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Unit 3 Study Guide

What is an income statement?

An income statement is a summary of a business’s transactions that shows net profit before and after taxes by analyzing sales, purchases, costs of goods sold, and operating expenses for a specific time period. In other words, an income statement summarizes:

• A business’s income and expenses over a period of time

• Where a business’s money came from and where it went

• How much money a business has made or lost over a period of time

Other names for income statements

An income statement is also sometimes called a(n):

• Earnings statement

• Operating statement

• Profit-and-loss statement

Categories appearing on income statements

Categories appearing on an income statement include:

• Revenue

  • Includes all of the money earned by a business from all sources

• Cost of goods sold/Cost of sales

  • Consists of all direct costs required to obtain and/or produce the goods or services that a business sells

• Gross profit

  • Determined by subtracting the cost of goods sold/cost of sales from revenue

  • Consists of the total profit made before all other remaining expenses have been sold

• Operating expenses

  • Address all expenses related to the business’s ongoing operations

  • Do not include non-operating expenses like taxes and interest expenses

• Operating earnings

  • Determined by subtracting the operating expenses from the gross profit

  • Also called operating income, operating profit, or income from operations

• Interest expense

  • Consists of interest paid to investors

• Taxes

  • Include income tax expenses imposed by the federal and state governments

• Net income

  • Indicates the business’s final profit

  • Consists of the money remaining after operating expenses, interest expense/ =interest income, and taxes are subtracted from gross profit

  • Is sometimes called net profit, net earnings, or the “bottom line”

Income statements are cumulative.

The income statement is cumulative because it represents a total for a specific time period, usually one year. A business must be able to see cumulative totals so that it can see where it is successful and where there might be trouble brewing.

Ways that a business can use its income statement

The income statement is a business’s best source of information regarding how well it is doing and where its weaknesses are.

Analyzing the income statement involves transforming the final numbers into financial ratios, which can be used to:

• Compare categories of financial data on the income statement

  • By themselves, the elements of an income statement are simply categories and

  • A business needs to be able to see how the categories are affecting each other and the bottom line.

• Compare categories over time

  • A business not only needs to know its financial circumstances for one year, but also over time.

  • Therefore, a business needs to be able to compare numbers from income statements of different

• Compare figures with those of competitors

  • A competitive analysis helps a business to see its strengths and weaknesses in relation to those of the

  • By comparing numbers from its income statement with those of its competitors, a business will know if it is operating as profitably as it should

The basics of cash flow

Cash flow:

• Is the movement of funds into and out of a business

• Determines the amount of cash the business has to work with at any given time

The importance of adequate cash flow

Adequate cash flow is essential to business success. Businesses that run low on cash can face serious problems. They may become insolvent, meaning that they are not be able to cover all of their expenses. Or, they may even fail—forcing them to close their doors for good.

Even businesses that make a profit may experience cash-flow problems. This happens sometimes because of the sources of the cash that flows into a business. Some sources are more reliable and steadier than others.

Sources of cash flowing into a business

Businesses receive cash from five main sources, including:

• Start-up money

  • Consists of funds used to bring a business into operations

• Sale of products

  • Usually is the primary way in which cash flows into an existing business

• Loans

  • Include money that the business borrows from banks, private investors,

• Interest

  • Includes cash earned on investments, credit customer interest payments,

• Sale of assets

  • Involves selling anything of value that a business owns, such as land, equipment,

Sources of cash flowing out of a business

Sources of cash that flow out of a business include:

• Operating expenses

  • Include all expenses related to the business’s ongoing operations (e.g., payroll, rent, mortgage payments, utility costs, supplies, shipping and delivery expenses, advertising costs, insurance, )

• Cost of goods

  • Can be a major expense for businesses that buy goods for resale, such as retailers

• Assets

  • Are necessary for business operations

• Loan payments

  • Consist of payments toward loan principal as well as interest expenses for the use of the borrowed money

• Taxes

  • Include income tax, property tax, sales tax, payroll tax,

• Miscellaneous

  • Can include legal fees, maintenance and reports, losses due to uncollectible accounts, emergencies,

What can cash flow statements tell us?

A cash flow statement is a financial summary with estimates as to when, where, and how much money will flow into and out of a business.

When?

• Knowing when money will flow in and out is important because it warns businesses when they will be low on

• Preparing a cash flow statement helps a business identify the high points, so it can be ready to handle the low points.

Where?

