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Small Business Management Chapter 10 PowerPoint
1.
© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. CHAPTER 10 Understanding a Firm’s Financial Statements
2.
© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. LEARNING OBJECTIVES By studying this chapter, you should be able to… 10-1 Describe the purpose and content of an income statement. 10-2 Describe the purpose and content of a balance sheet. 10-3 Use the income statement and balance sheets to compute a company’s cash flows. 10-4 Analyze the financial statements using ratios to see more clearly how management decisions affect a firm’s financial performance.
3.
© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. INTRODUCTION • Financial statements (accounting statements) – A firm’s income statement, balance sheet, and statement of cash flows.
4.
© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 10-1 THE INCOME STATEMENT • Income statement (profit and loss statement) – A financial report showing the amount of profits or losses from a firm’s operations over a given time period. • The time period is usually a month, a quarter, or a year. • In its most basic form, the income statement may be represented by the following equation: Sales (revenue) Expenses Profits (income)
5.
© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 10.1 The Income Statement: An Overview
6.
© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 10-1a The Income Statement: An Overview • Cost of goods sold – The cost of producing or acquiring goods 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 profits – Gross profits less operating expenses. • Interest expense – The cost of borrowed money. • Profits before taxes (taxable income) – Operating profits less interest expense. • Net profits – Earnings that may be distributed to the owners or reinvested in the company. • The net profits are the “bottom line” of an income statement.
7.
© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 10.2 Income Statement for JM Dalton, Inc., for the Year Ending December 31, 2018
8.
© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 10-1b The Income Statement Illustrated: JM Dalton, Inc. (slide 1 of 2) • Depreciation expense – The cost of a firm’s building and equipment, allocated over the asset’s useful life. • Profit margins – Profits as a percentage of sales. • Includes: • Gross profit margin. • Operating profit margin. • Net profit margin. • Dividends – A distribution of a firm’s profits to the owners.
9.
© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 10-1b The Income Statement Illustrated: JM Dalton, Inc. (slide 2 of 2) • The income statement answers the question “How profitable is the business?” • In providing the answer, the income statement reports financial information related to five broad areas of business activity: 1. Sales (revenue). 2. Cost of producing or acquiring the goods sold by the company. 3. Operating expenses, such as marketing expenses, rent, managers’ salaries, and depreciation expense. 4. Interest expense. 5. Tax payments.
10.
© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 10-2 THE BALANCE SHEET • Balance sheet – A financial report showing a firm’s assets, liabilities, and owners’ equity at a specific point in time. • It reports the dollar amounts of: • The assets a firm owns. • The liabilities (or debt) owed. • The amount of the owners’ investment in the business (owners’ equity) on that date. • In its simplest form, a balance sheet follows this formula: Total assets Debt Owners' equity
11.
© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 10.3 The Balance Sheet: An Overview
12.
© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 10-2a The Balance Sheet: An Overview (slide 1 of 9) • The balance sheet has three main components: 1. Assets. 2. Debt. 3. Owners’ equity.
13.
© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 10-2a The Balance Sheet: An Overview (slide 2 of 9) ASSETS • Assets are shown on the left side of a balance sheet. • They are always grouped into three categories: 1. Current assets. 2. Fixed assets. 3. Other assets.
14.
© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 10-2a The Balance Sheet: An Overview (slide 3 of 9) • Current assets (working capital) – Assets that can be converted into cash relatively quickly. • They primarily include: • Cash – Money in the bank as well as securities that can be sold very quickly, such as a government security. • Accounts receivable – The amount of credit extended to customers. • Inventory – A firm’s products held in anticipation of eventual sale in the ordinary course of business.
15.
© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 10-2a The Balance Sheet: An Overview (slide 4 of 9) • Fixed assets (property, plant, and equipment [PPE]) – Physical assets that will be used in the business for more than one year, such as equipment, buildings, and land. • Most fixed assets are depreciable assets. • Depreciable assets – Assets whose value declines, or depreciates, over time. • The original cost of these assets is shown on the balance sheet when they are purchased (as gross fixed assets). • Gross fixed assets – Depreciable assets at their original cost, before any depreciation expense has been taken.
