FINANCIAL
MANAGEMENT
TH
BBA 5
BY: ABDUL MOUEED
PH.D. FINANCE
IBMS, UAF
LECTURE CONTENT
• Financial Reporting
• Financial Statements
• Interpreting Financial Statements
FINANCIAL REPORTING
• The objectives of financial reporting and identify the qualitative
characteristics, conventions, and ethical considerations of accounting
information.
• To provide financial information about the reporting entity that is useful
to present and potential equity investors, lenders, and other creditors in
making decisions in their capacity as capital providers.
• Information that is decision-useful to capital providers may also be
useful to other users of financial reporting who are not capital providers.
FINANCIAL REPORTING OBJECTIVES
Assess cash flow prospects.
Capital providers and other users need information to help make judgments
about the entity’s ability to general cash flows.
Assess stewardship.
Capital providers and others need information about the entity’s resources
(assets), claims against them (liabilities and stockholders’ equity) and
changes in these resources and claims as impacted by transactions (earnings
and cash flows) and other economic events.
FINANCIAL REPORTING
• Financial Statements
Balance sheet
Income statement
Statement of retained earnings
Statement of cash flows
Changes in equity statement
FINANCIAL STATEMENTS
• Management’s explanations and other information, including underlying
assumptions and significant uncertainties about methods and estimates used in
the financial reports, constitute important components of financial reporting by
an entity.
• Because of a potential conflict of interest between managers, who prepare the
statements, and investors or creditors, who invest in or lend money to the
business, financial statements are audited by outside accountants to ensure their
reliability.
• Window-dressing or Manipulation.
USERS OF FINANCIAL INFORMATION
• Managers
• Shareholders or current investors
• Potential investors
• Financial institutions
• Suppliers
• Customers
QUALITATIVE CHARACTERISTICS
• In practice, accounting information…
• Is neither simple nor precise
• Rarely satisfies all criteria
• Often results from approximate measures
• Based on rules and conventions rather than exact amounts
QUALITATIVE CHARACTERISTICS
• The goal of generating accounting information is to provide data to
different users for different needs.
• How this goal is achieved provides interest and controversy in
accounting.
• To facilitate interpretation, the FASB has developed qualitative
characteristics of accounting information.
• The most important or fundamental qualitative characteristics are
relevance and faithful representation.
QUALITATIVE CHARACTERISTICS
• Comparability: The quality that enables users to identify similarities
and differences between two sets of economic phenomena.
• Verifiability: The quality that helps assure users that information
faithfully represents what it purports to depict.
• Timeliness: The quality that enables the user to receive information in
time to influence a decision.
• Understandability: The quality that enables users to comprehend the
meaning of the information they receive.
ACCOUNTING CONVENTIONS
• Since financial statement are based largely on estimates, the application
of accounting rules for recognition and allocation are critical.
• To deal with these constraints, five conventions help in the preparation
and interpretation of financial statements. They are:
1. Consistency,
2. Materiality,
3. Conservatism,
4. Full Disclosure, and
5. Cost-Benefit.
CONSISTENCY
• Means constantly applying policies or principles
• Once an accounting procedure is adopted by a company, it must
remain in use from one period to another, unless users are
informed of a change.
• Users can assume that no arbitrary changes in accounting measures and
procedures have taken place when interpreting financial statements.
CONSISTENCY (CONT’D)
• Changes in accounting measures and procedures may become
necessary.
• Example:
• A method of accounting for inventory may be changed because it is believed that
the new method improves the matching of revenues and costs.
• Generally accepted accounting principles require that changes and
their dollar effects be described in the notes to the financial
statements.
FULL DISCLOSURE
• Requires that financial statements and their notes present all information relevant
to users
• Financial statements should offer explanations needed to keep them from being
misleading.
• Many disclosures are required by the SEC and other official bodies
• Other disclosures are based the judgment of
accountants.
management and the company
• If too much information is disclosed, the notes obstruct rather than help
understanding.
EXAMPLES OF REQUIRED DISCLOSURES
• Changes of accounting practices
• Amount of depreciation expense on income statement
• Amount of accumulated depreciation on the balance sheet
• Accounting procedures used in preparing financial statements
• Important terms of the company’s debt
• Commitments and contingencies (emergencies)
• Important events taking place after the date of the statements
MATERIALITY
• Refers to the importance of an item or event.
• Information is material if its omission or misstatement could influence the economic
decisions of users taken on the basis of the financial statements
• If an item is relevant to the decisions a user of financial statements makes, it is
material.
• Is normally determined by relating an item’s dollar value to an element of the financial
statements.
• Some accountants believe an item that is 5% or more of net income is relevant
• Depends on the nature of the item
• The discovery of a bribe or theft, no matter what the amount involved, is considered
material.
CONSERVATISM
• Means that when there is uncertainty about which accounting procedure to use,
the one that is least likely to overstate assets and income should be used
• Should be used only when uncertainty exists
• If used incorrectly, leads to incorrect and misleading financial statements
• A common application is use of the lower-of-cost-or-market method of
accounting for inventories
• If market value > cost, use cost
• If market value < cost, use market value
COST-BENEFIT
• The cost benefit principle holds that the cost of providing information via the
financial statements should not exceed its utility to readers.
• Information must meet minimum levels of reliance and reliability to
be useful.
• Beyond that, the FASB and SEC, who require information, and the
accountant, who provides information, must judge the costs and
benefits in each case.
COSTS AND BENEFITS
• Costs
• Fall at first on the preparation of financial statements
• Ultimately are passed on to society in the form of prices
• Benefits
• Gained by both the preparers and users of financial statements