• Knowing where the money will come from is

• Preparing a cash flow statement helps a business identify different sources of cash flow and determine which are more or less likely to make payments to the business as

How much?

• Knowing how much cash is flowing into the business is the most important information that a cash flow statement

• If businesses know there will be a cash shortage one month, they can plan ahead to try to generate more income and/or reduce

Estimating cash flow figures

Since new businesses do not have financial data from previous years to predict future cash flow, they often rely on figures obtained through marketing research. They use this information to estimate the amount of cash they will need to survive until they begin to make a profit.

Established businesses use information from past financial statements to predict future cash flow. They often review previous income statements to determine how much cash is coming into and going out of the business. Then, they combine this information with information about industry trends and predictions.

Cash flow components and calculations

Cash flow statements typically include the following main parts:

• Beginning cash balance

  • Amount of money a business has available at the beginning of each month

• Cash receipts from:

  • Sale of goods and services

  • Loans

  • Sale of assets

  • Interest income

• Total cash receipts

  • Determined by adding all of the sources of income that the business lists under cash receipts

• Total cash available

  • Determined by adding the total cash receipts to the beginning cash balance

• Cash payments, including:

  • Cost of goods to be sold

  • Fixed expenses

  • Variable expenses

• Total cash paid out

  • Determined by adding together the items listed under cash payments

• Ending cash balance

  • Amount of cash that a business has left at the end of the month

  • Calculated by subtracting the total cash paid out from the total cash available

Ways to use a cash flow statement

After completing the cash flow statement, a business has a good idea of the amount of money that will flow in and out for the month or quarter. A positive cash flow means the business is solvent and has enough money on hand to meet its monthly obligations. A negative cash flow means that the business will need to obtain additional money and/or reduce expenses to continue operating.

The cash flow statement also indicates the financial condition of a business. Businesses with extra cash are able to invest that money in the business to grow and expand. This usually generates more sales, more cash, and more profit. The result is a successful, prosperous business that has the cash to continue growing, and cash reserves to protect it from the ups and downs of the marketplace.

Since new businesses do not have financial data from previous years to predict future cash flow, they often rely on.

The basics of balance sheets

A balance sheet:

• Is a financial statement that captures the financial condition of the business at that particular moment

• Is sometimes called a financial position statement

• Is a snapshot of the business’s financial condition

• Captures the business’s financial condition at a particular moment—somewhat like a photograph captures just one second of time

What does a balance sheet look like?

While an income statement reports net income or loss for an entire period, the balance sheet covers just one day in the period—usually the last day of the year, quarter, month, etc.

The balance sheet presents three important categories of financial information:

• Assets

  • Anything of value that a business or individual owns

  • Sometimes seen as uses for cash

• Liabilities

  • Debts, usually money, that the business owes

  • Sometimes seen as sources of cash

• Owner’s equity

  • The amount the owner has invested in the business, plus or minus profits and losses

  • The total value of the business

  • Also known as net worth

Assets, liabilities, and owner’s equity are the components of the basic accounting equation:

• Assets = Liabilities + Owner’s Equity

Although it contains three categories of financial information, the balance sheet is typically divided into just two parts—representing the two sides of the accounting equation:

• Assets

• Liabilities and Owner’s Equity

Assets are usually presented first—either at the top of the balance sheet or along the left side, depending on how the balance sheet is organized. Assets are listed in descending order. In other words, assets most like cash are listed at the top of the list, while assets least like cash appear at the bottom.

The business’s liabilities and owner’s equity are normally listed after—or to the right of—its assets. Liabilities, too, are listed in descending order. Liabilities that are due soonest are listed first, while liabilities due the longest time from now appear at the end of the list. The owner’s equity appears below the liabilities on the balance sheet, although still in the same section. This owner’s equity can be broken down into revenues and expenses, which happen to be the key components of the income statement.

Keep in mind that the balance sheet represents the basic accounting equation. Therefore, the balance sheet’s two parts—which represent the two sides of the accounting equation—should balance, or equal, each other.

Types of assets

Two types of assets are:

• Current assets: Assets that will become cash or be used within 12 months

• Fixed assets: Property that the company permanently owns; also known as capital assets

Assets: current or fixed?

Current assets include:

• Cash

• Inventory

• Accounts receivable: All monies owed to a firm by its customers

• Prepaid expenses

Fixed assets include:

• Land

• Buildings

• Vehicles

• Equipment

• Furniture

• Notes receivable

• Intangible assets (e.g., patents, copyrights, trademarks, goodwill, )

Accumulated depreciation on the balance sheet

Some fixed assets—including vehicles, equipment, and furniture—don’t hold their value over time. For

example, a company vehicle that cost $65,000 originally isn’t likely to be worth that much after 10 years. Instead, it is likely to decrease in value in 10 years’ time.

