Business 1220 Financial Accounting Exam Prep

Financial Statements are necessary for:

Accountants, company management teams, investors, creditors (paying bank, investment decisons, company performance, etc.)

Statement of Earnings

determines the after-tax net profit of an organization over a PERIOD OF TIME (Example: how many points did the blue jays score in the past year)

Balance Sheet

Determines the financial position of an organization at a SPECIFIC POINT IN TIME (Example: how many points did the blue jays score at one game)

Statement of Retained Earnings

Determines the cumulative after-tax profits that have been RETAINED OVER THE LIFE OF AN ORGANIZATION. (Example: how many points did the blue jays score from the day the team was formed to present day)

SOE

 A financial record of the firm’s gains and losses

 Over a period of time
 Not necessarily cash
 Also known as the income statement

Closer look at SOE

Net Sales
o Units sold Selling Price (Gross Sales)
o Less: Sales returns and allowances, Net discounts
o E.g. the sale price of an Xbox is $300 and 100 are sold in one year.

o $300100-sales returns and allowances, net discounts

Cost of Goods Sold
o The total cost of buying raw materials, and paying for all the factors that go into producing finished goods

Unites x costs

• beg. Inv. + purchases= end inv.

Solving for COGS

 The formula for solving COGS
o Beginning inventory + Purchases = COGAFS - Ending inventory = COGS o COGS (cost of goods sold) and COGAFS (cost of goods available for sale)

COGS Example

o You have one pencil at the beginning of the school year (Beginning Inventory) o You then purchase ten more pencils (Purchases)
o You now have 11 pencils (COGAFS)
o At the end of the year you have two pencils remaining (End Inventory)
o You have used nine pencils (COGS)

Operating Expenses

The costs associated with generating revenues such as research and development, selling general and admin, non-recurring, depreciation, advertising, utilities, rent etc.

Other Income/Other expenses

non-related to their primary business

Tax

Tax rate x Net profit before tax

Facts to Remember for SOE

o SOE (statement of earnings) reports on activities during a specific time period
o Company name, statement name, date at top
o Only the sales (revenues) generated and the expenses incurred to generate these sales during a specific period are recorded
o Structure of SOE includes Sales first, expenses, ending with earnings

Statements Compared to Eachother (SOE,BS)

Statement of Earnings
o Used for reporting over a period of time e.g. revenues, expenses, and net profit

Balance Sheet
o Used for reporting at a specific time
o Shows what a company owns in assets and liabilities, and has accrued in equity over owners’ equity or shareholders’ equity

o assets are something one owns whereas liabilities have accrued in equity over owners’ equity or shareholders’ equity

Balance Sheet

o There are only two ways to pay for assets:
o Equity and debt (one’s own money or borrowed money)

Current Assets

o Assets that can usually be turned into cash within one year

Long Term Assets

o Held in the company for a period greater than one year

Depreciation/Amortization

o The reduction in the value of an asset with the passage of time due particularly to wear and tear

o E.g. A million dollar car automatically loses value the second it is purchased and driven out of the car dealership

o This cost is allocated over the asset’s useful life through:
o Depreciation or amortization expense is found on the income statement

o Accumulated depreciation or amortization is found on the balance sheet

Intangibles

o Can’t be seen or touched

o Goodwill

o Patents

Current Liabilities

o Items the company should pay within the next year and are listed in order of due

dates
o E.g. Accounts Payable, Current Portion of LTD, Accrued Expenses, Income, Taxes Payable, Working Capital Loan

Long Term Liabilities

o Items the company will take longer than one year to pay and are also listed in order of due dates
o E.g. Car loan, Mortgage, Long-Term loans

Equity

o Represents the financial interest, stake or claim the owners have in the company

o Includes owner’s original investment plus or minus the accumulation of all incomes or losses that have been retained since the beginning of the company

Fundamental Accounting Equation

Assets= Liabilities + Equity

Statement of Retained Earnings

o Shows money reinvested into the company since its inception
o Links the statement of earnings and balance sheet together
o Formula to Calculate Retained Earnings (e.g. for 2014-2015 year):

o Retained earnings 2014(2014 balance sheet) + Net profit (from 2015 SOE) – Dividends paid (results of balance sheet equation also known as “plug”) = Retained earnings 2015

CONNECTED TO:

o Retained earnings account on the balance sheet

o Net profit after tax on the statement of earnings

Preparing the Statements

diagram

Current Assets

cash and other assets that are expected to be converted to cash within a year

Fixed Assets

Investments in property, plant and equipment

Intangible Assets

non-physical asset that has a useful life of greater than one year

Examples: trademarks, customer lists, motion pictures, franchise agreements, computer software etc.

