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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
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