KENNETH C HOLMES
APPLIED MANAGERIAL ACCOUNTING
PROFESSOR: JASON CADE
JANUARY 12, 2015
INDIVIDUAL PROJECT 1
MEMO
To: Board of Directors and Executive Management Team
From: Kenneth C Holmes, Corporate Financial Analyst
RE: Financial Statements and their use for planning, controlling, and decision making
Balance Sheet: Also referred to as the Statement of Financial Position, it is a key financial
statement used by facilitators and business entities, because it summarizes the financial position
(snapshot of the financial position) on a given date (Averkamp, 2015).
Who uses the Balance Sheet:


Creditors who need to know what a company owns and owes, to determine if they are
worthy of credit or additional credit.
Internal and external stakeholders including: company management and employees,
current and potential clients, current and future lenders and investors, suppliers,
competitors, government agencies, labor unions, and any party wishing to do business
with that entity.
Assets:




Assets: Resources owned by a company that have future economic value, and have a
debit balance.
They include: cash, petty cash, temporary investments, accounts receivable, inventory,
supplies, prepaid insurance/advertising/legal fees/rent, costs paid in advance not expired,
land, land improvements, buildings, equipment, goodwill, bond issue costs, etc.
Contra Assets: Asset accounts with credit balances.
They include: Allowance for doubtful accounts and accumulated depreciation of landimprovements/buildings/equipment/etc.
Asset planning focuses on accessing the current financial position and evaluating
opportunities. Management must determine if there are sufficient or excess assets (people,
facilities, equipment, distribution, and funding) to ensure proper production and inventory in
order to ensure a profitable bottom line, to plan for future needs, and to seek opportunities for
growth. Asset management serves to improve the corporate infrastructure, and ensure company
profits (liquidity) are compatible or better than competitors and industry average.
Asset control focuses on return on investment and asset efficiency. It is management’s
responsibility to utilize assets to achieve maximum profitability; this can be done through proper
investing of corporate funds, efficient production, inventory turnover, collection efforts, etc.
Assets are an integral part in decision making. It is management’s responsibility to
determine what their assets are, do they have sufficient or excess assets, and above all, to ensure
sufficient cash (liquid). Assessments must be made, and steps must be taken to ensure asset
levels meet or exceed company needs. Managers can use reports and ratios to determine the
status of their situation, determine how to correct the situation, and improve the bottom line.
Liabilities:








Liabilities: Obligations of the company, amounts owed to creditors for past transactions,
and normally have credit balances.
They include: notes payable, accounts payable, income taxes payable, customer deposits,
warranty liability, lawsuits payable, unearned revenues, bonds payable, amounts received
in advance of future services, etc.
Contra Liabilities: Liabilities with debit balances.
They include: discounts on notes payable, discounts on bonds payable, etc.
Contingent Liabilities: Potential liabilities that are contingent on events occurring or yet
to occur, and that may or may not become a liability.
Examples include: Warranty of company’s products, the guarantee of another parties
loan, lawsuits filed against a company, etc.
Current Liabilities: Debts payable in less than one year.
Long-term Liabilities: Debts payable in more than one year.
Liabilities are an integral part of planning. Liabilities involving creditors should be in line
with or below industry average. If debt is too high, steps must be taken to reduce that figure.
Warranty liabilities are a necessary part of business, they should be kept in line with industry
average, but they are a part of selling their products. These actions will improve the firm’s
bottom line, the firm’s image and attract investors and financing.
Controlling liabilities is of absolute necessity. No firm wants to operate on a high
leverage basis. Financing is part of doing business, but too much financing creates expenses that
will only reduce the bottom line. Investors and finance companies do not like high debt levels,
and the firm will find securing new stock holders, financing, or additional financing difficult.
Decision making regarding liabilities is vital. If a firm has too much debt, steps must be
taken to reduce that figure to an acceptable level. Firms that start up or expand using leverage
financing most often are placing the company in financial jeopardy, and possibly bankruptcy.
Some debts are necessary, bonds help raise money, and warranties are an essential part of selling
products.
Reports and Ratios Bases on Balance Sheet (Averkamp, 2015):

Common-Size Balance Sheet (Vertical Analysis): A balance sheet where every dollar
amount has been restated as a percentage of total assets and total liabilities.

