Review of Financial Statements
Discussions with instructors of down stream CBA core courses revealed their reliance on specific ACC 221 and ACC 222 subject matter. Finance 335 instructors assume that students understand the basics of TVM, financial statements, and cash forecasts. Instructors of Marketing 309 and Management 393 assume that students understand revenue/cost analysis (C-V-P model, evaluation of segment or product profitability, and outsourcing and pricing decisions). Instructors of Management 449 assume that students understand TVM, financial statement analysis, and revenue/cost analysis.
The Basics of Business and Financial Statements
For financial statement reporting purposes, business events are categorized into three types: financing, investing, and operating events. When a business is started financing must be arranged. With the financing the business invests in assets to be used to conduct business operations.
Periodically, owners and creditors want financial information about the business. Owners of a small business may want information very frequently, e.g., monthly, to help manage the business. Creditors may call for information less frequently to evaluate the company’s ability to repay a loan.
The basic financial statements and what they report are as follows. The income statement (sometimes referred to as the “ P&L” or profit and loss statement) reports revenue and expense events that occurred during the reporting period. Revenues minus expenses equals net income (also referred to as profit or earnings). The balance sheet reports the business’s assets, its liabilities, and the owners’ equity in the business as of the last day of the reporting period. The statement of cash flows reports cash inflows and cash outflows from financing events, investing events, and operations during the reporting period.
Financial statements reflect the effects of economic events on the business entity. Financing may be obtained from owners, lenders, or both. When owners provide financing, assets and owners’ equity on the balance sheet increase. When money is borrowed from lenders, assets and liabilities on the balance sheet increase. Neither of these financing events is reported on the income statement. When a business invests in assets like inventory or equipment, payment is made at time of purchase or the purchase is on credit, with payment due some time later. If assets are bought for cash, the balance sheet will report the asset purchased and show cash lower by the purchase price. If the item is purchased on credit, the balance sheet will report the asset purchased and a liability will have increased by the amount of credit extended by the seller. Neither of these investing events is reported on the income statement. The income statement reports only those events that reflect the measured net income from carrying out the operating activities of the business.
A couple of things make understanding net income difficult. First, it is common to think of money and income as being the same. When it comes to measuring business income, they are not. Think about this. If money is income, you would have to pay income tax on proceeds you got from a banker to buy a car. But you don’t. If income is money, wouldn’t you get to spend your gross pay instead of your net pay? Well, you don’t. Money and income are different concepts. “Money” refers to coin, currency, and checking account balances. Business “income” is a measure of change in a company’s assets and liabilities due to a very narrow range of economic events. What that should tell you is that there must be a very important relationship between the income statement and the balance sheet. The next paragraph explains that relationship.
At the heart of business net income measurement is the (accounting) equation “Assets = Liabilities + Owners’ equity.” However, to understand what is meant by net income, it is better to look at the equation in a different arrangement: Assets – Liabilities = Owners’ equity. “Assets minus liabilities” is referred to as “net assets.” Net income is the net of two types of events: revenue events and expense events. Revenue events are those events that increase net assets, and thus owners’ equity, due to the operations of the business. The primary revenue events are the transfer of product to customers (called sales on the income statement) and the providing of services to customers (called service revenue, e.g., consulting revenue, on the income statement). These revenue events generally increase cash or accounts receivable. Secondary revenue events include return on financial investments (interest revenue, dividend revenue) and gains from sale of operating assets or financial investments. Expense events are those events that decrease net assets, and thus decrease owners’ equity, due to the operations of the business. The phrase “due to the operations of the business” is critical to identifying revenue and expense events. For example, the issuance of shares of stock to owners in exchange for cash increases net assets, but is not a revenue event because it is not “due to the operations of the business.” Also a cash dividend payment to the owners decreases net assets, but is not considered an expense because it is not an event necessary to the operation of the business.
Financial Statement Components
The Income Statement
Sales are a measure of the market value of all products sold by the company. The sales amount does not necessarily reflect cash received. Sales may have been cash sales or credit sales. Credit sales result in accounts receivable appearing on the balance sheet. To determine cash collected from customers during the period, start with the sales amount and either deduct an increase in accounts receivable or add a decrease in accounts receivable. If receivables increase during the period, it means that sales have been made for which the cash has not been collected; hence, cash flow is lower that sales. Sales are reported net of sales returns and allowances and sales discounts.
