Chapter 10
Understanding A Firm’s Financial Statements
CHAPTER OUTLINE
Spotlight: J&S Construction Company
(http://www.jsconstruction.com)
1 The Lemonade Kids
 Financial statement (accounting statements) – reports of a firm’s financial
performance and resources, including an income statement, a balance sheet, and a
cash flow statement
 Setting Up the Business – determining firm’s assets and sources of financing
 Opening Day – developing alternate methods of payment rather than cash
 Collecting Accounts Receivable
 Strategic Planning for the Following Saturday
 The Second Saturday of Business
2 The Income Statement
Describe the purpose and content of an income statement.
 Definitions
 Income statement (profit and loss statement) – a financial report showing the
profits or losses from a firm’s operations over a given period of time
 Cost of goods sold – cost of producing or acquiring goods or service to be sold by
a firm
 Gross profit – sales less the cost of goods sold
 Operating expenses – costs related to marketing and selling a firm’s product or
service, general and administrative expenses, and depreciation
 Operating profits – earnings after operating expenses but before interest and taxes
are paid
 Interest expense – the cost of borrowed money
 Profits before taxes (taxable profits) – earnings after operating expenses and
interest expenses but before taxes
 Net profits – earnings that may be distributed to the owners or reinvested in the
company
 Depreciation expense – cost of a firm’s building and equipment, allocated over
their useful life
 Profit margins – Profits as a percentage of sales
 Answers question, “How profitable is the business?”
 Reports sales (revenue), cost of producing or acquiring the goods or services sold
by the company, operating expenses, interest expense, tax payments
 Allows business owner to consider how decision affect the company’s profits
3 The Balance Sheet
Explain the purpose and content of a balance sheet.
 Formula – Total assets = Debt + Ownership equity
 Assets
 Definitions
 Current assets – assets that can be converted into cash relatively quickly
102
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated or posted to a
publicly accessible website, in whole or in part.
Chapter 10
Understanding A Firm’s Financial Statements

Accounts receivable – amount of credit extended to customers that is currently
outstanding
 Inventory – firm’s raw materials and products held in anticipation of eventual
sale
 Working capital cycle – the process of converting inventory to cash
 Fixed assets (property, plant and equipment [PPE]) – Physical assets that will
be used in the business for more than one year, such as equipment, buildings,
and land.
 Depreciable assets – assets whose value declines, or depreciates, over time
 Gross fixed assets – Depreciable cost at their original cost before any
depreciating expense has been taken.
 Accumulated depreciation – total (cumulative) depreciation expense taken
over the assets’ life
 Net fixed assets – gross fixed assets less accumulated depreciation
 Other assets – A firm’s raw materials and products held in anticipation of
eventual sale.
 These are all things owned by the business
 Debt and Equity
 Debt –financing provided by creditors
 Current debt (short-term liabilities) – borrowed money that must be repaid within
12 months
 Accounts payable (also called trade credit)– Outstanding credit payable to
suppliers.
 Accrued expenses – Operating expenses that have been incurred but not paid.
 Short-term notes – Agreements to repay cash amounts borrowed from banks
or other lending sources within 12 months or less
 Long-term debt – loans from banks or other sources with repayment terms of
more than 12 months.
 Long-term notes – Agreements to repay cash amounts borrowed from banks
or other lending sources for periods longer than 12 months
 Ownership Equity
 Mortgage – a long term loan from a creditor for which real estate is pledged as
collateral
 Ownership equity – owners’ investments in a company plus cumulative net
profits retained in the firm
 Retained earnings – profits less less dividends paid over the life of a business
4 Viewing the Income Statement and Balance Sheet Together
How do financial statements how a firm’s financial position?
 Balance sheet is a view of the firm’s financial condition at a particular point in time
 Income statement shows results over a given period (a quarter or a year for example)
5 The Cash Flow Statement
Use the income statement and balance sheets to compute a company’s cash flows.
 Profits versus Cash Flows
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated or posted to a
publicly accessible website, in whole or in part.