For example: Total assets are 100% and all assets are stated as a percentage of total assets
(5%, 17%); total liabilities are 100% and all liabilities are stated as a percentage of total
liabilities (2%, 11%).
 A company can compare its percentage with other company’s and industry statistics to
determine if their percentage is reasonable.
 It allows more than one person to compare the items without revealing dollar amounts.
 Trend Analysis (Horizontal Analysis): It is a balance sheet that focuses on trends and
changes in financial statements over time. It compares two or more year’s statements, and
shows changes in dollars and percentage, and uses a base year.
 For example: The base year equals 100%, with all other years stated in some percentage
of the base.
 It helps analysts focus on key factors that affect profitability or financial position.
 Break Even Analysis (Break Even Point): Determines the level of sales at which profit
is zero.
 For example: Break even sales = fixed cost + variable cost, Profit = (Sales – Variable
expenses) – Fixed expenses, or Sales = Variable expenses + Fixed expenses + Profit.
 Working Capital: Indicates whether an entity will be able to meet its current obligations.
 Working Capital = Current Assets – Current Liabilities.
 Debt to Total Assets: Shows the percentage of a firm’s assets supported by debt
financing.
 Debt to total assets = total debt/total assets.
 Total Capitalization Ratio: Indicates the extent to which a firm is operating on its
equity. It shows the financial leverage of the firm.
 Total capitalization = long-term debt/ (long-term debt + shareholders equity).
 Interest Coverage Ratio: Indicates a firm’s ability to cover interest charges.
 Interest coverage = EBIT/interest charges.
 Current Ratio: Shows a firm’s ability to cover its current liabilities with its current
assets.
 Current Ratio = Current Assets/Current Liabilities.
 Quick Ratio (Acid Test Ratio): Indicates a firm’s ability to meet its current liabilities
with its most liquid assets.
 Quick Ratio = (current assets – inventory)/current liabilities.
 Quick Ratio = [(cash + temporary investments + accounts receivable)/current liabilities].
 Accounts Payable Turnover (PT): Indicates the promptness of payments to suppliers by
the firm.
 PT = annual credit sales/accounts payable.
 Payables Turnover in Days: Indicates the average number of days that account payables
are outstanding.
 PT in days = 365 days in the year/accounts payable turnover.
 Accounts Receivable Turnover: Indicates the number of times per year the accounts
receivable turns over.











Accounts Receivable turnover = net credit sales for the year/average accounts receivable
for the year.
Average Collection Period: Indicates the average number of days receivables are
outstanding.
Average collection period = 365 days in a year/accounts receivable turnover in a year.
Inventory Turnover: Indicates the number of times per year the inventory turns over.
Inventory turnover = cost of goods sold for the year/average inventory for the year.
Total Assets Turnover: Indicates how effectively a firm utilizes its assets to generate
sales.
Total assets turnover = net sales/total assets.
Days Sales in Inventory: Indicates the average number of days it took to sell the average
inventory during the year.
Days sales in inventory = 365 days in a year/inventory turnover in a year.
Debt to Equity Ratio: Shows the extent which the firm is financed by debt.
Debt to equity = (total liabilities/total stockholder’s equity) : 1
Owner’s Equity:





