Understanding the
Numbers: Essential for
the Entrepreneur
A Student Tutorial
Ever thought or said:
• “I did not do well in my accounting
and finance classes . I just am not
good with numbers”
• “Finance scares me.”
• “I try, but I just can’t get it.”
If not, great, but if so, you may try to
avoid accounting and finance. Why is
that a mistake?
Reasons to Learn Finance
• There are things you cannot learn
about a company any other way.
• If you do not understand financial
statements and what they tell you,
you will be missing some critical
information about the firm.
• And hiring someone to do it for you,
DOES NOT WORK!!
Understanding
Financial Statements
• Goal: Understand the financial
consequences of decisions
• There are three basic financial (or
accounting) statements:
– Income Statement
– Balance Sheet
– Cash Flow Statement
The Goal:
Making
Good
Financial
Decisions
3 types of
financial
statements
Income Statement (1)
• Indicates the firm’s profits over a
period of time
– Usually monthly, quarterly or
annually
• Basic form:
Sales
(Revenues)
Expenses
Profits
Basic
purpose
and format
of an
income
statement
Income Statement (2)
• The Income Statement starts with
sales (revenues).
Sales (Revenue)
= # of units sold X
sales price per unit
minus
Cost of Goods Sold
equals
Gross Profit
From Sales,
subtract the Cost
of Goods Sold to
obtain the Gross
Profit
Can you
compute
gross
profits?
Income Statement (3)
What is cost of goods sold?
Cost of goods sold is determined by:
• The cost of producing or acquiring
a single unit of the firm’s products
or services
• The number of units sold
Cost of
goods
sold
=
cost per
unit
X
number
of units
sold
Computing
cost of
goods
sold
Income Statement (4)
• Next compute operating income
(earnings before interest & taxes)
Sales Revenue
minus
Cost of Goods Sold
equals
Gross Profit
minus
Operating Expenses
equals
Operating Income
From Gross Profits
subtract
Operating
Expenses to
obtain Operating
Income
Can you
compute
operating
income;
also called
earnings
before
interest
and taxes
(EBIT)?
Income Statement (5)
What are operating expenses?
In addition to the cost of goods sold, you need
to convince someone to buy what you are
selling. So, you will have;
Marketing expenses
• And you have operating overhead—the light
bill must be paid. So, you will have:
General & administrative expenses
• And if you have equipment and buildings. You
will have:
Depreciation expense
(More will be said about depreciation later.)
Operating
expenses
include
marketing
expenses,
G&A, and
depreciation
Income Statement (6)
A Comment on Operating Income
• Operating Income is the total profit a
firm makes from running the business
before paying creditors (interest
expense) for the use of debt, and
paying income taxes to the
government.
• Operating income is the best profit
indicator of how well a company is
doing in its business.
Income Statement (7)
• Next we compute earnings before
taxes (EBT)
From Operating
Income, subtract
Interest Expense to
obtain Earnings
Before Taxes
Operating Income
minus
Interest Expense
equals
Earnings Before Taxes
Can you
compute
earnings
before
taxes?
Income Statement (8)
Interest Expense: The Cost of
Borrowing Money
• A lender charges interest to loan
money, which is shown as interest
expense in the income statement of
the borrower.
• Interest expense is the result of the
interest rate and the amount
borrowed.
Interest
Rate
x
Amount
Borrowed
Interest
Expense
You have
to pay the
banker to
use the
bank’s
money!!
Income
Statement
Earnings Before
Taxes: (9)
Computing
Earning Before Taxes:
= Operating Income – Interest Expense
An Illustration
= $15,000 - ($50,000 X .06)
= $15,000 - $3,000 = $12,000
If a firm has:
$15,000 in operating income and $50,000
in debt at a 6% interest rate, then:
Operating Income
$ 15,000
Interest Expense
$ 3,000
The Earnings before taxes is:
$ 12,000
Computing
a firm’s
earnings
before taxes
Income Statement (10)
• Finally, we calculate net income
From Earnings
Before Taxes
subtract Income
Taxes to obtain
the Net Income
Operating Income
minus
Interest Expense
equals
Earnings Before Taxes
minus
Income Taxes
equals
Net Income
Can you
compute
net
income?
Net Income:
Income
Statement
(11)
(Earnings
before
taxes)-(Tax rate)*(Earnings
Computing
before taxes)Net Income Illustrated
$12,000 - (25%)*($12,000) =
$12,000 - $3,000 = $9,000
If a firm has:
Operating Income of
$15,000
Earnings before taxes of
$12,000
And pays 25% on income taxes.
