Student Tutorial on Financial Statements

7/28/2019 Student Tutorial on Financial Statements

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Understanding theNumbers: Essential for

the Entrepreneur

A Student Tutorial


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Ever thought or said:

I did not do well in my accountingand finance classes . I just am notgood with numbers

Finance scares me. I try, but I just cant get it.

If not, great, but if so, you may try to

avoid accounting and finance. Why isthat a mistake?


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Reasons to Learn Finance

There are things you cannot learnabout a company any other way.

If you do not understand financial

statements and what they tell you,you will be missing some criticalinformation about the firm.

And hiring someone to do it for you,DOES NOT WORK!!


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UnderstandingFinancial Statements

Goal: Understand the financialconsequences of decisions

There are three basic financial (oraccounting) statements:

Income Statement

Balance Sheet

Cash Flow Statement

The Goal:MakingGood

FinancialDecisions

3 types of

financialstatements


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Income Statement (1)

Indicates the firms profits over aperiod of time

Usually monthly, quarterly or

annually Basic form:

Sales(Revenues)

ProfitsExpenses

Basicpurposeand formatof anincomestatement


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The Income Statement starts withsales (revenues).

From Sales,subtract the Cost

of Goods Sold toobtain the GrossProfit

Sales (Revenue)

Cost of Goods Sold

Gross Profit

minus

equals

Can youcomputegrossprofits?= # of units sold X

sales price per unit


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What is cost of goods sold?

Cost of goods sold is determined by:

The cost of producing or acquiringa single unit of the firms productsor services

The number of units sold

Cost ofgoodssold

=cost per

unit X

numberof units

sold

Computingcost ofgoodssold


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Next compute operating income(earnings before interest & taxes)

From Gross ProfitssubtractOperatingExpenses to

obtain OperatingIncome

Sales Revenue

Cost of Goods Sold

Gross Profit

minus

equals

Operating Expenses

Operating Income

minus

equals

Can youcomputeoperatingincome;

also calledearningsbeforeinterestand taxes(EBIT)?


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What are operating expenses?

In addition to the cost of goods sold, you need

to convince someone to buy what you areselling. So, you will have;

Marketing expenses

And you have operating overheadthe lightbill must be paid. So, you will have:

General & administrative expenses

And if you have equipment and buildings. Youwill have:

Depreciation expense

(More will be said about depreciation later.)

Operatingexpensesinclude

marketingexpenses,G&A, anddeprecia-tion


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A Comment on Operating Income

Operating Income is the total profit afirm makes from running the business

before paying creditors (interestexpense) for the use of debt, andpaying income taxes to thegovernment.

Operating income is the best profitindicator of how well a company isdoing in its business.


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Next we compute earnings beforetaxes (EBT)

From OperatingIncome, subtractInterest Expense toobtain Earnings

Before Taxes

Interest Expense

Operating Income

Earnings Before Taxes

minus

equals

Can youcomputeearnings

beforetaxes?


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Income Statement (8)Interest Expense: The Cost of

Borrowing Money A lender charges interest to loan

money, which is shown as interestexpense in the income statement ofthe borrower.

Interest expense is the result of theinterest rate and the amount

borrowed.

InterestRate

AmountBorrowed

InterestExpensex

You haveto pay thebanker touse the

banksmoney!!


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Income Statement (9)Computing Earning Before Taxes:

An Illustration

If a firm has:

$15,000 in operating income and $50,000in debt at a 6% interest rate, then:

Operating Income $ 15,000Interest Expense $ 3,000

The Earnings before taxes is: $ 12,000

Computinga firmsearningsbefore taxes

Earnings Before Taxes:

= Operating Income Interest Expense

= $15,000 - ($50,000 X .06)

= $15,000 - $3,000 = $12,000


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Finally, we calculate net income

From EarningsBefore Taxessubtract Income

Taxes to obtainthe Net Income

Interest Expense

Operating Income

Earnings Before Taxes

minus

equals

Income Taxes

Net Income

minus

equals

Can youcomputenetincome?


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Income Statement (11)Computing Net Income Illustrated

If a firm has:

Operating Income of $15,000Earnings before taxes of $12,000And pays 25% on income taxes.

The Net income is: $ 9,000

Computing

incometaxes tofind netincome

Net Income:

(Earnings before taxes)-(Tax rate)*(Earningsbefore taxes)

$12,000 - (25%)*($12,000) =

$12,000 - $3,000 = $9,000


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Sales Revenue

Cost of Goods Sold

Operating Expenses

Gross Profit

Operating Income

Interest Expense

Operating Income

Earnings Bef Taxes

Income Taxes

Net Income

Operatin

gActivities

FinancingActivities

minus

minus

minus

minus

equals

equals

equals

equals

What have we learned about theincome statement?

