Introduction to Key Financial Statements
Introduction to Key Financial Statements
What you’ll learn to do: identify key financial statements and their components, and explain the primary use of each type of statement
In this section you will learn about key financial statements of accounting: the balance sheet, income statement, statement of owner’s equity, and statement of cash flows. By examining the components of each you will see the connections between the statements and be able to use this information to help you determine the point at which your business be
1. Basic Accounting Procedures
What are the six steps in the accounting cycle?
Using generally accepted accounting principles, accountants record and report financial data in similar ways for all firms. They report their findings in financial statements that summarize a company’s business transactions over a specified time period. As mentioned earlier, the three major financial statements are the balance sheet, income statement, and statement of cash flows.
People sometimes confuse accounting with bookkeeping. Accounting is a much broader concept. Bookkeeping,the system used to record a firm’s financial transactions, is a routine, clerical process. Accountants take bookkeepers’ transactions, classify and summarize the financial information, and then prepare and analyze financial reports. Accountants also develop and manage financial systems and help plan the firm’s financial strategy.
The Accounting Equation
The accounting procedures used today are based on those developed in the late 15th century by an Italian monk, Brother Luca Pacioli. He defined the three main accounting elements as assets, liabilities, and owners’ equity. Assets are things of value owned by a firm. They may be tangible, such as cash, equipment, and buildings, or intangible, such as a patent or trademarked name. Liabilities—also called debts—are what a firm owes to its creditors. Owners’ equity is the total amount of investment in the firm minus any liabilities. Another term for owners’ equity is net worth.
The relationship among these three elements is expressed in the accounting equation:
The accounting equation must always be in balance (that is, the total of the elements on one side of the equals sign must equal the total on the other side).
Suppose you start a coffee shop and put $10,000 in cash into the business. At that point, the business has assets of $10,000 and no liabilities. This would be the accounting equation:
The liabilities are zero and owners’ equity (the amount of your investment in the business) is $10,000. The equation balances.
To keep the accounting equation in balance, every transaction must be recorded as two entries. As each transaction is recorded, there is an equal and opposite event so that two accounts or records are changed. This method is called double-entry bookkeeping.
Suppose that after starting your business with $10,000 cash, you borrow another $10,000 from the bank. The accounting equation will change as follows:
Now you have $20,000 in assets—your $10,000 in cash and the $10,000 loan proceeds from the bank. The bank loan is also recorded as a liability of $10,000 because it’s a debt you must repay. Making two entries keeps the equation in balance.
The Accounting Cycle
The accounting cycle refers to the process of generating financial statements, beginning with a business transaction and ending with the preparation of the report. Exhibit 14.5 shows the six steps in the accounting cycle. The first step in the cycle is to analyze the data collected from many sources. All transactions that have a financial impact on the firm—sales, payments to employees and suppliers, interest and tax payments, purchases of inventory, and the like—must be documented. The accountant must review the documents to make sure they’re complete.
Next, each transaction is recorded in a journal, a listing of financial transactions in chronological order. The journal entries are then recorded in ledgers, which show increases and decreases in specific asset, liability, and owners’ equity accounts. The ledger totals for each account are summarized in a trial balance, which is used to confirm the accuracy of the figures. These values are used to prepare financial statements and management reports. Finally, individuals analyze these reports and make decisions based on the information in them.
Technological Advances
Over the past decade, technology has had a significant impact on the accounting industry. Computerized and online accounting programs now do many different things to make business operations and financial reporting more efficient. For example, most accounting packages offer basic modules that handle general ledger, sales order, accounts receivable, purchase order, accounts payable, and inventory control functions. Tax programs use accounting data to prepare tax returns and tax plans. Point-of-sale terminals used by many retail firms automatically record sales and do some of the bookkeeping. The Big Four and many other large public accounting firms develop accounting software for themselves and for clients.
Accounting and financial applications typically represent one of the largest portions of a company’s software budget. Accounting software ranges from off-the-shelf programs for small businesses to full-scale customized enterprise resource planning systems for major corporations. Although these technological advances in accounting applications have made the financial aspects of running a small business much easier, entrepreneurs and other small-business owners should take to time to understand underlying accounting principles, which play an important role in evaluating just how financially sound a business enterprise really is.
