1. 1 Business Math Chapter 20: Financial Statements

2. Cleaves/Hobbs: Business Math, 7e Copyright 2005 by Pearson Education, Inc. Upper Saddle River, NJ 07458 All Rights Reserved 2 20.1 The Balance Sheet Prepare the balance sheet Prepare the vertical analysis of a balance sheet Prepare a horizontal analysis of a balance sheet

3. Cleaves/Hobbs: Business Math, 7e Copyright 2005 by Pearson Education, Inc. Upper Saddle River, NJ 07458 All Rights Reserved 3 20.1.1 Prepare a balance sheet Owners, creditors and investors need to know the financial condition of a business before they can make decisions and plans. Two important financial statements are the balance sheet and the income statement. On the balance sheet, the assets = liability + equity, hence the name, balance sheet.

4. Cleaves/Hobbs: Business Math, 7e Copyright 2005 by Pearson Education, Inc. Upper Saddle River, NJ 07458 All Rights Reserved 4 Key Terms Balance sheet: financial statement that indicates the worth or financial condition of a business as of a certain date. Assets: properties or anything of monetary value owned by the business. Current assets: assets that are normally turned into cash within a year. Plant and equipment: assets used in transacting business.

5. Cleaves/Hobbs: Business Math, 7e Copyright 2005 by Pearson Education, Inc. Upper Saddle River, NJ 07458 All Rights Reserved 5 Cash: a current asset of money in the bank or cash on hand. Accounts receivable: a current asset that is the money owed by customers. Note receivable: a current asset that is a promissory note owed to the business. Merchandise inventory: a current asset that is the value of merchandise on hand. Key Terms

6. Cleaves/Hobbs: Business Math, 7e Copyright 2005 by Pearson Education, Inc. Upper Saddle River, NJ 07458 All Rights Reserved 6 Business equipment: value of equipment such as tools, display cases and machinery owned by the business. Office furniture and equipment: value of office furniture such as computers, printers, and copiers owned by the business. Building: value of buildings and structures owned by the business. Land: value of the grounds or land owned by the business. Key Terms

7. Cleaves/Hobbs: Business Math, 7e Copyright 2005 by Pearson Education, Inc. Upper Saddle River, NJ 07458 All Rights Reserved 7 Liabilities: amounts the business owes. Current liabilities: debts that must be paid in a short period of time. Long-term liabilities: current liabilities that are paid over a long period of time. Accounts payable: a current liability for merchandise or services that has not been paid. Key Terms

8. Cleaves/Hobbs: Business Math, 7e Copyright 2005 by Pearson Education, Inc. Upper Saddle River, NJ 07458 All Rights Reserved 8 Note payable: promissory notes that are owed. Mortgage payable: a long-term liability for the building and land the business owns. Owner’s equity or stockholder’s equity: the difference between the assets and the liabilities. Capital, proprietorship or net worth: other terms for owner’s equity. Key Terms

9. Cleaves/Hobbs: Business Math, 7e Copyright 2005 by Pearson Education, Inc. Upper Saddle River, NJ 07458 All Rights Reserved 9 How to prepare a balance sheet 1.Find and record the total assets, working by asset category. (Total assets= total current assets + total plant and equipment.) -(a) List the current assets and draw a single line underneath the last entry. -(b) Add the entries and record total current assets, drawing a single line underneath the total. -Repeat step (a) for plant and equipment and step (b) for total plant and equipment assets. -Add the category totals and draw a double line underneath the grand total.

10. Cleaves/Hobbs: Business Math, 7e Copyright 2005 by Pearson Education, Inc. Upper Saddle River, NJ 07458 All Rights Reserved 10 Prepare a balance sheet (cont.) 2.Find and record the total liabilities, working by liability category. - Repeat step 1a for current liabilities and step 1b for total current liabilities. - Repeat step 1a for long term liabilities and step 1b for total long term liabilities. - Add the category totals and draw a single line underneath the total. Total liabilities = total current liabilities + total long-term liabilities.

11. Cleaves/Hobbs: Business Math, 7e Copyright 2005 by Pearson Education, Inc. Upper Saddle River, NJ 07458 All Rights Reserved 11 3. Find and list the total owner’s equity. (a) List the equity entries and draw a single line underneath the last entry. (b) Add the entries and draw a single line underneath the total. 4. Find and record the total liabilities and owner’s equity and draw a double line underneath the grand total. Total liabilities and owner’s equity = total liabilities + total owner’s equity. Prepare a balance sheet (cont.)

12. Cleaves/Hobbs: Business Math, 7e Copyright 2005 by Pearson Education, Inc. Upper Saddle River, NJ 07458 All Rights Reserved 12 A = L + E 5. Confirm that the double line grand totals from step 1 (Total assets) and step 4 (Total liabilities + total owner’s equity) match up. Assets = Liabilities + Owner's Equity

13. Cleaves/Hobbs: Business Math, 7e Copyright 2005 by Pearson Education, Inc. Upper Saddle River, NJ 07458 All Rights Reserved 13 Look at this example Prepare a balance sheet using Figure 20-1 in your text as a guide for Sander’s Woodworks for December 31 st. Assets include: cash ($1,973); AR ($2,118); merchandise inventory ($18,476); equipment ($18,951). Liabilities include: AP ($2,317); wages payable ($684); mortgage note payable ($15,286). Owner’s capital is $22,871.

14. Cleaves/Hobbs: Business Math, 7e Copyright 2005 by Pearson Education, Inc. Upper Saddle River, NJ 07458 All Rights Reserved 14 Check your work.