103
Chapter 10
Understanding A Firm’s Financial Statements

Cash flow statement – a financial report showing a firm’s sources of cash as well
as its uses of cash
 Accrual-basis accounting – an accounting method of recording profits when
earned and expenses when incurred, whether or not the profit has or the expense
paid
 Cash-basis accounting – an accounting method of recording profits when cash is
received and recording expenses when they are paid
 Profits based on an accrual accounting system will differ from the firm’s cash
flows
 Sales reported in an income statement include both case sales and credit sales;
total sales do not correspond to the actual case collected
 Some inventory purchases are financed by credit, so inventory purchases do
not exactly equal cash spent for inventory
 Depreciation expense shown in the income statement is a noncash expense
 Measuring a Firm’s Cash Flows
 Cash inflows and outflows explained by three activities
 Generating cash flows from day-to-day business operations
 Buying or selling fixed assets
 Financing the business
 Cash Flows From Day-To-Day Business Operations
 Converts the company’s income statement from an accrual basis to a cash
basis
 Two steps required
 Add back depreciation to net profits, since depreciation is not a cash
expense
 Subtracting any uncollected sales and payments for inventory
 Investing in Fixed Assets – equipment or buildings (example)
 Financing the Business
6 Evaluating a Firm’s Financial Performance
Analyze the financial statements using ratios to see how well a firm is doing
 Entrepreneur’s decisions basically in four areas
 Firm’s ability to pay its debt as it comes due
 Company’s profitability from assets
 Amount of debt the business is using
 Rate of return earned by the owners on their equity investment
 Pendley & Associates’ Liquidity (Ability to Pay Its Debt)
 Definitions
 Liquidity – the degree to which a firm has working capital available to meet
maturing debt obligations
 Current ratio – a measure of a company’s relative liquidity, determined by
dividing current assets by current liabilities
 Pendley & Associates’ Profitability on Its Assets
104
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated or posted to a
publicly accessible website, in whole or in part.
Chapter 10
Understanding A Firm’s Financial Statements

Return on assets – a measure of a firm’s profitability relative to the amount of its
assets, determined by dividing operating profits by total assets (see Exhibit 10-9
Return on Assets: An Overview)
 Definitions
 Operating profit margin – a measure of how well a firm is controlling its costs
of goods sold and operating expenses relative to sales, determined by dividing
operating profits by sales
 Total asset turnover – a measure of how efficiently a firm is using its assets to
generate sales, calculated by dividing sales by total assets
 Pendley & Associates’ Debt – debt ratio is a measure of what percentage of a firm’s
assets is financed by debt, determined by dividing total debt by total assets
 Pendley & Associates’ Return on Equity
 Return on equity – a measure of the rate of return owners receive on their equity
investment, calculated by dividing net profits by ownership equity
 Financial leverage – the impact (positive or negative) of financing with debt
rather than with equity.
 A firm with a high (low) return on assets will have a high (low) return on
equity
 As a firm’s debt ration increases, return on equity will increase if the return on
assets is greater than the interest rate paid on any debt, but return on equity
will decrease if the return on assets is less than the interest rate
ANSWERS TO END-OF-CHAPTER DISCUSSION QUESTIONS
1. Explain the purposes of the income statement and balance sheets?
The income statement reports the results of periodic operations, detailing sales
revenue, cost of goods sold, selling expenses, administrative expenses, interest
expense, and other income and expenses. It culminates in a bottom line statement
of net profit (or loss). The balance sheet is the statement that details and classifies
the firm’s various assets and liabilities and the ownership equity in the business.
Total assets always equal the sum of liabilities and ownership equity. The final net
profit (or loss) shown on the income statement adjusts the value of the ownership
equity reported on the balance sheet.
2. What determines a company’s profitability?
A company’s profit is a primary source of financing for future growth. The more
profitable a company is, the more funds it will have for growth. Thus, we need to
know the factors that drive profits so that we can make the needed profit
projections. A company’s net income, or net profit, depends on four variables:

Amount of sales. Much that we project about a company’s financial future is
driven by the assumptions we make regarding future sales.