1. The Balance Sheet
In what terms does the balance sheet describe the financial condition of an organization?
The balance sheet, one of three financial statements generated from the accounting system, summarizes a firm’s financial position at a specific point in time. It reports the resources of a company (assets), the company’s obligations (liabilities), and the difference between what is owned (assets) and what is owed (liabilities), or owners’ equity.
The assets are listed in order of their liquidity, the speed with which they can be converted to cash. The most liquid assets come first, and the least liquid are last. Because cash is the most liquid asset, it is listed first. Buildings, on the other hand, have to be sold to be converted to cash, so they are listed after cash. Liabilities are arranged similarly: liabilities due in the short term are listed before those due in the long term.
The balance sheet as of December 31, 2018, for Delicious Desserts, Inc., a fictitious bakery, is illustrated in Table 14.1. The basic accounting equation is reflected in the three totals highlighted on the balance sheet: assets of $148,900 equal the sum of liabilities and owners’ equity ($70,150 + $78,750). The three main categories of accounts on the balance sheet are explained below.
| Balance Sheet for Delicious Desserts | |||
|---|---|---|---|
| Delicious Desserts, Inc. | |||
| Balance Sheet as of December 31, 2018 | |||
| Assets | |||
| Current assets: Cash Marketable securities Accounts receivable Less: Allowance for doubtful accounts Notes receivable Inventory Total current assets |
$45,000 1,300 |
$15,000 4,500 43,700 5,000 15,000 |
83,200 |
| Fixed assets: Bakery equipment Less: Accumulated depreciation Furniture and fixtures Less: Accumulated depreciation Total fixed assets Intangible assets: Trademark Goodwill Total intangible assets Total assets |
$56,000 16,000 $18,450 4,250 |
$40,000 14,200 $ 4,500 7,000 |
54,200 11,500 $148,900 |
| Liabilities and owners’ equity | |||
| Current liabilities: Accounts payable Notes payable Accrued expenses Income taxes payable Current portion of long-term debt Total current liabilities |
$30,650 15,000 4,500 5,000 5,000 |
$60,150 |
|
| Long-term liabilities: Bank loan for bakery equipment Total long-term liabilities Total liabilities |
$10,000 |
10,000 |
$ 70,150 |
| Owners’ equity: Common stock (10,000 shares outstanding) Retained earnings Total owners’ equity Total liabilities and owners’ equity |
$30,000 48,750 |
78,750 $148,900 |
|
Assets
Assets can be divided into three broad categories: current assets, fixed assets, and intangible assets. Current assets are assets that can or will be converted to cash within the next 12 months. They are important because they provide the funds used to pay the firm’s current bills. They also represent the amount of money the firm can quickly raise. Current assets include:
- Cash: Funds on hand or in a bank
- Marketable securities: Temporary investments of excess cash that can readily be converted to cash
- Accounts receivable: Amounts owed to the firm by customers who bought goods or services on credit
- Notes receivable: Amounts owed to the firm by customers or others to whom it lent money
- Inventory: Stock of goods being held for production or for sale to customers
Fixed assets are long-term assets used by the firm for more than a year. They tend to be used in production and include land, buildings, machinery, equipment, furniture, and fixtures. Except for land, fixed assets wear out and become outdated over time. Thus, they decrease in value every year. This declining value is accounted for through depreciation. Depreciation is the allocation of the asset’s original cost to the years in which it is expected to produce revenues. A portion of the cost of a depreciable asset—a building or piece of equipment, for instance—is charged to each of the years in which it is expected to provide benefits. This practice helps match the asset’s cost against the revenues it provides. Because it is impossible to know exactly how long an asset will last, estimates are used. They are based on past experience with similar items or IRS guidelines for assets of that type. Notice that, through 2018, Delicious Desserts has taken a total of $16,000 in depreciation on its bakery equipment.
Intangible assets are long-term assets with no physical existence. Common examples are patents, copyrights, trademarks, and goodwill. Patents and copyrights shield the firm from direct competition, so their benefits are more protective than productive. For instance, no one can use more than a small amount of copyrighted material without permission from the copyright holder. Trademarks are registered names that can be sold or licensed to others. One of Delicious Desserts’ intangible assets is a trademark valued at $4,500. Goodwill occurs when a company pays more for an acquired firm than the value of its tangible assets. Delicious Desserts’ other tangible asset is goodwill of $7,000.
