Many of our clients that form Delaware companies are from California.  Also, a majority of these businesses are physically operating in California.  The reason they form a Delaware company may be because California’s corporate law structure is known for being one of the worst out of the 50 states.  So rather than form a California company, they will form a Delaware company and register it to do business in California. For more information on registering as a foreign entity in California, click HERE to see our previous article on this topic.

Also, while operating in California, many of these businesses choose to operate under a different name than what was filed with the Delaware Secretary of State.  California states that individuals or entities doing business for profit under a name different from the owner’s full legal name must file a “Fictitious Name Statement” with the county clerk’s office in the county where the business resides. This is called a “Doing Business As” name or “DBA”.  Before applying for a DBA in California, they require that you register your Delaware company as a foreign entity in the state of California.

By registering as a foreign entity, you will receive a Certificate of Authority.  This will be needed when you register a DBA.

Example of a DBA:  let’s say John Slice forms a Delaware company called “John Slice LLC” but he wants to operate in California under the name “Good Guy Delivery Service” instead of using his business’ legal name. In order to use Good Guy Delivery Service, John will need to register that name as a fictitious business name with the county clerk’s office in the county where he resides.

Beware! Filing a DBA does NOT protect you from personal liability the way incorporating does. When we file your LLC or Corporation with the Delaware Division of Corporations it creates a whole new entity, which is separate, in most legal respects, from its owners.

Now that we have completed our guides to understanding your company’s balance sheet (Part I and Part II) and income statement (Part I and Part II), it is time to turn our attention to the third and final of the major financial statements, the statement of cash flows.  Like the income statement, the statement of cash flows gives us a picture of a company’s performance for a period of time, usually a calendar year or quarter.  But while the income statement is concerned with tracking net income, the statement of cash flows, as the name implies, is concerned with reporting changes in a firm’s cash position.  As we take a look at our sample statement of cash flows and decipher its entries, we will see that a company’s net income is very different from its cash position.

As we can note from the above sample of our fictitious ABC Corporation, the statement of cash flows is broken down into three categories—operating activities, investing activities, and financing activities—plus a summary section at the bottom.  If you are now familiar with the balance sheet and income statement from our previous posts, you should recognize most of the line items here because what the statement of cash flows does is pull information from those two statements in order to analyze their effects on ABC’s cash position.  As we go through the entries below, you may want to refer back to  ABC’s balance sheet and income statement to see where the numbers are coming from.

Net Income – Is the “bottom line” figure from the income statement.

Increases in Accounts Receivable, Inventories, Accounts Payable, and Accrued Payroll – These are all calculated by taking the difference between these figures on two successive balance sheets (e.g. 2010 and 2009 year-end).  For simplicity’s sake we only provided one year’s balance sheet for ABC Corp., but once your business has produced two or more balance sheets you would simply use the two most recent ones in order to make these calculations.  One important thing to note here is that an increase in a current asset decreases cash while an increase in a current liability increases cash.  For example, if your inventory (a current asset) increased, your cash would have to decrease by a like amount to pay for that inventory.

Cash Used to Acquire Fixed Assets – Calculated by taking the difference between the “Fixed Assets” entries on the two most recent balance sheets.

Sale of Short-Term Investments – Reflects short-term investments that have been converted to cash.

Increase in Notes Payable – Indicates the amount of additional short-term debt ABC has taken on.

Net Change in Cash – Equals the sum of the net cash provided by operating, investing, and financing activities.

Cash at Beginning of Year – Equals the Cash figure at the top of the most recent balance sheet.

Cash at End of Year – Cash at beginning of year minus the net change in cash.

Next, we will teach you how to analyze the statement of cash flows and show you why one item on it just might be the single most important figure to look at when analyzing any company.

In our previous post we presented readers with the income statement of the fictitious ABC Corporation duplicated above.  In that entry we gave a brief explanation of each of the items on the income statement that may be helpful to review before proceeding further into this post, which is aimed at teaching you to analyze the income statement for information about the financial situation of a business.

Let’s start our income statement analysis by calculating a very important financial ratio, gross profit margin (also known as gross margin).  The math here is about as easy as it gets, gross profit margin is equal to gross profit divided by total revenue.  In ABC’s case we come up with a gross profit margin of 0.60 or 60% ($90,000/$150,000).  Gross profit margin can be thought of as a measure of efficiency, it tells us how much money is left over from sales after accounting for the cost of the goods sold.  While average profit margins vary greatly from industry to industry, as a general rule a higher gross profit margin indicates a more efficient company within its field.

The next figure we want to calculate is operating income or operating profit, as it is sometimes referred to.  Once again, the math is simple: operating income is equal to gross profit minus operating expenses ($90,000 – $5,000 – $45,000 = $40,000 in our example).  Operating income puts a dollar figure on the amount of money that a business is generating from its core activities and is closely watched by lenders and investors as a gauge of a firm’s ability to repay loans or pay dividends to investors.  If a business is experiencing growth in its operating revenues, then it will have more money available for expansion, debt repayment, or any other management initiatives.  The converse is also true of course, so if your business’s operating income has been steadily declining this should give some cause for concern.

Now let’s go ahead and calculate ABC’s operating margin, which is equal to operating income divided by total revenue ($40,000/$150,00) or 26.67%.  Operating margin tells us how much a company keeps from each dollar of sales, before it has to pay interest and taxes.  As with profit margins averages will vary among different industries, but the higher the figure, the better.  Looking at your company’s operating margins over time, by comparing different years’ income statements, can be an effective tool to measure how effective your firm is at keeping what it earns in sales revenue.  If your revenues are increasing but your margins are shrinking, it may be time to assess whether those additional revenues are worth the money it costs to acquire them.

So hopefully now you have an idea of what the income statement can tell you about your business and how to calculate some simple, yet important, ratios that will also be of interest to lenders and investors. As with our discussion of balance sheets, this series on the income statement is not meant to have been an exhaustive analysis.  We have left out a discussion of some of the more complex items that can appear on the income statements of large corporations, such as amortization and depreciation, although we may cover these in future posts. In any event you should now have the tools to understand a good deal about your own company’s income statement, and if you wish to read further, we’d once again recommend an introductory undergraduate or MBA-level financial management textbook.