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Financial statements present the results of operations and the financial position of the company. Four
statements are commonly prepared by publicly-traded companies: balance sheet, income statement,
cash flow statement and statement of changes in equity.
Heading has three items: (1) the legal name of the entity; (2) the title (i.e., balance sheet or statement of
financial position); and (3) the date of the statement.
The balance sheet itself presents the company's assets, liabilities and shareholders' equity.
Assets are items that provide probable future economic benefits
Liabilities are obligations of the firm that will be settled by using assets
Equity (variously called stockholders equity, shareowners equity or owners equity) is the residual
interest that remains after you subtract liabilities from asset
Assets are broken down into current and noncurrent (or long-term). Assets are listed from top to
bottom in order of decreasing liquidity, i.e., how fast they can be converted to cash.
Current assets are cash and other assets that are expected to be used during the normal operating cycle of
the business, usually one year. They typically include cash and cash equivalents, short-term investments,
accounts receivables, inventory and prepaid expense. Noncurrent assets will not be realized in full within
one year. They typically include long-term investments: property, plant and equipment; intangible assets
and other assets.
Liabilities are listed in order of expected payment. Obligations expected to be satisfied within one year
are current liabilities. They include accounts payable, trade notes payable, advances and deposits, current
portion of long-term debt and accrued expenses. Noncurrent liabilities include bonds payable and other
forms of long-term capital.
The structure of the owners' equity section depends on whether the entity is an individual, a partnership or
a corporation. Assuming it's a corporation, the section will include capital stock, additional paid-in
capital, retained earnings, accumulated other comprehensive income and treasury stock.
Balance sheet data can be used to compute key indicators that reveal the company's financial structure
and its ability to meet its obligations. These include working capital, current ratio, quick ratio, debt-equity
ratio and debt-to-capital ratio.
Income Statement
The income statement (also known as the profit and loss statement or P&L) tells you both the earnings
and profitability of a business. The P&L is always for a specific period of time, such as a month, a quarter
or a year. Because a company's operations are ongoing, from a business perspective these cut-offs are
arbitrary, and they result in many of the problems in income measurement. Nevertheless, periodic income
statements are essential, because they allow users to compare results for the company over time and to the
results of other firms for the same period. Depending on the industry, year over year comparisons that
eliminate seasonal variables may be especially useful.
Of course, accounting is vastly more complicated than this representation, and debits and credits are
recorded under many rules and treatments for many accounts. But ultimately, if all the credits to OE
during a period are greater than the debits, you have net income and OE (in the form of retained earnings)
increases; if there are more debits than credits, you have a net loss and OE decreases.
The format of the income statement is broken into several parts:
Net Sales
Cost of Goods Sold / Manufactured and Sold
Gross Profit
Operating Expenses
Distribution / Selling
General & Administrative
Operating Income
Other Income (Expense)
Taxable Income
Income Tax Expense
Income from continuing operations is the heart of the P&L. It includes sales (or revenue), cost of goods
sold, operating expenses, gains and losses, other revenue and expense items that are unusual or infrequent
but not both, and income tax expense.
This section of the income statement is used to compute the key profitability ratios of gross margin,
operating margin, and pretax margin that help readers assess the ability of the company to generate
income from its activities. Results from continuing operations are of primary interest because they are
ongoing and can be predictive of future earnings; investors put less weight on discontinued operations
(which are about the past) and extraordinary items (unusual and infrequent, thus unlikely to reoccur).
Net income is the "bottom line"; it is expressed both on an actual and, after comprehensive income, on a
per share basis.
Net cash flow from operating activities (sales, inventories, rent, insurance, etc.)
Cash flow from investing activities (e.g. buying and selling equipment)
Cash flow from financing activities (e.g. selling common stock, paying off long-term debt)
Exchange rate impact
Net increase (decrease) in cash
Cash and equivalents at start of period
Cash and equivalent at end of period
Schedule of non-cash financing and investing activities (e.g. conversion of bonds)
There are two methods for preparing the cash flow statement, direct and indirect. Using the direct method,
the accountant shows the items that affected cash flow, such as cash collected from customers, interest
received, cash paid to suppliers, etc. The indirect method adjusts net income for any revenue and expense
item that did not result from a cash transaction.
The margin of safety is the excess of budgeted (or actual) sales dollars over the break-even volume of
sales dollars. It is the amount by which sales can drop before losses are incurred. The higher the margin
of safety, the lower the risk of not breaking even and incurring a loss. The formula for the margin of
safety is:
Margin of safety in dollars = Total budgeted (or actual) sales − Break-even sales
The margin of safety can also be expressed in percentage form by dividing the margin of safety in dollars
by total dollar sales
The breakeven point is the sales volume at which a business earns exactly no money. The breakeven point is useful
for the following reasons:
Determine the amount of remaining capacity after the breakeven point is reached, which tells you the
maximum amount of profit that can be generated.
Determine the impact on profit if automation (a fixed cost) replaces labor (a variable cost)
Determine the change in profits if product prices are altered
Determine the amount of losses that could be sustained if the business suffers a sales downturn
Management should constantly monitor the breakeven point, particularly in regard to the last item noted, in order to
reduce the breakeven point whenever possible. Ways to do this include:
Cost analysis. Continually review all fixed costs, to see if any can be eliminated. Also review variable costs
to see if they can be eliminated, since doing so increases margins and reduces the breakeven point.
Margin analysis. Pay close attention to product margins, and push sales of the highest-margin items, to
reduce the breakeven point.
Outsourcing. If an activity involves a fixed cost, consider outsourcing it in order to turn it into a per-unit
variable cost, which reduces the breakeven point.
Pricing. Reduce or eliminate the use of coupons or other price reductions, since it increases the breakeven
point.
To calculate the breakeven point Sales Revenue, divide total fixed expenses by the contribution margin.
Contribution margin is sales minus all variable expenses, divided by sales. The formula is:
A more refined approach is to eliminate all non-cash expenses (such as depreciation) from the numerator, so that the
calculation focuses on the breakeven cash flow level.
Another variation on the formula is to focus instead on the number of units that must be sold in order to break even,
rather than the sales level in dollars. This formula is: