FINANCIAL STATEMENTS Chapter 3 Balance Sheet Income Statement Statement of Cash Flows

FINANCIAL STATEMENTS

Chapter 3

Balance SheetIncome Statement

Statement of Cash Flows

THE STRUCTURE OF FINANCIAL ACCOUNTS

A. Accounting is fundamentally the process of how we organize the way we think about the financial aspects of our business.

B. Two Important Financial Statements1. Income Statement2. Balance Sheet

C. Two additional financial statements1. Statement of Cash Flows2. Statement of changes in owner equity

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Finance from a Personal ViewpointA. All us own things and owe moneyB. If we own more than we owe – we are

said to have a positive net worth.C. In Accounting & Finance:

1. What we own are called Assets. 2. What we owe are called Liabilities.3. If our Assets exceed our Liabilities then

we have [positive] Equity.4. Accordingly: Assets = Liabilities +

Equity5. Savings are the difference between

what we earn and what we consume: S = E – C


Balance Sheet

A. The Balance Sheet answers two general questions:

1. How has the business invested its capital (money)?a. Current Assets (cash, receivables, inventory)b. Fixed Assets (plant, property, equipment)

2. How has the business financed its investment?a. Personal Funds (owner’s capital)b. Borrowing: short-term (current liabilities)

and/or long-term (loan paid back over several years)

c. Trade Credit from suppliersd. Later: Reinvesting a portion of profits in the

business

The Asset Accounts

A. Current Assets (in order of liquidity)1. Cash2. Receivables3. Inventory4. Prepaid Expenses

B. Fixed or Long-Term Assets1. Plant (buildings)2. Property (land)3. Equipment (computers to trucks)

The Asset Accounts

C. Fixed or Long-Term Assets (cont.)4. Effects of Wear and Tear over time

a. Depreciation Expense: a non-cash expense that in theory creates a “fund” which will be used later to replace the worn-out asset.

b. In actuality: it is a “tax shelter”. It reduces our taxable income.

c. Assets are depreciated over their expected economic life to zero. Book Value = 0

d. However, even worn out assets may have a market value.

D. Asset accounts carry Debit Balances

The Liability Accounts

A. Short-Term or Current Liabilities1. Payables

a. Employeesb. Trade and other Creditorsc. Tax authorities

2. Current portion of Long-term debtB. Long-term Liabilities

1. Mortgages2. SBA loans (typ. 5 to 7 years max. with

exceptions)C. Liability accounts carry Credit Balances

The Equity Accounts

A. Owner’s Capital1. Owner’s Equity2. Owner’s Draw3. Retained Earnings

B. Equity accounts carry Credit BalancesC. The Accounting Equation

Assets (Debits) = Liabilities + Equity (Credits)

Balance Sheet Example

ASSETS LIABILITIES AND EQUITYCurrent Assets Current Liabilities Cash 29,221.46$ Accounts Payable 3,759.90$ Accounts Recievable 11,950.10 Notes Payable 5,000.00 Inventory 26,191.45 Accrued Wages Payable 3,800.00 Prepaid Expenses 2,013.89 Accrued Taxes Payable 1,200.00 Total Current Assets $69,376.90 Total Current Liabilities $13,759.90

Fixed Assets Long-Term Liabilities Gross Property and Equipment 85,000.00$ Mortgage on Building 54,420.00$ Less: Accum. Depreciation 31,602.60 Total Long-Term Liabilities 54,420.00$ Net Property and Equipment 53,397.40 Land 7,000.00 Owner's Equity

Total Long-Term Assets 60,397.40$ Paid-in-Capital 50,000.00$ Retained Earnings 11,594.40 Total Owner's Equity 61,594.40$

Total Assets $129,774.30 Total Liabilities and Owner' Equity $129,774.30

Balance Sheet for Fiscal Year ending December 31, 2013Coastal Marine Services


INCOME STATEMENT

A. The income statement gives information relating to the firm’s Revenues and Expenses for the last accounting (fiscal) period.

B. The I/S is frequently called the P&L (Profit and Loss).

C. The most important use is for determining how profitably a business is operating.

D. Revenues have Credit Balances and Expenses have Debit Balances.

Income Statement Example

Total Revenue 224,000$ Cost of Goods Sold 140,200$ Gross Profit 83,800 Overhead Expenses 15,230 Operating Income 68,570 Depreciation Expense 2,179 Earnings Before Interest & Taxes 66,391 Interest Expense 5,052 Net Profit 61,339

Coastal Marine SuppliesIncome Statement for Fiscal Year ending December 31, 2013

Income Statement (Sole Prop.)Revenues

- Cost of Goods SoldLabor + Materials

= Gross Profit- Overhead Expenses

Utilities, rent, advertising, etc.= Operating Profits (= EBITDA)

- Depreciation Expense (non-cash!)= Earnings before Interest & Taxes (EBIT)

- Interest Expense= Net Income or Net Profit


STATEMENT OF CASH FLOWSA. The statement of cash flows shows the

financial analyst, stockholder, or other interested parties where the firm’s cash came from and how it was used.