DO NOTcontinueuntil youknow and

understandthe formatandcontent ofan income

statement.


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Income Statement (13)An Example

The Income Statement for Trimble & Associates:

Sales $850

Cost of Goods Sold 550

Gross Profit on Sales $300

Operating Expenses:

Marketing Expenses 90

General & Admin Expenses 80

Depreciation 30

Total Operating. Expenses $200

Operating Income 100Interest Expense 20

Earnings Before Tax 80

Income Tax (25%) 20

Net Income 60

Incomefromoperating

thebusiness

Incomeafter\paying

interest

Cost ofborrowing


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Income Statement (14)Summary

The Income Statement answers thequestion:

How profitable is the business?

The Income Statement reports on fivebroad areas:

Sales (Revenue)

Costs of producing or acquiring the

firms goods or services Operating Expenses

Financing costs (interest expense)

Tax payments


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Income Statement (15)Can You Put It Together?

Cost of Goods Sold $250

Depreciation $ 8

Sales $290

Income Taxes(25%) $ 2

Admin. &Sales Exp. $ 18

Interest Expense $ 6

Organize this Income statement Put thepieceswherethey go!!

4. Goodjudgment

Gross Profit on Sales $

Operating Expenses:

Total Op. Exp. $

Operating Income $

Earnings Before Taxes $

Net Income $


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Gross Profit on Sales $

Operating Expenses:

Total Op. Exp. $

Operating Income $

Earnings Before Taxes $

Net Income $

Here You Go!


Depreciation $ 8

Sales $290




Depreciation $ 8

Sales $290





26

14

8

6


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Income Statement (16)A Concluding Thought

Congratulations!! You should beable to understand the incomestatement and what it is telling you.

We are now ready to examine thebalance sheet, which measures thefirms current financial position.

Lets continue.


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Balance Sheet (1)

A Snapshot of a companys financialposition at a specific point in time

The Income Statement covers a period intime (Jan 1 Dec 31, 2007)

The Balance Sheet represents a specificmoment (December 31, 2007)

In its simplest form, the Balance Sheet

is:

Totalassetsalwaysequal

debt plusequity.

TotalAssets

Owners

EquityOutstanding

Debt

Debt & Equity


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Balance Sheet (2)Three main parts

Assets

What the company owns

Liabilities (Debt)

What the company owes

Owners Equity (Net Worth)

The amount invested by theowners (stockholders)

The difference between Assets andLiabilities

Basicpieces ofthebalance

sheet

Continue


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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, Accruedexpenses, Short-term notes)

Long-term debt (Long-term notes, Mortgages)

Owners equity: owners investment in

the company

A lookinside thebalancesheet

-Cash Flow2. Forecast

3. Determineandevaluate

4. Goodjudgment


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Balance Sheet (4)Assets: Current Assets

Current assets are also called grossworking capital

Current assets comprise the assets

that are relatively liquid Cash

Accounts Receivable

Inventories

Other current assets

(e.g., prepaid expenses)

Currentassets:the firmsliquid

assets;includescash andassetsthat cansoon beconvertedinto cash


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Balance Sheet (5)Assets: Fixed Assets

Fixed assets include:

Machinery and Equipment

Buildings and Land

The cost of a fixed asset is recordedin the balance sheet and depreciatedover its useful life.

The Income Statement reports the

depreciation expense for each year.

The Balance Sheet reports theaccumulated depreciationdepreciationtaken on an asset over all its life.

Fixedassetsmay alsobe called

plant &equipment

B l Sh t (6)


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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!!

Depreciationexpense isNOT a cashexpense!!!


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Balance Sheet (7)Gross Versus Net Fixed Assets

Gross Fixed Assets is the originalamount paid for a firms fixed assets.

Net Fixed Assets is the gross fixedassets minus the total depreciation(accumulated depreciation) taken on

the fixed assets. That is,

Gross fixedassets

accumulateddepreciation =

net fixedassets-

So:

net fixedassets =gross fixed

assetsaccumulateddepreciation


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Balance Sheet (8)An Example of Depreciation

You purchase equipment for $10,000with an expected life of 5 years. Howmuch will the depreciation expense beeach year, as reported in the incomestatement?$2,000 ($10,000 5 years = $2,000)

What will the balance sheet look likeover the 5 years?

