Understanding the Numbers: Essential for the Entrepreneur A Student Tutorial.

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!!

UnderstandingFinancial 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)

ProfitsExpenses

Basic purpose and format of an income statement


• The Income Statement starts with sales (revenues).

From Sales, subtract the Cost of Goods Sold to obtain the Gross Profit

Sales (Revenue)

Cost of Goods Sold

Gross Profit

minus

equals

Can you compute gross profits?= # of units sold X

sales price per unit


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 Xnumber of units

sold

Computing cost of goods sold


• Next compute operating income (earnings before interest & taxes)

From Gross Profits subtract Operating Expenses to obtain Operating Income

Sales Revenue

Cost of Goods Sold

Gross Profit

minus

equals

Operating Expenses

Operating Income

minus

equals

Can you compute operating income; also called earnings before interest and taxes (EBIT)?


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.


• Next we compute earnings before taxes (EBT)

From Operating Income, subtract Interest Expense to obtain Earnings Before Taxes

Interest Expense

Operating Income

Earnings Before Taxes

minus

equals

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

Amount Borrowed

Interest Expensex

You have to pay the banker to use the bank’s money!!

Income Statement (9)Computing Earning Before Taxes:

An Illustration

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

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

The Earnings before taxes is: $ 12,000

Computing a firm’s earnings before taxes

Earnings Before Taxes:

= Operating Income – Interest Expense

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

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


• Finally, we calculate net income

From Earnings Before Taxes subtract Income Taxes to obtain the Net Income

Interest Expense

Operating Income

Earnings Before Taxes

minus

equals

Income Taxes

Net Income

minus

equals

Can you compute net income?

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 income taxes to find net income

Net Income:

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

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

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


Sales Revenue

Cost of Goods Sold

Operating Expenses

Gross Profit

Operating Income

Interest Expense

Operating Income

Earnings Bef Taxes

Income Taxes

Net Income

Op

erat

ing

Act

ivit

ies

Fin

anci

ng

Act

ivit

ies

minus

minus

minus

minus

equals

equals

equals

equals

What have we learned about the income statement?

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:

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 100

Interest Expense 20

Earnings Before Tax 80

Income Tax (25%) 20

Net Income 60

Income from operating the business

Income after \paying interest

Cost of borrowing

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?

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 the pieces where they go!!4. Good judgment

Gross Profit on Sales $

Operating Expenses:

Total Op. Exp. $

Operating Income $

Earnings Before Taxes $

Net Income $

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

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 always equal debt plus equity.

Total Assets

Owner’s Equity

Outstanding Debt

Debt & Equity

Balance Sheet (2) Three main parts

• Assets– What the company owns

• Liabilities (Debt)– What the company owes

• Owner’s Equity (Net Worth)– The amount invested by the owners

(stockholders)– The difference between Assets and

Liabilities

Basic pieces of the balance sheet

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 fixedassets

accumulateddepreciation =

net fixedassets-

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 5Gross fixed assets $10K $10K $10K $10K $10KAccumulated depre 2K 4K 6K 8K 10KNet 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 MUST equal total debt plus owner’s equity

Total Assets

Owner’s Equity

Outstanding Debt

Debt & 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 ownersNote: 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

Cumulative Profits

Owners’ Investment

Cumulative Dividends

Retained Earnings

Owners’ Equity

Owners’ Investment

Retained earnings: A concept that many students fail to understand. Do you?

Balance Sheet (16) An Example

ASSETS DEBT AND EQUITY Current Assets Current Liabilities:

Cash $50 Accounts payable $20

Accounts 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 $300

Accum 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:

Balance Sheet (17) Putting it together

Given the information below, can you arrange 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)


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





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





Balance Sheet (20) Income Statement and Balance Sheet

The Income Statement and Balance Sheet complement each other

Jan

uar

y 1

Dec

emb

er 3

1

Balance Sheet on December 31, 2006

Balance Sheet on December 31, 2007

YEAR 2007

Income Statement for 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

Expense incurred

Cash received

Expense paid

Accrual-basis accounting

Cash-basis accounting


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?

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

Accrual Cash


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 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-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 working capitalWhich 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) Cash Flow Statement for Trimble AssociatesOperating 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 ActivitiesLess 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

Cha

nge

in n

et

wor

king

cap

ital

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

Operating activities:

PlusLessLessLessPlusCash flows from operations:

Investment activitiesLess

Financing activitiesLessLessPlusPlusTotal 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

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 under-stand the cash flow state-ment? Look at the three cash flow activities.

Cash Flow Statement (16) Examples of Cash Flow Patterns

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)

Some of the more important

cash flow patterns are:

Op

erat

ion

s

Fin

anci

ng

Inve

stm

ents

CONGRATULATIONS!!

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!!!

Go Celebrate!

Understanding the Numbers: Essential for the Entrepreneur A Student Tutorial.

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Transcript of Understanding the Numbers: Essential for the Entrepreneur A Student Tutorial.