B. The firm has 3 possible Sources & Uses of Cash:1. Operating Activity (profits from sales)2. Financing activity (borrowing)3. Investing activity (buying/selling assets)


STATEMENT OF CASH FLOWS A.Cash Flows from Operating Activities;

1. Net income; what's left after expenses and taxes.

2. Adjustments to determine operating cash flows;a. + Depreciation expense; (a non-cash

expense)b. - Increases in current asset accounts.c. + Decreases in current asset accounts.d. + Increases in current liability accounts.e. - Decreases in current liability accounts.

3. Net cash flows from operating activities.


STATEMENT OF CASH FLOWSB. Cash Flows from Investing Activities;

1. - Increases in investments (buying securities).

2. + Decreases in investments (selling securities).

3. + Interest/dividends received from investments.

4. - Increases in plant, property, and equipment

5. + Decreases in plant, property, and equipment.

6. = Net cash flows from investing activities.


STATEMENT OF CASH FLOWS

C. Cash Flows from Financing Activities1. - Payments of interest on debt2. Net cash flows from financing activities.

D. Net change cash @ End of Year 1. Minus Owner’s Draw2. Change in Cash Balance from last year

FINANCIAL RATIO ANALYSISA. The objective of financial ratio analysis

(FRA) is to direct owner-manager attention to areas of concern in the financial performance of the business.

B. Five Areas of Owner/manager Focus1. Liquidity Management2. Asset Management3. Debt Management4. Profitability5. Investment Performance

Liquidity Management

A. Liquidity ratios measure the business's ability to pay their bills.1. Current Ratio

CR = Current Assets Current LiabilitiesRule of Thumb: best when greater than 2 times

2. Quick RatioQR = (Current Assets – Inventory) ÷ Current Liab.Rule of Thumb: should be at least 1:1

3. Cash Ratio (the most critical measure)CR = Cash ÷ Current LiabilitiesCritical ratio for businesses with little access to borrowing. Must be able to pay suppliers!

Asset Management

A. Asset utilization ratios measure the efficiency of asset management. We want just enough to support the current level of sales and maybe a little room to grow.1. Days Sales Outstanding (DSO)

DSO = A/R average credit sales per dayHow many days does it take to collect money owed to the business?

2. Inventory Turnover (ITO)ITO = Cost of Goods Sold ÷ [Average] InventoryWe want to turnover inventories as quickly as possible – increases profitability while minimizing the amount of capital tied up in inventory.

Asset Management

3. Total Asset Turnover (TATO)TATO = net sales total assetsAre we the right size? Too little means growth is tough. Too much means capital is inefficiently invested. Should be close to 1:1

4. Fixed Asset Turnover (FATO)FATO = net sales net fixed assetsNet means after subtracting accumulated depreciation. Best estimate is 0.5 to 1.

Debt Management

A. Debt Management or Leverage ratios are designed to measure the extent to which Debt is used to finance assets. 1. Debt Ratio (DR)

DR = total debt total assetsThe rule of thumb for small businesses has never been really set. However, unlike large businesses, it should be significantly less than 50%. Otherwise, a significant portion of your profits will go to the bank as interest.

Debt Management

2. Times Interest Earned (TIE)TIE = Operating Income Interest ExpenseLenders are interested in this value since the ability to pay interest on borrowed funds is captured by this ratio. A high ratio is preferred to a low one. The general R of T is at least 3 to 4 times.

3. Fixed Charge Coverage (FCC)FCC = (Interest Expenses + Lease Expenses) ÷ EBITLease expenses, like interest expenses, must be paid if the leased assets are to continue in the possession of the lessee. You want this ratio to be greater than 3:1.

PROFITABILITY RATIOS

A. The ability of a business to generate profits is a function of two major factors. The first is sales revenues and the second is cost control.1. Gross Profit Margin (GPM)

GPM = Gross Profit Net SalesThe gross profit margin ratio measures how many cents of every sales dollar is consumed by labor and materials.

2. Operating Profit Margin (OPM)OPM = Operating Income Net SalesThe OPM ratio measures how much of each sales dollar remains after covering all the operating expenses of the business.

PROFITABILITY RATIOS

3. Net Profit Margin (NPM)NPM = net income net salesNPM is a direct measure of how much of every sales dollar results in [accounting method] profits

INVESTMENT PERFORMANCEA. The two concepts covered in this

section, return on assets and return on equity, are really are measures of how well our business is generating a return on our investment.1. Return on Investment (ROI)

ROA = net income total assetsROA is a measure of gross investment efficiency. If we consider the total investments in the assets of the business like money in the bank, ROA is akin to a rate of interest earned on that investment.

