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Summary Financial Analysis (Bus101)
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NOTE ON EVALUATING FINANCIAL PERFORMANCEIf we are to be effective as an entrepreneur, there is a certain body of
knowledge and skills that we must master. Otherwise, we will be at a distinct
disadvantage in operating a going concern. Understanding the informational
content of financial statements is one such area. This note has been written in the
hopes of providing a basic common body of knowledge in this regard. We will
first look at the format of the financial statements typically used in business.
Second, we will then use ratio analysis as a way to evaluate a company's financial
position.
UNDERSTANDING FINANCIAL STATEMENTS
Think of financial statements as consisting of certain pieces of important
information about the firm's operations that are reported in the form of (1) an
income statement, (2) a balance sheet, and (3) a cash flow statement. We will look
at each of these statements in turn.
The Income Statement
The main elements of an income statement, or profit and loss statement as
some call it, are shown in Exhibit 1. In this exhibit, we observe that the top part of
the income statement, beginning with sales and continuing down through the
operating income or earnings before interest and taxes, is affected solely by the
firm's operating decisions. These decisions involve such matters as sales, cost of
goods sold, marketing expenses and general and administrative expenses.
However, no financing costs are included to this point.
Below the line reporting operating income, we see the results of the firm's
financing decisions, along with the taxes that are due on the company's income.
Here the company's interest expense is shown, which is the direct result of the
amount of debt borrowed and the interest rate charged by the lender (Interest
expense = amount borrowed x interest rate). The resulting profits before tax and
the tax rates imposed on the company then determine the amount of the tax
liability, or the income tax expense. The final number, the net profits after
taxes, is the income that may be distributed to the company's owners or reinvested
in the company, provided of course there is cash available to do so. (As we shall
see later, merely because there are profits does not necessarily mean there is any
cash - possibly a somewhat surprising fact to us, but one we shall come to
understand.)
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,EXHIBIT 1
The Income Statement: An Overview
Sales
Gross profit
Operating expenses: Marketing and selling expenses and general
and administrative expenses
Operating income (Earnings before interest and taxes)
Profits before taxes
Profits after taxes
An example of an income statement is provided in Exhibit 2 for the LM
Manufacturing Company. As shown in the exhibit, the firm had sales of $830,000
for the 12-month period ending December 31, 2006. The cost of manufacturing
their product was $539,000, resulting in a gross profit of $291,000. The firm then
had $190,000 in operating expenses, which involved selling expenses, general and
administrative expenses, and depreciation expenses. After deducting the operating
expenses, the firm's operating profits (earnings before interest and taxes)
amounted to $101,000. This amount represents the income generated as if LM
Manufacturing was an all-equity company. To this point, we have calculated the
profits resulting only from operating activities, as opposed to financing decisions,
such as how much debt or equity is used to finance the company's operations.
We next deduct LM's interest expense (the amount paid for using debt
financing) of $20,000 to arrive at the company's profit before tax of $81,000.
Lastly, we deduct the income taxes of $17,000 to leave the net profit after tax of
$64,000. At the bottom of the income statement, we also see the amount of
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,common dividends paid by the firm to its owners in the amount of $15,000,
leaving $49,000, which eventually increases retained earnings in the balance sheet.
EXHIBIT 2
Income Statement (figures in $ thousands)
The LM Manufacturing Company
For the Year Ending December 31, 2006
Sales $830
Cost of Goods Sold $539
Gross Profit on Sales $291
Operating Expenses:
Marketing Expenses $91
General and Administrative Expenses $71
Depreciation $28
Total Operating Expenses $190
Operating Income (EBIT) $101
Interest Expense $20
Earnings Before tax $81
Income Tax $17
Earnings after Tax $64
Dividends Paid $15
Change in Retained Earnings $49
TESTING YOUR UNDERSTANDING
The Income Statement
Given the information below, see if you can construct an income statement. What
are the firm’s gross profits, operating income, and net income? Which expense is a
non-cash expense? (The solution to this problem is given a few pages later.)
Interest expense $10,000 Sales $400,000
Cost of Goods Sold $160,000 Stock Dividends $5,000
Selling expenses $70,000 Income Taxes $20,000
Administrative expenses $50,000 Depreciation expense $20,000
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, The Balance Sheet
While the income statement reports the results from operating the business
for a period of time, such as a year, the balance sheet provides a snapshot in time
of the firm's financial position. Thus, a balance sheet captures the cumulative
effect of prior decisions down to a single point in time.
The relationship between the timing of an income statement and a balance
sheet is represented graphically in Exhibit 3.
EXHIBIT 3
Visual Perspective of the Relationship
Between the Balance Sheet and Income Statement
Here we see two periods of operations, 2005 and 2006. There would be an income
statement for the period of January 1 through December 31 for the operations of
the year 2006 and a balance sheet reporting the company's financial position as of
December 31 of each year, i.e. 2005 and 2006. Thus, the balance sheet on
December 31, 2006 is a statement of the company's financial position at that
particular date in time, which is the result of all financial transactions since the
company began its operations.
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