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Financial Statements for Management and Operations
Financial Accounting Management
Our Focus
The main focus of this course is to analyze and use financial statementsfor the purposes of:
Speaking with lenders Internal management Tax returns
The Basic Financial Statements
You should prepare and understand three basic financial statements:the balance sheet, which is a record of
assets, liabilities and capital at a specific point in time;
the income (profit and loss) statement, which is a summary of your earnings, expenses and net profit (or loss) over a given period of time; and
the cash flow projection, which shows the actual inflows and actual outflows of cash into and out of your business.
The Balance Sheet
The balance sheet is a snapshot of the company's financial standing at an instant intime. The balance sheet shows thecompany's financial position, what it owns(assets) and what it owes (liabilities and networth). The "bottom line" of a balance sheetmust always balance (i.e. assets = liabilities+ net worth). The individual elements of abalance sheet change from day to day andreflect the activities of the company.
The Balance Sheet
Assets represent the company's use of funds. The company uses cash or other funds provided by the creditor/investor to acquire assets. Assets include all the things of value that are owned or due to the business.
Liabilities represents a company's obligations to creditors while net worth represents the owner's investment in the company.
Current Assets
Current assets are those which mature in less than one year. They are the sum of the following categories:
Cash Accounts Receivable (A/R) Inventory (Inv) Notes Receivable (N/R) Prepaid Expenses Other Current Assets
Fixed Assets
Fixed assets represent the use of cash to purchase physical assets whose life exceeds one year. They include assets such as:
Land Building Machinery and Equipment Furniture and Fixtures Leasehold Improvements
Calculating Fixed Assets
When a fixed asset is purchased for use in theoperations of the business it is recorded at cost.As the asset wears out, an amount is charged toexpense and accumulated annually in a contra-account known as accumulated depreciation.
The gross fixed asset (purchase price) less theaccumulated depreciation equals the Net FixedAsset Value (also known as book value).
Gross Fixed Assets (Purchase Price) - AccumulatedDepreciation = Net Fixed Assets (Book Value)
Intangibles
Intangibles represent the use of cash to purchase assets with an undetermined life and they may never mature into cash.For most analysis purposes, intangibles are ignored as assetsand are deducted from net worth because their value isdifficult to determine.
Intangibles consist of assets such as:
Research and Development Patents Market Research Goodwill Organizational Expense
Current Liabilities
Current liabilities are those obligations that will mature and must be paid within 12 months.
Current liabilities consist of the following obligation accounts:
Accounts Payable -- Trade (A/P) Accrued Expenses Notes Payable -- Bank (N/P Bank) Notes Payable -- Other (N/P Other) Current Portion of Long term Debt
Non-Current Liabilities
Non-current liabilities are those obligations that will not become due and payable in thecoming year. There are three types of non-current liabilities, only two of which arelisted on the balance sheet:
Non-current Portion of Long Term Debt (LTD)
Subordinated Officer Loans (Sub-Off) Contingent Liabilities
Equity
Equity or Net Worth represents the owners‘share in the financing of all the assets. Itconsists of two types of equity; purchasedequity, and earned equity. Purchased equityconsists of:
Preferred Stock (P/S) Common or Capital Stock (C/S) Paid in Capital
The Income Statement
The Income Statement is also known as the “P&L” (Profit and Loss)
A company's income statement is a record of its earnings or losses for agiven period. It shows all of the moneya company earned (revenues) and all of themoney a company spent (expenses) duringthis period.
An Example
Income Statements for the Years Ending 2003 and 2004
Sales $800,000 $850,000Less Cost of Goods Sold (200,000) (250,000)Gross Profit on Sales 600,000 600,000Less General Operating Expenses (180,000) (200,000)Less Depreciation Expense (50,000) (50,000)Operating Income 370,000 350,000Other Income 60,000 90,000EBIT 430,000 480,000Less Interest Expense (50,000) (30,000)Less Taxes (50,000) (60,000)Net Earnings 330,000 390,000Less Dividends Paid (70,000) (80,000)Retained Earnings 260,000 310,000
Explanations
Gross Profit on Sales = Gross MarginGPS = NS – COGSOperating Income = GP – OE – DepreciationEBIT (Earnings Before Interest & Taxes) =
OE +/- OI(OL) +/- Extraordinary Income/Loss
Explanations
Net Earnings (Loss) = EBIT – Interest – TaxesRetained Earnings = Net Earnings -
Dividends
Statement of Cash Flow
Cash flow from an operating perspective ismost important for the businessmanager/owner in a small privately-heldcompany.