INVESTMENT PERFORMANCE

2. Return on Owner’s Equity (ROE)ROE = net income owner’s equityThe reason for this ratio is that owner’s want to determine the return they are earning on their "equity" or the portion of the business they own, net of liabilities.

3. Basic Earning Power (BEP)BEP = EBIT Total AssetsThe BEP ratio measures the effectiveness of the business in generating income from its asset investment.

DUPONT SYSTEM OF FINANCIAL ANALYSIS

A. The DuPont System was developed as a methodology to improve the usefulness of financial ratio analysis. It is a guide to the management options available to remedy poor financial performance.

B. The DuPont system divides the business into two focus areas; Cost Control and Capital Structure. Cost control is concerned with operating and non-operating expenses. Capital structure addresses the use of debt to finance assets.

DUPONT SYSTEM OF FINANCIAL ANALYSIS

A. The Basic DuPont Relationship1. ROA = Net Income (NI) / Total Assets

(TA)2. ROE = Net Income / Owner’s equity

(OE)3. ROE = ROA x Equity Multiplier (EM)4. EM can be rewritten as TA/OE5. ROA = (NI/Net Sales) * (Net Sales/TA)6. We can then write that:

ROE = x x = ROE is a function of cost control (NI/NS), asset management (NS/TA) and debt management (TA/OE).

HOMEWORK QUESTIONS

1. Do high current and quick ratios always indicate that the business is effectively managing its liquidity position? Explain

2. What does a low inventory turnover ratio tell us about the business’ managing of inventory?

3. Which asset management ratios address the ability to manage credit extended to customers?

4. Most small business have a times interest earned ratio in the 4 to 5 times range. How do we interpret that ratio?

5. Most small businesses have total asset turnover (TATO) ratios greater than 2 times. Is a business okay with a TATO ratio of 1 time?

6. How do we interpret a Gross Profit Margin of 46%?

HOMEWORK QUESTIONS

7. The DuPont System defines a specific relationship between ROA, ROE, and debt leverage. Explain.

8. Name two strategies that the owner can use to increase a low current ratio?

9. If a business borrows money, what is the immediate effect on the Current ratio?

10. If it uses that money to pay its suppliers, what effect does it have on the Current ratio?

11. Ryngard's Custom Furniture sales last year were $38,000, and its total assets were $16,000. What was its total assets turnover ratio (TATO)?

12. Ajax Giro's sales last year were $435,000, its operating costs were $362,500, and its interest charges were $12,500. What was the firm's times-interest-earned (TIE) ratio?

HOMEWORK QUESTIONS

13. Royce Business Supply’ sales last year were $280,000, and its net income was $32,000. What was its net profit margin?

14. Eden Gardens Nursery’s total assets last year were $175,000. It’s net income was $38,500. What was its basic earning power ratio (BEP)?

HOMEWORK PROBLEMBalance Sheet: Franco’s Pizzeria for FY ending 12-

31-2103Assets 2013 Cash and securities $ 2,500 Accounts receivable 11,500 Inventories 16,000 Total current assets $30,000 Net plant and equipment $20,000 Total assets $50,000

Liabilities and Equity Accounts payable $ 9,500 Notes payable 7,000 Accruals 5,500 Total current liabilities $22,000 Vehicle Loan $15,000 Total Debt $37,000 Owner’s equity $ 2,000 Retained earnings 11,000 Total owner’s equity $13,000 Total liabilities and equity $50,000

HOMEWORK PROBLEM

Income Statement: Franco’s Pizzeria for FY ending 12-31-2103

Income Statement: Franco’s Pizzeria for FY ending 12-31-2103 Net sales $87,500 Operating costs except depreciation 81,813 Depreciation 1,531 Earnings before interest and taxes (EBIT) $ 4,156 Less interest 1,375 Earnings before taxes (EBT) $ 2,781 Taxes 973 Net income $ 1,808

HOMEWORK PROBLEM

A. Compute the following ratios for Franco’s business:1. Current ratio:

___________________________________2. Quick ratio:

_____________________________________3. Days Sales Outstanding? (Assume a

365-day year) ________________________4. Inventory Turnover:

___________________________5. Total Asset Turnover:

__________________________6. Debt Ratio:

_________________________________

HOMEWORK PROBLEM

7. ROA: ______________________________________

8. ROE: _______________________________________

9. Gross Profit Margin: _______________________

10.Operating Profit margin: ________________________

11.Net Profit margin: _____________________________

12.The Equity Multiplier: _________________________

Documents

FINANCIAL STATEMENTS Chapter 3 Balance Sheet Income Statement Statement of Cash Flows