Liabilities
Liabilities are the amounts a firm owes to creditors. Those liabilities coming due sooner—current liabilities—are listed first on the balance sheet, followed by long-term liabilities.
Current liabilities are those due within a year of the date of the balance sheet. These short-term claims may strain the firm’s current assets because they must be paid in the near future. Current liabilities include:
- Accounts payable: Amounts the firm owes for credit purchases due within a year. This account is the liability counterpart of accounts receivable.
- Notes payable: Short-term loans from banks, suppliers, or others that must be repaid within a year. For example, Delicious Desserts has a six-month, $15,000 loan from its bank that is a note payable.
- Accrued expenses: Expenses, typically for wages and taxes, that have accumulated and must be paid at a specified future date within the year although the firm has not received a bill
- Income taxes payable: Taxes owed for the current operating period but not yet paid. Taxes are often shown separately when they are a large amount.
- Current portion of long-term debt: Any repayment on long-term debt due within the year. Delicious Desserts is scheduled to repay $5,000 on its equipment loan in the coming year.
Long-term liabilities come due more than one year after the date of the balance sheet. They include bank loans (such as Delicious Desserts’ $10,000 loan for bakery equipment), mortgages on buildings, and the company’s bonds sold to others.
Owners’ Equity
Owners’ equity is the owners’ total investment in the business after all liabilities have been paid. For sole proprietorships and partnerships, amounts put in by the owners are recorded as capital. In a corporation, the owners provide capital by buying the firm’s common stock. For Delicious Desserts, the total common stock investment is $30,000. Retained earnings are the amounts left over from profitable operations since the firm’s beginning. They are total profits minus all dividends (distributions of profits) paid to stockholders. Delicious Desserts has $48,750 in retained earnings.
2. The Income Statement
How does the income statement report a firm’s profitability?
The balance sheet shows the firm’s financial position at a certain point in time. The income statement summarizes the firm’s revenues and expenses and shows its total profit or loss over a period of time. Most companies prepare monthly income statements for management and quarterly and annual statements for use by investors, creditors, and other outsiders. The primary elements of the income statement are revenues, expenses, and net income (or net loss). The income statement for Delicious Desserts for the year ended December 31, 2018, is shown in Table 14.2.
| Income Statement for Delicious Desserts | |||
|---|---|---|---|
| Delicious Desserts, Inc. | |||
| Income Statement for the Year Ending December 31, 2018 | |||
| Revenues | |||
| Gross sales | $275,000 | ||
| Less: Sales discounts | 2,500 | ||
| Less: Returns and allowances | 2,000 | ||
| Net sales | $270,500 | ||
| Cost of Goods Sold | |||
| Beginning inventory, January 1 | $ 18,000 | ||
| Cost of goods manufactured | 109,500 | ||
| Total cost of goods available for sale | $127,500 | ||
| Less: Ending inventory December 31 | 15,000 | ||
| Cost of goods sold | 112,500 | ||
| Gross profit | $158,000 | ||
| Operating Expenses | |||
| Selling expenses | |||
| Sales salaries | $31,000 | ||
| Advertising | 16,000 | ||
| Other selling expenses | 18,000 | ||
| Total selling expenses | $ 65,000 | ||
| General and administrative expenses | |||
| Professional and office salaries | $20,500 | ||
| Utilities | 5,000 | ||
| Office supplies | 1,500 | ||
| Interest | 3,600 | ||
| Insurance | 2,500 | ||
| Rent | 17,000 | ||
| Total general and administrative expenses | 50,100 | ||
| Total operating expenses | 115,100 | ||
| Net profit before taxes | $ 42,900 | ||
| Less: Income taxes | 10,725 | ||
| Net profit | $ 32,175 | ||
Revenues
Revenues are the dollar amount of sales plus any other income received from sources such as interest, dividends, and rents. The revenues of Delicious Desserts arise from sales of its bakery products. Revenues are determined starting with gross sales, the total dollar amount of a company’s sales. Delicious Desserts had two deductions from gross sales. Sales discounts are price reductions given to customers that pay their bills early. For example, Delicious Desserts gives sales discounts to restaurants that buy in bulk and pay at delivery. Returns and allowancesis the dollar amount of merchandise returned by customers because they didn’t like a product or because it was damaged or defective. Net sales is the amount left after deducting sales discounts and returns and allowances from gross sales. Delicious Desserts’ gross sales were reduced by $4,500, leaving net sales of $270,500.
