1. Describe the purpose and content of an income statement.

2. Explain the purpose and content of a balance sheet.

3. Explain how viewing the income statement and balance sheets together gives a more complete picture of a firm’s financial position.

4. Use the income statement and balance sheets to compute a company’s cash flows.

5. Analyze the financial statements using ratios to see more clearly how decisions affect a firm’s financial performance.

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Understanding Financial Statements

• Financial Statements (Accounting Statements) Reports of a firm’s financial performance and

resources Helps determine a startup’s financial requirements Assesses the financial implications

of a business plan

• Basic Financial Statements Income statement Balance sheet Cash flow statement

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Understanding the Income Statement

• Income Statement A report showing the profit or loss from a firm’s

operations over a given period of time.

“How profitable is the business?” Sales (revenue) – Expenses = Profits (income)

– Revenue from product or service sales

– Costs of producing product/service (cost of goods sold)

– Operating expenses (marketing, selling, general and administrative expenses, and depreciation)

– Financing costs (interest paid)

– Tax payments

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The Income Statement (cont’d)

• Cost of Goods Sold The cost of producing or acquiring goods or services

to be sold by a firm

• Gross Profit Sales less the cost of goods sold

• Operating Expenses Costs related to marketing and selling a firm’s product

or service, general and administrative expenses, and depreciation

• Operating Income Earnings before interest and taxes are paid

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The Income Statement (cont’d)

• Financing Costs The amount of interest owed to lenders on borrowed

money

• Net Income Available To Owners (Net Income) Income that may be distributed to the owners or

reinvested in the company

• Depreciation Expense Costs related to a fixed asset, such as a building or

equipment, distributed over its useful life

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The Income Statement: An Overview10.1

The Income Statement (cont’d)

10–8

Operating Activities

Sales Revenue

=

=

=

Operating Income

Earnings Before Taxes

Net Income Availableto Owners

Cost of producing or acquiring product or service(cost of goods sold)

Gross profit

Marketing and selling expenses, general and administrative expenses and depreciation(operating expenses)

,

–

=

–

Financing Activities

Operating Income

Interest expense on debt (financing costs)

–

Taxes

Earnings Before Taxes

Income taxes–

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10.2 Income Statement for Houser & Associates, Inc., for the Year Ending December 31, 2013

35%–

65%

100%Percent of Sales

12%

–24%

–2%9%

–2%

7%

Gross profit margin

Operating profit margin

Net profit margin

The Balance Sheet

• Balance Sheet A report showing a firm’s assets, liabilities, and

owners’ equity at a specific point in time Total Assets = Debt + Owner’s equity

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10–11

10.3 The Balance Sheet: An Overview

The Balance Sheet: Current Assets

• Current Assets (Working Capital) Assets that can be converted to cash within the firm’s

operating cycle Cash

Currency and negotiable instruments

Accounts receivable Amount of credit extended to customers that is currently

outstanding

Inventory Raw materials and products held in anticipation of sale

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10.4 The Working Capital Cycle

The Balance Sheet: Fixed Assets

• Fixed Assets (Plant, Property, and Equipment) Relatively permanent resources intended for use in

the business (not for resale)

• Depreciable Assets Assets whose value declines (depreciates) over time

• Gross Fixed Assets Original cost of depreciable assets before any

depreciation expense has been taken

• Accumulated Depreciation Total depreciation expense taken over the assets’ life

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The Balance Sheet: Fixed Assets (cont’d)• Net Fixed Assets

Gross fixed assets less accumulated depreciation

• Other Assets Assets other than current assets and fixed assets,

such as patents, copyrights, and goodwill that have an estimated value

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The Balance Sheet: Debt

• Debt Business financing provided by a creditor

• Current Debt (Short-Term Liabilities) Accounts payable: trade credit payable to suppliers Accrued expenses: short-term liabilities incurred but not paid Short-term notes: Cash amounts borrowed that must be

repaid within a short period of time

• Long-Term Debt Loans and mortgages with maturities greater than

one year

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The Balance Sheet: Debt (cont’d)

• Mortgage A long-term loan from a creditor for which real estate

is pledged as collateral.

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The Balance Sheet: Types of Financing

• Owners’ Equity Money that the owners invest in the business

Owners are “residual owners” of the firm. Creditors have first claim on the assets of the firm.