Current Liability

the amount of money the company owes and must pay within the coming year

Long Term Liability

Debts due after one year from the date of the balance sheet

Equity account

the owners interest in the company assets

Balance Sheet

Presents the financial position of an enterprise as of a particular day

income Statement

measures how profitable the corporation was during a particular period of time

Prepaid Expenses

intended to be used up in the short term, such as property or equipment rental and fire. E.g. magazine subscriptions are paid for the entire year at once but customers receive one issue per month.

Depreciation (Amortization)

Depreciation (amortization) Expense- is found on the income statement (as an operating expense)

Accumulated Depreciation (Amortization) – is found on the balance sheet as a contract account

- Accumulated depreciation is the depreciation expense that has been recorded on the income statement over the life of the fixed asset

Depreciation Example

Historical Cost

• Truck costs $100,000

• Purchased on January 1st, 2010

• Expected to last five years (useful life)

  Fixed Asset

- Truck is recorded as its original cost (never changes)

Accumulated Depreciation

- A portion of the original cost that has been depreciated (reduced) as an expense over the years

Depreciation Expense

• $100,000 / 5 years = $20,000 each year for 5 years

• Straight-line method of depreciation

o Historical cost / useful life

Additional Facts to Remember

• Historical cost never changes

• Net= historical cost – accumulated depreciation

• Historical cost, accumulated depreciation and net will appear on the balance sheet

• Depreciation expense appears on the income statement

• Gross profit= sales – COGS

• COGS= Beg.Inv + Purchases =COGAFS – End. Inv.

Statement of Cash Flow

Identifies specific activities that provide or consume cash during a specific period of time

Operations

measures the cash flow associated with normal business activities

Financing

how much debt or equity has been acquired or retired over the year

Investing

Outlines all cash movements relating to the acquired and disposals of non-current assets

Net Cash Flow

the sum of three components

1. Operating

2. Financing

3. Investing Activities

Financial Ratio Analysis

a useful financial management tool developed to assist in identifying, interpreting and evaluating changes in the financial performance and condition of a business over a period of time

The Importance of Cash Flow (Assets)

• When assets decrease, cash increase

• -  When assets increase, cash decrease

• -  E.g. you own a pair of Dr.Dre beats headphones (asset) and you sell them to someone

  else and receive $50 (cash). Although by selling the headphones your assets

  decreased, you gained an extra $50 increasing your cash

• -  E.g. you want to buy back the headphones so you pay $50 to the person you sold the

  headphones to. Your assets have now increased bu

The Importance of Cash Flow (Liability and Owners Equity)

• When liabilities increase, cash increase

• When liabilities decrease, cash decrease

• E.g. you get a bank loan of $5,000. You know owe the bank $5,000 increasing your

  liabilities but you also now have an extra $5,000 increasing your cash

• E.g. when you pay back your bank loan of $5,000, your liabilities decrease as you do not owe the bank any more money, however, you have also lost $5,000 to the bank decreasing your cash as well

Statement of Cash Flow

- The balance sheet provides a preview of a company’s financial position but fails to show how the financial position of the company has changed over time

-  Statement of Earnings shows the gains and losses compared to sales over a period of time but only explains a little about how a company uses its funds

-  The statement of cash flows is composed of three sections:

o Operations: Shows how much cash is being made and spent on everyday operations

o Financial Activities: Shows how much cash is made through financial activities such as debt or equity

o Investigating Activities: Shows how much cash was used or made from investments ( this section focuses on fixed assets)

Steps to Building a Statement of Cash Flow

1. State the net earnings

2. Group account changes into operations, financing or investing activities

3. Place dividends/drawings in the financing section

4. Add total cash from operations, financing and investing activities to get the net cash flow figure

5. Net cash flow + Beginning Cash = Ending Cash

Interpreting the Statement of Cash Flow

- Questions to answer when interpreting statements of cash flows:
o Was cash generated from operations?
o Is net income a source of cash and what does this tell us?

o What are the sources and uses of cash from operations?

o What are the remaining major sources and uses?
o Recommendations for the future?