Expenses
Expenses are the costs of generating revenues. Two types are recorded on the income statement: cost of goods sold and operating expenses.
The cost of goods sold is the total expense of buying or producing the firm’s goods or services. For manufacturers, cost of goods sold includes all costs directly related to production: purchases of raw materials and parts, labor, and factory overhead (utilities, factory maintenance, machinery repair). For wholesalers and retailers, it is the cost of goods bought for resale. For all sellers, cost of goods sold includes all the expenses of preparing the goods for sale, such as shipping and packaging.
Delicious Desserts’ cost of goods sold is based on the value of inventory on hand at the beginning of the accounting period, $18,000. During the year, the company spent $109,500 to produce its baked goods. This figure includes the cost of raw materials, labor costs for bakery workers, and the cost of operating the bakery area. Adding the cost of goods manufactured to the value of beginning inventory, we get the total cost of goods available for sale, $127,500. To determine the cost of goods sold for the year, we subtract the cost of inventory at the end of the period:
The amount a company earns after paying to produce or buy its products but before deducting operating expenses is the gross profit. It is the difference between net sales and cost of goods sold. Because service firms do not produce goods, their gross profit equals net sales. Gross profit is a critical number for a company because it is the source of funds to cover all the firm’s other expenses.
The other major expense category is operating expenses. These are the expenses of running the business that are not related directly to producing or buying its products. The two main types of operating expenses are selling expenses and general and administrative expenses. Selling expenses are those related to marketing and distributing the company’s products. They include salaries and commissions paid to salespeople and the costs of advertising, sales supplies, delivery, and other items that can be linked to sales activity, such as insurance, telephone and other utilities, and postage. General and administrative expenses are the business expenses that cannot be linked to either cost of goods sold or sales. Examples of general and administrative expenses are salaries of top managers and office support staff; utilities; office supplies; interest expense; fees for accounting, consulting, and legal services; insurance; and rent. Delicious Desserts’ operating expenses totaled $115,100.
Net Profit or Loss
The final figure—or bottom line—on an income statement is the net profit (or net income) or net loss. It is calculated by subtracting all expenses from revenues. If revenues are more than expenses, the result is a net profit. If expenses exceed revenues, a net loss results.
Several steps are involved in finding net profit or loss. (These are shown in the right-hand column of Table 14.2.) First, cost of goods sold is deducted from net sales to get the gross profit. Then total operating expenses are subtracted from gross profit to get the net profit before taxes. Finally, income taxes are deducted to get the net profit. As shown in Table 14.2, Delicious Desserts earned a net profit of $32,175 in 2018.
It is very important to recognize that profit does not represent cash. The income statement is a summary of the firm’s operating results during some time period. It does not present the firm’s actual cash flows during the period. Those are summarized in the statement of cash flows, which is discussed briefly in the next section.
3. The Statement of Cash Flows
Why is the statement of cash flows an important source of information?
Net profit or loss is one measure of a company’s financial performance. However, creditors and investors are also keenly interested in how much cash a business generates and how it is used. The statement of cash flows, a summary of the money flowing into and out of a firm, is the financial statement used to assess the sources and uses of cash during a certain period, typically one year. All publicly traded firms must include a statement of cash flows in their financial reports to shareholders. The statement of cash flows tracks the firm’s cash receipts and cash payments. It gives financial managers and analysts a way to identify cash flow problems and assess the firm’s financial viability.