This reduction in the value of goods or assets over a period of time is called depreciation. One way to indicate that some of a business’s fixed assets have dropped in value is to include accumulated depreciation in the assets section of the balance sheet. The accumulated depreciation represents the total loss in fixed assets’ value that the business has incurred. Since it represents a loss, accumulated depreciation is subtracted from the total value of the fixed assets listed on the balance sheet.

Amortization on the balance sheet

While intangible assets cannot be seen or touched, they can be quite valuable to a business. Examples:

• A patent, which gives a business the exclusive rights to an invention or process for a set length of time

• Goodwill, which represents any advantage that a business acquires beyond the value of its products or service

Unfortunately, intangible assets—like some fixed assets—may also drop in value over time. This decrease in value is amortized, or written off, over an extended period of time (ranging from a minimum of 17 years for patents to 40 years for goodwill and copyrights). Like accumulated depreciation, amortization is included in the assets section of the balance sheet and subtracted from the total value of the fixed assets listed.

Types of liabilities

Two types of liabilities are:

• Current liabilities: Debts that must be paid within one year

• Long-term liabilities: Debts that will take longer than one year to pay

Liabilities: Current or long-term?

Current liabilities include:

• Accounts payable: All monies owed by the business to others

• Employee wages

• Taxes payable

• Notes payable

• Accruals: Debts incurred but not yet billed

• Current portion of long-term debt

Long-term liabilities include:

• Mortgage

• Long-term debt

Equity: Owners’ Equity and Book Value

Whatever value—positive or negative—is left in a business after liabilities have been subtracted from assets is owners’ equity. For public companies (companies with shares traded on the stock market), this value is called stockholders’ equity. Potential investors might also call this the company’s net worth or book value.

It’s important to note that owners’ equity is not the same as the company’s actual worth. Book value and fair market value are two different things. You see, on the balance sheet, assets are not necessarily listed at their fair market value. It’s just the way accounting works. Some assets, such as land or equipment, are listed at their value at the time of purchase—or even less than that value due to depreciation. Here are a couple of examples:

Griffin’s Dairy Farm bought 80 acres of land in 1989 for $96,000. On the balance sheet, this asset is still listed at $96,000, even though its fair market value is now over $550,000. Therefore, the business has nearly $450,000 in additional land assets that don’t show up on the balance sheet or in owners’ equity.

Sew-Rite Tailor Shop purchased a professional sewing machine several years ago for $2,000. Even though its value on the balance sheet has depreciated to $0, the machine is still an asset to the business because it still works perfectly and helps the business to make money. In addition, the machine could still be sold for at least $1,000 at fair market value. This is another example of an asset that doesn’t show up on the balance sheet.

How is the balance sheet used?

Businesses need to know how they are doing on a regular basis, and preparing a balance sheet is the best way to do that. The balance sheet shows what a business owns and what it owes—in other words, its financial strengths and weaknesses.

In addition, a business needs to know how much cash it has available to put to work in its day-to-day operations. This cash is often referred to as working capital. To determine how much working capital it has, a business can subtract its current liabilities from its current assets. The excess assets that it owns represent the business’s working capital. Another way to show this relationship is:

Working Capital = Current Assets – Current Liabilities

Businesses also create balance sheets to show to creditors and investors when they seek financing for day-to-day operations or for expansion. These balance sheets provide clues to creditors and investors regarding a business’s ability to do such things as satisfy creditors, manage inventory, and collect receivables.

For example, creditors and investors often compare a business’s total assets and total liabilities to determine what percentage of the business’s debts are owed to creditors and what percentage are owed to the business’s owner(s). To gather this data, creditors and investors usually calculate the financial leverage ratio, also known as the debt-leverage ratio.

A business’s debt-leverage ratio is equal to total liabilities divided by total assets and can range from zero to 100. Creditors and investors typically look for a low debt-leverage ratio because it indicates that the business has little debt when compared to its owner’s equity. Therefore, providing financing to the company would probably involve little risk. However, a high debt-leverage ratio indicates that the business already owes a great deal of money to creditors and investors. Lending money to a business with a high debt-leverage ratio would involve a great deal more risk. As a result, creditors and investors are not as likely to lend to a business with a high debt-leverage ratio.