Financial Accounting
Fall, 2021
Lecture 2
A Further Look at Financial Statements
Assistant Prof. Dr. Ibrahim MERT
Istanbul Aydin University
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Agenda
• The Classified Balance Sheet
- Current Assets
- Long-Term Investments
- Property, Plant, and Equipment
- Intangible Assets
- Current Liabilities
- Long-Term Liabilities
- Stockholders’ Equity
• Using the Financial Statements
- Ratio Analysis
- Using the Income Statement
- Using the Statement of Stockholders’ Equity
- Using a Classified Balance Sheet
- Using the Statement of Cash Flows
• Financial Reporting Concepts
- The Standard-Setting Environment
- Cost Constraint
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1. The Classified Balance Sheet
A classified balance sheet groups similar assets and similar
liabilities by using some standard classifications and
sections.
This is useful for analyses because items within a group have
similar economic characteristics.
Standard balance sheet classification:
Assets
Current (Short-term) assets
Long-lived assets
- Long-term investments
- Property, plant, and equipment
- Intangible assets
Liabilities and Stockholders’ Equity
Current (Short-term) liabilities
Long-term liabilities
Stockholders’ equity
These groupings help financial statement readers determine:
(1) whether the company has enough assets to pay its short- and longterm debts as they come due, and
(2) how much are the claims of short- and long-term creditors on the
company’s total assets.
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1. The Classified Balance Sheet
XYZ Corporation
Balance Sheet
30-Nov-17
Assets
Current assets
Cash
Debt investments
Account receivable
Notes receivable
Inventory
Supplies
Prepaid insurance
Total current assets
Long-term assets
Stock investments
Investment in real estate
Property, plant, and equipment
Land
Equipment
24,000
Less: Accumulated
Depreciat.-Equipment 5,000
Intangible assets
Patents
Total long-term assets
Total assets
Liabilities and Stockholders' Equity
Current liabilities
Notes payable
Accounts payable
Unearned sales revenue
Salaries and wages payable
Interest payable
Total current liabilities
Long-term liabilities
Mortgage payable
Notes payable
Total current liabilities
Total liabilities
Stockholders' equity
Common stock
Retained earnings
Total stockholders' equity
Total liabilities and stockholders' equity
$6,600
2,000
7,000
1,000
3,000
2,100
400
$22,100
5,200
2,000
10,000
19,000
3,100
$39,300
$61,400
$11,000
2,100
900
1,600
450
16,050
10,000
1,300
11,300
27,350
14,000
20,050
34,050
61,400
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1. The Classified Balance Sheet
CURRENT ASSETS: CAs are assets that a company expects to
convert into cash, sell or consume (use up) within one year or
its operating cycle, whichever is longer.
XYZ Corporation
Balance Sheet
30-Nov-17
Assets
Current assets
Cash
Debt investments
Account receivable
Notes receivable
Inventory
Supplies
Prepaid insurance
Total current assets
$6,600
2,000
7,000
1,000
3,000
2,100
400
$22,100
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1. The Classified Balance Sheet
LONG-TERM ASSETS: LTAs are assets that a company expects
to convert into cash or consume (use up) more than one year.
Long-term investments:
(1) Stocks and bonds of other corporations that are held for
more than one year,
(2) Lands or buildings that are held for speculative purpose and
NOT currently in use for a company’s operating activities, and
(3) Long-term notes receivables.
Property, plant, and equipment: PPEs are assets with
relatively long useful lives that are currently used in operating
activities of the business. This category includes lands,
buildings, equipment, delivery vehicles, and furnitures.
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LONG-TERM ASSETS:
Depreciation is the allocation of the cost of an asset to a number of years.
The accumulated depreciation shows the total amount of depreciation that the
company has expensed in the asset’s life.
Tangible Assets: TAs has physical substance (existence).
Intangible Assets: IAs do NOT have physical substance (existence) but may be
very valuable (e.g. goodwill).