Costs of goods sold. This reflects the cost of producing or acquiring the goods
or services to be sold.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated or posted to a
publicly accessible website, in whole or in part.
105
Chapter 10



Understanding A Firm’s Financial Statements
Operating expenses. Operating expenses include expenses such as those related
to marketing and distributing the product. We want, as best we can, to classify
these expenses as either expenses that do not vary as sales increase or decrease
(fixed operating expenses) or expenses that change proportionally with sales
(variable operating expenses).
Interest expense. When we borrow money, we agree to pay interest on the loan
principal. If we borrow $25,000 for a full year and commit to paying 12-percent
interest, our interest expense will be $3,000 for the year (12% ´ $25,000).
Taxes. For the most part, the firm’s taxes are a percentage of taxable income.
The rate increases as the amount of income increases.
3. Distinguish among (a) gross profit, (b) operating profits, and (c) net profits.
a. Gross profit is sales (revenue) less the cost of producing or acquiring the
product or service. It is the difference between what the product costs the
producer and what the producer sells it for.
b. Operating profits are determined by deducting operating expenses and
depreciation expense from gross profit.
c. Net profits are the income that may be distributed to the owners or reinvested
in the company.
4. The balance sheet reports information on a firm’s (1) assets, (2) debt, and (3)
equity. What is included in each of these reported categories?
Assets include everything owned by the company. Assets are basically divided in
current assets (assets that can be converted into cash relatively quickly), fixed assets
(assets that take much longer to convert into cash), and other assets (such as patents,
copyrights, and goodwill).
Debt is financing provided by a creditor and is divided into current (short-term)
debt that must be repaid within 12 months and long-term debt that includes loans
from banks or other sources that are generally loaned for longer than 12 months
(for example, for a mortgage).
Equity is money that the owners invest in the business as well as the cumulative
amount of profits that have been retained in the business.
5. How are ownership equity and debt different?
Ownership equity is the money invested in a firm by the owners (including
stockholders) for use in conducting the business. Debt is the money loaned to a
business that establishes a debtor-creditor relationship.
6. Distinguish between common stock and retained earnings.
Common stock is an investment in the firm while retained earnings are profits less
withdrawals (dividends) over the life of a business.
106
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated or posted to a
publicly accessible website, in whole or in part.
Chapter 10
Understanding A Firm’s Financial Statements
7. What is the relationship between an income statement and a balance sheet?
The income statement reports the results of periodic operations, detailing sales
revenue, cost of goods sold, selling expenses, administrative expenses, interest
expense, and other income and expenses. It culminates in a bottom line statement
of net profit (or loss). The balance sheet is the statement that details and classifies
the firm’s various assets and liabilities and the ownership equity in the business.
Total assets always equal the sum of liabilities and ownership equity. The final net
profit (or loss) shown on the income statement adjusts the value of the ownership
equity reported on the balance sheet.
8. Why aren’t a firm’s cash flows equal to its profits?
The cash flow statement shows a firm’s sources of cash as well as its uses of cash
indicating where cash came from and went to in a business. Profits are the result of
an increase in cash that is created by spending less than what is earned by the
business through sales of products/services.
9. Describe the three major components of a cash flow statement.
The three major components of a cash flow statement are the net profits less
depreciation, and cost of products/services sold.
10. What questions do financial ratios help answer about a firm’s financial
performance?
Financial ratios restate selected income statement and balance sheet data to provide
information that helps the management of a venture compare how it is doing
relative to previous periods of time in the company and how it is doing compared
to other ventures within the same industry.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated or posted to a
publicly accessible website, in whole or in part.