The Net income is:
$
9,000
Computing
income
taxes to
find net
income
Income Statement (12)
Operating Activities
Sales Revenue
minus
Cost of Goods Sold
equals
Gross Profit
minus
Operating Expenses
equals
Operating Income
Financing Activities
What have we learned about the
income statement?
Operating Income
minus
Interest Expense
equals
Earnings Bef Taxes
minus
Income Taxes
equals
Net Income
DO NOT
continue
until you
know and
understand
the format
and
content of
an income
statement.
Income Statement (13)
An Example
The Income Statement for Trimble & Associates:
Cost of
borrowing
Income
from
operating
the
business
Income
after
\paying
interest
Sales
Cost of Goods Sold
Gross Profit on Sales
Operating Expenses:
Marketing Expenses
90
General & Admin Expenses
80
Depreciation
30
Total Operating. Expenses
Operating Income
Interest Expense
Earnings Before Tax
Income Tax (25%)
Net Income
$850
550
$300
$200
100
20
80
20
60
Income Statement (14)
Summary
• The Income Statement answers the
question:
“How profitable is the business?”
• The Income Statement reports on five
broad areas:
– Sales (Revenue)
– Costs of producing or acquiring the
firm’s goods or services
– Operating Expenses
– Financing costs (interest expense)
– Tax payments
Income Statement (15)
Can You Put It Together?
Organize this Income statement
Gross Profit on Sales
Operating Expenses:
Total Op. Exp.
Operating Income
$
Admin. &Sales Exp. $ 18
$
$
Earnings Before Taxes $
Net Income
Cost of Goods Sold $250
$
Depreciation
$
8
Interest Expense
$
6
Sales
$290
Income Taxes(25%) $
2
Put the
pieces
where
they go!!
4. Good
judgment
Here You Go!
Gross Profit on Sales
Operating Expenses:
Total Op. Exp.
Operating Income
$ 40
Cost of Goods Sold $250
Admin. &Sales Exp. $ 18
$ 26
$ 14
Earnings Before Taxes $
8
Net Income
6
$
Depreciation
$
8
Interest Expense
$
6
Sales
$290
Income Taxes(25%) $
2
Income Statement (16)
A Concluding Thought
• Congratulations!! You should be
able to understand the income
statement and what it is telling you.
• We are now ready to examine the
balance sheet, which measures the
firm’s current financial position.
• Let’s continue.
Balance Sheet (1)
• A Snapshot of a company’s financial
position at a specific point in time
– The Income Statement covers a period in
time (Jan 1 – Dec 31, 2007)
– The Balance Sheet represents a specific
moment (December 31, 2007)
• In its simplest form, the Balance Sheet
is:
Total
Assets
Outstanding
Debt
Owner’s
Equity
Debt & Equity
Total
assets
always
equal
debt plus
equity.
Balance Sheet (2)
Three main parts
• Assets
– What the company owns
• Liabilities (Debt)
– What the company owes
Basic
pieces of
the
balance
sheet
• Owner’s Equity (Net Worth)
– The amount invested by the
owners (stockholders)
– The difference between Assets and
Liabilities
Continue
Balance Sheet (3)
Three main parts
• Total Assets, the sum of:
• Current Assets (Cash, A/R, Inventory)
• Fixed Assets (Machinery and equipment,
Buildings, Land)
• Other Assets (Long-term investments,
Patents)
• Debt and Equity, the sum of:
– Total Debt, including:
• Current debt (Accounts payable, Accrued
expenses, Short-term notes)
• Long-term debt (Long-term notes, Mortgages)
– Owner’s equity: owner’s investment in
the company
A look
inside the
balance
sheet
-Cash Flow
2. Forecast
3. Determine
and
evaluate
4. Good
judgment
Balance Sheet (4)
Assets: Current Assets
• Current assets are also called gross
working capital
• Current assets comprise the assets
that are relatively liquid
–
–
–
–
Cash
Accounts Receivable
Inventories
Other current assets
(e.g., prepaid expenses)
Current
assets:
the firm’s
“liquid”
assets;
includes
cash and
assets
that can
soon be
converted
into cash
Balance Sheet (5)
Assets: Fixed Assets
• Fixed assets include:
– Machinery and Equipment
– Buildings and Land
• The cost of a fixed asset is recorded
in the balance sheet and depreciated
over its useful life.
