FINANCIAL STATEMENTS
Chapter 4
Balance Sheet
Income Statement
Statement of Cash Flows
Dr. David P. Echevarria
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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 Statements
1. Income Statement
2. Balance Sheet
C. Two additional financial statements
1. Statement of Cash Flows
2. Statement of changes in owner equity
Dr. David P. Echevarria
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Finance from a Personal Viewpoint
A. All us own things and owe money
B. 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 + Equity
5. Savings are the difference between what we
earn and what we consume: S = E – C
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Balance Sheet
A. The Balance Sheet answers two general questions:
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 suppliers
d. Later: Reinvesting a portion of profits in the business
1.
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The Asset Accounts
A. Current Assets (in order of liquidity)
1.
2.
3.
4.
Cash
Receivables
Inventory
Prepaid Expenses
B. Fixed or Long-Term Assets
1. Plant (buildings)
2. Property (land)
3. Equipment (computers to trucks)
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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
Dr. David P. Echevarria
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The Liability Accounts
A. Short-Term or Current Liabilities
1. Payables
a. Employees
b. Trade and other Creditors
c. Tax authorities
2. Current portion of Long-term debt
B. Long-term Liabilities
1. Mortgages
2. SBA loans (typ. 5 to 7 years max. with
exceptions)
C. Liability accounts carry Credit Balances
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The Equity Accounts
A. Owner’s Capital
1. Owner’s Equity
2. Owner’s Draw
3. Retained Earnings
B. Equity accounts carry Credit Balances
C. The Accounting Equation
Assets (Debits) = Liabilities + Equity (Credits)
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Balance Sheet Example
Coastal Marine Services
Balance Sheet for Fiscal Year ending December 31, 2013
ASSETS
Current Assets
Cash
Accounts Recievable
Inventory
Prepaid Expenses
Total Current Assets
$ 29,221.46
11,950.10
26,191.45
2,013.89
$69,376.90
Fixed Assets
Gross Property and Equipment
Less: Accum. Depreciation
Net Property and Equipment
Land
Total Long-Term Assets
$ 85,000.00
31,602.60
53,397.40
7,000.00
$ 60,397.40
Total Assets
$129,774.30
Dr. David P. Echevarria
LIABILITIES AND EQUITY
Current Liabilities
Accounts Payable
Notes Payable
Accrued Wages Payable
Accrued Taxes Payable
Total Current Liabilities
$
3,759.90
5,000.00
3,800.00
1,200.00
$13,759.90
Long-Term Liabilities
Mortgage on Building
Total Long-Term Liabilities
$ 54,420.00
$ 54,420.00
Owner's Equity
Paid-in-Capital
Retained Earnings
Total Owner's Equity
$ 50,000.00
11,594.40
$ 61,594.40
Total Liabilities and Owner' Equity $129,774.30
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INCOME STATEMENT
A. The income statement gives information
relating to the firm’s Revenues and Expenses
for the last accounting (fiscal) period.
B. The I/S is frequently called the P&L (Profit
and Loss).
C. The most important use is for determining
how profitably a business is operating.
D. Revenues have Credit Balances and
Expenses have Debit Balances.
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Income Statement Example
Coastal Marine Supplies
Income Statement for Fiscal Year ending December 31, 2013
Total Revenue
Cost of Goods Sold
Gross Profit
Overhead Expenses
Operating Income
Depreciation Expense
Earnings Before Interest & Taxes
Interest Expense
Net Profit
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$ 224,000
$ 140,200
83,800
15,230
68,570
2,179
66,391
5,052
61,339
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Income Statement (Sole Prop.)
Revenues
- Cost of Goods Sold
Labor + 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
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STATEMENT OF CASH FLOWS
A. 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)
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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.
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Chapter 3
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Page 14
STATEMENT OF CASH FLOWS
B. 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.
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Chapter 3
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Page 15
STATEMENT OF CASH FLOWS
C. Cash Flows from Financing Activities
1. - Payments of interest on debt
2. Net cash flows from financing activities.
D. Net change cash @ End of Year
1. Minus Owner’s Draw
2. Change in Cash Balance from last year
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Chapter 3
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Page 16
FINANCIAL RATIO ANALYSIS
A. 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 Focus
1.
2.
3.
4.
5.
Liquidity Management
Asset Management
Debt Management
Profitability
Investment Performance
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Liquidity Management
A. Liquidity ratios measure the business's
ability to pay their bills.