Using income statement and balance sheet data, the statement of cash flows divides the firm’s cash flows into three groups:
- Cash flow from operating activities: Those related to the production of the firm’s goods or services
- Cash flow from investment activities: Those related to the purchase and sale of fixed assets
- Cash flow from financing activities: Those related to debt and equity financing
Delicious Desserts’ statement of cash flows for 2018 is presented in Table 14.3. It shows that the company’s cash and marketable securities have increased over the last year. And during the year the company generated enough cash flow to increase inventory and fixed assets and to reduce accounts payable, accruals, notes payable, and long-term debt.
| Statement of Cash Flows for Delicious Desserts | ||
|---|---|---|
| Delicious Desserts, Inc. | ||
| Statement of Cash Flows for 2018 | ||
| Cash Flow from Operating Activities | ||
| Net profit after taxes | $32,175 | |
| Depreciation | 1,500 | |
| Decrease in accounts receivable | 3,140 | |
| Increase in inventory | (4,500) | |
| Decrease in accounts payable | (2,065) | |
| Decrease in accruals | (1,035) | |
| Cash provided by operating activities | $29,215 | |
| Cash Flow from Investment Activities | ||
| Increase in gross fixed assets | ($ 5,000) | |
| Cash used in investment activities | ($5,000) | |
| Cash Flow from Financing Activities | ||
| Decrease in notes payable | ($ 3,000) | |
| Decrease in long-term debt | (1,000) | |
| Cash used by financing activities | ($4,000) | |
| Net increase in cash and marketable securities | $20,215 | |
4. Analyzing Financial Statements
- How can ratio analysis be used to identify a firm’s financial strengths and weaknesses?
Individually, the balance sheet, income statement, and statement of cash flows provide insight into the firm’s operations, profitability, and overall financial condition. By studying the relationships among the financial statements, however, one can gain even more insight into a firm’s financial condition and performance. A good way to think about analyzing financial statements is to compare it a fitness trainer putting clients through various well-established assessments and metrics to determine whether a specialized fitness program is paying dividends for the person in terms of better strength, endurance, and overall health. Financial statements at any given time can provide a snapshot of a company’s overall health. Company management must use certain standards and measurements to determine whether they need to implement additional strategies to keep the company fit and making a profit.
Ratio analysis involves calculating and interpreting financial ratios using data taken from the firm’s financial statements in order to assess its condition and performance. A financial ratio states the relationship between financial data on a percentage basis. For instance, current assets might be viewed relative to current liabilities or sales relative to assets. The ratios can then be compared over time, typically three to five years. A firm’s ratios can also be compared to industry averages or to those of another company in the same industry. Period-to-period and industry ratios provide a meaningful basis for comparison, so that we can answer questions such as, “Is this particular ratio good or bad?”
It’s important to remember that ratio analysis is based on historical data and may not indicate future financial performance. Ratio analysis merely highlights potential problems; it does not prove that they exist. However, ratios can help managers monitor the firm’s performance from period to period to understand operations better and identify trouble spots.
Ratios are also important to a firm’s present and prospective creditors (lenders), who want to see if the firm can repay what it borrows and assess the firm’s financial health. Often loan agreements require firms to maintain minimum levels of specific ratios. Both present and prospective shareholders use ratio analysis to look at the company’s historical performance and trends over time.
Ratios can be classified by what they measure: liquidity, profitability, activity, and debt. Using Delicious Desserts’ 2018 balance sheet and income statement (Table 14.1 and Table 14.2), we can calculate and interpret the key ratios in each group. Table 14.4 summarizes the calculations of these ratios for Delicious Desserts. We’ll now discuss how to calculate the ratios and, more important, how to interpret the ratio value.
Liquidity Ratios
Liquidity ratios measure the firm’s ability to pay its short-term debts as they come due. These ratios are of special interest to the firm’s creditors. The three main measures of liquidity are the current ratio, the acid-test (quick) ratio, and net working capital.
The current ratio is the ratio of total current assets to total current liabilities. Traditionally, a current ratio of 2 ($2 of current assets for every $1 of current liabilities) has been considered good. Whether it is sufficient depends on the industry in which the firm operates. Public utilities, which have a very steady cash flow, operate quite well with a current ratio well below 2. A current ratio of 2 might not be adequate for manufacturers and merchandisers that carry high inventories and have lots of receivables. The current ratio for Delicious Desserts for 2018, as shown in Table 14.4, is 1.4. This means little without a basis for comparison. If the analyst found that the industry average for small bakeries was 2.4, Delicious Desserts would appear to have low liquidity.