16.
© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 10-2a The Balance Sheet: An Overview (slide 5 of 9) • Each year, the assets are depreciated over their expected useful life, and the accumulated depreciation is reported in the balance sheets and subtracted from the original cost of the fixed asset to yield the net fixed asset. • Accumulated depreciation – Total (cumulative) depreciation expense taken over an asset’s life. • Net fixed asset – Gross fixed assets less accumulated depreciation. • Other assets – Intangible assets, such as patents, copyrights, and goodwill.
17.
© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 10-2a The Balance Sheet: An Overview (slide 6 of 9) DEBT AND EQUITY • The right side of the balance sheet, showing debt and equity, indicates how a firm is financing its assets. • Financing comes from two main sources: 1. Debt (liabilities). 2. Owners’ equity.
18.
© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 10-2a The Balance Sheet: An Overview (slide 7 of 9) • Debt – Financing provided by creditors. • Debt can be current (short-term) debt or long-term debt. • Current debt (short-term liabilities) – Borrowed money that must be repaid within 12 months. • Examples of current debt include the following: • Accounts payable (trade credit) – Outstanding credit that is owed to suppliers. • Accrued expenses – Operating expenses that have been incurred but not paid; shown as an expense in the income statement and as a liability in the balance sheet until paid. • Short-term notes – Agreements to repay cash amounts borrowed from banks or other lending sources within 12 months or less.
19.
© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 10-2a The Balance Sheet: An Overview (slide 8 of 9) • Long-term debt – Loans from banks or other sources with repayment terms of more than 12 months. • Examples of long-term debt include the following: • Long-term note – Agreements to repay cash amounts borrowed from banks or other lending sources, plus interest, for periods longer than 12 months. • Mortgage – A long-term loan to purchase a building or land.
20.
© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 10-2a The Balance Sheet: An Overview (slide 9 of 9) OWNERS’ EQUITY • Owners’ equity – Owners’ cash investments in a company plus the net profits that have been retained in the firm. • Common stock – Stock shares that represent ownership in a corporation. • Retained earnings – Cumulative net profits retained in a company over the life of the business. • Owners’ equity can be calculated as follows: Owners' equity Owners' investment Cumulative profits Cumulative dividends paid to owners
21.
© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 10.4 Balance Sheets for JM Dalton, Inc., for December 31, 2017, and December 31, 2018
22.
© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 10-2b The Balance Sheet Illustrated: JM Dalton, Inc. (slide 1 of 2) • The balance sheet shows the financial position of a firm at the beginning and at the end of a period of time. • The balance sheet shows: • Total amount of beginning and ending assets. • How much has been invested in current assets and in fixed assets. • How much debt and equity were used to finance the assets. • How much of the equity came from investments made by the owner (common stock) and how much came from reinvesting profits in the business (retained earnings). • Changes in the amounts between the two dates. • A balance sheet helps the small business owner know the financial strengths and capabilities of the business—something that cannot be known in any other way. • A balance sheet provides information on how effectively the firm’s assets are being managed and on the financing of the assets.
23.
© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 10-2b The Balance Sheet Illustrated: JM Dalton, Inc. (slide 2 of 2) • Because the balance sheet offers an snapshot of a firm’s financial condition at a specific point in time and the income statement reports a firm’s performance over a period, both are needed to fully evaluate a firm’s financial position. • Three financial reports are needed to evaluate a firm’s performance over a given time: 1. A balance sheet showing a firm’s financial position at the beginning of a year. 2. A balance sheet for the end of the year. 3. An income statement spanning the time between the two balance sheets.
24.
© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 10.5 Viewing the Income Statement and Balance Sheet Together
25.
© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 10-3 THE STATEMENT OF CASH FLOWS: AN OVERVIEW • Effectively managing cash flows in critical for small business owners. • Statement of cash flows – A financial report showing a firm’s sources of cash as well as its uses of cash. • A statement of cash flows answers the questions “Where did the cash come from?” and “Where did the cash go?”
26.
© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 10-3a Profits Versus Cash Flows • The profits shown on a company’s income statement are not the same as its cash flows. • An income statement is not a measure of cash flows because it is calculated on an accrual basis rather than a cash basis. • Accrual-basis accounting – An accounting method of recording profits when earned and expenses when incurred, whether the profits have been received in cash or the expenses paid. • Cash-basis accounting – An accounting method of recording profits when cash is received and recording expenses when they are paid.
27.
© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 10-3b Measuring a Firm’s Cash Flows • Cash flow activities – Operating, investing, and financing activities that result in cash inflows or outflows. • Generating cash flows from day-to-day business operations (operating activities). • Cash is generated in the normal course of operating a business on a daily basis by purchasing inventory on credit, selling on credit, paying for the inventory, and finally collecting on the sales made on credit. • Buying or selling fixed assets (investing activities). • These are not included in the income statement and appear only as changes from one balance sheet to the next. • Financing the business (financing activities). • Cash inflows and outflows occur when the company borrows or repays debt, when it distributes money to the owners, or when the owners put money into the business in the form of additional equity.
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© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 10-3c The Statement of Cash Flows Illustrated: JM Dalton, Inc. (slide 1 of 2) ACTIVITY 1: JM DALTON’S OPERATING CASH FLOWS • Cash flows from operations are calculated by adding back the depreciation expense to the net profits and then subtracting (or adding) any increase (or decrease) in accounts receivable and inventory, or any decrease (or increase) in accounts payable. ACTIVITY 2: JM DALTON’S INVESTING CASH FLOWS • Investments in fixed assets are recorded in the statement of cash flows as a change in gross fixed assets, as shown in a firm’s balance sheets. ACTIVITY 3: JM DALTON’S FINANCING CASH FLOWS • Financing a business involves borrowing money, repaying debts, investing by owners, and paying dividends or selling/repurchasing stock.
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Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 10-3c The Statement of Cash Flows Illustrated: JM Dalton, Inc. (slide 2 of 2) • The process used to compute cash flows: 1. Only use net profits and depreciation expense from the income statement. 2. Rely on the following guidelines: • A decrease in an asset is a source of cash. • An increase in an asset is a use of cash. • An increase in debt or equity is a source of cash. • A decrease in debt or equity is a use of cash. 3. Use every change in the balance sheets, with two exceptions: 1. Ignore accumulated depreciation and net fixed assets, since they involve the noncash item of depreciation, and use only the change in gross fixed assets. 2. Disregard the change in retained earnings since it equals net profits and dividends paid.
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Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 10.6 Cash Flow Statement for JM Dalton, Inc., for the Year Ending December 31, 2018
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Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 10-4 EVALUATING A FIRM’S FINANCIAL PERFORMANCE • Once a firm’s owner understands the content of the accounting statements, she or he should think how her or his decisions have affected the financial position of the business.
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Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 10-4a Evaluating a Firm’s Financial Performance: An Overview (slide 1 of 4) • An entrepreneur’s decisions play out primarily in four ways when it comes to finances: 1. The ability to pay debt as it comes due. 2. The profits generated from the firm’s assets (return on assets). 3. Financing the firm by using debt. 4. The rate of return on owners’ equity investment (return on equity).