XYZ Corporation
Balance Sheet
30-Nov-17
Long-term assets
Stock investments
Investment in real estate
Property, plant, and equipment
Land
Equipment
24,000
Less: Accumulated
Depreciat.-Equipment 5,000
Intangible assets
Patents
Total long-term assets
Total assets
5,200
2,000
10,000
19,000
3,100
$39,300
$39,300
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1. The Classified Balance Sheet- Total Assets
XYZ Corporation
Balance Sheet
30-Nov-17
Assets
Current assets
Cash
Debt investments
Account receivable
Notes receivable
Inventory
Supplies
Prepaid insurance
Total current assets
Long-term assets
Stock investments
Investment in real estate
Property, plant, and equipment
Land
Equipment
24,000
Less: Accumulated
Depreciat.-Equipment 5,000
Intangible assets
Patents
Total long-term assets
Total assets
$6,600
2,000
7,000
1,000
3,000
2,100
400
$22,100
5,200
2,000
10,000
19,000
3,100
$39,300
$61,400
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1. The Classified Balance Sheet
CURRENT LIABILITIES: CLs are obligations that the company is to pay or
performed within one year or its operating cycle, whichever is longer.
XYZ Corporation
Balance Sheet
30-Nov-17
Liabilities and Stockholders' Equity
Current liabilities
Notes payable
Accounts payable
Unearned sales revenue
Salaries and wages payable
Interest payable
Total current liabilities
$11,000
2,100
900
1,600
450
16,050
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1. The Classified Balance Sheet
LONG-TERM LIABILITIES: LTLs are obligations that a company expects to
pay more than one year later.
XYZ Corporation
Balance Sheet
30-Nov-17
Liabilities and Stockholders' Equity
Long-term liabilities
Mortgage payable
Notes payable
Total long-term liabilities
10,000
1,300
11,300
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1. The Classified Balance Sheet-TOTAL LIABILITIES
XYZ Corporation
Balance Sheet
30-Nov-17
Liabilities and Stockholders' Equity
Current liabilities
Notes payable
Accounts payable
Unearned sales revenue
Salaries and wages payable
Interest payable
Total current liabilities
Long-term liabilities
Mortgage payable
Notes payable
Total long-term liabilities
Total liabilities
$11,000
2,100
900
1,600
450
16,050
10,000
1,300
11,300
27,350
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1. The Classified Balance Sheet
SHAREHOLDERS’ EQUITY: SHE consists of two parts:
Paid-in Capital (Common stock + Preferred Stock) is the investments of
assets into the business by the stockholders (investors, owners).
Retained earnings are the income (profit) retained for use in the business.
XYZ Corporation
Balance Sheet
30-Nov-17
Liabilities and Stockholders' Equity
Stockholders' equity
Common stock
Retained earnings
Total stockholders' equity
14,000
20,050
34,050
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1. The Classified Balance Sheet
LIABILITIES and STOCKHOLDERS’ EQUITY:
XYZ Corporation
Balance Sheet
30-Nov-17
Liabilities and Stockholders' Equity
Current liabilities
Notes payable
Accounts payable
Unearned sales revenue
Salaries and wages payable
Interest payable
Total current liabilities
Long-term liabilities
Mortgage payable
Notes payable
Total long-term liabilities
Liabilities and Stockholders' Equity
Stockholders' equity
Common stock
Retained earnings
Total stockholders' equity
Total liabilities and stockholders' equity
$11,000
2,100
900
1,600
450
16,050
10,000
1,300
11,300
14,000
20,050
34,050
61,400
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2. Using the Financial Statements
2.1. Ratio Analysis
A ratio expresses the mathematical relationship between one quantity and
another.
RA expresses the relationship among selected items of financial statement
data.
1) Profitability Ratios: Measure the income or operating success of a
company for a given period of time.
2) Liquidity Ratios: Measure short-term ability of the company to pay its
maturing obligations and to meet unexpected needs for cash.
3) Solvency Ratios: Measure the ability of the company to survive over a
long period of time, meaning, the ability of paying all debts.
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2.1.1. Profitability Ratios:
Margin Ratios: MRs represent the company’s ability to
convert revenues into profits (income):
Main Margin Ratios:
• Gross Profit (income) Margin,
• Operating Profit (income) Margin, and
• Net Profit (income) Margin,
Other Ratios: Cash Flow Margin, EBIT Margin, EBITDA Margin, EBITDAR, NOPAT, Operating
Expense Ratio, and Overhead Ratio.
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2.1.1. Profitability Ratios-Margin Ratios
Net Revenues
$14,500 Gross Income Margin=
COGS
(8,400) Gross Income / Net Revenues x 100
Gross Income
6,100
6,100 / 14,500 = 42.0%
Selling, General &Adm. Exp.