107
Chapter 10
Understanding A Firm’s Financial Statements
COMMENTS ON CHAPTER “YOU MAKE THE CALL” SITUATIONS
Situation 1
1. What did Donahoo’s balance sheet look like at the outset of the firm’s life?
Change in
Date
Assets
1-Jan
Plus $1,500
Balance Sheet
Assets
Cash
Change in
Debt +
Equity
Debt + Equity
$1,500
Debt $ 500
Equit
1,000
Plus $500
Plus $1,000
y
Total
$1,500
Total $1,500
2. What did the firm’s balance sheet look like after each transaction?
Change in
Date
Change in
Assets
2-Jan
Assets
Cash
Less $500
Plus $1,000
Inventory
Total
Debt +
Equity
Debt + Equity
$1,000 Accts
payable
1,000 Debt
$2,000 Equity
Total
$ 500
500
Plus $500
1,000
$2,000
108
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated or posted to a
publicly accessible website, in whole or in part.
Chapter 10
Understanding A Firm’s Financial Statements
Change in
Change in
Assets
3-Jan
Assets
Cash
Debt + Equity
$1,000 Payables
Plus $250
Receivables
250 Debt
Less $200
Inventory
800 Equity
Plus $50
$2,050
$ 500
500
1,050
Change in
Assets
15-Jan
Assets
Cash
Debt + Equity
$1,000 Payables
Receivables
Plus $200
Inventory
250 Debt
1,000 Equity
$2,250
500
Assets
1,050
$2,250
Debt + Equity
Cash sale: +
$50
Payables
Cash
$ 700 Debt
Dividend: $100
Equity
Total cash $300
Plus $450
Plus $200
Change in
Assets
Reduce debt: $250
Debt +
Equity
$ 700
Change in
31-Jan
Plus $50
$2,050
Change in
Date
Debt +
Equity
Debt +
Equity
$ 700
250
1,050
Plus $50
$2,000
Receivables
700
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated or posted to a
publicly accessible website, in whole or in part.
109
Chapter 10
Understanding A Firm’s Financial Statements
Less $400
Inventory
600
$2,000
3. Ignoring taxes, determine how much income Donahoo earned during January.
Prepare an income statement for the month. Recognize an interest expense of 1
percent for the month (12 percent annually) on the $500,000 long-term debt,
which has not been paid but is owed.
January 3
Revenues
$
Cost of goods sold
Gross
profits
Jan 1 – Jan
31
$
$
(200)
profits/operating
Interest
(1%/month)
250
January 31
$
50
expense
Net Income
(400)
$
-$
50
500
100
(600)
$
-$
100
Free cash flow
Operating Perspective
Operating income
Depreciation Expense
EBITDA
$
$
$
$
150
(5)
$
4. What was Donahoo’s cash flow for the month of January?
Beginning cash (January
1)
Ending cash (January 31)
Net change in cash
750
1,50
0
700
(800
)
150
--150
110
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated or posted to a
publicly accessible website, in whole or in part.
145
Chapter 10
Understanding A Firm’s Financial Statements
Change in current assets
Cash
Accounts
receivable
Inventory
Change in
current assets
Change
in
accounts
payable
Change in net working
capital
Free cash flow (operating)
Free cash flows
Financing perspective
Dividends
Debt retirement
Interest expense
Change
in
accounts
payable
Interest paid
Free cash flow
$
$
(800)
700
600
500
700
$
(200)
$
350
$
$
100
250
5
(5)
$
--350
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated or posted to a
publicly accessible website, in whole or in part.
111
Chapter 10
Understanding A Firm’s Financial Statements
Situation 2
1. Given the information provided by the financial statements, what would you tell
Abrahams? (As part of your answer, calculate the firm's cash flows.)
Explain to Ms. Abrahams that his equation for determining cash flows (profits +
depreciation), although correct once in a while, can be very misleading. The cash
flows can be better determined as follows:
Firm’s cash flows:
Operating income
Depreciation
Earnings before interest, taxes, and depreciation
Cash taxes
After-tax cash flows from operations
$19,000
5,000
$24,000
8,000
$16,000
Change in net working capital:
Change in current assets
Change in non-interest bearing short-term debt
Change in net working capital
$10,000
3,000
$7,000
Investment in fixed assets
Decrease in other assets
($5,000)
2,000
Firm’s cash flows:
$6,000
Financing cash flows:
Interest
Dividends
$3,000
3,000
Financing cash flows
$6,000
Thus, the Turpen Company generated $6,000 in cash flows, which were used to
pay dividends and interest to investors. Also, we should notice that of the $6,000
that was paid to investors, $2,000 came from a reduction in cash balances. If the
cash had not been reduced, there would have been only $4,000 available to the
investors. In short, there is no money available for Rose.