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Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 10-4a Evaluating a Firm’s Financial Performance: An Overview (slide 2 of 4) ABILITY TO REPAY DEBT COMING DUE • Liquidity – The degree to which a firm has cash available to meet maturing debt obligations. • Current ratio – A measure of a company’s relative liquidity. • The current ratio is calculated as: Current assets Current ratio Current liabilities PROFITABILITY ON ASSETS (RETURN ON ASSETS) • Return on assets – A measure of a firm’s profitability relative to the amount of its assets. • Return on assets is computed as follows: Operating profits Return on assets Total assets
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Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 10-4a Evaluating a Firm’s Financial Performance: An Overview (slide 3 of 4) • Return on assets can be separated into two components: 1. Operating profit margin – A measure of how well a firm is controlling its cost of goods sold and operating expenses relative to sales. • Operating profit margin is computed as: Operating profits Operating profit margin Sales 2. Total asset turnover – Management using the firm’s assets to generate sales. • Total asset turnover is computed as: Sales Total asset turnover Total assets
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Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 10-4a Evaluating a Firm’s Financial Performance: An Overview (slide 4 of 4) FINANCING THE BUSINESS WITH DEBT • Debt ratio – A measure of what percentage of a firm’s assets is financed by debt. • The debt ratio is computed as follows: Total debt Debt ratio Total assets PROFITS EARNED BY THE OWNER (RETURN ON EQUITY) • Return on equity – A measure of the rate of return that owners receive on their equity investment. • Return on equity is computed as follows: Net profits Return on equity Total owners' equity
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Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 10.7 Financial Ratio Analysis for JM Dalton, Inc.
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Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 10-4b Evaluating a Firm’s Financial Performance Illustrated: JM Dalton, Inc. (slide 1 of 3) JM DALTON’S ABILITY TO PAY DEBT COMING DUE • JM Dalton has $3.50 in current assets for every $1 of short-term debt, compared to an industry average of $2.70 of current assets for every $1 in short-term debt. • Thus, based on the current ratio, JM Dalton is more liquid than the average firm in the industry. JM DALTON’S PROFITABILITY ON ASSETS (RETURN ON ASSETS) • JM Dalton’s return on assets of 10.87 percent is less than the industry norm of 13.2 percent, indicating that Dalton is generating less profit from operations on each dollar of assets than its competitors.
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Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 10-4b Evaluating a Firm’s Financial Performance Illustrated: JM Dalton, Inc. (slide 2 of 3) • Based on the operating profit margin, JM Dalton is competitive when it comes to keeping costs and expenses low relative to sales. • JM Dalton only generates $0.92 in sales per dollar of assets, while the competition produces $1.20 in sales from every dollar in assets. • Thus, it is not using its assets efficiently. JM DALTON’S DEBT FINANCING • JM Dalton uses less risk than the average firm in the industry. • Thus, it has less financial risk. • Because Dalton has less debt to repay, it will be able to survive a downturn in the economy more easily than the average company in the industry.
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Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 10-4b Evaluating a Firm’s Financial Performance Illustrated: JM Dalton, Inc. (slide 3 of 3) JM DALTON’S PROFITS TO THE OWNERS (RETURN ON EQUITY) • Because JM Dalton’s return on equity is lower than the industry average for return on equity, this indicates that the firm’s owners are not receiving a return on their investment equivalent to that of owners of comparable businesses. • A firm with a high (low) return on assets will have a high (low) return on equity. • As the amount of a firm’s debt increases, its return on equity will increase, provided that the return on assets is higher than the interest paid on any debt. • JM Dalton has a lower return on equity in part because it has a lower return on assets, and it also uses less debt than the average firm in the industry, causing its return on equity to be lower than that of other firms.
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Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Key Terms (slide 1 of 2) accounts payable (trade credit) accounts receivable accrual-basis accounting accrued expenses accumulated depreciation balance sheet cash cash-basis accounting cash flow activities common stock cost of goods sold current assets (working capital) current debt (short-term liabilities) current ratio debt debt ratio depreciable assets depreciation expense dividends financial statements (accounting statements) fixed assets (property, plant, and equipment [PPE]) gross fixed assets gross profits income statement (profit and loss statement)
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Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Key Terms (slide 2 of 2) interest expense inventory liquidity long-term debt long-term note mortgage net fixed assets net profits operating expenses operating profit margin operating profits other assets owners’ equity profit margins profits before taxes (taxable income) retained earnings return on assets return on equity short-term notes statement of cash flows total asset turnover
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