It is critical to operate "profitability" and notoperate with negative or break-even cash-flow. Therefore, managing cash-flow iscritical.
Statement of Cash Flows
The statement of cash flow reports the movementof cash into and out of a business in a given year.
Cash Flow Statements are broken down intothree sections:
Operating activities Investing activities Financing activities
Cash Receipts
Cash Receipts from Customers:
Net Sales + Beginning A/R (1/1/00) -Ending A/R (12/31/00) = CashReceipts from Customers
Cash Payments for Inventory
Cash Payments for Inventory:
Ending Inventory (12/31/00) -Beginning Inventory (1/1/00) +Beginning A/P (1/1/00)- Ending A/P(12/31/00) = Cash Paid for Inventory
Cash Paid for Operating Expenses
Cash Paid for Operating Expenses:
Operating Expenses – DepreciationExpenses + Ending Prepaid Expenses –Beginning Prepaid Expenses +Beginning Expenses Payable – EndingExpenses Payable = Cash paid forOperating Expenses
Cash Paid for Interest Expense
Cash Paid for Interest Expense:
Interest Expense per P&L + BeginningInterest Payable - Ending InterestPayable = Cash Paid for Interest Expense
Net Cash Provided (Used) by Operating Activities
A company generates cash from operating its business. A key number is net Cash provided from operating activities. This total includes some items fromthe statement of earnings; such as:
net earnings, showing the company’s profit (or loss); and
depreciation expense.
Net cash provided from operating activities also includes changes in someitems from the statement of financial position:
Inventory changes. (Increases in inventories use cash and reductions provide cash).
Changes in accounts receivable, the sales the company has not yet been paid for. (Increases use cash and decreases provide cash).
Changes in accounts payable. (Increases provide cash and decreases use cash).
The statement of cash flows adds the net cash from each type of operating activity and reports the company’s total net cash provided (or used) by all operating activities.
Net Cash Provided (Used) by Investing Activities
Net Cash Provided (Used) by Investing Activitiesmight include investments in property (land), plant(factories and assembly plants) and equipment(machines, trucks, computer systems, telephonesystems). Investing in such assets is a use of cash.selling them is a source of cash.
The Statement of Cash Flows adds the net cashFrom each type of investing activity and reports thecompany’s total net cash provided (or used) by allinvesting activities.
Working Capital
Working Capital = Current Assets –Current Liabilities.
Working Capital measures how much the Company has in liquid assets togrow its business.
Net Cash Provided (Used) by Financing Activities
Net Cash Provided (Used) by Financing Activitiesincludes the sources and uses of cash for financingactivities. Sources of cash include what a companyraises by selling stocks and bonds and by borrowingfrom banks.
The Statement of Cash Flows adds the net cashFrom each type of financing activity and reports thecompany’s total net cash provided (or used) by allfinancing activities.
Sources of Working Capital
Sources of additional working capital includethe following:
Existing cash reserves Profits (when you secure it as cash !) Payables (credit from suppliers) New equity or loans from shareholders Bank overdrafts or lines of credit Long-term loans
Some Ratios
Liquidity Ratios - a company's ability to meet its short-term obligations
Current Ratio = current Assets/current liabilities
Acid Test (Quick Ratio - no inventory) = current assets-inventory/current liabilities
Working Capital = current assets -current liabilities (how much cash is available to grow the company)
Some Ratios
There are many ratios that can be used to analyze acompany's financial position.
Profitability Ratios - the primary measure of acompany's success. These include:
Return on Equity = earnings after taxes/equity
Return on Assets = earnings after taxes/total assets
Return on Sales = earnings after taxes/total sales
More Profitability Ratios
A profit margin measures how much a company earnings relate to its sales.
A net profit margin measures earnings after taxes.The return on assets (ROA) is a snapshot of the
performance of the management of the company (not from a stockholder perspective).
The return on equity (ROE) is important from a stockholder perspective.
Leverage Ratios
How much debt is a company using to support its obligations? What is the debt to equity?
The debt to equity (debt or financial leverage) ratio indicates the extent to which the business relies on debt financing.Upper acceptable limits of the debt to equity (debt or financialleverage) ratio is usually 2:1; with no more than one-third ofdebt in long-term borrowings. A high financial leverage or debt to equity ratio indicatespossible difficulty in paying interest and principal whileobtaining more funding.
Make sure the leverage ratios are as low as possible.
Summary
The financial accounting principles in this course are importantto understand terminology and build a foundation tounderstanding financial statements.
It is important to understand a company's profitability, itsearning power and control over expenses. Is a companymanaging its operations correctly?
What is the current status of the cash flow management of thecompany and how does it relate to operations andmanagement?