THE BASICS OF FINANCIAL STATEMENTS
AND
FINANCIAL STATEMENT ANALYSIS

 1.  INTRODUCTION

Accounting is a system that accumulates and measures economic data about an enterprise and communicates that data to various decision makers. Accounting's primary functions are to record, classify and summarize financial transactions, culminating in the preparation of financial statements.

A.  Financial statements are the primary means by which businesses communicate their financial position and the result of operations. There are four main financial statements:

1. The balance sheet.

2. The income statement.

3. The statement of cash flows.

4. The retained earnings statement.

B.  Bookkeeping is that aspect of the accounting process that focuses on measuring a firm's daily activities. The bookkeeping process begins with a transaction (an economic event that is accounted for) and results in financial statements. Whether the bookkeeping system is manual or computerized, it follows the same basic principle:

Transactions  »  Journal  »  Ledger  »  Financial Statement

II. CONCEPTS UNDERLYING FINANCIAL STATEMENTS

1. Going concern. A company is assumed to be in business indefinitely unless there is evidence to the contrary.

2. Historical cost. Under the historical cost assumption, accountants have traditionally valued most assets at their original or acquisition cost.

3. Matching. The matching concept states that when specific revenues are recognized in a period, the expenses incurred in generating those revenues should also be assigned to that period.

4. Conservatism. The conservatism principle applies to judgments made in uncertain situations; if alternative values are possible and the accountant is uncertain about which to choose, it supports the choice of the option least likely to overstate assets and profits.

5. Time period. To provide timely information about a company's progress, it is useful to prepare periodic performance reports. The most commonly used time periods are the month, the quarter and the year.

6. Money measurement. Accounting is based on the assumption that money is an appropriate basis for accounting measurement and analysis. Only transaction data capable of being expressed in monetary terms are included in the accounting records of a business.

7. Materiality. An item is considered material if it would influence or change the judgment of a reasonable person.

8. Consistency. Financial statements are most useful when information about a company is measured and disclosed in the same manner from one accounting period to the next. Consistency does not preclude changing from one accounting method to another accounting method, but if such a change is made, the company must disclose the nature of and reason for the change and its dollar effects.

9. Full disclosure. Accountants strive to reveal information that is of sufficient importance to influence the judgment and decisions of an informed user.

III. THE FINANCIAL STATEMENTS AND RATIO ANALYSIS

A.  At the outset, it is important to note that if statements are prepared on a cash basis, only transactions that involve cash are recorded. Small businesses will often use this accounting convention - "cash basis" - even though it is not in accordance with generally accepted accounting principles. "Cash basis" statements will not recognize accounts receivable from or accounts payable to outside sources. 

The accrual method is the generally accepted method of accounting. This method accounts for transactions in the period in which the business activity occurred, regardless of the period in which the cash was actually received or disbursed. An important concept in accrual basis accounting is the theory of "matching" the expenses with the revenue that it produced.

B.  Levels of Outside Accountant's Involvement

1. Compiled financial statements - Prepared from accounting records supplied by the company. The CPA must disclaim any opinion on the financial report and no negative assurance may be given either.

2. Reviewed financial statements - The CPA provides limited, negative assurance on the reliability of the financial statements. A review consists principally of inquiries of company personnel and analytic procedures applied to financial data. It is substantially less in scope than an audit.

3. Audited financial statements - The CPA plans and performs extensive tests on the accounting data and systems underlying the financial statements with a view toward rendering an opinion as to the material fairness of the financial statements and their conformity with generally accepted accounting principles.

C.  The Four Main Financial Statements

1.  The Balance Sheet

A balance sheet is a financial statement that lists an entity's assets, its liabilities and the equity of the owners at a specific point in time.

Assets are economic resources that are owned by the business entity.

Liabilities represent the claims of creditors against these assets.

Owner’s equity represents the owners residual claim to the assets of an entity after the creditor's claim has been satisfied.

At any given time, the assets of a business equal the total claims against those assets by its creditors and owners. This relationship is contained in the balance sheet or accounting equation which is expressed as follows:

Assets = Liabilities + Owners' Equity

Assets are generally classified into three categories.

