Chapter 2 Financial Statements and the
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  • April, 98 22 AC110 CHAPTER 2 LECTURE NOTES
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Chapter 2 Financial Statements and the Chapter 2 Financial Statements and the Presentation Transcript

  • Chapter 2 Financial Statements and the Annual Report
  • Key Concepts & Objectives
    • Objectives & Characteristics of Financial Reports
    • Classified Balance Sheet
    • Multi-Step Income Statement
    • Sales – CGS = GM – Op Exp – Income Taxes = Net Income
    • Financial Statement Analysis
      • Liquidity Measures
      • Solvency Measures
      • Profitability Measures
    • Components of the Annual Financial Report
    Assets = Liabilities + Owners’ Equity (CA + LTA) = (CL + LTL) + (CC + RE)
  • Objectives of Financial Reporting Assess cash flows to/from company Summarize revenue inflows & expense outflows Primary Objective: Provide Info for Decision making Secondary Objectives: Reflect resources and claims to them
  • Qualitative Characteristics Understandable Relevant Reliable To those willing to take the time to understand it (What Financial Statement information should be ) Has capacity to make a difference Represents what it purports to
  • Qualitative Characteristics (What Financial Statement information should be ) Why? What does this help accomplish? Why? What does this help accomplish? between companies Comparable from one period to the next Consistent
  • Qualitative Characteristics Materiality Can sometimes bend the accounting rules if insignificant Conservatism All else equal, choose least optimistic alternative, recognize expense and/or liability before event finalized
  • Classified Financial Statements
    • Reflects expansions of basic financial statement equations
    • Conveys additional information to users
    • Permits financial statement analyses through a set of ratios
    • Classified by Management
    • Used by Analysts
    • Represents GAAP
  • Basic Structure of a Classified Balance Sheet
    • Current assets (CA)
    • + Noncurrent (long-term) assets (LTA)
    • Total assets
    • Current liabilities (CL)
    • + Noncurrent (long-term) liabilities (LTL)
    • + Stockholders’ equity (CC + RE)
    • Total Liabilities & Stockholders’ Equity
    Represents an expansion of the basic accounting equation: A = L + OE
  • Typical Operating Cycle ACCTS. RECEIVABLE CASH INVENTORY Concept: Time it takes to go from cash back to cash $$ $$ $$ Important to know, since it takes cash to grow the business !
    • Current Asset : One year or the operating cycle -- whichever is longer
      • Usually one year is longer than operating cycle
      • Cash plus other assets expected to:
    • To be converted to or realized in Cash , ( eg, A/R )
    • Or sold or consumed during Operating Cycle (generally within a one year period) ( eg, Supplies )
    Current Assets (CA) : Concept
  • Examples of Current Assets Turned into cash or consumed(used)? Turned into cash or consumed(used)? Turned into cash or consumed(used)? Turned into cash or consumed(used)? Cash Used Cash Used Once these items are used up, what do they become? Where are they found on the F/S? They become EXPENSES ! Cash and Cash Equivalents (e.g., bank deposits) Accounts Receivable (A/R) Inventories Short-term Investments Prepaid Expenses (rent)
    • Concept: Long-term Assets . . . .
      • Provide benefits to company, that are
      • Expected to last beyond one year
    • Categories:
      • Investments in Securities of another entity
      • Property, Plant & Equipment (PP&E)
      • Intangibles (eg, patents)
    Long Term (Noncurrent) Assets (LTA) Again, L-T Assets turn into Cash or are used up ( Expenses )
    • Securities of another organization:
      • Stocks & bonds of another company
      • Government debt (bonds, U.S. T Bills)
    • Management’s intent is to hold those assets beyond current year
    • Other less common examples:
      • Land held for future use
      • Buildings & Equipment not used in current operations
    Investments : Definition
    • Key Concepts:
      • Tangible, productive assets used in daily operations, and
      • Not intended for resale ( Helps make the company’s product/service )
    • These assets are subject to depreciation expense (means that asset is being “used up” over time):
      • Accumulated Depreciation - keeps track of cumulative depreciation expense of all years (CONTRA-ASSET)
    • Depreciation exception is property -- “ Land” Why ?