(1,850)
Research & Development Exp.
(950) Operating Income Margin=
Depreciation/Amortization
(300) Operating Income/Net Revenuex100
Extraordinary (Unusual) Exp.
(150)
2,850 / 14,500 = 19,7%
Other Operating Exp.
0
.
Operating Income
2,850
Net Income Margin=
Interest Expense
(100) Net Income / Net Revenue x 100
Income Before Tax
2,750
2,063 / 14,500 = 14.2%
Income Tax
687
Income After Tax (Net Income)
2,063
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2.1.1. Profitability Ratios-Return Ratios
Return Ratios: RRs represent the company’s ability
to generate returns to its shareholders.
Main Return Ratios:
• Return-on assets (ROA)
• Return-on equity (ROE),
Other Ratios: cash return on assets, return on debt, return on retained earnings, return on
revenue, risk-adjusted return, return on invested capital (ROIC), and return on capital
employed.
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2.1.1. Profitability Ratios-Return Ratios
Return-on assets (ROA)
Net Income
$10,000
Assets at the beginning of the period 14,000
Assets at the end of the period
16,000
Average Assets
15,000
ROA = Net Income / Average Assets = 10,000 / 15,000 = 67%
Return-on equity (ROE)
Net Income
$20,000
Equity at the beginning of the period 15,000
Equity at the end of the period
21,000
Average Equity
18,000
ROE = Net Income / Average Shareholders’ Equity = 20,000 / 18,000 = 111%
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2. Using the Financial Statements
2.2. Using the Income Statement
 The income statement reports how successful a company is at generating
a profit from its revenues.
 The income statement reports the amount earned during the period
(revenues) and the costs incurred during the period (expenses).
Earnings per share (EPS), measures the net income earned on each
share of common stock .
(in million)
2011
Net Income
$1,300
Preferred dividends
0
Shares outstanding at the beginning of year 420
Shares outstanding at the end of year
390
2010
$1,500
0
410
420
Earnings per Share (EPS)=
(Net Income – Preferred Dividends) / Average Common Shares Outstanding
2011
($1,300-$0)/((420+390)/2) = 3.2
2010
.
($1,500-$0)/((410+420)/2) = 3.6
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2.3. Using the Statement of Stockholders’ Equity
 Stockholders’ equity is comprised of two parts: paid-in capital and
retained earnings.
 Paid-in capital is concluded with common stock and preferred stock
(capital invested by the investors).
 The retained earnings statement describes the changes in retained
earnings during the year.
 This statement adds net income to beginning retained earnings and then
subtracts dividends to arrive at ending retained earnings.
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2.3. Using the Statement of Stockholders’ Equity
Changes on stockholders’ equity:
 Common stock increased in
the first year as the result of
an issuance of shares.
 Common stock decreased
In the second year.
Even though it had an
issuance of common stock
that increase was much
smaller than the decrease
caused by a stock repurchase.
 XYZ paid dividends each year.
XYZ Corporation
Statement of Stockholders' Equity
(in millions)
Balances at February 28, 2015
Issuance of common stock
Net income
Dividends
Other Adjustments
Balances at February 28, 2016
Issuance of common stock
Repurcchase of common stock
Net income
Dividends
Other Adjustments
Balances at February 28, 2017
Nr. of Common Retained
Stock
Earnings
246
$4,397
237
1,317
-234
1,001
483
$6,481
303
-729
1,277
-238
-285
57
$7,235
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2.4. Using a Classified Balance Sheet
Balance Sheet: XYZ Corp. Balance Sheet as of Feb 26, 2011
.
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2.4. Using a Classified Balance Sheet
Liquidity Ratios
Liquidity is a company’s ability to pay obligations expected to become due
within the next year or operating cycle.
Liquidity ratios measure the short-term ability of the company to pay its
maturing obligations and to meet unexpected needs for cash.
Bankers to give credit, or suppliers to sell products would look closely at the
relationship of its current assets and current liabilities.
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2.4. Using a Classified Balance Sheet
Liquidity Ratios
Working Capital: One measure of liquidity is working capital, which is the
difference between current assets and current liabilities:
Working Capital = Current Assets – Current Liabilities
When current assets exceed current liabilities, working capital is positive.
