Understanding the Financial Statements

(c) 2001 Contemporary Engineering Economics

1www.izmirekonomi.edu.tr

Asst. Asst. Prof. Dr. Prof. Dr. Mahmut Ali Mahmut Ali GÖKÇE, Izmir University of EconomicsGÖKÇE, Izmir University of Economics

SpringSpring, 2007, 2007

Understanding the Financial Statements

(c) 2001 Contemporary Engineering Economics www.izmirekonomi.edu.tr



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Chapter 13Understanding Financial Statements Accounting: The

Basis of Decision-Making

Financial Statements: Financial Status for Businesses

Financial Ratios: Using Ratios to Make Business Decisions




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Chapter Opening Story – WorldCom’s False Reporting

Accounting Rule Says:Operating expenses should be expensed during the yearthey incur. What WorldCom Did:Operating expenses are capitalized by spreading them over 7 years, just like capital expenditure.




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Result: WorldCom Reports “Profit” instead of “Loss”




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A. Why Engineers need to understand the financial statements?




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Accounting – The Language of Business




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Financial Status for Business




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B. Understanding the Balance Sheet

1. The basic accounting equation and the definition of capital

2. How to instantly determine liquidity and too much debt

3. How the firm gets equity: only two ways




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The Basic Accounting Equation

For the Balance Sheet Presentation

For the Financial Analysis

Assets - Liabilities = Owners’ Equity

Assets = Liabilities + Owners’ Equity




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How Items Are Arranged on the Balance Sheet

AssetsLiabilities

Owners’ Equity




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Using the Four Quadrants of the Balance Sheet and Why?

ASSETS LIABILITIES

Current Assets

Long-Term Assets

Current Liabilities

Long-Term Liabilities

Equity

=

1. Owner Contributions2. Retained Earnings




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How to Instantly Determine Liquidity and Too Much Debt Liquidity

Too Much Debt?

Current Ratio (2:1)

Debt To Equity Ratio




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Liquidity – Current Ratio

ASSETS LIABILITIES

Current Assets

Long-Term Assets

Current Liabilities


Equity1. Owner Contributions2. Retained Earnings




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Too Much Debt? – Debt to Equity Ratio

ASSETS LIABILITIES

Current Assets

Long-Term Assets

Current Liabilities


Equity1. Owner Contributions2. Retained Earnings

Deb

t




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How the Firm Gets Equity: Only Two Ways

Owners’ Contributions

Retained Earnings




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1. How to Use profit check points

2. Why gross margin is the critical measure for engineers?

3. How does inventory production impact profit?

C. Using the Income Statement to Manage a Business




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Basic Income Statement Equation

Revenue

Expenses

Net Income (Loss)

-




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Why Gross Margin is the Critical Measure for Engineers?

Sales

Cost of Goods Sold

Gross Margin




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How Inventory Production Impacts Profit

Calculating the Cost of Goods Sold

Beginning Inventory

+ Additions to Inventory

- Ending Inventory

Cost of Goods Sold




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How to Use Profit Check Points

ABC Company, Inc.

Statement of Operations (Year Ended December 31, 200x)

Sales $5,000,000 100.0%

Less: Cost of Goods Sold 3,250,000 65.0%

Gross Profit 1,750,000 35.0%

Less: Selling, G&A Expenses 1,000,000 20.0%

Operating Profit 750,000 15.0%

Less: Interest 250,000 5.0%

Net Income Before Taxes (NIBT) 500,000 10.0%

Less: Taxes 175,000 3.5%

Net Income $325,000 6.5%

Bottom line




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Operating Margin versus Net Margin

Net margin

Operatingmargin




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D. Understanding the Statement of Cash Flows




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1. The business operating cycle: How a business earns its cash

2. Sources and Uses of Cash

3. The engineer’s focus on the investing section: Capital Budgeting




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Shareholders

Fixed Assets

Debt holders

Inventory

Government

Customers

CASHFrom cash sales

To pay taxes

From creditsales

To pay labor,materials, and overhead

To pay interestand principal

From sale of debt

To purchase

From sale

To pay dividend, To purchase back shares

From saleof shares




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The Cash Flow – Business Cycle

Inventory

Production

Cash

Accountsreceivable

Fixed assets

CashSales

CreditSales

Collection ofreceivable

Investment

Depreciation

• Changes in equity• Changes in liabilities

• Pay taxes• Pay interest• Pay dividends

• Labor• Materials• Overhead




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Documents

Understanding the Financial Statements