    Property, Plant & Equipment
    • Assets that
      • lack in physical substance , but
      • provide long-term benefits to entity
    • Asset’s cost is amortized ( us ed up ) over useful (economic) life as Amortization Expense -- similar to Depreciation Expense
    • Examples: Trademarks, Copyrights, Patents, Logos
    Intangibles : Concepts
    • Debts owed to others and classified similar to assets (Current / Long Term):
      • based on the Operating Cycle or 1 year, whichever is longer
    • Current Liabilities: due within 1 year
    • Long-term Liabilities: due after 1 year
    Liabilities : Concepts
    • Definition: Debts due in one year or less
    • Examples:
      • Accounts Payable (trade credit)
      • Wages/salaries Payable
      • Taxes Payable (various)
      • Short-term Notes Payable (eg., due to banks)
    Current Liabilities: Concepts
    • Definition: Obligations not paid or satisfied:
      • due in more than 1 year
    • Typical accounts include:
      • Notes Payable/Mortgage Payable
      • Bonds Payable
      • Long-term Leases
    Long-Term Liabilities: Concepts
    • Defn: Owners’ claims to resources (ASSETS)
    • Claims come from two sources:
      • Contributed capital -- eg, Common Stock... represents owners original investment
      • Earned capital -eg, Retained Earnings represents earnings (NI) left in the company and reinvested
    • All other claims (all creditors) have priority over owners’/stockholders’ claims!
    Stockholders' Equity: Concepts
    • Most corporations have a single class:
      • Common Stock
    • Some corporations have a second class:
      • Preferred Stock
      • Preferences: Generally dividend priority with trade-off of voting rights
    Contributed Capital: Concepts Represents original amount of owners investments and basic ownership form
    • Financial analysts and managers utilize:
      • various methods and tools (eg, web), but
      • primarily ratios and formulas using financial statements
    • Analysts generally review the company’s:
      • 1. Past performance (Annual Report)
      • 2. Current financial position (SEC’s 10-Q)
      • 3. Future potential (forecasted earnings and cash flow) as well as estimated risks (MDA)
    Financial Statement Analysis
  • Analysis of Liquidity
    Two liquidity measures of particular interest to bankers and other creditors Current Ratio Working Capital Defn: Ability of company to pay debts as they become due. A short-term solvency measure Quick Ratio
  • Ben & Jerry’s Consolidated Balance Sheet
    • Current Assets $68,113 $68,063
    • Current Liabilities $18,058 $17,040
    • Working
    • Capital = C.A. minus C.L. $50,055 $51,023
    • What does this mean? Interpret.
    1996 1995 (in 000’s) What does this mean? Interpret . Current = Current Assets 3.77:1 3.99:1 Ratio Current Liabilities Current Ratio
  • Quick Ratio
    • Concept: Most stringent measure of liquidity for a company
    • Focus is on most liquid current assets
    • Sometimes referred to as the Acid-Test Ratio
    • Excludes Inventory and A/R – Why?
    Quick Ratio Quick Ratio = Cash + Marketable Securities Current Liabilities
  • Analysis of Solvency
    Two Solvency measures are of particular interest to investors and many creditors Defn: Ability of company to remain in business over the long run. Debt-to-equity ratio Debt to Equity ratio Debt to Total Assets ratio
    • Debt-to-Total-Assets Ratio =
    • Total liabilities
    • Total assets
    • What does this mean? Interpret.
    • $ 53,980 $ 52,543
    • $136,665 $131,074
    • 39.5% 40.1%
    Ben & Jerry’s Consolidated Balance Sheet Defn: The proportion of assets provided (and claimed) by creditors 1996 1995 (in 000’s) Debt to Assets Ratio
    • Debt-to-Equity Ratio:
    • Total Liabilities__
    • Stockholders’ Equity
    • What does this mean? Interpret.
    • $ 53,980 $ 52,543
    • $ 82,685 $ 78,531
    • 65.3% 66.9%
    Ben & Jerry’s Consolidated Balance Sheet Defn: Relative proportion of assets provided by creditors vs. owners – What does a 50% ratio mean? 1996 1995 (in 000’s) Debt to Equity Ratio
  • Sales – Cost of Goods Sold ( Inventory Exp ) Gross Profit or Gross Margin Operating expenses: – Selling Expenses – General & Administrative Expenses Income from Operations +/– Other Revenues and Expenses Income before Taxes – Income Tax Expense Net Income (Loss) Four important summary measures What does each one tell us? Basic Structure of a Multi-Step Income Statement
  • Analysis of Profitability Gross Profit % Profit Margin % Earnings per Share Return on Stockholders’ Equity Of particular interest to current and potential investors Price to Earnings Ratio
    • DEFN: What percentage (how many cents) of every $ of sales are left over after paying the cost of the product ?
