How to Use Financial Statements


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How to Use Financial Statements

  1. 2. How to Use Financial Statements A Guide to Understanding the Numbers AUTHOR: James Bandler PUBLISHER: McGraw-Hill DATE OF PUBLICATION: 1994 NUMBER OF PAGES: 147 pages Book pic
  2. 3. <ul><ul><li>Financial statements are not solely for accountants, economists and businessmen. </li></ul></ul><ul><ul><li>Knowing how to read and understand financial statements can help you know your company better, can help you plan investments, spot industry trends and can help you find a better job. </li></ul></ul><ul><ul><li>This book gives you a clear and simple way of reading and understanding financial statements. </li></ul></ul>THE BIG IDEA
  3. 4. What Are Financial Statements and What Do They Tell Us <ul><li>Financial statements are necessary sources of information about a company. </li></ul><ul><li>Financial statements consist of three separate but interrelated topics: </li></ul><ul><ul><li>Statement of financial position or balance sheet </li></ul></ul><ul><ul><li>Profit or loss or the income statement </li></ul></ul><ul><ul><li>Statement of cash flow </li></ul></ul>
  4. 5. <ul><li>Primary users of financial statements are: </li></ul><ul><ul><li>Owners/investors </li></ul></ul><ul><ul><li>Lenders </li></ul></ul><ul><ul><li>Managers </li></ul></ul><ul><ul><li>Suppliers </li></ul></ul><ul><ul><li>Customers </li></ul></ul><ul><ul><li>Attorneys and litigants </li></ul></ul><ul><ul><li>Employees and jobseekers </li></ul></ul>Who Uses Financial Statements and What Do They Look For
  5. 6. <ul><li>Accrual Accounting is the concept of recognizing revenue and expense when reading and analyzing financial statements. This records revenue as it is earned and expenses as it is incurred, even if no money has changed hands. </li></ul><ul><li>Revenue is recognized upon completion of a sale or service which requires a client to make payment. </li></ul><ul><li>Expenses are recorded at the time it is incurred or when a company receives supplies or services - regardless of whether cash payment had been made. </li></ul><ul><li>Accrual Accounting and Depreciation </li></ul><ul><li>The cost is matched against the revenue that will be generated over a particular period. </li></ul>An Introduction to Accrual Concept
  6. 7. Balance sheet lists and totals the company’s assets, liabilities and the owner’s equity at the end of each operating period. Three board categories: Assets = Liabilities + Owner’s Equity Balance sheet should always have equal assets to liabilities and owner’s equity. To get owner’s equity: Owner’s Equity = Assets – Liabilities The Statement of Financial Position or Balance Sheet
  7. 8. <ul><li>Items found in the balance sheet are as follows: </li></ul><ul><li>Assets </li></ul><ul><ul><li>Current Assets. Includes cash, things easily converted to cash, and things that enable a company to make products or render services that generate cash. </li></ul></ul><ul><ul><li>Non-current Assets. This includes properties, plants, and equipment used in the production of products and services. </li></ul></ul><ul><li>Liabilities </li></ul><ul><ul><li>Current Liabilities. Discloses amounts owed by the company, such as debt, unpaid bills, expenses not yet paid or yet to be paid within a period of one year. </li></ul></ul><ul><ul><li>Long-term debt. These are obligations not due for payment within the following year. </li></ul></ul>The Statement of Financial Position or Balance Sheet
  8. 9. <ul><ul><li>Owner’s equity. This consists of both the funds contributed to the company for the purchase of ownership and the accumulation of profit not yet paid to the owners in the form of dividends or other capital distribution. </li></ul></ul><ul><li>Balance sheet can tell the amount the company has in debt in relation to its owner’s equity, the leverage. A company is highly leveraged if total liabilities are large in relation to owner’s equity. </li></ul>The Statement of Financial Position or Balance Sheet
  9. 10. <ul><li>Income Statement shows if the company is making profit or incurring losses. It subtracts the cost of doing business from the revenue gained from the sales of products or services. It directly affects the balance sheet. </li></ul><ul><ul><li>Revenues (net sales). These are products sold or various sales and services rendered regardless if cash was received. </li></ul></ul><ul><ul><li>Cost of goods sold. These are all cost allocated to inventory that was sold during the period. </li></ul></ul><ul><ul><li>Gross Profit. It is the difference between revenues and the cost of goods sold. </li></ul></ul>The Profit and Loss or Income Statement
  10. 11. <ul><ul><li>Operating expenses. These are expenses incurred to keep the business running day to day. </li></ul></ul><ul><ul><ul><li>General and administrative cost </li></ul></ul></ul><ul><ul><ul><li>Selling expenses </li></ul></ul></ul><ul><ul><li>Provision for income tax. This is the income tax expense and is based on the company’s income tax rate. </li></ul></ul><ul><ul><li>Net income. This is also called the “bottom-line”. It is what is left after all cost of doing business is deducted from revenues earned. </li></ul></ul>The Profit and Loss or Income Statement