Owner’s Equity: Also called Residual of Assets Less Liabilities, and the Book Value
of a company, and normally have credit balances.
Owner’s Equity = Assets – Liabilities or Assets = Liabilities + Owner’s Equity
Examples include: paid in capital, common stock, preferred stock, paid-in capital in
excess of par value-common stock, paid-in capital in excess of par value-preferred stock,
paid-in capital from treasury stock, treasury stock, retained earnings, etc.
Contra Owner’s Equity: Owner’s equity accounts with debit balances.
Example is treasury stock.
Owner’s equity is a key element in planning. It represents free cash and the stock side of
the business, and is the Book Value of the business. Corporations go to great lengths to seek
opportunities to attract investors, it is how they raise money to operate, expand, and improve
their position. A business with strong a strong cash flow will find it easier to secure investors and
financing, while a business with a poor cash flow will find it very difficult to secure investors
and financing.
Controlling owner’s equity is essential. Investors and finance companies look at their
return on investment, the business looks at both ROI and the efficiency with which they use their
assets. A strong ROI indicates a healthy business that uses its assets efficiently and seeks to
satisfy all their stakeholders, a weak ROI shows a business that is inefficient and will have
difficulty securing investors and financing.
The decision making process is vital for owner’s equity. A business that has a poor cash
flow or ROI shows they are unsuccessful at utilizing their assets, will have difficulty securing
credit, and must take steps to improve their position. A business with a strong cash flow or ROI
proves they are successful at utilizing their assets to create a strong business, and will find it
easier to secure credit.
Income Statement: Also called the Profit and Loss Statement (P&L), Statement of Operations,
and Statement of Income. It summarizes a firm’s revenues and expenses (profitability) over a
period of time ending with a net income or loss for the period. The time frame can be annually,
quarterly, or any period necessary to the entity. It must show revenues, expenses, gains, and
losses, but does not include receipts or cash disbursements (Averkamp, 2015).
Benefits of a profitable Income Statement:



Shows the entity uses borrowed and invested funds successfully.
The entity will more easily secure additional or future financing, and/or investors.
Will look favorable to internal and external stakeholders doing business or considering
doing business with the entity.
Disadvantages of a negative Income Statement:



Shows unsatisfactory use of borrowed and invested funds.
Entity is likely to have difficulty securing credit or additional credit from banks, lenders,
and creditors.
Will reflect poorly on internal and external stakeholders.
Elements of the Income Statement:













Earnings Per-Share: The portion of a company’s profit allocated to outstanding shares
of common stock (Earnings Per Share Definition, 2015).
It serves as an indicator of a company’s profitability.
Revenues (Operating Expenses): Funds generated by the selling of products.
Service Revenue (fees earned): funds generated by the selling of services.
Non-Operating Revenue: Funds a business earns outside of purchasing and selling of
goods and services.
They include: Interest on idle cash, rental income, etc.
Receipts: Funds received or collected.
Gains: Increase in funds when the amount received is more than the book value.
Operating Expenses: Expenses incurred in order to earn normal operating revenues.
Examples include: Sales, commissions, salaries and wages, bonuses, vacations, cost of
goods sold, utilities, purchase of property, depreciation, etc.
Non-Operating Expenses: They are related to the finance function of the business.
Examples include: interest expense, and other investment expenses.
Losses: Reduction in funds when the amount received is less than the book value.




Net Income: Funds remaining after deducting expenses from revenues and gains, and is
positive.
Net Loss: When revenues and gains less expenses is negative.
Discontinued Items: The elimination of a major part of the business such as an entire
division of the company.
Extraordinary Items: Things that are unusual in nature and infrequent in occurrence,
and include: losses due to natural disasters, foreign takeover of U.S, oil refinery, etc.
Since the income statement shows how a business uses borrowed and invested funds,
proper planning is a necessity. A business with a profitable income statement clearly shows a
well-run business, one with a weak income statement clearly indicates a poorly run business, the
stronger the income statement, the more appealing to the public, clients, investors, and lenders.
Controlling the factors involved in the income statement is vital. A business needs strong
sales, fees, receipts, and few losses to be successful. If sales and receipts are low, and losses are
high, management needs to strengthen the numbers by securing new clients, increasing sales, and
reducing losses. If sales and receipts are high and losses are low or non-existent, management
needs to ensure they stay on that path, and continue to improve the bottom line. All this should
be done in an effort to present a good image, and secure investors and financing.
The decision making process should address where the business stands, and how to
maintain or improve their position. If the business needs improvement, decision must be made as
to how to improve the situation, and actions must be taken to make the changes necessary, or
face the consequences. If the business is in a good financial position, decisions must be made to
maintain and improve their position. A profitable business will always appeal to investors and
lenders, a non-profitable business is not attractive to investors and lenders.
Reports and Ratios Based on Income Statement (Averkamp, 2015):








