teaching note on financial statements (1)

8/10/2019 Teaching Note on Financial Statements (1)

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NOTE ON EVALUATING FINANCIAL PERFORMANCE

If we are to be effective as an entrepreneur, there is a certain body ofknowledge and skills that we must master. Otherwise, we will be at a distinct

disadvantage in operating a going concern. Understanding the informationalcontent of financial statements is one such area. This note has been written in thehopes of providing a basic common body of knowledge in this regard. We willfirst look at the format of the financial statements typically used in business.Second, we will then use ratio analysis as a way to evaluate a companys financialposition.

UNDERSTANDING FINANCIAL STATEMENTS

Think of financial statements as consisting of certain pieces of important

information about the firms operations that are reported in the form of !"# anincome statement, !$# a balance sheet, and !%# a cash flow statement. We will lookat each of these statements in turn.

The Income Statement

The main elements of an income statement, or profit and loss statement assome call it, are shown in &'hibit ". In this e'hibit, we observe that the top part ofthe income statement, beginning with sales and continuing down through theoperating incomeor earnings e!ore interest an" ta#es, is affected solely by thefirms operating decisions. These decisions involve such matters as sales, cost ofgoods sold, marketing e'penses and general and administrative e'penses.(owever, no financing costs are included to this point.

)elow the line reporting operating income, we see the results of the firmsfinancing decisions, along with the ta'es that are due on the companys income.(ere the companys interest e#penseis shown, which is the direct result of theamount of debt borrowed and the interest rate charged by the lender !Intereste'pense * amount borrowed ' interest rate#. The resulting pro!its e!ore ta#andthe ta' rates imposed on the company then determine the amount of the ta'liability, or the income ta# e#pense. The final number, the net pro!its a!ter

ta#es, is the income that may be distributed to the companys owners or reinvestedin the company, provided of course there is cash available to do so. !+s we shallsee later, merely because there are profits does not necessarily mean there is anycash possibly a somewhat surprising fact to us, but one we shall come tounderstand.#

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E$%I&IT '

The Income Statement( An O)er)ie*

Sales

-ross profit

Operating e'penses /arketing and selling e'penses and generaland administrative e'penses

Operating income !&arnings before interest and ta'es#

0rofits before ta'es

0rofits after ta'es

+n e'ample of an income statement is provided in &'hibit $ for the 1//anufacturing 2ompany. +s shown in the e'hibit, the firm had sales of 34%5,555for the "$month period ending 6ecember %", $557. The cost of manufacturingtheir product was 38%9,555, resulting in a gross profit of 3$9",555. The firm thenhad 3"95,555 in operating e'penses, which involved selling e'penses, general andadministrative e'penses, and depreciation e'penses. +fter deducting the operatinge'penses, the firms operating profits !earnings before interest and ta'es#amounted to 3"5",555. This amount represents the income generated as if 1/

/anufacturing was an alle:uity company. To this point, we have calculated theprofits resulting only from operating activities, as opposed to financing decisions,such as how much debt or e:uity is used to finance the companys operations.

We ne't deduct 1/s interest e'pense !the amount paid for using debtfinancing# of 3$5,555 to arrive at the companys profit before ta' of 34",555.1astly, we deduct the income ta'es of 3";,555 to leave the net profit after ta' of37


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common dividends paid by the firm to its owners in the amount of 3"8,555,leaving 3


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The &a6ance Sheet

While the income statement reports the results from operating the businessfor a period of time, such as a year, the balance sheet provides a snapshot in timeof the firms financial position. Thus, a balance sheet captures the cumulative

effect of prior decisions down to a single point in time.

The relationship between the timing of an income statement and a balancesheet is represented graphically in &'hibit %.

E$%I&IT 2

Vis-a6 Perspecti)e o! the Re6ationship

&et*een the &a6ance Sheet an" Income Statement

(ere we see two periods of operations, $558 and $557. There would be an incomestatement for the period of @anuary " through 6ecember %" for the operations of

the year $557 and a balance sheet reporting the companys financial position as of6ecember %" of each year, i.e. $558 and $557. Thus, the balance sheet on6ecember %", $557 is a statement of the companys financial position at thatparticular date in time, which is the result of all financial transactions since thecompany began its operations.

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Testing 1o-r Un"erstan"ing(

The Income Statement( %o* Di" 1o- Do7

&arlier on, we provided data and asked you to prepare an income statement basedon the information. Aour results should be as follows

Sales 3


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If it is a partnership, the e:uity comprises the partners contribution to the businessand the retained profits. Dinally, for a corporation, e:uity includes the purchase ofthe companys stock by the investor !including both par value and paid in capital#and the retained profits to that point in time.