– The Income Statement reports the
depreciation expense for each year.
– The Balance Sheet reports the
accumulated depreciation—depreciation
taken on an asset over all its life.
Fixed
assets
may also
be called
plant &
equipment
Balance Sheet (6)
Depreciating Fixed Assets
• Remember that
– When a fixed asset is purchased, the firm
pays cash, and so:
• Fixed assets increase in the balance
sheet.
• Cash decreases in the balance sheet.
– But the depreciation expense is
NOT a cash event.
• Depreciation expense is recorded in
the income statement
• Accumulated depreciation increases
in the balance sheet
• There is NO cash involved!!
Depreciation
expense is
NOT a cash
expense!!!
Balance Sheet (7)
Gross Versus Net Fixed Assets
• Gross Fixed Assets is the original
amount paid for a firm’s fixed assets.
• Net Fixed Assets is the gross fixed
assets minus the total depreciation
(accumulated depreciation) taken on
the fixed assets. That is,
Gross fixed
assets
accumulated
depreciation
net fixed
= assets
So:
net fixed
assets =
gross fixed
assets –
accumulated
depreciation
Balance Sheet (8)
An Example of Depreciation
• You purchase equipment for $10,000
with an expected life of 5 years. How
much will the depreciation expense be
each year, as reported in the income
statement?
$2,000 ($10,000 ÷ 5 years = $2,000)
• What will the balance sheet look like
over the 5 years?
End of Year
1
2
3
4
5
Gross fixed assets $10K $10K $10K $10K $10K
Accumulated depre
2K
4K
6K
8K 10K
Net fixed assets
$8K $6K $4K $2K $0K
Balance Sheet (9)
Assets: Other Assets
• Other assets includes intangibles,
such as:
– Patents
– Copyrights
– Goodwill
And for a start-up company:
– Organizational costs
The firm’s
other
assets
Balance Sheet (10)
Debt And Equity
• Remember
Total
Assets
Outstanding
Debt
Owner’s
Equity
Debt & Equity
Total
assets
MUST
equal
total debt
plus
owner’s
equity
Balance Sheet (11)
Debt or Liabilities
• Debt is financing provided by a
creditor
• Debt is divided in two parts:
– Current debt or short-term
liabilities
– Long-term debt
Where
does debt
come
from?
Balance Sheet (12)
Short-term Liabilities
• Liabilities due within 12 months
– Accounts Payable or Trade Credit:
• Credit extended by suppliers for the
purchase of inventories
• Usually given 30-60 days to pay
– Accrued Expenses:
• Operating expenses that are owed but
not yet paid
– Short-term Notes:
• Short-term loans from banks or other
financial institutions
Short-term
liabilities
is debt
that must
be repaid
within 12
months
-Cash Flow
2. Forecast
3. Determine
4. Good
judgment
Balance Sheet (13)
Long-term Liabilities
• Loans from banks or other sources
that that come due after 12 months
• Usually loans to finance long-term
capital investments, such as
machinery and equipment.
Long-term
liabilities
(debt)
Loans that
come due
after 12
months
Balance Sheet (14)
Owners’ Equity
• Owner’s Equity is the money
invested by the owners
Note: They are residual owners, because in
a liquidation, stockholders are paid last
• Equity consists of:
– Amount invested when purchasing
ownership in the business
– Retained Earnings: All the profits
retained in the company (profits not paid
out in dividends to the owners)
Owners
have 2
ways to
invest in a
business:
• Buy
stock
• Reinvest
all or
part of
the
firm’s
profits
Balance Sheet (15)
Owners’ Equity
• Retained Earnings is the
accumulated profits (gains-losses) of
the business, less the dividends paid
to stockholders since the firm was
created
Owners’
Equity
Owners’
Equity
Owners’
Investment
Owners’
Investment
Cumulative
Profits
Cumulative
Dividends
Retained
Earnings
Retained
earnings: A
concept
that many
students fail
to
understand.
Do you?
Balance Sheet (16)
An Example
The Balance Sheet for Trimble & Associates:
ASSETS
DEBT AND EQUITY
Current Assets
Cash
Accounts receiv
Inventories
Total current assets
Fixed assets:
Gross fixed assets
Accum depreciation
Net fixed assets
TOTAL ASSETS
Current Liabilities:
$50 Accounts payable
80 Short-term notes
220 Total current debt
$350 Long-term debt
Total debt:
$960 Common stock
-390 Retained earnings
$570 Total common equity
$920 TOTAL DEBT AND EQUITY
$20
80
$100
200
$300
$300
320
$620
$920
Balance Sheet (17)
Putting it together
Given the information below, can you
ASSETS
arrange theFIRST:
balance sheet?