• Retained earnings Profits less withdrawals (dividends) over the life of the

business

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Owners’equity =

Owners’investment –

Cumulative dividends paid to owners

Cumulativeprofits+

Owners’equity =

Owners’investment +

Earnings retained within the business

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10.5 Balance Sheets for Houser & Associates, Inc., for December 31, 2012 and 2013

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The Fit of the Income Statement and Balance Sheet10.6

The Cash Flow Statement

• Cash Flow Statement A financial report showing a firm’s income (cash)

when it is received and expenses when they are paid. Cash flows from normal operations (operating activities)

Cash flows related to the investment in or sale of assets (investment activities)

Cash flows related to financing the firm (financing activities)

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Profits Versus Cash Flows

• Accrual-Basis Accounting Matches revenues when they are earned against the

expenses associated with those revenues. Sales reflect both cash and credit (noncash) sales. Inventory purchased on credit is a noncash expense. Depreciation is a noncash expense. Income tax is accrued and not entirely expensed.

• Cash-Basis Accounting Reports transactions only when cash is received or a

payment is made.

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Measuring Cash Flows

• Cash Flows from Daily Operations Net cash flows generated from operating a business

Calculated by adding back to operating income depreciation, deducting income taxes, and factoring in any changes in net working capital.

• Adjusted Income After-tax cash flow

• Net Working Capital Money invested in current assets less accounts

payable and accruals

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Measuring Cash Flows (cont’d)

• Cash Flows from Investment Activities Cash inflows and outflows resulting from the sale or

purchase of equipment or another depreciable asset

• Cash Flows from Financing Activities Cash inflows and outflows resulting from:

Paying dividends and interest expense.

Increasing or decreasing short-term and long-term debt.

Issuing or repurchasing stock.

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Computing Cash Flows from Assets

10–25

After-Tax Cash Flowsfrom Operations

CashFlows

from Assets

Changes inOperating

Working Capital

Changes inLong-Term

Assets

After-tax cash flowsfrom operations

Investments inoperating

working capital

Investmentsin long-term

assets

Cashflows from

assets=

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Computing Other Cash Flows

• After-Tax Cash Flows From Operations

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Net income Depreciationexpense

InterestExpense

After-tax cash

flows from operations

= + +

• Operating Working Capital

Currentassets

Operating Working Capital

= – Account payableand accruals

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Cash Flow Statement for Houser & Associates, Inc., for the Year Ending December 31, 2013

10.7

Cash Flows from Financing

10–28

Cash Flowsfrom Financing

Interest and Dividends

Paid to Investors

Increase in Debt(firm issues new debt)

Increase in Equity(firm issues new stock)

Decrease in Debt

(firm repays debt)

Decrease in Equity(firm repurchasesoutstanding stock)

Increases in Cash Flows from Financing

Decreases in Cash Flows from Financing

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Evaluating a Firm’sFinancial Performance

• Factors Impacting the Firm’s Financial Situation The firm’s ability to pay its debt as it comes due.

The firm’s profitability from assets.

The amount of debt the business is using.

The rate of return earned by the owners on their equity investment.

• Financial Leverage The impact (positive or negative) of financing with

debt rather than with equity.

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Financial Ratio Analysis for Houser & Associates, Inc.10.8

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Return on Assets: An Overview10.9

Looking Ahead: Financial Forecasting

• Pro Forma Financial Statements Statements that project a firm’s financial performance

and condition

Purposes of pro forma statements: How profitable can the firm be expected to be, given the

projected sales levels and the expected sales expense relationships?

What will determine the amount and type of financing (debt or equity) to be used?

Will the firm have adequate cash flows? If so, how will they be used; if not, where will the additional cash come from?

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Key Termsaccounts payable (trade credit) accounts receivable

accrual-basis accounting

accrued expenses

accumulated depreciation

balance sheet

cash

cash-basis accounting

cash flow activities

cash flow statement

common stock

cost of goods sold

current assets (working capital) current debt (short-term liabilities)

current ratio

debt

debt ratio

depreciable assets

depreciation expense

dividend

financial leverage

financial statements (accounting

statements)

fixed assets (property, plant and equipment [PPE])

gross fixed assets

gross profit

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Key Termsincome statement (profit and loss

statement)

interest expense

inventory

liquidity

long-term debt

long-term notes

mortgage

net fixed assets

net profits

operating expenses

operating profit margin

operating profits

other assets

owners’ equity

profit margins

profits before taxes (taxable profits)

retained earnings

return on assets

return on equity

short-term notes

total asset turnover

working capital cycle

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