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The &a6ance Sheet( An O)er)ie*

+SS&TS

2urrent assets

Di'ed or longterm assets

Other assets

Total assets

1I+)I1ITI&S !6&)T# +B6 &FUITA !B&T WO=T(#

2urrent !shortterm# liabilities !debt#

1ongterm liabilities !debt#

Total liabilities !debt#

&:uity !net worth#

Total liabilities !debt# and e:uity !net worth#

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)alance sheets for the 1/ /anufacturing 2ompany are presented in&'hibit 8, both on 6ecember %", $558 and 6ecember %", $557. We have includedtwo balance sheets so that we may see the financial position of the firm at thebeginning and end of $557. )y e'amining these two balance sheets, along withthe income statement for $557, we will have a more complete picture of the firms

operations, as reflected in its financial statements. We are then able to see whatthe firm looked like at the beginning of $557 !balance sheet on 6ecember %",$558#C what happened during the year !income statement for $557#, and the finaloutcome at the end of the year !balance sheet on 6ecember %", $557#.

The balance sheet data for the 1/ /anufacturing 2ompany shows the firmhaving begun the year with 345


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Income ta' payable 3"$ 3";+ccrued wages and salaries 3< 3s profits to assets relationship is presented in &'hibit ;.

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E$%I&IT

LM Man-!act-ring Pro!its to Assets Re6ationship !or Fisca6 1ear En"e"

Decemer 2'3 +445

The operating return on assets for 1/ /anufacturing, and thecorresponding industry norm, is shown below

1/ Industry

assetson

returnOperating*

assetstotal

profitsoperating

* 555,9$;3

555,"5"3

* "5.49P

(ence, we see that 1/ /anufacturing is not earning an e:uivalent return oninvestment to the average firm in the industry. Dor some reason, management isnot generating as much income on 3" of assets as is their competitors.

E)a6-ating ?atson@s Li8-i"it0( %o* Di" 1o- Do7

Watson Industry

2urrent ratio 5.97 ".";+cidtest ratio 5.4" 5.9$

+ccounts receivable turnover 8.8$ "5.54Inventory turnover "8.5% "4.%$

Watson is not as li:uid as the average firm in the industryMno matter how youmeasure itQ They do not have the li:uid assets to cover current liabilities, nor dothey convert receivables and inventories to cash as :uickly.

Total +ssets39$;,555

6ebt3$99,555

&:uity37$4,555

produced

3"5",555operatingprofits

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If we were the managers of 1/ /anufacturing, we would not be satisfiedwith merely knowing that we are not earning a competitive return on the firmsassets. We would also want to know why we are below average. Dor moreunderstanding, we may separate the operating return on assets, O=O+, into twoimportant pieces, these being the operating profit margin and the total asset

turnover. The firms O=O+ is a multiple of these two ratios, and may be shownalgebraically as follows

O=O+ * R !&:. 7a#

or more completely,

O=O+ * R !&:. 7b#

1ooking at the first component of the O=O+, operating profit margin, wecan know that five factors or Edriving forcesE affect this ratio. The driving forcesinclude

". The number of units of product sold.$. The average selling price for each product unit.%. The cost of manufacturing or ac:uiring the firms product.


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O=O+ * R !&:. 7a#

We see that for 1/ /anufacturing,

O=O+1/ * "$."7P R 5.49 * "5.49P

and for the industry,

O=O+Ind * ""P R ".$5 * "%.$P

2learly, 1/ /anufacturing is competitive when it comes to keeping costsand e'penses in line relative to sales, as reflected by the operating profit margin.In other words, management is performing satisfactorily in managing the fiveEdriving forcesE of the operating profit margin listed above. (owever, when welook at the total asset turnover, we can see why management is less thancompetitive on its operatinag return on assets. The firm is not using its assetsefficiently. 1/ /anufacturing only generates 3.49 in sales per one dollar ofassets, while the competition is able to produce 3".$5 in sales from every dollar

investment in assets. (ere is the companys problem.

Testing 1o-r Un"erstan"ing( E)a6-ating ?atson@s Operating Ret-rn on

Assets

-iven the following financial information for the Watson 2ompany !e'pressed in3 thousands#, evaluate the firm>s operating return on assets !O=O+#.

+ccounts receivables 3


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problems. +re we over invested in all assets, or more so in accounts receivable orinventory or fi'ed assets? To answer this :uestion, we merely e'amine theturnover ratios for each respective asset.

Turnover ratio for 1/ Industry

+ccounts receivable

*555,;43

555,4%53*"5.7s debt ratio and thetimes interest earned. (ow does Watson>s practices compare to the industry.What are the implications of your findings?

Total debt 3$7,"9;&:uity

2ommon stock 3"5,7$;=etained earnings 3"%,"7

teaching note on financial statements (1)

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