End of Year 1 2 3 4 5Gross fixed assets $10K $10K $10K $10K $10KAccumulated depre 2K 4K 6K 8K 10KNet fixed assets $8K $6K $4K $2K $0K


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Balance Sheet (9)Assets: Other Assets

Other assets includes intangibles,such as:

Patents

Copyrights Goodwill

And for a start-up company: Organizational costs

The firmsotherassets


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Balance Sheet (10)Debt And Equity

Remember TotalassetsMUSTequal

total debtplusownersequity

TotalAssets

Owners

EquityOutstanding

Debt

Debt & Equity


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Balance Sheet (11)Debt or Liabilities

Debt is financing provided by acreditor

Debt is divided in two parts: Current debt or short-term

liabilities

Long-term debt

Wheredoes debt

come

from?


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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 otherfinancial institutions

Short-termliabilitiesis debtthat must

be repaidwithin 12months-Cash Flow

2. Forecast

3. Determine

4. Goodjudgment


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Balance Sheet (13)Long-term Liabilities

Loans from banks or other sourcesthat that come due after 12 months

Usually loans to finance long-term

capital investments, such asmachinery and equipment.

Long-termliabilities(debt)

Loans that

come dueafter 12months


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Balance Sheet (14)Owners Equity

Owners Equity is the moneyinvested by the owners

Note: They are residual owners, because in

a liquidation, stockholders are paid last Equity consists of:

Amount invested when purchasingownership in the business

Retained Earnings: All the profitsretained in the company (profits not paidout in dividends to the owners)

Ownershave 2ways toinvest in a

business: Buy

stock

Reinvest

all orpart ofthefirmsprofits


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Balance Sheet (15)Owners Equity

Retained Earnings is theaccumulated profits (gains-losses) ofthe business, less the dividends paid

to stockholders since the firm wascreated

Owners

EquityCumulative

ProfitsOwners

InvestmentCumulativeDividends

RetainedEarnings

Owners

EquityOwners

Investment

Retainedearnings: Aconceptthat manystudents failtounderstand.Do you?


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Balance Sheet (16)An Example

ASSETS DEBT AND EQUITY

Current Assets Current Liabilities:

Cash $50 Accounts payable $20Accounts receiv 80 Short-term notes 80

Inventories 220 Total current debt $100

Total current assets $350 Long-term debt 200

Fixed assets: Total debt: $300

Gross fixed assets $960 Common stock $300Accum depreciation -390 Retained earnings 320

Net fixed assets $570 Total common equity $620

TOTAL ASSETS $920 TOTAL DEBT AND EQUITY $920

The Balance Sheet for Trimble & Associates:


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Balance Sheet (17)Putting it together

Given the information below, can youarrange the balance sheet?Remember: ASSETS = LIABILITIES + EQUITY

Cash $ 70

Accounts Receivable $ 220

Inventories $ 310

Total Current Assets $ 600

Gross Fixed Assets $2,500

Accumulated Depreciation $(300)

Net Fixed Assets $2,200

Assets:

Current Assets

Fixed Assets

TOTAL ASSETS $ 2,800

FIRST: ASSETS

Cash $ 70


Inventories $ 310



Accumulated Depreciation $(300)



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Balance Sheet (18)Putting it together

Common Stock $ 900

Long-term debt $ 800

Total Owners Equity $1,750

Total Debt $1,050

Total Current Liabilities $ 250

Short-term Notes $ 20

Accounts Payable $ 230

Liabilities:Current Liabilities:

Owners Equity:

TOTAL DEBT&EQUITY $ 2,800

NEXT: DEBT & EQUITY

Retained Earnings $ 850

Common Stock $ 900



Total Debt $1,050






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Balance Sheet (19)All Together

The complete balance sheet is as followsAssets:Current Assets

Fixed Assets

TOTAL ASSETS $ 2,800

Liabilities:Current Liabilities:

Owners Equity:

TOTAL DEBT&EQUITY $ 2,800

Cash $ 70


Inventories $ 310



Accumulated Depreciation $ 300


Common Stock $ 900



Total Debt $1,050






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Balance Sheet (20)Income Statement and Balance Sheet

The Income Statement and BalanceSheet complement each other

January

1

Decemb

er31

Balance Sheeton December31, 2006

Balance Sheeton December31, 2007

YEAR 2007

Income Statement for 2007


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Balance Sheet (21)Concluding Thought

A balance sheet indicates a firmsfinancial position in terms of theassets owned and how these assets

have been financed by debt andowners equity.

With an understanding of the incomestatement and the balance sheet, we

can now look at the Cash FlowStatement.

DONTCONTINUE

if you donot fullyunderstandthe balancesheet!! Goback untilyou havegrasped all

the parts ofthe balancesheet.


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Cash Flow Statement (1)

Cash is King!!