  11. 12. <ul><li>Statement of cash flow essentially converts income statement into sources and uses of cash. </li></ul><ul><ul><li>Conceptual basis for determining cash flow </li></ul></ul><ul><ul><ul><li>Cash flow statement begins with net income and assumes that all transactions (revenues and expenses) are made in cash during the operating period. </li></ul></ul></ul><ul><ul><li>Calculating cash flow </li></ul></ul><ul><ul><ul><li>Add back to net income, depreciation . </li></ul></ul></ul><ul><ul><ul><li>Deducted from cash flow: accounts receivable, inventory and investment activities . </li></ul></ul></ul><ul><ul><ul><li>Cash from financial activities can increase or decrease cash flow. </li></ul></ul></ul>The Statement of Cash Flow
  12. 13. <ul><li>Alternative format for statement of cash flows </li></ul><ul><li>Show how much cash was made from sales, utilized for production and spent for operating expenses. </li></ul><ul><li>Computed as: </li></ul><ul><li>Cash revenue = Accrual Revenue + Beginning Accounts Receivable - Ending Accounts Receivable </li></ul><ul><li>Cost of goods sold / production cost = Beginning Accounts Payable + Purchases - Ending Accounts Payable </li></ul><ul><li>Operating expense = Total Beginning Accrual Expenses - Total Ending Accrual Expenses. </li></ul><ul><li>Using the statement of cash flow </li></ul><ul><li>Analyzing cash flow of a company should be done over an operating period of several years and in detail. </li></ul>The Statement of Cash Flow
  13. 14. <ul><li>Important accounting issues and rules give additional meaning. </li></ul><ul><li>A growth or decline in a company’s business, its ability to create cash or meet its obligations, its efficiency and profitability can affect the balance sheet, income statement and cash flow. </li></ul>Following a Transaction through the Financial Statements
  14. 15. <ul><li>Take note of the specific methods used by the company to effectively compare and analyze financial statements. </li></ul><ul><ul><li>Inventory valuation alternatives </li></ul></ul><ul><ul><ul><li>First in - First out (FIFO) </li></ul></ul></ul><ul><ul><ul><li>Last in - First out (LIFO) </li></ul></ul></ul><ul><ul><ul><li>Average cost method </li></ul></ul></ul><ul><ul><li>Depreciation methods </li></ul></ul><ul><ul><ul><li>Straight line method </li></ul></ul></ul><ul><ul><ul><li>Accelerated method </li></ul></ul></ul>Special Inventory Valuation and Depreciation Reporting Issues
  15. 16. <ul><li>The following information is required in computing depreciation: </li></ul><ul><ul><li>Cost of asset. Includes the asset’s purchase price and all cost incurred to get the asset in the position and condition for operation / use. </li></ul></ul><ul><ul><li>2. Useful life. Estimates the serviceable or productive years of the asset. </li></ul></ul><ul><ul><li>3. Residual or salvage value. Approximates the amount the company can get from the sale of the asset at the end of its useful life. </li></ul></ul>Special Inventory Valuation and Depreciation Reporting Issues
  16. 17. <ul><li>These are assets lumped together in the category “other assets” seen on the balance sheets: </li></ul><ul><ul><li>Intangible assets. Assets that can not be seen nor felt but generate revenues. </li></ul></ul><ul><ul><li>2. Good will. Excess amount a company has paid over the book value assets of a company (subsidiary or affiliate) it has acquired. </li></ul></ul><ul><ul><li>3. Amortization. Cost of intangibles which are charged over the period they are expected to generate income. </li></ul></ul>Intangible Assets and Amortization
  17. 18. <ul><li>Service companies differ on how they generate revenues and other financial characteristics. </li></ul><ul><li>They can be grouped into: </li></ul><ul><ul><li>Financial Service Companies. These normally show large amount of loans and investment against owner’s equity. </li></ul></ul><ul><ul><ul><li>Banks </li></ul></ul></ul><ul><ul><ul><li>Insurance companies </li></ul></ul></ul><ul><ul><ul><li>Securities brokerage </li></ul></ul></ul><ul><ul><li>2. Capital Intensive Companies. Revenues mainly come from property, plants and equipment. </li></ul></ul><ul><ul><li>3. People Intensive Companies. These companies provide professional services. </li></ul></ul>Service Companies
  18. 19. <ul><li>The Generally Accepted Accounting Principles (GAAP) standardizes how financial statements are prepared so that you can effectively compare a company with another in the industry. </li></ul><ul><li>All information or disclosures needed by the reader to understand the financial statements, the company’s accounting practices as well as the auditor’s opinion can be found in the footnotes of a financial statement. </li></ul>What are the Rules that Preparers of Financial Statement Must Play By?