• Ultimately are passed on to society in the form of social benefits from
more efficient allocation of resources
INTERPRETING FINANCIAL STATEMENTS
• Assets, liabilities, and stockholders’ equity sections are subdivided into useful
categories.
ASSETS
Current assets
Investments
Property, plant, and equipment
Intangible assets
LIABILITIES
Current liabilities
Long-term liabilities
STOCKHOLDERS’ EQUITY
Contributed capital
Retained earnings
• Most companies use similar subdivisions,
but subdivisions usually depend upon the
type of business
CURRENT ASSETS
• Cash and other assets that are reasonably expected to be converted to cash,
sold, or consumed within one year
• Or within the normal operating cycle of the business,
• Normal Operating Cycle
• The average time needed to go from cash to cash
• Spend cash to buy merchandise inventory
• Sell inventory on account
• Collect cash
• The normal operating cycle is usually less than one year
EXAMPLES OF CURRENT ASSETS
• Cash/bank
• Temporary investments
• Accounts receivable/debtors
• Inventory/stock
• Prepaid expenses
INVESTMENTS
1. Assets
2. Usually long-term,
3. Not used in the normal operation of the business
4. Management does not plan to convert to cash within the next
year
FIXED ASSETS
PROPERTY, PLANT, AND EQUIPMENT
• Includes long-term asset used in the continuing operation of the
business.
• These assets represent a place to operate (land and buildings)
• Equipment to produce, sell, deliver, and service the company’s
goods
PROPERTY, PLANT, AND EQUIPMENT
• Also called
• Operating assets
• Fixed assets
• Tangible assets
• Long-lived assets
• Plant assets
• The costs of these assets are depreciated
• Spread over the periods they benefit
• Past depreciation is recorded in the Accumulated Depreciation accounts
INTANGIBLE ASSETS
• Long-term assets that have no physical substance
• But have a value based on rights or privileges that belong to their
owner.
• These assets are recorded at cost.
• The cost is spread over the expected life of the right or privilege.
EXAMPLES OF INTANGIBLE ASSETS
• Patents (design)
• Copyrights
• Goodwill
• Franchises
• Trademarks
CURRENT LIABILITIES
• Obligations that must be satisfied within one year or within the
normal operating cycle, whichever is longer
• Typically paid from current assets or by incurring new shortterm liabilities
• Examples: Notes payable, accounts payable, current portion of
long-term debt, salaries and wages payable, taxes payable,
customer advances (unearned revenues)
LONG-TERM LIABILITIES
• Debts of the business that fall due more than one year in the
future or beyond the normal operating cycle, which will be paid
out of noncurrent assets
• Examples: Mortgages payable, long-term notes, bonds payable,
employee pension obligations, and long-term lease liabilities
DEFERRED INCOME TAXES
• Are often disclosed as a separate category in the long-term liability
section of the balance sheet of publicly held corporations.
• Are the result of different rules that apply for measuring income
taxes for tax purposes and for financial reporting purposes.
• Amount is the cumulative annual difference between income taxes payable
to governments and income tax expense reported on the income statement
STOCKHOLDERS’ EQUITY
• Made up of two components on the balance sheet:
• Contributed or paid-in capital
• Retained Earnings
• Generally, contributed capital is shown as two amounts:
• Par value of the issued stock
• Amounts paid in, or contributed, in excess of the par value per share
MULTISTEP INCOME STATEMENTS
Presented in a series of steps, or subtotals, to arrive at net income
Step
1
2
3
4
Service Company
Income from operations
Income before income taxes
Net income
Merchandising or Manufacturing
Company
Gross margin
Income from operations
Income before income taxes
Net income
Notice that the multistep income statement for a service company
and a merchandising or manufacturing company both include three
of the same steps.
MULTISTEP INCOME STATEMENTS
Step
1
2
3
4
Service Company
Income from operations
Income before income taxes
Net income
Merchandising or Manufacturing
Company
Gross margin
Income from operations
Income before income taxes
Net income
• Merchandising companies buy and sell products
• Manufacturing companies make and sell products
• Both require an additional step in the multistep income statement for the
cost of the goods that are sold
• Service companies only have operating costs – they do not sell a physical product
Gross Margin = Net Sales – Cost of Goods Sold
EARNINGS PER SHARE
• Performance measure shown on the income statement
Net Income
Earnings per Share 
Number of Shares of Common Stock Outstandin g
• Useful in assessing a company’s
• Profit earning success
• Earnings in relation to the market price of its stock
DELL INCOME STATEMENT
WORKING CAPITAL
The amount by which total current assets exceed total current liabilities
Working Capital  Total Current Assets - Total Current Liabilitie s
Current assets. Assets that will be converted to cash or used up
within one year or one operating cycle, whichever is longer
Current liabilities. Debts that must be paid or obligations that
must be performed within one year or one operating cycle,
whichever is longer
WORKING CAPITAL (CONT’D)
•Working capital is used to buy inventory, obtain credit,
and finance expanded sales.
•Lack of working capital can lead to a company's failure.
•Working capital for Cruz Corporation:
Current assets
Current liabilities
Working capital
$467,424
– 170,732
$ 296,692
CURRENT RATIO
The ratio of current assets to current liabilities
Current Assets
Current Ratio 
Current Liabilitie s
• Is closely related to working capital
• Believed by many to be a good indicator of a company’s
ability to
• Pay its bills
• Repay outstanding debt
EVALUATION OF PROFITABILITY
• Profitability means the ability to earn a satisfactory income.
• Common profitability measures:
• Profit margin
• Asset turnover
• Return on assets
• Debt to equity ratio
• Return on equity
PROFIT MARGIN
Shows the percentage of each sales dollar that results in net income.
Net Income
Profit Margin 
Net Sales
Profit margin for Cruz Corporation:
$58,000
 .046 (4.6%)
Profit Margin 
$1,248,624
This means that on each dollar of net sales, Cruz
Corporation made 4.6 cents.
ASSET TURNOVER
Measures how efficiently assets are used to produce sales
Net Sales
Asset Turnover 
Average Total Assets
Shows a meaningful relationship between an income statement
figure and a balance sheet figure
• Shows how many dollars of sales were generated by
each dollar of assets
• A high asset turnover means a company uses its
assets productively
ASSET TURNOVER (CONT’D)
Asset turnover for Cruz Corporation:
Net Sales
Asset Turnover 
Average Total Assets
$1,248,624
$1,248,624