Calculation: COGS to Sales

COGS ($)/ Net Sales ($) * 100 = %

Calculation: Gross income/profit to sales

Gross income ($)/ Net sales ($) * 100= %

Calculation: Operating expenses to sales

Operating expenses ($)/ Net sales ($) *100= %

Calculation: Net income before Tax

income before interest and taxes ($)/ net sales ($)*100= %

Calculatio: Net income/ profit margin to net sales

Net income ($)/Net sales ($)* 100= %

Calculations: Return on Equity

net income, usually after tax, before dividends ($)/ average years equity ($)*100= %

Calculation: Average years equity

last years ending equity ($) + this years ending equity ($)/2

Calculation : Age of Accounts Recivable

1. Calculate average daily sales

• Average daily sales= total period net sales ($)/number of days in period = $/day

2. Calculate the number of days net sales represented by level of accounts receivable currently outstanding

• Age of accounts receivable= accounts receivable ($)/average daily sales ($/day)= days

3. Average daily sales is calculated by

• Average daily sales= Total sales for the period/ number of days in the period

Calculation: Age of Inventory

1. Calculate daily COGS:

• Average daily COGS= total period COGS ($)/number of days in period = $/day
  

2. Calculate the number of days goods sold represented by the inventory currently on hand

• Age of inventory= ending inventory ($)/average daily COGS ($/day)= days

Calculation: Average Age of Accounts Payable

1. Calculate average daily purchases:

• Average daily purchases= total period purchases ($)/# of days in period = $/day revenue

2. Calculate the number of days of purchases represented by the accounts payable currently owing

• Age of accounts payable= accounts payable ($)/average daily purchases ($/day) = days

Calculation: Inventory Turnover

COGS ($)/average inventory ($) = times

Calculation: Average Inventory

beginning inventory + ending inventory /2

Calculation: Fixed Asset Turnover

net sales ($)/average net fixed assets ($) = times

Calculation: Average Net Fixed Assets

beginning net fixed assets + ending net fixed assets/2

Calculation: Total Asset Turnover

net sales ($)/average total assets ($) = times

Calculation: Average Total Asset

beginning total assets + ending total assets /2

Calculation: Currnet Ratio

total current assets ($)/total current liabilities ($) =? /1

Calculation: Acid Test Ratio

cash + marketable securities+ accounts receivable /current liabilities =?/1

Calculation: Working Capital

current assets ($)-current liabilities ($) = $

Calculation: Net worth to Total Assets

total shareholders’ equity ($)/total assets ($)*100=%

Calculation: Total Debt to Total Assets

total liabilities ($)/total assets ($)*100=%

Calculation: Total Debt to equity Ratio

total debt ($)/equity ($)

Calculation: Intrest Coverage

income before interest and taxes ($)/interest expenses ($)= times

Calculation: Sales Growth

year 2 sales ($)-year 1 sales ($) /year 1 profits ($)*100= %

Calculation: Profit Growth

year 2 profit ($)-year 1 profit ($)/year 1 profit ($)*100= %

Calculation: Asset Growth

year 2 total assets ($)-year 1 total assets ($)/year 1 total assets ($)*100= %

Ratio Analysis

•  Ratio analysis is used to evaluate the performance of a company, discover new information within the statement of earnings and balance sheet, and provides information about the business for business making by internal and external users

•  Helps to identify potential issues of a business

Who Looks at Ratio Analysis

• Creditors

• shareholders

• managers

Why Look At Ratios

• Uncovers relationships between financial statement items

• Aids in identifying, evaluating and interpreting changes in financial performance over a period of time

• Required for future business-making decisions

Ratio Analysis: 5 categories

• Profitability

• Efficiency

• Liquidity

• Stability

• Growth

Profitability

Vertical Analysis

• Items from income statement are expressed in percentages of net sales

• Provides information on how much income is generated from one dollar in sales

Return on Equity

• Measures the income generated as a percentage of the company’s equity

• The amount of income the company makes for each dollar invested by the owners

• Looks at the return on capital invested in the business as well

o Return on capital= earnings/average equity

Efficencey

Age of Accounts receivable
- Determines number of days it takes to collect money from those who owe

Age of Inventory
- Determines number of day inventory will sit before it is sold

Age of Accounts Payable
- Determines the number of days it takes to pay creditors

Liquidity

- Determines if the company will be able to meet its current liabilities

Current Ratio

• For every dollar in current liabilities, how many current assets are there?

Acid Test

• For every dollar in current liabilities, how easily is cash attainable?

• Do not include inventory in the acid test

Working Capital

• How much money is left over after current liabilities are paid

Stability

• Major goal is to have a stable financial structure (balance assets with debt and equity)

• Helps assess financial risk of the firm

• May highlight large problems that may lead to bankruptcy

  Net worth: Total Assets

• How much of the assets are financed by equity?