1. Current Ratio
CR = Current Assets  Current Liabilities
Rule of Thumb: best when greater than 2 times
2. Quick Ratio
QR = (Current Assets – Inventory) ÷ Current Liab.
Rule of Thumb: should be at least 1:1
3. Cash Ratio (the most critical measure)
CR = Cash ÷ Current Liabilities
Critical ratio for businesses with little access to
borrowing. Must be able to pay suppliers!
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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 day
How many days does it take to collect money owed to the
business?
2. Inventory Turnover (ITO)
ITO = Cost of Goods Sold ÷ [Average] Inventory
We want to turnover inventories as quickly as possible –
increases profitability while minimizing the amount of
capital tied up in inventory.
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Asset Management
3. Total Asset Turnover (TATO)
TATO = net sales  total assets
Are 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 assets
Net means after subtracting accumulated
depreciation. Best estimate is 0.5 to 1.
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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 assets
The 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.
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Debt Management
2. Times Interest Earned (TIE)
TIE = Operating Income  Interest Expense
Lenders 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) ÷ EBIT
Lease 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.
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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 Sales
The 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 Sales
The OPM ratio measures how much of each sales dollar
remains after covering all the operating expenses of the
business.
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PROFITABILITY RATIOS
3. Net Profit Margin (NPM)
NPM = net income  net sales
NPM is a direct measure of how much of every
sales dollar results in [accounting method] profits
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INVESTMENT PERFORMANCE
A. 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 assets
ROA 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.
Dr. David P. Echevarria
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INVESTMENT PERFORMANCE
2. Return on Owner’s Equity (ROE)
ROE = net income  owner’s equity
The 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 Assets
The BEP ratio measures the effectiveness of the
business in generating income from its asset
investment.
Dr. David P. Echevarria
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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 nonoperating expenses. Capital structure addresses the
use of debt to finance assets.
Dr. David P. Echevarria
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DUPONT SYSTEM OF FINANCIAL ANALYSIS
A. The Basic DuPont Relationship
1.
2.
3.
4.
5.
6.
ROA = Net Income (NI) / Total Assets (TA)
ROE = Net Income / Owner’s equity (OE)
ROE = ROA x Equity Multiplier (EM)
EM can be rewritten as TA/OE
ROA = (NI/Net Sales) * (Net Sales/TA)
We can then write that:
𝑵𝑰
𝑵𝑺
𝑻𝑨
𝑵𝑰
ROE = x x
=
𝑵𝑺 𝑻𝑨 𝑶𝑬 𝑶𝑬
ROE is a function of cost control (NI/NS), asset
management (NS/TA) and debt management
(TA/OE).
Dr. David P. Echevarria
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HOMEWORK QUESTIONS
1.
2.
3.
4.
5.
6.
Do high current and quick ratios always indicate that the
business is effectively managing its liquidity position? Explain
What does a low inventory turnover ratio tell us about the
business’ managing of inventory?
Which asset management ratios address the ability to manage
credit extended to customers?
Most small business have a times interest earned ratio in the 4
to 5 times range. How do we interpret that ratio?
Most small businesses have total asset turnover (TATO) ratios
greater than 2 times. Is a business okay with a TATO ratio of 1
time?
How do we interpret a Gross Profit Margin of 46%?
Dr. David P. Echevarria
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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?
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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)?
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HOMEWORK PROBLEM
Balance Sheet: Franco’s Pizzeria for FY ending 12-31-2103
Assets
Cash and securities
Accounts receivable
Inventories
Total current assets
Net plant and equipment
Total assets
Dr. David P. Echevarria
2013
$ 2,500
11,500
16,000
$30,000
$20,000
$50,000
Liabilities and Equity
Accounts payable
Notes payable
Accruals
Total current liabilities
Vehicle Loan
Total Debt
Owner’s equity
Retained earnings
Total owner’s equity
Total liabilities and equity
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$ 9,500
7,000
5,500
$22,000
$15,000
$37,000
$ 2,000
11,000
$13,000
$50,000
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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
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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: _________________________________
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HOMEWORK PROBLEM
7. ROA: ______________________________________
8. ROE: _______________________________________
9. Gross Profit Margin: _______________________
10. Operating Profit margin: ________________________
11. Net Profit margin: _____________________________
12. The Equity Multiplier: _________________________
Dr. David P. Echevarria
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35