Cost of Goods Sold
Cost of goods sold is an expense reflecting the fact that inventory is used up when a sale is made. For a retailer, the underlying cash flow could be called “cash paid to merchandise suppliers.” To determine cash paid to merchandise suppliers and add (deduct) an increase (decrease) in inventory and deduct (add) an increase (decrease) in accounts payable to merchandise suppliers. Cost of goods sold is based on the cost flow assumption used (LIFO, FIFO, or weighted average). Hence two companies’ financial statements are not comparable unless both use the same costing method.
Gross Profit (Gross Margin)
Gross profit (margin) is equal to net sales minus cost of goods sold.
All expenses, other than cost of goods sold, interest expense, and income tax expense, are often combined into one line on the income statement. Sometimes this amount is called selling and administrative expenses rather than operating expenses. To determine the underlying cash flow, (1) add (deduct) an increase (decrease) in prepaid expenses, (2) deduct (add) an increase (decrease) in accrued liabilities, and (3) deduct depreciation expense.
EBIT stands for Earnings Before Interest and (income) Tax.
Interest expense is the cost of debt financing incurred for the period. To the extent that interest expense has not been paid, interest payable will appear on the balance sheet. To determine cash paid for interest, start with interest expense and deduct (add) an increase (decrease) in interest payable.
EBT stands for Earnings Before (income) Tax.
Income Tax Expense
Income tax expense is the amount of income tax that has already been paid or will be paid in the future on the year’s EBT. All income taxpayers are on a pay-as-you-go basis. A corporation must make estimated income tax payments during its tax year. By year-end, most of the income tax will have been paid. The amount yet to be paid will be reported as a liability on the balance sheet. A corporation may use certain accounting principles (such as accelerated depreciation) on the income tax return to reduce current period taxable income and postpone payment of income tax for a number of years. If that is the case, deferred income tax liability will appear on the balance sheet. To determine cash paid for income taxes, deduct (add) an increase (decrease) in income tax payable and deduct (add) an increase (decrease) in deferred income tax.
Net income is the excess of revenue events over expense events. It is the measured increase in net assets, and thus owners’ equity, due to carrying out the operations of the company.
The Balance Sheet
Current assets includes cash plus those assets to be turned into cash (marketable securities and A/R) or used up (inventory and prepaid expenses) within one year of the balance sheet date or the operating cycle, whichever is longer. (See observation 10 below.) For most companies the relevant time period is one year.
Cash and Cash Equivalents
Cash includes coin, currency, and checking account balances. Cash equivalents are highly liquid debt securities with a maturity date so near that their market value will not change significantly with a change in interest rates.
Marketable securities are financial securities, other that cash equivalents, that management plans to hold for no longer than one year from the balance sheet date. These securities are reported at their fair market value.
If a company makes credit sales, accounts receivable appears on the balance sheet and reflects the amounts from credit sales yet to be collected. Accounts receivable is typically reported net of the company’s best estimate of the amount of the receivables that is net expected to be collected.
Inventory, for a merchandising firm, represents to cost of product purchased but not yet sold. When the product is sold, inventory is decreased and cost of goods sold on the income statement is increased. Inventory, for a manufacturing firm, is comprised of raw materials, work in process, and finished goods. Inventory value on the balance sheet is based on the cost flow assumption used by the company (LIFO, FIFO, or weighted average). Hence two companies’ financial statements are not comparable unless both use the same costing method.
Prepaid expenses appears on the balance sheet when a company has paid for such items as supplies, insurance coverage, and rental rights prior to the time when these items will be used in carrying out the operations of the business. In the period these assets are used up, prepaid expense on the balance sheet decreases and an expense is recognized on the income statement.