Current assets - include cash and other assets expected to be converted into cash within one year, such as marketable securities, accounts receivable, notes receivable, inventories and prepaid expenses.

Property, plant and equipment (fixed assets) - includes business assets that have relatively long lives. These assets are typically not for resale and are used in the production or sale of other goods and services. Examples: land, plant, equipment, machinery, furniture and fixtures.

Other assets - include the company's investments in securities, such as stocks and bonds, an intangible asset (valuable rights), such as patents, franchise costs and copyrights.

Liabilities are generally divided into two classes.

Current liabilities - the amounts owed to creditors that are due within one year, such as accounts payable, notes payable and accrued liabilities.

Long-term liabilities - claims of creditors that do not come due within one year. Included in this category are mortgages, bonded indebtedness and long-term bank loans.

Owners' equity - the claims of owners against the business. This is a residual amount computed by subtracting liabilities from assets. Its balance is increased by any profit and reduced by any losses incurred by the business.

Note the following points about a balance sheet:

It is prepared as of a specific date.

Assets and liabilities are generally listed in order of liquidity.

Most assets are listed at historical cost less depreciation. Investments are usually the only assets to be stated at the lower of cost or market.

There are assets that may not be listed on the balance sheet. Examples would be goodwill that was not purchased, quality workforce or research and development costs.

Contingent liabilities are usually not included on a balance sheet.

Sample balance sheet:

Exhibit 1

JONES CORPORATION
Balance Sheet
December 31, 1991

Balance Sheet Ratios

Ratio analysis is a useful technique for evaluating the various financial characteristics of company. A ratio simply defines a relationship between two numbers.

Balance sheet ratios measure liquidity (the ability of a firm to meet its current debts) and leverage (the extent to which the company is dependent upon the financing of creditors). The three principal measures of liquidity are calculated as follows:

(a) Current Ratio = Current Assets / Current Liabilities

This ratio measures the extent to which current assets are available to meet the payment schedule of a company's debts. Whether a specific current ratio is adequate depends on the nature of the business and the characteristics of its assets and liabilities.

The asset-test ratio focuses on the most liquid asset by excluding inventories. This ratio measures the firm's ability to meet its current obligations even if none of the inventory can be sold.

(c) Working Capital = Current Assets - Current Liabilities

This ratio is another way to look at the relationship between current assets and current liabilities. Most financially healthy businesses have positive working capital. Minimum working capital requirements are often stipulated in loan agreements.

Financial leverage refers to the use of debt to finance the assets of a company. Leverage adds risk to the operation of the firm; if a firm does not generate enough revenues to pay the interest on its debt, its creditors can force it into bankruptcy. Two widely used financial leverage ratios are as follows:

(a) Debt ratio = Total Liabilities /  Total Liabilities + Owners' Equity

(b) Debt to Equity = Total Liabilities /  Total Owners' Equity

(c) These ratios indicate to creditors how well protected they are in the event the firm becomes insolvent. A high ratio has a negative influence on a company's ability to obtain additional financing.

2. The Income Statement

a. The income statement, sometimes called the statement of earnings or the profit-and-loss statement, measures a company's revenues, expenses and resulting net income over a specified period of time. In contrast, the balance sheet measures the company's financial condition at a specific point in time.

b. While there is no rigid format governing income statements, there are several categories that appear in most financial statements.

i. Revenues - Amounts received from the sale of products or services.

ii. Cost of goods sold - The cost of inventory or goods sold to customers. Cost of goods sold is calculated by adding purchases to beginning inventory and subtracting ending inventory.

iii. Gross profit (or gross margin) - The difference between sales and cost of goods sold. (This amount, stated as a percentage, is a very significant number because it indicates the average mark-up on the merchandise sold.)

iv. Selling, general and administrative expenses - The operating expenses of the company, including such expenses as salaries and wages, depreciation, utilities, supplies, taxes, bad debts, advertising, insurance, etc.