2. How would you describe the cash flow pattern for the Turpen Company?
The primary sources of cash are (a) income plus depreciation (a noncash charge)
and (b) increasing short-term borrowings in the form of accounts payable and
accruals. The primary uses are (a) increased investments in accounts receivable,
inventories, and fixed assets and (b) payment of dividends.
112
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated or posted to a
publicly accessible website, in whole or in part.
Chapter 10
Understanding A Firm’s Financial Statements
Situation 3
1. Compute the financial ratios discussed in the chapter for Wholesome Foods for
2010 and 2011.
2010
Current ratio
2011
1.84
2.02
Return on assets
19.6%
17.9%
Operating profit margin
13.3%
13.1%
Total asset turnover
1.47
1.37
Debt ratio
55.1%
56.7%
Return on equity
23.4%
20.9%
Calculations:
2010
2011
Current ratio
138,300/75,000
169,000/84,400
Return on assets
80,000/408,300
85,000/475,000
Operating profit margin
80,000/600,000
80,000/650,000
Total asset turnover
600,000/408,300
650,000/475,000
Debt ratio
225,000/408,300
269,400/475,000
Return on equity
42,900/183,300
43,000/205,600
2. Acquire a small firm’s financial statements. Review the statements and describe
the firm’s financial position. Find our if the owner agrees with your conclusions
Answers will vary. This would also require either bringing some financial
statements to class and having the students review them or, assuming wifi is
available in the classroom, having students pull up this information on their laptops
and then evaluating the financial data.
3. Interpret your findings, both for the firm’s financial ratios compared to those of
the peer group and for the cash flow statement.
Answers will vary depending on the chosen firm’s financial ratios.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated or posted to a
publicly accessible website, in whole or in part.
113
Chapter 10
Understanding A Firm’s Financial Statements
SUGGESTED SOLUTION TO CASE 10: DIETRICH & MERCER, INC.
1. How would you evaluate the company’s liquidity?
Liquidity is the degree to which a firm has working capital available to meet maturing
debt obligations. To assess the company’s ability to pay its current liabilities,
several computations can be done to make this determination:
 Assess working capital which is use to evaluate a company’ ability to pay
current liabilities,
 Compute the current ratio, which is a more reliable indicator of the ability to
pay current liabilities than working capital.
 Compute the quick ratio, which considers current assets, unlike the other two
computations.
Assess the company’s historical performance in generating operating profits on
its assets.
2010 Return on Assets (Operating Profits / Total Assets) was 11.4%
$2,766,000 / $24,267,000
20111 Return on Assets was 10.4%
($2,868,000 / $27,434,000)
2.
In 2011 assets increased and profits decreased. Additional analysis could include
computing the company’s debt ratio to measure what percentage of the firm’s assets if
financed by debt (determined by dividing total debt by total assets).
3. Describe how the business is financed.
The business is financed with both debt and equity. Via debt they have a $2.3m note to
the bank, $4.4m of credit via accounts payable, and $8.1m long-term debt. Via equity
they have $2.08 of common stock and additional paid-in-capital and $8.2m in retained
earnings.
4.
Do Dietrich and Mercer receive a good return on their equity investment in the
business?
Return of equity is a measure of the rate of return that owners receive on their equity
investment calculate by dividing net profits by ownership equity.
2010 Return on equity was 11.4%
($1,044,000 / $9,136,000)
2011 Return on equity was 10.3%
($1,063,000 / 10,291,000)
Because they had a lower return on assets in 2011, it stands that they will have a lower
return on equity in 2011. It simply is not possible to have a good return on equity if you
are not earning a good return on your assets. Also, as the amount of the firm’s debt
increases, its return on equity will increase provided that the return on assets is higher
than the interest rate paid on any debt.
114
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated or posted to a
publicly accessible website, in whole or in part.