Property, Plant, and Equipment
Property (land) is reported on the balance sheet at its historical cost. Plant (buildings) and equipment are reported on the balance sheet at their historical cost less accumulated depreciation. Accumulated depreciation is that portion of historical cost that has already been recognized as depreciation expense on the income statement. To the extent the buildings and equipment are related to a firm’s manufacturing activity, the related depreciation expense becomes part of factory overhead. The factory overhead is reflected in work in process inventory, then in finished goods inventory, and finally in cost of goods sold. If the buildings and equipment are not related to manufacturing activity, the related depreciation expense will be reported as part of operating expenses.
Intangible assets include such assets as copyrights, patents, trade names, trademarks, and goodwill. To the extent the intangible assets are related to a firm’s manufacturing activity, the related amortization expense becomes part of factory overhead. The factory overhead is reflected in work in process inventory, then in finished goods inventory, and finally in cost of goods sold. If the intangibles are not related to manufacturing activity, the related amortization expense will be reported as part of operating expenses.
This category of non-current assets is comprised of investments in financial securities. These securities are reported on the balance sheet at their fair market value unless they are securities without a market value or they are debt securities that management intends to hold to maturity.
Current liabilities are those liabilities expected to be paid off with current assets or replaced with other current liabilities.
Accounts payable represents a liability to merchandise (or raw material) suppliers for inventory acquired but not yet paid for.
“Accrued liabilities” is a balance sheet caption that summarizes numerous liabilities stemming from the incurring of operating expenses before the period of payment. For example, during the last week of the year the employees may work for the company, but payday may occur after year-end. The cost of the employee services in reported as an expense of the year, and a liability for wages is recorded and reported as part of accrued liabilities on the balance sheet. Other liabilities included in accrued liabilities include property taxes payable, rent payable, and utilities payable.
Interest payable is the liability for interest cost incurred but not yet paid by the end of the period.
Income Tax Payable
Income tax payable represents that portion of the company’s current year income tax liability that remains unpaid at year-end.
Deferred Income Tax Liability
This liability results principally from the use of accelerated depreciation on the corporate tax return while the straight-line method is used on the income statement. Accelerated depreciation means that, in the early years of the life of a depreciable asset more than the straight-line amount of depreciation expense is used on the tax return to decrease the current year income tax liability. This defers the payment of the tax to the later years of the asset’s life when, because of lower amounts of depreciation expense on the tax return, the company’s tax liability is high.
A note payable typically arises when cash is borrowed from a financial institution in exchange for a promissory note. The note may be either a current or a long-term liability. The note is reported on the balance sheet at the present value of future cash payments to be made, discounted at the effective rate of interest on the note.
A bond is essentially a promissory note, except that it is typically used to borrow much larger amounts of money for longer periods of time, and it is a much more complex financial instrument than a promissory note. The bond is reported on the balance sheet at the present value of future cash payments to be made, discounted at the effective rate of interest on the bond.
Stockholders’ equity represents owners’ rights to the assets of the business. Owners’ rights come from two sources: owner investment of personal assets in the company and profitable operations. Owners’ equity on a per share basis (book value per share) is not a good measure of the amount of cash an owner would receive upon disposition of the stock. Under normal circumstances, the value of a share of stock depends on what buyers in the market are willing to pay. In the case of liquidation of the company owners most often receive, after payment of creditors, less than book value.
Preferred Stock + Additional Paid-in Capital on Preferred Stock
These accounts normally represent the amount preferred stockholders would receive upon liquidation of the company, assuming sufficient cash was available after payment of creditors.
Common Stock + Additional Paid-in Capital on
These accounts represent common shareholder rights to assets due to their investment of assets in the business.
Retained earnings is a measure of profitability of the business to date, less all dividends declared on all classes of stock. It represents common stockholders’ rights to the corporate assets, except to the extent of dividends in arrears on cumulative preferred stock.
Treasury stock represents the cost of shares of stock that the company has bought back from stockholders. Treasury stock, normally common stock, is typically bought to be resold to employees in a stock option plan or bought to increase the market price of the stock. Treasury shares have no rights to dividends and voting.
The Statement of Cash Flows
This financial statement discloses a company’s cash flows from operating activities, financing activities, and investing activities. The operating activities section typically starts with net income and converts that number to cash flow from operating activities by making adjustments to it for accruals and deferrals, non-cash revenue and expense items, and gains/losses relating to investing and financing events. Typical cash flow events reflected in the financing activities section include issuance of equity securities, issuance and retirement of debt securities, treasury stock transactions, and payment of cash dividends. Typical cash flow events reflected in the investing activities section include purchase and sale of land, buildings, equipment, intangible assets and investments in financial securities.