When this occurs, there is greater likelihood that the company will pay its
liabilities.
When working capital is negative, a company might NOT be able to pay
short-term creditors, and the company might ultimately be forced into
solvency (bankruptcy).
XYZ had working capital in 2011 of $1,810 million ($10,473 million - $8,663
million).
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2.4. Using a Classified Balance Sheet
Liquidity Ratios
Current Ratio: CR is computed as current assets divided by current
liabilities.
Current Ratio = Current Assets / Current Liabilities
The CR is a more dependable indicator of liquidity than working capital.
XYZ Corp. ($ in millions)
ABC Corp.
Industry Average
Meanings of results: XYZ’s 2011 current ratio of 1.21:1 means that for every
dollar of current liabilities, XYZ has $1.21 of current assets.
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2.4. Using a Classified Balance Sheet
Solvency Ratios
Solvency: Solvency is the ability of a company to meet its long-term
financial obligations.
Long-term creditors and stockholders are interested in a company’s
solvency—its ability to pay interest as it comes due and to repay the balance
of a debt due at its maturity.
Solvency ratios measure the ability of the company to survive over a long
period of time.
DEBT-TO-ASSETS RATIO: The DTAR is one measure of solvency.
It is calculated by dividing total liabilities (both current and long-term) by total
assets.
It measures the percentage of total financing provided by creditors rather than
stockholders.
Debt financing is more risky than equity financing because debt must be repaid at
specific points in time, whether the company is performing well or not.
The higher the percentage of debt financing, the riskier the company.
Debt-to-Assets Ratio = Total Debt / Total Assets
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2.4. Using a Classified Balance Sheet
Solvency Ratios
DEBT TO ASSETS RATIO
XYZ Corp. ($ in millions)
ABC Corp. Industry Avrg.
The 2011 ratio of 59% means that every dollar of assets was financed by 59
cents of debt.
XYZ’s ratio exceeds the industry average of 57% and is significantly higher than
ABC’s ratio of 42%.
The higher the ratio, the more reliant the company is on debt financing. This
means the company has a lower equity “buffer” available to creditors if the
company becomes insolvent. Thus, from the creditors’ point of view, a high ratio
of debt to assets is undesirable.
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2.5. Using Cash Flow Statement
 In the statement of cash flows, net cash provided by operating activities is
intended to indicate the cash-generating capability of the company.
 However, net cash provided by operating activities fails to take into
account that a company must invest in new property, plant, and
equipment (capital expenditures) just to maintain its current level of operations.
 Companies also must at least maintain dividends at current levels to
satisfy investors.
Free cash flow describes the net cash provided by operating activities after
adjusting for capital expenditures and dividends paid.
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2.5. Using Cash Flow Statement
Free Cash Flow = Net Cash Provided by Operating Activities –
Capital Expenditures – Cash Dividends
For example: A company produced and sold 10,000 pc.
It reported $100,000 net cash provided by operating activities.
 In order to maintain production at 10,000 pc, the company invested $15,000
in equipment.
 It also decided to pay $5,000 in dividends.
Its free cash flow was $80,000 (=$100,000 - $15,000 - $5,000).
Net cash provided by operating activities
$100,000
Less: Expenditures on property, plant, and equipment -15,000
Less: Dividends paid
-5,000
Free cash flow
$80,000
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3. Financial Reporting Concepts
3.1. The Standard-Setting Environment
- The type of financial information to disclose?
- What format to use?
- How to measure assets, liabilities, revenues, and expenses?
 The International Accounting Standards Board (IASB) issues standards
called International Financial Reporting Standards (IFRS),
 All companies in Turkey get guidance from a set of accounting standards that
have authoritative support, referred to as generally accepted accounting
principles (GAAP).
 The Capital Markets Board (CMB) is the agency of Turkey that oversees
Turkish financial markets and accounting standard-setting bodies.
 The Accounting and Auditing Standards Board (AASB) is the primary
accounting standard-setting body in Turkey.
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3.2. Cost Constraint
 Providing information is costly.
 Cost constraints means that the cost of the information
shouldn’t be more than the expected benefit.
 In deciding whether companies should be required to provide a
certain type of information, accounting standard-setters consider
the cost constraint.
 It weighs the cost that companies will incur to provide the
information against the benefit that financial statement users will
gain from having the information available.
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