  19. 20. <ul><li>Some of the disclosures commonly found are: </li></ul><ul><ul><li>General </li></ul></ul><ul><ul><li>Summary of significant accounting policies: </li></ul></ul><ul><ul><ul><li>Principles of consolidation </li></ul></ul></ul><ul><ul><ul><li>Revenue recognition </li></ul></ul></ul><ul><ul><ul><li>Treatment of “excess of purchase price over net assets of business acquired” </li></ul></ul></ul><ul><ul><ul><li>Property and equipment </li></ul></ul></ul><ul><ul><ul><li>Inventory </li></ul></ul></ul><ul><ul><ul><li>Research and development </li></ul></ul></ul><ul><ul><ul><li>Definition of cash equivalents </li></ul></ul></ul><ul><ul><ul><li>Warranties of any other unusual terms of sale </li></ul></ul></ul><ul><ul><li>Description of credit facilities </li></ul></ul>What are the Rules that Preparers of Financial Statement Must Play By?
  20. 21. <ul><ul><li>Description of terms and funding of employee’s benefits and retirement plans </li></ul></ul><ul><ul><li>Reconciliation of income tax expenses </li></ul></ul><ul><ul><li>Long term debt maturities </li></ul></ul><ul><ul><li>Property and casualty insurance </li></ul></ul><ul><ul><li>Transactions with insiders or related entities </li></ul></ul><ul><ul><li>Major customers and suppliers </li></ul></ul><ul><ul><li>Industry segment information </li></ul></ul><ul><ul><li>Current cost or replacement value of non-monetary assets </li></ul></ul><ul><ul><li>Contingent liabilities </li></ul></ul><ul><ul><li>Events subsequent to the date of the financial statements </li></ul></ul><ul><ul><li>Opinion letters </li></ul></ul>What are the Rules that Preparers of Financial Statement Must Play By?
  21. 22. <ul><li>Understand the relationships of the data presented in the financial statements. These relationships are analyzed by means of ratios. </li></ul><ul><ul><li>Some useful ratios and what they tell us: </li></ul></ul><ul><ul><ul><li>Leverage Ratio </li></ul></ul></ul><ul><li> = Total liabilities  owner’s equity </li></ul><ul><ul><ul><li>2. Current ratio and Quick ratio </li></ul></ul></ul><ul><li>Quick ratio = total cash, short term marketable securities and accounts receivable  current liabilities </li></ul><ul><li>Current ratio = total current assets  total current liabilities </li></ul>Some Basic Tools of Financial Analysis
  22. 23. <ul><ul><li>3. Debt Coverage ratio </li></ul></ul><ul><li>= total of net income + non cash charge  current maturities of long term debt </li></ul><ul><ul><li>4. Accounts Receivable collection period </li></ul></ul><ul><ul><li>= Accounts receivable  sales for the period x number of days for the period </li></ul></ul><ul><ul><li>5. Days inventory supply </li></ul></ul><ul><ul><li>= inventory  cost of goods sold for the period x number of days for the period </li></ul></ul><ul><ul><li>6. Return on assets </li></ul></ul><ul><ul><li>ROA = net income  total assets </li></ul></ul><ul><ul><li>7. Return on equity </li></ul></ul><ul><ul><li>ROE = Net income  owner’s equity </li></ul></ul>Some Basic Tools of Financial Analysis
  23. 24. The Limitations of Financial Statements Though it represents a fair representation of a company’s current condition, most data are based on estimates, forecast and assumptions.
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