Some Observations About Financial Statements (f/s)
- Financial statements made available to individuals outside of the company (external f/s) represent highly aggregated information.
- Operating expenses on the traditional external income statement are classified by function, e.g., manufacturing, administrative, selling. Expenses on an income statement used for management decision-making may be classified by behavior, i.e., by the way they behave with changes in activity level.
- Balance sheet assets are a mix of values: historical cost (land), depreciated historical cost (buildings and equipment), historical cost or lower of cost or market (inventory), and current market value (some investments in financial securities).
- Not all of a company’s assets are on its balance sheet. The value of research and development in process is not because the cost of R&D activity is expensed as incurred. Trade names, like Coke, are not on the balance sheet if their value accrues due to advertising, since all advertising costs are expensed as incurred. Other intangibles, like copyrights and patents, developed rather than purchased, are also typically not on the balance sheet. Intangible assets that have been purchased will appear on the balance sheet. The value of a company’s culture, trained and dedicated employees, loyal customers, and vendor relationships are examples of other assets not reflected on the balance sheet. This situation exists because it is often difficult to know whether an expenditure of cash results in a probable future economic benefit. The value of the Coke trade name is the result of millions of dollars of advertising over the decades. Would you be able to determine the increase in value of the trade name due to a $10 million dollar advertising campaign? Probably not. That is why the cost of advertising is recognized as an expense of the current period, with none of the expenditure going to increase the balance sheet amount at which the trade name is reported.
- Stockholders’ equity (assets – liabilities) is not a measure of the value of a company. The best measure of a company’s value is a bona fide offer for the purchase of all of its common stock. The market value of the common stock (market capitalization) of a publicly traded company is another measure of a company’s worth. The spread between a company’s market valuation and its book value (stockholders’ equity) reflects both the company’s unreported assets and the company’s potential for making future profits. For knowledge-based companies, that spread is very large.
- A business whose financial statements you are analyzing may be a sole proprietorship, a partnership, a corporation, or a limited liability company (LLC). How you evaluate the company’s profitability depends on the form of business organization used. If you see income tax expense subtracted on the income statement to arrive at net income, the business is a corporation that did not make or did not qualify for the “S Corp” election. The tax is the corporate income tax. Business income of a sole proprietorship, partnership, S Corp, LLP, or LLC is not taxed at the corporate level. Rather, the income is included on the income tax return(s) of the owner(s) and taxed at individual income tax rates. In these situations, income tax expense is not included as an expense in arriving at the net income of the business. Additionally, the balance sheet would not show income tax payable or deferred income tax liability.
- Audited financial statements are presumed to have greater reliability than unaudited financial statements. Audited financial statements are typically required by lenders when large amounts are involved or if a company wishes to issue financial securities in the capital market. After reviewing the company’s internal control system, verifying the existence of company assets and liabilities, and carrying out other audit processes, the auditor issues an opinion on the financial statements. In a “clean opinion,” the auditor, a CPA, attests that the financial statements fairly reflect the operations, financial position, and cash flows of the company in accordance with generally accepted accounting principles.
- Each and every revenue and expense event has two effects on the balance sheet. Each revenue event increases an asset or decreases a liability and increases retained earnings. Each expense event decreases an asset or increases a liability and decreases retained earnings. The net effect of business operations is called net income.
- Current assets are reported on the balance sheet in order of liquidity: cash and cash equivalents, marketable securities, receivables, inventory, and prepaid expenses.
- The term “operating cycle” refers to the process of buying or manufacturing inventory, selling the inventory on credit, and collecting the receivable. The operating cycle is reflected in the listing of current assets. The length of a company’s operating cycle can be calculated by adding the results of two ratios: average A/R collection period and average sale period.
- There are three important dates pertaining to a cash dividend: the date of declaration, the date of record, and the date of payment. On the date of declaration, a current liability for the dividend is created and retained earnings is decreased. There is no financial statement impact at the date of record. At the date of payment, cash is decreased, as is the dividend liability that had been created at the date of declaration.