Common-Size Income Statement (Vertical Analysis): It presents all of the income
statement amounts as a percentage of net sales or revenue.
One can compare the percentage to other companies and industry statistics.
Trend Analysis (Horizontal Analysis): It is an income statement that focuses on trends
and changes in financial statements over time. It compares two or more year’s statements,
and shows changes in dollars and percentage, and uses a base year.
For example: The base year equals 100%, with all other years stated in some percentage
of the base.
It helps analysts focus on key factors that affect profitability or financial position.
Variance Reports: State the differences between budgeted amounts and actual income
or expenses (Lee, 2015).
They are used to make changes in financial forecasts and monitor performance.
They can be used for any statement, and for any comparison.













Gross Profit Margin: Indicates the percentage of sales dollars available for expenses
and profit after the cost of merchandise is deducted from sales.
Gross margin = gross profit/net sales.
Profit Margin (After Tax): Tells the firm’s profitability after taking account of all
expenses and income taxes from sales.
Profit margin (after tax) = net income after tax/net sales.
Earnings Per-Share (EPS): Expresses net income after taxes on a per-share of common
stock basis (Earnings Per Share Definition, 2015).
Earnings per share = net income after tax/weighted average number of common stock
share outstanding.
For example: EPS = $8,000 /1500 shares = $5.33 per share of common stock.
Times Interest Earned: Indicates a company’s ability to meet the interest payments on
its debts.
Times interest earned = earnings for the year before interest and income tax
expense/interest expense for the year.
Return on Investment: Indicates the profitability on the assets of a firm after all
expenses and taxes.
ROI = net profit after taxes/total assets.
Return on Stockholder’s Equity (After Tax): Indicates the profitability to the
shareholders of the firm (after all expenses and taxes).
Return of stockholder’s equity (after tax) = net income for the year after taxes/average
stockholder’s equity during the year.
Statement of Cash Flows: Also called the Cash Flow Statement, it is a key statement used by
business people and investors. It reports the cash generated and used during a specific time
period, and presents the information reported in the Income Statement. The time period is chosen
by the entity, and can be any period useful to the entity (Averkamp, 2015).
Elements of the Statement of Cash Flow:





Operating Activities: Converts the items reported on the income statement from the
accrual basis to the cash.
The accounts include: accounts receivable, inventory, supplies, prepaid insurance, other
current assets, notes payable, accounts payable, wages payable, payroll taxes payable,
interest payable, income taxes payable, unearned revenues, and other current liabilities.
Investing Activities: Reports the purchase and sale of long-term investments, and
property, plant, and equipment.
Those accounts include: Long-term investments, land, buildings, equipment, furniture
and fixtures, and vehicles.
Financing Activities: Reports changes in the balances of the short-term and long-term
liabilities, and stockholder’s equity accounts.





