Small Business Management Chapter 10 PowerPoint

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CHAPTER
10
Understanding a
Firm’s Financial
Statements

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.

INTRODUCTION
• Financial statements (accounting
statements) – A firm’s income statement,
balance sheet, and statement of cash flows.

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)
 

10.1 The Income Statement: An Overview

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.

10.2 Income Statement for JM Dalton, Inc., for the Year Ending December 31, 2018

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.

10-1b The Income Statement
• 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.

10-2 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
 

10.3 The Balance Sheet: An Overview

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.

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.

• 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.

• 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.

• 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.

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.

• 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.

• 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.

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
 


10.4 Balance Sheets for JM Dalton, Inc., for December 31, 2017, and December 31, 2018

10-2b The Balance Sheet
• 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.

10-2b The Balance Sheet
• 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.

10.5 Viewing the Income Statement and Balance Sheet Together

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?”

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.

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.

10-3c The Statement of Cash Flows
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.

10-3c The Statement of Cash Flows
• 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.

10.6 Cash Flow Statement for JM Dalton, Inc., for the Year Ending December 31, 2018

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.

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).

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


• 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


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


10.7 Financial Ratio Analysis for JM Dalton, Inc.

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.

• 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.

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.

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)

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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