- A corporation receives authorization to issue shares of stock from the state in which it was incorporated. It subsequently issues (sells) all or part of those shares in exchange for some type of consideration, typically cash. Later, the company may buy back some of the shares it had issued. The shares bought back are called treasury shares or treasury stock. At any point in time, the number of shares issued less the number of treasury shares equals the number of shares outstanding. Shares outstanding are shares still in the hands of shareholders and are the shares that have rights to receive dividends and, in the case of common shares, the right to vote for members of the board of directors.
- Most issues of stock have a par value per share. This concept, established a century ago in an attempt to protect creditors’ rights, has virtually no significance in today’s economic setting. Often, though, the fixed dividend on preferred stock is set forth as a percent of par value. For example, 4%, $200 par value preferred stock pays an annual dividend of $8.
SPECIMEN FINANCIAL STATEMENTS
|less: Costs of Goods Sold||-30,000||-31,000||-40,000|
|less: Selling & Administration Expense||-8,400||-8,500||-8,600|
|Earnings Before Interest and Tax||11,600||12,500||7,400|
|less: Interest Expense||-900||-900||-1,800|
|Earnings Before Income Tax||10,700||11,600||5,600|
|less: Income Tax Expense||-3,210||-3,480||-1,680|
|Accounts Receivable (net)||12,200||13,100||11,540|
|Total Current Assets||25,200||29,520||24,640|
|Total Current Liabilities||1,700||1,900||2,100|
|Long-Term Liab - Notes Payable||9,000||9,000||18,000|
|Long-Term Liab – Deferred Tax Liability||2,000||2,800||3,900|
|Pref. Stock (7%, $100 par, cumul.)||5,000||5,000||5,000|
|Paid in Capital in excess of par-PS||1,000||1,000||1,000|
|Common Stock ($2 par value)||12,090||12,090||12,090|
|Paid in Capital in excess of par - CS||2,000||2,000||2,000|
|less: Treas. Stock (100 shares)||(1,000)||(1,000)||(1,000)|
|Total Stockholders’ Equity||32,500||38,820||40,640|
|Total Liab. and Stockholders’ Eq.||$45,200||$52,520||$64,640|
WEBCRAWLER FINANCIAL RATIOS
|1. ROA (Net Income + Interest Expense)/Average Total Assets|
|8120+900 = 9020 = 18%||3920+1800 = 5720 = 10%|
|(45200+52520)/2 48860||(52520 + 64640)/2 58580|
|2. ROE Net Income/Average Stockholders’ Equity|
|8120 = 8120 = 23%||3920 = 3920 = 10%|
|(32500+38820)/2 35660||(38820+40640)/2 39730|
|3. ROCS NI-PS Dividends/Average CS Equity|
|8120-350 = 7770 = 26%||3920-350 = 3570 = 11%|
|(26500+32820)/2 29660||(32820+34640)/2 33730|
|4. Debt/Assets Total Debt/Total Assets|
|13700 = 26%||24000 = 37%|
|5. GM% Gross Margin/Net Sales|
|21000 = 40%||16000 = 29%|
|6. Ret. On Sales Net Income/Net Sales|
|8120 = 16%||3920 = 7%|
|7. Current Ratio Current Assets/Current Liabilities|
|29520 = 16||24640 = 12|
|8. AR Turnover Net Sales/Average Accounts Receivable (net)|
|52000 = 4.11||56000 = 4.55|
|9. Ave. days to Collect AR 365/AR Turnover Ratio|
|365 = 89 days||365 = 80 days|
|10. Inventory Turnover Cost of Goods Sold/Average Inventory|
|31000 = 3.73||40000 = 4.51|
|11. Ave. days in Inventory 365/Inventory Turnover Ratio|
|365 = 98 days||365 = 81 days|
|12. Times Interest Earned EBIT/Interest Expense|
|12500 = 13.9 times||7400 = 4.1 times|
|13. Price-Earnings Selling Price per share/EPS|
|14. Earnings per share (Net Income-PS Dividends)/average # shares of CS outstanding|
|8120-350 = $1.31||3920- 350 = $0.60|