Cash flow problems is a major reason for

small firms failingeven at times whenthe business is profitable.

Run out of cash

and your business will fail!

CASH ISKING is notsomeclich, buta principleyou cannotafford toviolate!


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Cash Flow Statement (2)Accrual versus Cash Accounting

You must understand the differencebetween accrual-basis accountingand cash-basis accounting.

With the exception of very smallbusinesses, the income statementand the balance sheet are based onaccrual accounting.

When accrual accounting is used,profits and cash flows will not beequal.


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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 earnedExpense incurred Cash receivedExpense paid

Accrual-basisaccounting

Cash-basisaccounting



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Cash Flow Statement (4)Why Profits and Cash Flow

are NOT the Same

The differences between profits andcash flows can result from:

Sales reported on the IncomeStatement include cash and creditsales

Some purchases are financed bycreditso no cash is involved

Depreciation expense is a non-cashexpense.

Income tax on the income statementmay be accrued and paid in later

periods.

Profits willnever tellyou howmuch cashyougenerated!!


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Cash Flow Statement (5)Accrual vs. Cash Again

Which type of accounting would recordthe following?

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 months utility bill

Accrual Cash


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The Cash Flow Statement answersa very important question:

Where did the cash comefrom and where did the

cash go?

C h Fl St t t (7)


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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 thebeginning of the year (end of lastyear) and the balance sheet for thecurrent year end.



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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

Changesin thebalancesheet

affectcashflows.


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Cash inflows and outflows resultfrom three activities:

Operating Activities:

Cash flow from normal operations Investment Activities:

Cash flow related to the investmentin or sale of assets

Financing activities:Cash flow related to financing thefirm

Threeactivitiescausecash to

increaseordecrease


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Cash Flow Statement (10)Operating Activities

Cash flow from operations consistsof the net flow of cash from day-to-day business activities

Start with Operating income

Add back Depreciation expense(a non-cash expense)

Subtract income taxes(to work on an after-tax basis)

Subtract increase in net workingcapitalWhich 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 iscash flowfromopera-

tions?

C S (11)


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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-termassets (changes in goodwill, patents, etc.)

What iscash flowfrominvestmentactivities?


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Cash Flow Statement (12)Financing Activities

Financing activities include:

Paying dividends and interest expense

Increasing or decreasing short-term andlong-term debt

Increase: borrowing more money

Decrease: paying off debt

Owners invest more or less in business

Buy more stock Company buys owners stock back

What iscash flowfromfinancing

activities?



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Cash Flow Statement (13)Cash Flow Statement for Trimble Associates

Operating Activities

Operating income $ 100Plus depreciation 30Less income taxes (20) $ 110Change 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 ActivitiesLess increase in gross fixed assets $ (100)

Financing Activities

Less interest expenses $ (20)Less dividends paid (15)Plus incr in short-term notes 20Plus incr in long-term notes 50Total Financing Activities $ 35

Increase (Decrease) in cash $ 5

Changeinnet

workingcapital

C S ( )


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Cash Flow Statement (14)Can You Arrange this Cash Flow Statement?

Operating activities:

PlusLessLess

LessPlusCash flows from operations:

Investment activitiesLess

Financing activities

LessLessPlusPlusTotal financing activities

Increase (Decrease) in cash

Operating Income $120

Depreciation $ 40

Taxes $(30)

Increases in accts receivable $(20)

Increases in inventories $(10)

Increases in accounts payable $ 5

Increase in gross fixed assets $(90)

Interest expenses $(30)

Increases in short-term notes $ 15

Increases in long-term notes $ 30

Dividends paid $(10)

$100

$ 5

$ 100

$ (90)

$ 5

$ 15

C h Fl St t t (15)


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Cash Flow Statement (15)Interpreting the Cash Flow Statement

To understand what the cashflow statement is saying, look atthe 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 activatespositive or negative?

Want tounder-stand thecash flow

state-ment?Look atthe threecash flow

activities.

C h Fl St t t (16)


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Cash Flow Statement (16)Examples ofCash Flow Patterns

Using cash flows from operations and financing

to invest in long-term assets (fixed assets)

Using cash flows from operations to expand thebusiness and repay creditors and/or owners

Negative cash flow from operations funded by

selling long-term assets and additional financingSustaining negative cash flows and investmentto expand the business through financing

(Could be a start-up that has yet to break even)

Some of the more importantcash flow patterns are:


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CONGRATULATIONS!!

You have completed the task!

Hopefully, your persistence has paidoff and you understand financial

statements much more fully and anyfear of financial statements has beenreduced.

GoCelebrate!

Student Tutorial on Financial Statements

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