It also involves the issuance and repurchase of the company’s own bonds and stock, as
well as short-term and long-term borrowings and repayment.
Those accounts include: notes payable, bonds payable, deferred income taxes, preferred
stock, paid-in capital in excess of par-preferred stock, common stock, paid-in capital in
excess of par-common stock, treasury stock, paid-in capital from treasury stock, and
retained earnings.
Supplemental Information: Discloses the amount of interest and income taxes paid, and
significant changes not involving cash (exchange of company stock for company bonds).
Depreciation Expense: The accounts involves are depreciation and depreciation
expense.
Disposal of Assets: Allows for the recording of disposal of assets with a gain or loss on
the net income of the Cash Flow Statement.
Planning is essential since the cash flow statement is used by business people and
investors. A business must show they can use invested funds wisely, and control financing cost
to maintain a healthy cash flow. Proper planning will help ensure sufficient income to provide
stockholders dividends, and minimizing financing will help reduce debt expenses. Investors and
lenders look favorably to a healthy cash flow. If a business’s cash flow is low, steps need to be
taken to increase the cash flow including: selling inventory, collecting on accounts, reducing
debt, investing funds wisely, and securing investors.
Since controlling focuses on ROI and asset efficiency, it is vital to a healthy business. A
healthy bottom line requires a business being on budget, efficient use of all assets, controlling
resource cost, controlling labor expenses, obtaining sales goals, controlling and reducing debt,
securing investors, controlling these factors is necessary. A business may need to reduce some
of these factors to improve their bottom line, and a healthy business needs to maintain and
improve these factors. All this is done to obtain a healthy bottom line.
Decision making is essential for a positive cash flow. If a firm has a poor cash flow, they
may need to streamline by improving production efficiency, sell inventory, control labor and
hours, and reduce debt. If a firm has a healthy cash flow, they need to maintain and improve their
position, streamlining to improve efficiency, and seeking profitable opportunities is a good place
to start.
Reports and Ratios Based on Statement of Cash Flows (Averkamp, 2015):


Free Cash Flow: State how much cash is left over from operations after a company pays
for its capital expenditures (additions to property, plant, and equipment).
Free cash flow = cash flow provided by operating activities (-) capital expenditures.
Statement of Stockholder’s Equity: Also called the Statement of Owner’s Equity, or the Book
Value of the corporation. It is an annual report presenting the individual components and
changes to the stockholder’s equity accounts during the same period as the income statement and
the statement of cash flows, and includes the amounts of comprehensive income not reported on
the income statement (Averkamp, 2015).
Stockholder’s Equity = Assets – Liabilities
Elements of the Statement of Stockholder’s Equity:




Paid-in Capital (Contributed Capital): Reports the amount the corporation received
when the shares of stock were issued.
Retained Earnings: It is the amount of net income the entity keeps in the stockholder’s
equity account. It is the corporation’s cumulative net-income (from the date of
incorporation to the current balance sheet date) less the cumulative amount of dividends
declared.
Accumulated other Comprehensive Income: Income that was not reported as net
income on the income statement.
Those transactions include: foreign currency transactions, hedges, pension liabilities, and
unrealized gains and losses on investments.
Planning a healthy book value is vital. Stockholders invest in a business to obtain
dividends, and a healthy business is attractive to investors and lenders. Planning a healthy
business requires assessing the current financial position, intelligent use of assets, controlling
liabilities, and seeking opportunities to improve the bottom line.
Controlling owner’s equity means utilizing assets efficiently to obtain the highest ROI
possible. To do this, assets need to be maximized, and liabilities need to be minimized or
controlled. All this is done to ensure stockholders and investors are satisfied with their ROI and
continue their investment.
The decision making process requires understanding how investors and stakeholders
analyze this information. Successful use of assets, and minimizing or controlling liabilities,
proves an intelligent use of company resources, and help to improve the bottom line. All
stakeholders want to know they made a wise investment, and maintaining a healthy bottom line
is a great way to ensure their decision, and to maintain your investors.
REFERENCES
Averkamp, H. (2015). Balance Sheet Explanation. Retrieved from
www.accountingcoach.com/balance sheet/explanation
Averkamp, H. (2015). Financial Ratios Explanation. Retrieved from
www.accountingcoach.com/financial ratios/explanation
Averkamp, H. (2015). Income Statement Explanation. Retrieved from
www.accountingcoach.com/income statement/explanation
Averkamp, H. (2015). Statement of Cash Flows Explanation. Retrieved from
www.accountingcoach.com/statement of cash flows/explanation
Averkamp, H. (2015). Statement of Stockholder's Equity Explanation. Retrieved from
www.accountingcoach.com/statement of stockholder's equity/explanation
Earnings Per Share Definition. (2015). Retrieved from www.investopedia.com/terms/rearnings
per share
Lee, R. (2015). How to Explain Variances in Monthly Financial Statements. Retrieved from
Chron.com: www.smallbusinesschron.com>....>Financial Statements