    Ben & Jerry’s Consolidated Statement of Income (in 000’s) 1996 1995 1994 Net sales $ 167,155 $ 155,333 $ 148,802 Cost of sales 115,212 109,125 109,760 Gross profit 51,943 46,208 39,042 Gross profit % = 31.1% 29.7% 26.2% What does this mean? Interpret. Gross Profit (Margin) % = Gross Margin Sales Gross Profit %
    • DEFN: How much has the company earned as profit for every dollar of sales it made?
    (in 000’s) 1996 1995 1994 Net sales $ 167,155 $ 155,333 $ 148,802 Net income (loss) $ 3,926 $ 5,948 $ (1,869) Profit margin % = 2.3% 3.8% - 1.3% Ben & Jerry’s Consolidated Statement of Income What does this mean? Interpret . Profit Margin % = Net Income Sales Profit Margin %
    • DEFN: What is the proportionate amount of income earned by each share of Common Stock?
    (in 000’s) 1996 1995 1994 Net income (loss) $ 3,926 $ 5,948 $ (1,869) Weighted avg. # shares outstanding = 7,230 7,222 7,148 EPS = $ 0.54 $ 0.82 $ (0.26) Ben & Jerry’s Consolidated Statement of Income What does this mean? Interpret. EPS = ________ __ Net Income______ ___ Wtd. avg. # Common Shares outstanding Earnings per Share
  • Price-Earnings Ratio
    • Concept: A key measure of how the market values the company
    • Relationship : The higher the ratio, the greater the (stock market) demand for this company’s stock
    • P-E Ratio reflects both historical and expected growth in earnings and sales
    Price to Earnings = ____________ EPS______________ Ratio Price per Share of Common Stock P-E Ratio
    • DEFN: What is the percentage return that each owner has earned on their investment?
    (in 000’s) 1996 1995 1994 Net income (loss) $ 3,926 $ 5,948 $ (1,869) Average S/E $ 80,608 $ 75,516 $ 73,382 ROE % = 4.9% 7.9% - 2.5% Ben & Jerry’s Consolidated Financial Statements Return on S/E = _______ Net Income__________ Average Stockholders’ Equity What does this mean? Interpret. ROE
  • Statement of Retained Earnings
    • Purpose of statement:
      • explains changes to R/E during a reporting period
    • Two primary components:
      • Net Income (or Net Loss ) for the period
      • Dividends paid during period
  • Dixon Sporting Goods, Inc . (“who”) Statement of Retained Earnings (“what”) for the Year Ended December 31, 1999 (“when”) Retained earnings, January 1, 1999 $ 271,500 Add: Net income for 1999 41,000 $ 312,500 Less: Dividends declared and paid in 1999 (25,000 ) Retained earnings, December 31, 1999 $ 287,500 Note: This is a review since we covered R/E in Chapter 1
  • Statement of Stockholders’ Equity
    • Shows changes in all equity accounts including:
      • Sales and purchases of capital stock
    • Includes:
    Statement of Retained Earnings Add: Net Income Deduct: Dividends
    • Summarizes cash flows ( sources and uses ) from:
      • Operating activities
      • Investing activities
      • Financing activities
    • Required of all public corporations
    • Other entities generally prepare for management purposes
    Statement of Cash Flows (SCF)
  • Net income $ 3,926 ( NOTE: Adjustments to reconcile Net Income to net cash provided by operating activities - omitted here) Net cash provided by Operating activities 14,255 Net cash used for Investing activities (12,951) Net cash used for Financing activities (446) Effect of exchange rates on cash (160) Increase in Cash and equivalents 698 Cash and equivalents at beginning of year 35,406 Cash and equivalents at end of year $ 36,104 Ben & Jerry’s (“who”) Statement of Cash Flows (“what”) for year ended December 28, 1996 (“when”)
    • Management's Discussion & Analysis
    • Summary of financial data
    • Letters to stockholders
    • Financial statements
    • Footnotes to financial statements
    • Report of independent auditors
    Elements of an Annual Report Harcourt Brace & Company items and derived items:
  • Summary: Key Concepts & Objectives
    • Objectives & Characteristics of Financial Reports
    • Classified Balance Sheet
    • Multi-Step Income Statement
    • Sales – CGS = GM – Op Exp – Income Taxes = Net Income
    • Financial Statement Analysis
      • Liquidity Measures
      • Solvency Measures
      • Profitability Measures
    • Components of the Annual Financial Report
    Assets = Liabilities + Owners’ Equity (CA + LTA) = (CL + LTL) + (CC + RE)