Debt: Equity

• For each dollar in equity, how much money is there in liabilities?

Interest Coverage

• Can the company pay the interest on its debt?

• Earnings before interest and tax is used for interest coverage

Growth

• Determines if the company is growing

• Asset growth

• Earnings growth

• Sales growth

• Equity growth

• Need two years of numbers to solve

Using Ratios for Analysis

• Ask why? Or so what?

• What’s the cause?

• Look at raw numbers

• Look for increasing or decreasing trends

• Does this make sense in the situation?

• How does the company stack up in the industry?

Interpreting Ratios

• Look for increasing and decreasing trends

• Why has the ratio changed?

o Look at the numerators and denominators

• How does the company stack up against the industry?

o Look at competitor ratios
o Consider outside environment

Projected Statements

• Projected statements are statements prepared to assess what a business can expect in the future

• This is used by entrepreneurs, managers and lenders

• Projected statements are either for two years or between high and low sales scenarios

Sources of Information

• Information used on projected statements usually come from either a managers’ best estimate, past financial performance or case information

• Projected statements use assumptions

• Assumptions must be reasonable (within the realm of reason)

Projected Statements if Earnings

• always begin with the statement of earnings

• being with the sales estimate (either your own or managers’ assumption)

• must project two years or a high/low scenario

• remember: sales next year is equivalent to sales last year

Operating Expenses

• after calculating sales, COGS, and gross profit, use the vertical analysis to identify the different trends in the expenses

• make an assumption on what percentage of sales each expense will be for the projected income statement only for expenses that experience fluctuations in sales

• some expenses are estimated as a dollar value vs. percentage of sales

• these expenses do not change when sales increases or decreases

• depreciation, rent and interest expense are always projected as a dollar value

• examples of expenses that do not vary include sales, accounting, legal, parking and

  depreciation

• always state assumptions

Projecting Tax Expense

• use the same tax rate as the previous year

• if tax rate is not provided, calculate from the previous years’ statements

• if there is absolutely no way of calculating the tax expense, only then can you assume

  25% as the tax rate

Projected statement of Retained Earnings

• start with the previous year’s retained earnings which will be found on the previous year’s balance sheet

• add projected net income from the projected income statement

• identify if drawings or dividends have been paid

• calculate the ending retained earnings which will also be used on the balance sheet under equity

Projecting Current Assets (Balance Sheet)

• for cash, use the amount from the previous year

• for accounts receivable, use the age of accounts receivable formula from ratio analysis

• for inventory, use the ending inventory from the projected statement of earnings

Projecting Fixed Assets

• the fixed assets usually remain the same unless the company has sold some of its assets

• add projection depreciation from statement of earnings to the previous years’ accumulated depreciation

Projecting Current Liabilities

• the working capital loan will be solved as the PLUG and will be the last account to be solved for

• for accounts payable, use the age of accounts payable formula and daily purchases

• if there is no purchases figure provided, use COGS figure as a substitute

Projecting Long-Term Liabilities

• may have to make adjustments by reducing long term debt by the current portion long term debt

Projecting Equity

• common stock should remain the same unless stated otherwise

• retained earnings can be found on the projected statement of retained earnings

The PLUG

• the plug is known as the unknown

• should be the last account to solve for

• make sure that assets equal to liabilities and equity

• A=L+E

Seasonality

• Some of the business’s cash needs fluctuate based on the time of year

• E.g. a swim suit store would increase in sales during the summer season but decrease in sales during the winter season

• For companies that are seasonal, increase the size of the plug by the required amount of money needed to cover peak times

Sensitivity Analysis

- The three accounts that should be considered when performing sensitivity analysis are o Days accounts receivable

o Days account payable

o Days inventory

• Choose the one account that is the most vulnerable to change based on the case being

  analyzed

• Determine what would happen if the average number of days increases or decreases

  from projections and recalculate the dollar value for the account for two years

• Asses the overall impact that increase and decrease in average days have on the plug

Sensitivity Analysis: Formulas

Days A/R = AR/ sales/ 365

Days A/P = AP/ purchases/ 365

Days INV= INV/ COGS/ 365

The 4 C’s Of Credit

• Credit enables a company or organization to purchase goods or services in the present and pay for them in the future

• The 4 C’s of credit measures risk

• The 4 C’s include:

o Conditions of the business o Character
o Capacity to repay
o Collateral