Remember: ASSETS = LIABILITIES + EQUITY
Assets:
Current Assets
Fixed Assets
TOTAL ASSETS
Gross Fixed Assets
$2,500
Inventories
$ 310
Net Fixed Assets
$2,200
Cash
$
70
Accumulated Depreciation $(300)
$ 2,800
Total Current Assets
$ 600
Accounts Receivable
$ 220
Balance Sheet (18)
Putting it together
NEXT: DEBT & EQUITY
Liabilities:
Current Liabilities:
Owners’ Equity:
TOTAL DEBT&EQUITY $ 2,800
Total Current Liabilities
$ 250
Total Owners’ Equity
$1,750
Accounts Payable
$ 230
Common Stock
$ 900
Short-term Notes
$
Total Debt
$1,050
Long-term debt
$ 800
Retained Earnings
$ 850
20
Balance Sheet (19)
All Together
The complete balance sheet is as follows
Assets:
Current Assets
Liabilities:
Current Liabilities:
Cash
$
Accounts Receivable
70
Accounts Payable
$ 230
$ 220
Short-term Notes
$
Inventories
$ 310
Total Current Liabilities
$ 250
Total Current Assets
$ 600
Long-term debt
$ 800
Total Debt
$1,050
Fixed Assets
Gross Fixed Assets
$2,500
20
Owners’ Equity:
Accumulated Depreciation $ 300
Common Stock
$ 900
Net Fixed Assets
$2,200
TOTAL ASSETS
$ 2,800
Retained Earnings
Total Owners’ Equity
$ 850
$1,750
TOTAL DEBT&EQUITY $ 2,800
Balance Sheet (20)
Income Statement and Balance Sheet
Income Statement for 2007
December 31
January 1
The Income Statement and Balance
Sheet complement each other
YEAR 2007
Balance Sheet
on December
31, 2006
Balance Sheet
on December
31, 2007
Balance Sheet (21)
Concluding Thought
• A balance sheet indicates a firm’s
financial position in terms of the
assets owned and how these assets
have been financed by debt and
owner’s equity.
• With an understanding of the income
statement and the balance sheet, we
can now look at the Cash Flow
Statement.
DON’T
CONTINUE
if you do
not fully
understand
the balance
sheet!! Go
back until
you have
grasped all
the parts of
the balance
sheet.
Cash Flow Statement (1)
“Cash is King!!
Cash flow problems is a major reason for
small firms failing—even at times when
the business is profitable.
Run out of cash
and your business will fail!
CASH IS
KING is not
some
cliché, but
a principle
you cannot
afford to
violate!
Cash Flow Statement (2)
Accrual versus Cash Accounting
• You must understand the difference
between accrual-basis accounting
and cash-basis accounting.
• With the exception of very small
businesses, the income statement
and the balance sheet are based on
accrual accounting.
• When accrual accounting is used,
profits and cash flows will not be
equal.
Cash Flow Statement (3)
Accrual and Cash Accounting Again
• Recording income and expenses:
– Accrual-basis: When there is a commitment
– Cash-basis:
When money changes hands
Income earned
Cash received
Expense incurred Expense paid
Accrual-basis
accounting
Cash-basis
accounting
Cash Flow Statement (4)
Why Profits and Cash Flow
are NOT the Same
• The differences between profits and
cash flows can result from:
– Sales reported on the Income
Statement include cash and credit
sales
– Some purchases are financed by
credit—so no cash is involved
– Depreciation expense is a non-cash
expense.
– Income tax on the income statement
may be accrued and paid in later
periods.
Profits will
never tell
you how
much cash
you
generated!!
Cash Flow Statement (5)
Accrual vs. Cash Again
Which type of accounting would record
the following?
Accrual
Income tax expense that has not been paid
Insurance premium paid in advance
Customer pays for a good to be delivered
Equipment is sold, with a 30 day note
Customer pays and takes equipment sold
Customer receives a service estimate
Payment of last month’s utility bill
Cash
Cash Flow Statement (6)
The Cash Flow Statement answers
a very important question:
“Where did the cash come
from and where did the
cash go?”