v. Net income from operations (or operating income) - The result of gross profit minus expenses. This amount is one of the most important measures of a company's performance.

vi. Interest expense - The cost of using borrowed funds. This expense is reported separately from operating expenses because it is a function how assets are financed rather than how they are used.

vii. Income tax - Shown after all the other expenses have been deducted because it is a function of the company's income before taxes.

viii. Earnings (net income) - Always reported at the bottom of a company's income statement.

c. Sample income statement:

Exhibit 2

JONES CORPORATION
Income Statement
For the Year Ended December 31,1991

d. Income Statement Ratios

i. Analysts employ financial ratios because numbers in isolation have little value. The knowledge that net income is $1 million is more informative if it can be compared against the sales figure that produced this income and the assets or owners' equity available to the firm.

ii. Financial ratios are particularly useful for analyzing a company's performance relative to its industry.

iii The significant financial ratios from the income statement are:

(a) Gross Profit = Gross Profit /  Margin Net Sales

Gross profit margin is a measure of a company's ability to meet its selling, general and administrative expenses and to earn a profit. Changes in this ratio may indicate changes in sales prices, changes in unit costs for goods purchased or changes in the sale mix (the quantity of goods with low profit margins that is sold compared to the quantity of goods with high profit margins sold). Trends in a company's gross profit margin are significant, as is a comparison of a company's gross profit margin with that of other businesses in the industry.

(b) Operating Profit = Operating Profit /  Margin Net Sales

Operating profit is also known as net income from operations and operating income. This ratio is an extremely important measure of management's ability to control operating costs and raise productivity. Operating income is profit from continued operations before depreciation, interest, taxes and irregular gains or losses. A company's operating profit margin is often a better measure of management skill than is its net profit margin.

(c) Net Profit = Net Profit Before Tax / Margin Net Sales

Net profit margin is calculated before deducting income tax because tax rates and tax liabilities vary among companies for many reasons. Making comparisons after taxes is more difficult to interpret. This ratio enables the analyst to compare a company's return on sales with a performance of other companies in the industry.

3. Statement of Cash Flows

The purpose of the statement of cash flows is to identify the sources and uses of cash during the accounting period. To do this, the statement divides a business' operations into three main activity groups that cause assets to change: operating, investing and financing activities. The information contained on the statement is helpful in answering questions such as the following:

i.   Why does net income differ from the associated cash receipts and payments?

ii. Did the company's cash result from operations, sale of assets, bank loans or investments by owners?

iii. Is the cash generated from the company's operations sufficient to continue paying the dividend or to continue operations?

iv. Did the company use its cash to buy new assets? Reduce debt? Pay dividends?

By presenting information on how cash is obtained and used by a business, the statement of cash flows provides insight into transactions and events that cannot be obtained by examining the other financial statements.

The first activity disclosed in the statement is operating activities.

i.   Using net income as the starting point for this measure of cash changes indicates the direct link between the income statement and the statement of cash flows. Note that net income is adjusted for non-cash items which affect net income but not cash.

ii. Most expenses involve a corresponding outflow of cash. Depreciation, however, although it is deducted as an expense from net income, does not require the use of cash. Since depreciation is a non-cash reduction in net income, it is added back to determine cash flow from operations.

iii. Changes in the balances of current accounts other than cash also have implications for cash flow. The increase in accounts receivable is subtracted from net income because the increase results from sales included in net income that have not yet been collected in cash. In addition, the increase in merchandise inventory is deducted because cash was spent to acquire the additional inventory.

iv. As a rule, decreases in current assets other than cash and increases in current liabilities are added back to net income, whereas increases in current assets and decreases in current liabilities are subtracted.

Investing activities involve changes in a firm's long-term investments and property, plant and equipment. Exhibit 3 reveals that machinery was sold for $80,000.

Financing activities involve liabilities and stockholders' equity items, including amount raised from the sale of long-term debt and common stock and dividends paid on common stock. Items such as stocks, bonds and loans provide a business with cash inflows and commit it to eventual cash outflows (e.g., dividends and repayment of principle). Transactions involving long-term debt and common stock are illustrated in exhibit 3.