 2.0 times
Asset Turnover 
($635,664  $594,480)  2 $615,072
Average total assets is computed by adding total assets at
the beginning of the year to total assets at the end of the
year and dividing by 2.
This means that Cruz produces
$2.00 in sales for each $1.00
invested in average total assets
RETURN ON ASSETS
Measures how efficiently a company uses its assets to produce
income
Net Income
Return on Assets 
Average Total Assets
RETURN ON ASSETS (CONT’D)
Combines profit margin and asset turnover
Net Income
Net Sales
Net Income


Net Sales
Ave. Total Assets
Ave. Total Assets
Profit Margin
Indicates incomegenerating
strength of a
firm’s resources

Asset Turnover

Return on Assets
Indicates how efficiently
the company is using all
its assets
• Return on assets overcomes the limitations of profit margin and asset turnover
ratios
– Profit margin does not consider the assets necessary to produce income
– Asset turnover ratio does not take into account the amount of net income produced
RETURN ON ASSETS (CONT’D)
Return on assets for Cruz Corporation:
Net Income
Return on Assets 
Average Total Assets
$58,000
Return on Assets 
($635,664  $594,480)  2
$58,000

 .094 or 9.4%
$615,072
This means that for
each dollar invested
by stockholders,
Cruz’s assets generate
9.4 cents of net
income
Profit Margin  Asset Turnover  Return on Assets
4.6%

2.0 times

9.2% *
*Difference due
to rounding
DEBT TO EQUITY RATIO
Shows the proportion of the company’s assets that is financed by creditors in
comparison to that financed by stockholders
Total Liabilitie s
Debt to Equity 
Stockholde rs' Equity
• A company with a high debt to equity ratio is at risk in poor economic times
because it must continue to repay creditors
• A company with a low debt to equity ratio is safer because stockholders do
not have to be repaid and dividends can be deferred
RETURN ON EQUITY
Measures how much income was earned on each dollar invested by stockholders
Net Income
Return on Equity 
Average Stockholde rs' Equity
• Acceptability of a company’s return on equity ratio depends on how much
– The company earned in prior years
– Other companies in the same industry earned
RETURN ON EQUITY (CONT’D)
Return on equity for Cruz Corporation:
Return on Equity 
Net Income
Average Stockholde rs' Equity
$58,000
$58,000

 .146 or 14.6%

$397,972
($393,732  $402,212)  2
Average stockholders’ equity is computed by adding total
stockholders’ equity at the beginning of the year to total
stockholders’ equity at the end of the year and dividing by 2.
This means that Cruz earned 14.6
cents for every dollar invested by
stockholders