The acid-test (quick) ratio is like the current ratio except that it excludes inventory, which is the least-liquid current asset. The acid-test ratio is used to measure the firm’s ability to pay its current liabilities without selling inventory. The name acid-test implies that this ratio is a crucial test of the firm’s liquidity. An acid-test ratio of at least 1 is preferred. But again, what is an acceptable value varies by industry. The acid-test ratio is a good measure of liquidity when inventory cannot easily be converted to cash (for instance, if it consists of very specialized goods with a limited market). If inventory is liquid, the current ratio is better. Delicious Desserts’ acid-test ratio for 2018 is 1.1. Because the bakery’s products are perishable, it does not carry large inventories. Thus, the values of its acid-test and current ratios are fairly close. At a manufacturing company, however, inventory typically makes up a large portion of current assets, so the acid-test ratio will be lower than the current ratio.
Net working capital, though not really a ratio, is often used to measure a firm’s overall liquidity. It is calculated by subtracting total current liabilities from total current assets. Delicious Desserts’ net working capital for 2018 is $23,050. Comparisons of net working capital over time often help in assessing a firm’s liquidity.
Profitability Ratios
To measure profitability, a firm’s profits can be related to its sales, equity, or stock value. Profitability ratiosmeasure how well the firm is using its resources to generate profit and how efficiently it is being managed. The main profitability ratios are net profit margin, return on equity, and earnings per share.
The ratio of net profit to net sales is the net profit margin, also called return on sales. It measures the percentage of each sales dollar remaining after all expenses, including taxes, have been deducted. Higher net profit margins are better than lower ones. The net profit margin is often used to measure the firm’s earning power. “Good” net profit margins differ quite a bit from industry to industry. A grocery store usually has a very low net profit margin, perhaps below 1 percent, whereas a jewelry store’s net profit margin would probably exceed 10 percent. Delicious Desserts’ net profit margin for 2018 is 11.9 percent. In other words, Delicious Desserts is earning 11.9 cents on each dollar of sales.
The ratio of net profit to total owners’ equity is called return on equity (ROE). It measures the return that owners receive on their investment in the firm, a major reason for investing in a company’s stock. Delicious Desserts has a 40.9 percent ROE for 2018. On the surface, a 40.9 percent ROE seems quite good. But the level of risk in the business and the ROE of other firms in the same industry must also be considered. The higher the risk, the greater the ROE investors look for. A firm’s ROE can also be compared to past values to see how the company is performing over time.
Activity Ratios
Activity ratios measure how well a firm uses its assets. They reflect the speed with which resources are converted to cash or sales. A frequently used activity ratio is inventory turnover. The inventory turnover ratio measures the speed with which inventory moves through the firm and is turned into sales. It is calculated by dividing cost of goods sold by the average inventory. (Average inventory is estimated by adding the beginning and ending inventories for the year and dividing by 2.) Based on its 2018 financial data, Delicious Desserts’ inventory, on average, is turned into sales 6.8 times each year, or about once every 54 days (365 days ÷ 6.8). The acceptable turnover ratio depends on the line of business. A grocery store would have a high turnover ratio, maybe 20 times a year, whereas the turnover for a heavy equipment manufacturer might be only three times a year.
Debt Ratios
Debt ratios measure the degree and effect of the firm’s use of borrowed funds (debt) to finance its operations. These ratios are especially important to lenders and investors. They want to make sure the firm has a healthy mix of debt and equity. If the firm relies too much on debt, it may have trouble meeting interest payments and repaying loans. The most important debt ratio is the debt-to-equity ratio.
The debt-to-equity ratio measures the relationship between the amount of debt financing (borrowing) and the amount of equity financing (owners’ funds). It is calculated by dividing total liabilities by owners’ equity. In general, the lower the ratio, the better. But it is important to assess the debt-to-equity ratio against both past values and industry averages. Delicious Desserts’ ratio for 2018 is 89.1 percent. The ratio indicates that the company has 89 cents of debt for every dollar the owners have provided. A ratio above 100 percent means the firm has more debt than equity. In such a case, the lenders are providing more financing than the owners.
5. Financial Statements: Interconnectivity
LEARNING OUTCOMES
- Explain how the balance sheet, income statement, statement of owner’s equity, and statement of cash flows are connected
Watch the following video, and pay special attention to the interconnection between the four financial statements required by GAAP.
You can view the transcript for “Financial Statements – Interconnectivity” (opens in new window).
- Introduction to Key Financial Statements. Authored by: Linda Williams and Lumen Learning. License: CC BY: Attribution