The net increase shown in the bottom of Exhibit 3 is the change in the cash balance from the beginning to the end of the accounting period. The statement of cash flows shows why the cash balance change by $555,000 during the accounting period.

Sample statement of cash flows:

Exhibit 3

ROBBINS MACHINE SHOP, INC.
Statement of Cash Flows
For the Year Ended December 31, 1991

4. Statement of Retained Earnings

A financial statement called the statement of retained earnings is often included with the income statement, balance sheet and statement of cash flows in a company's financial statements. The statement of retained earnings explains any changes in the balance of the retained earnings account during the accounting period and relates the income statement to the balance sheet. The statement can be divided into three sections.

i.  Prior period adjustments - necessary when a company has incorrectly recorded an item in a prior accounting period.

ii. Net income - the net income figure on the statement of retained earnings is the same number reported in the income statement.

iii. Dividends – represent distributions to the stockholders in the form of cash, other assets or the company's own stock. Usually, only a portion of the income earned in the year is paid out in dividends.

Some companies combine the income statement and the retained earnings statement in a single statement. The principal advantage of combining the two statements is that all items affecting income appear on a single statement.

Sample Retained Earnings Statement

Exhibit 4

STRAWSER BOOKS, INC.
Retained Earnings Statement
For Year Ended December 31, 1991

D. MANAGEMENT RATIOS

Management ratios are extremely important in evaluating management performance. Usually, they are derived from both the balance sheet and the income statement. Some of these ratios evaluate how certain assets are turned into cash and provide information on how efficiently the enterprises uses its assets. Other management ratios assist in evaluating how well the company has operated during the year. Following are some of the key management ratios:

a. Inventory Turnover = Cost of Goods Sold / Average Inventory at Cost

The inventory turnover ratio measures how rapidly inventory is sold. The inventory turnover divided by 365 indicated the average number of days it takes to sell inventory. Generally speaking, the higher the inventory turnover, the more profitable the enterprise.

b. Accounts Receivable Turnover  = Credit Sales  /   Average Accounts Receivable

This ratio provides an indicator of how successfully a company collects its receivables. Receivables should be collected in accordance with their terms. If the company is slow in converting its receivables into cash, its liquidity may be seriously undermined.

c. Rate of Return on Assets  = Net Profit Before Tax  /   Total Assets

This ratio measures how efficiently profits are being generated from the business' assets. The best comparison is with the ratios of companies in similar business or industry. A ratio that is low compared to the industry average indicates that business assets are being used inefficiently.

d. Rate of Return on Common Stock Equity  = Net Income - Preferred Dividends  /  Common Stockholders' Equity

This ratio gives the percentage return on funds invested in the business by its owners. If the ROE is less than the rate of return on a relatively risk free investment, such as a money/market fund or savings account, the owner may be wise to sell his or her interest in the company.

IV. LIMITATIONS OF FINANCIAL STATEMENTS

Although financial statements provide useful information, they have definite limitations. For example, accountants do not include as assets certain items that are critical to the growth and well-being of a company. The quality of its employees is probably the most significant asset for many businesses, yet this vital asset is not reflected in the balance sheet. Although omission is understandable, it is a definite limitation.

The balance sheet seldom discloses the current market value of assets. Although historical cost is defended by accountants as an objective, reliable method of valuation, it is clearly less useful to the decisions of users than current market value of assets.

In addition, the estimates used to determine depreciation, collectibility of receivables, saleability of inventory, pension expense, guarantee costs and other items that affect both the income statement and balance sheet may not be accurate.

Finally, accounting numbers are affected by the choice of accounting methods made by the company. The choice of an accounting method may have a significant impact on the income reported in the income statement and the value of the asset reported in the balance sheet.

In closely held businesses, it is not uncommon for the financial statements to reflect discretionary choices of the business owner as opposed to being limited to stating ordinary and necessary business expenses. The analyst should carefully consider the effects of management choices on the results of operations as reported in the financial statements. Sometimes, significant adjustments can be required to restate the financial statements to accurately portray the operations of the business.