction from $87,000 to $60,000 indicates a repayment of $27,000 to creditors.
- Notes payable: Reduced from $110,000 to $100,000, resulting in a $10,000 repayment to the bank.
- Income tax: A decrease from $135,000 to $130,000 means a $5,000 payment to the Tax Office to reduce tax liability.
- Reduction in long-term debt: Mortgages reduced from $520,000 to $500,000, resulting in a $20,000 payment to the mortgagor.
- Gross fixed asset expansion: An increase from $1,610,000 to $1,800,000 indicates a $190,000 expenditure on acquiring assets.
- Dividends to shareholders: Of the $120,000 net profit after tax, only $20,000 was retained, with the remaining $100,000 disbursed as dividends.
The total use of funds amounts to $352,000, aligning with the total source of funds.
ABC Pty (Ltd) Cash Flow Statement
For the Period from December 31, 2020, to December 31, 2021
| Sources of Funds | Amount (Thousands of Dollars) |
|---|---|
| Net Profit After Tax | 120,000 |
| Increases in Working Capital | |
| Depreciation | 100,000 |
| Accounts Payable | 27,000 |
| Notes Payable | 10,000 |
| Income Tax | 5,000 |
| Cash | 2,000 |
| Marketable Securities | 25,000 |
| Total Increases in Working Capital | 42,000 |
| Reduction in Long Term Debt | 20,000 |
| Gross Fixed Asset Expansion | 190,000 |
| Total Decreases in Working Capital | 132,000 |
| Dividends to Shareholders | 100,000 |
| Total Sources of Funds | 352,000 |
| Uses of Funds | Amount (Thousands of Dollars) |
|---|---|
| Decreases in Working Capital | |
| Accounts Receivable | 50,000 |
| Stock | 55,000 |
| Total Decreases in Working Capital | 105,000 |
| Dividends to Shareholders | 100,000 |
| Total Uses of Funds | 205,000 |
Conclusion
In conclusion, our exploration of financial concepts draws parallels with the precision of engineering blueprints, emphasizing the importance of equilibrium. From the foundational equation Assets = Equities + Liabilities to the nuanced interplay of balance sheets, income statements, and cash flow statements, we’ve navigated the financial landscape. The analogy between financial planning and engineering principles, particularly the application of the right-hand rule, underscores the need for meticulous balance to ensure stability.
Specifically, in understanding cash flow statements, we likened financial sources and uses to the carefully orchestrated forces in engineering. Much like engineers balance forces for structural integrity, businesses must judiciously manage their sources and uses of funds for sustained financial health. As we conclude, embrace this equilibrium, strategically apply financial principles, and steer your business toward resilience and prosperity. Below are some books that can assist you on your way to understanding finance and accounting as an engineer, technician or technical professional.
