Introduction to Financial

Statements

Donald S. Appleby

Adjunct Assistant Professor

Dept. of Electrical and Computer Engineering

The University of Alabama at Birmingham

© Donald S. Appleby, 2009. All rights reserved.

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Why Analyze Statements?

Management To evaluate business performance To compare performance with others To discern trends To make decisions

Creditors To assess credit worthiness/risk

Investors, analysts, unions, government For general information

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The Financial Statements

Preliminary Concepts Read the footnotes that accompany the statements Verify that the statements were independently audited Look for qualified opinions from the accountants

expressing areas of concern Understand the accounting principles being used

Ex. LIFO and FIFO

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1 - The Balance Sheet

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The Balance Sheet

Also called the Statement of Financial Position Reports financial position at a point in time Lists assets, liabilities, and owners equity

The Accounting Equation Assets = Liabilities + Owners Equity

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The Balance Sheet

Look at an example of a comparative balance sheet Accounts are listed in order of decreasing liquidity

Ease of conversion to cash Grouped as

Current duration of a year or less

Non-current duration over a year

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Assets

Current Long-term

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Current Assets

Cash Marketable Securities Accounts Receivable (less allowance for bad debts) Inventory (at lower of cost or market)

Raw materials Work in process Finished goods

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Long-Term Assets

Investments and Intangible Assets Patents, trademarks, copyrights Goodwill Ownership of other companies, joint ventures

Fixed Assets Property Plant Equipment

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Net Book Value

Gross book value Less: Accumulated Depreciation Equals: Net Book Value Gross book value is a record of the original price paid for the asset. Accumulated depreciation is the total depreciation expense

recorded against the asset.

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Depreciation Methods

Always seek professional guidance Modified Accelerated Cost Recovery System

(MACRS) Accelerated Cost Recovery System (ACRS) Terms you may encounter

Straight line Accelerated

Double declining balance Sum of the years digits

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Liabilities

Current Long-term

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Current Liabilities

Accounts Payable Notes Payable Current-Portion of Long-Term Debt

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Long-Term Liabilities

Long-Term Debt

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Stockholders’ Equity

Preferred Stock Receives dividends (but not an obligation) Less risk than common stock (liquidation priority) Not considered owners; generally don’t vote

Common Stock Ownership of the business Amount shown is historical not market value

Paid-In Capital Capital paid-in in excess of par value of stock

Retained Earnings Total of all profits that were re-invested in the business rather

than distributed as dividends

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2 - The Income Statement

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Income Statement

Also called Statement of Earnings Profit and Loss Statement

Objective is to match expenses to revenue for a given period of time

Revenue – Expenses = Profit

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Components: Gross Profit

Revenue (or sales) Less: Cost of Goods Sold …directly allocated cost of production Gross Profit (or gross margin)

Cost of Good Sold Raw materials Purchased components Direct labor Operation and repair of manufacturing equipment Other manufacturing expenses such as utilities, maintenance of the

manufacturing facility

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Components: Operating Income

Gross Profit Less: Operating Expenses …not directly allocated to COGS

General and administrative expenses Depreciation (a non-cash expense) Other expenses

Operating Income (excludes investment income, interest, and taxes)

General and administrative expenses Staff expenses, executive salaries Selling expenses, promotions, advertising R&D

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Putting It Together

Revenue Less: COGS

Equals: Gross Profit Less: Operating Expenses

Equals: Operating Income

Operating income is focused on the profit being generated by operations. It excludes, or filters out, the effects of interest and taxes. See EBIT.

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Earnings

EBIT: Earnings Before Interest and Taxes

EBITDA: Earnings Before Interest, Taxes, Depreciation, and Amortization

Focuses more on cash flow / cash management Depreciation and amortization are non-cash expenses

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3 – Statement of Cash Flows

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Statement of Cash Flows

FASB requires a report on the firm’s cash flows for the accounting period

Statement is also called Sources and Uses of Funds

Need to understand Working Capital “Working capital” refers to the funds used to carry

out the daily operations of the business Invested in inventory Invested in A/R

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Sources and Uses of Cash

Increase* of an asset is a use of cash So decrease of an asset is a source of cash

Increase of a liability is a source of cash So decrease of a liability is a use of cash

Comments Depreciation reflects a decrease in the value of an asset, so

it is a source of cash Think of net worth as a “liability” An increase in net income increases net worth and is thus a

source of cash

*Increase and decrease refer to changes from the beginning of the accounting period to the end of the accounting period.

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Comments regarding cash

Accrual method of recognizing income Effect of lags in collecting cash Effect of depreciation on cash flow

More about cash later