Cash Flow Statement (7)
Data Needed to Compute Cash Flows
• From the income statement:
–
–
–
–
Depreciation expense
Operating income
Interest expense
Income tax expense
• Changes in the balance sheet at the
beginning of the year (end of last
year) and the balance sheet for the
current year end.
Cash Flow Statement (8)
Changes in the Balance Sheet
that Affect Cash Flows
• Cash increases if:
– Reduce assets
– Borrow more money (increase debt)
– Owners invest more in the business
• Cash decreases if:
– Increase assets
– Repay (decrease) debt
– Owners withdraw money from the
company
Changes
in the
balance
sheet
affect
cash
flows.
Cash Flow Statement (9)
• Cash inflows and outflows result
from three activities:
– Operating Activities:
Cash flow from normal operations
– Investment Activities:
Cash flow related to the investment
in or sale of assets
– Financing activities:
Cash flow related to financing the
firm
Three
activities
cause
cash to
increase
or
decrease
Cash Flow Statement (10)
Operating Activities
• Cash flow from operations consists
of the net flow of cash from day-today business activities
• Start with
• Add back
Operating income
Depreciation expense
(a non-cash expense)
• Subtract
income taxes
(to work on an after-tax basis)
• Subtract
capital
increase in net working
Which consists of:
– Increase in A/R
(a use of cash)
– Increase in inventories (a use of cash)
– Decrease in A/P
(a source of cash)
What is
cash flow
from
operations?
Cash Flow Statement (11)
Investment Activities
• Investment activities consist of
– The purchase or sale of fixed assets
(change in gross fixed assets)
– The purchase or sale of other long-term
assets (changes in goodwill, patents, etc.)
What is
cash flow
from
investment
activities?
Cash Flow Statement (12)
Financing Activities
Financing activities include:
– Paying dividends and interest expense
– Increasing or decreasing short-term and
long-term debt
• Increase: borrowing more money
• Decrease: paying off debt
– Owners invest more or less in business
• Buy more stock
• Company buys owner’s stock back
What is
cash flow
from
financing
activities?
Cash Flow Statement (13)
Change in net
working capital
Cash Flow Statement for Trimble Associates
Operating Activities
Operating income
$ 100
Plus depreciation
30
Less income taxes
(20) $ 110
Change in net working capital:
Less increases in A/R
$ (5)
Less increases in inventories
(40)
Plus increases in A/P
5
(40)
Cash flows from operations
$ 100
Investment Activities
Less increase in gross fixed assets
$ (100)
Financing Activities
Less interest expenses
$ (20)
Less dividends paid
(15)
Plus incr in short-term notes
20
Plus incr in long-term notes
50
Total Financing Activities
$ 35
Increase (Decrease) in cash
$ 5
Cash Flow Statement (14)
Can You Arrange this Cash Flow Statement?
Operating activities:
Plus
Less
Less
Less
Plus
Cash flows from operations:
Investment activities
Less
Financing activities
Less
Less
Plus
Plus
Total financing activities
Increase (Decrease) in cash
Interest expenses
$(30)
Operating Income
$120
Taxes
$(30)
Increase in gross fixed assets $(90)
$100
Increases in long-term notes
$ 30
Depreciation
$ 40
Increases in short-term
$ 100 notes $ 15
$ receivable
(90)
Increases in accts
$(20)
$ 5payable $ 5
Increases in accounts
$
5
$ 15
Increases in inventories
$(10)
Dividends paid
$(10)
Cash Flow Statement (15)
Interpreting the Cash Flow Statement
• To understand what the cash
flow statement is saying, look at
the signs (+ or -) of the three
cash flow activities:
– Is cash flow from operations positive or
negative?
– Is cash flow from investment activities
positive or negative?
– Is cash flow from financing activates
positive or negative?
Want to
understand the
cash flow
statement?
Look at
the three
cash flow
activities.
Cash Flow Statement (16)
Examples of Cash Flow Patterns
Some of the more important
cash flow patterns are:
Using cash flows from operations and financing
to invest in long-term assets (fixed assets)
Using cash flows from operations to expand the
business and repay creditors and/or owners
Negative cash flow from operations funded by
selling long-term assets and additional financing
Sustaining negative cash flows and investment
to expand the business through financing
(Could be a start-up that has yet to break even)
CONGRATULATIONS!!
Go
Celebrate!
You have completed the task!
Hopefully, your persistence has paid
off and you understand financial
statements much more fully and any
fear of financial statements has been
reduced.
Way to go!!!