1 Interpreting Financial Statements Objective Contrast Economic and Accounting Models Value of Accounting Information

2 Contents Functions of Financial StatementsFunctions of Financial Statements Review of Financial StatementsReview of Financial Statements Analysis Using Financial RatiosAnalysis Using Financial Ratios Working CapitalWorking Capital Constructing a Financial Planning ModelConstructing a Financial Planning Model

3 Functions of Financial Statements Financial Statements: – –Provide information to the owners & creditors of a firm about the current status and past performance – –Provide a convenient way for owners & creditors to set performance targets & to impose restrictions of the managers of the firm – –Provide a convenient templates for financial planning

4 Review of Financial Statements Balance Sheet Income Statement Statement of Cash Flow

5 The Balance Sheet Summarizes a firms assets, liabilities, and owner’s equity at a moment in time Prepared according to GAAP, Generally Accepted Accounting Principles – –GAAP modified occasionally by the Financial Accounting Standards Board

6 The Balance Sheet Major Divisions: – –Assets Current assets (less than a year) Long-term assets (longer than a year – –Depreciation – –Liabilities and Stockholder’s Equity Liabilities – –Current Liabilities – –Long-term debt Equity

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8 The Income Statement Summarizes the profitability of a company during a time period Major Divisions: – –Revenue & cost of goods sold » »Gross margin – –General administrative and selling expenses (GS&A) » »Operating income – –Debt service » »Taxable income – –Corporate Taxes » »Net income

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10 The Cash-Flow Statement Show the cash that flowed into and from a firm in during a time period – –Focuses attention on a firm’s cash situation A firm may be profitable and short of cash – –Unlike the balance sheet and income statement, cash flow statements are independent of accounting methods The IRS uses accounting income to compute tax, so accounting rules have a second order effect on cash flows through taxes

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13 Financial Ratios Return Ratios Profitability Ratios Liquidity Ratios Shareholder Ratios Leverage Ratios Activity Ratios

14 Examples: Return Ratios

15 Examples: Activity Ratios

16 Example: Financial Leverage

17 Examples: Liquidity Ratios

18 Examples: Shareholder Ratios See Yahoo Finance for Additional Shareholder Ratios Market Capitalization = Share Price x Shares Outstanding

19 Ratio Comparisons Establish Your Perspective Shareholder employee, Management, or Union Creditor Predator, Customer, Supplier, Competitor, Trade Association Establish Benchmarks Other companies ratios The firm’s historical ratios Data extracted from financial markets

20 Working Capital Represents the amount of day-by-day operating liquidity available to a business Working Capital = Current Assets – Current Liabilities Example: Working Capital = 360 – = 103.4

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