15. Cleaves/Hobbs: Business Math, 7e Copyright 2005 by Pearson Education, Inc. Upper Saddle River, NJ 07458 All Rights Reserved 15 20.1.2 Prepare a vertical analysis A vertical analysis shows the ratio of each item on the balance sheet to total assets. To find the ratios, use the formula of R= P/B Each item on the balance sheet is a percentage (P) and the total assets are the base (B). Their ratio “R” is expressed as a percent.

16. Cleaves/Hobbs: Business Math, 7e Copyright 2005 by Pearson Education, Inc. Upper Saddle River, NJ 07458 All Rights Reserved 16 Look at Figure 20-2 What is the ratio between cash and total assets? 4.8% What is the ratio between total plant and equipment and total assets? 45.2% What is the ratio between the mortgage note payable and total assets? 37.1%

17. Cleaves/Hobbs: Business Math, 7e Copyright 2005 by Pearson Education, Inc. Upper Saddle River, NJ 07458 All Rights Reserved 17 Look at the complete vertical analysis of Sander’s Woodworks

18. Cleaves/Hobbs: Business Math, 7e Copyright 2005 by Pearson Education, Inc. Upper Saddle River, NJ 07458 All Rights Reserved 18 20.1.3 Prepare a horizontal analysis of the balance sheet Another way to analyze information on a comparative balance sheet is to compare item by item in a horizontal analysis. A horizontal analysis compares the same item for two different years, recording both the amount of increase (or decrease) and the increase (or decrease) as a percent of the earlier year’s amount.

19. Cleaves/Hobbs: Business Math, 7e Copyright 2005 by Pearson Education, Inc. Upper Saddle River, NJ 07458 All Rights Reserved 19 Prepare a horizontal analysis 1.Prepare a balance sheet for two or more years; record each year’s amounts in separate columns. 2.Create an additional column labeled “amount of increase (decrease)” for each yearly item. a) Subtract the smaller amount from the larger amount and record the difference. b) If the earlier year’s amount is larger than the more recent year’s amount, record the difference in step 2a as a decrease using parentheses or a negative (minus) sign.

20. Cleaves/Hobbs: Business Math, 7e Copyright 2005 by Pearson Education, Inc. Upper Saddle River, NJ 07458 All Rights Reserved 20 Prepare a horizontal analysis (cont.) 3. Create an additional column label percent increase (decrease); for each year item, divide the amount of increase (decrease) by the earlier year’s amount and record the difference as a percent. Percent increase (decrease) = amount of increase (decrease) x 100% earlier year’s amount

21. Cleaves/Hobbs: Business Math, 7e Copyright 2005 by Pearson Education, Inc. Upper Saddle River, NJ 07458 All Rights Reserved 21 Look at this example

22. Cleaves/Hobbs: Business Math, 7e Copyright 2005 by Pearson Education, Inc. Upper Saddle River, NJ 07458 All Rights Reserved 22 Tip! Which year is the base in the percent of increase? In a horizontal analysis, the earlier year is always the base year in calculating percent increase or decrease. It is possible to have a 0% change if there is no dollar change in the amounts.

23. Cleaves/Hobbs: Business Math, 7e Copyright 2005 by Pearson Education, Inc. Upper Saddle River, NJ 07458 All Rights Reserved 23 20.2 Income statements Prepare an income statement Prepare a vertical analysis of an income statement Prepare a horizontal analysis of an income statement

24. Cleaves/Hobbs: Business Math, 7e Copyright 2005 by Pearson Education, Inc. Upper Saddle River, NJ 07458 All Rights Reserved 24 Income statement: a financial statement; the net income of a business over a period of time. Total sales: earnings from the sale of goods or the performance of services. Sales returns or allowances: refunds or adjustments for unsatisfactory merchandise or services. Net sales: total sales minus sales returns or allowances. Key Terms

25. Cleaves/Hobbs: Business Math, 7e Copyright 2005 by Pearson Education, Inc. Upper Saddle River, NJ 07458 All Rights Reserved 25 Cost of goods sold: cost to the business for merchandise or goods sold. Gross profit or gross margin: net sales minus the cost of goods sold. Operating expenses: overhead or cost incurred in operating a business. Net income or net profit: gross profit or gross margin minus the operating expenses. Key Terms

26. Cleaves/Hobbs: Business Math, 7e Copyright 2005 by Pearson Education, Inc. Upper Saddle River, NJ 07458 All Rights Reserved 26 Prepare an income statement 1. Find and record net sales. (a) Record gross sales (b) Record sales returns and allowances (c) Subtract sales returns and allowances from gross sales 2. Find and record the cost of goods sold. Record cost of beginning inventory Record cost of purchases Record cost of ending inventory Add cost of beginning inventory and cost of purchases and subtract cost of ending inventory.

27. Cleaves/Hobbs: Business Math, 7e Copyright 2005 by Pearson Education, Inc. Upper Saddle River, NJ 07458 All Rights Reserved 27 Prepare an income statement (cont.) COGS = cost of beginning inventory + cost of purchases – cost of ending inventory 3. Find and record gross profit from sales = net sales – cost of goods sold. 4. Find and record total operating expenses: list the operating expenses and add the entries. 5. Find and record net income = gross profit from sales –operating expenses.

28. Cleaves/Hobbs: Business Math, 7e Copyright 2005 by Pearson Education, Inc. Upper Saddle River, NJ 07458 All Rights Reserved 28 Look at this example Complete the income statement for Corner Grocery using the following information: Gross sales: $25,283 Returns and allowances: $492 Cost of beginning inventory: $5,384 Cost of purchases: $18,923 Cost of ending inventory: $5,557 Total operating expenses: $3,750

29. Cleaves/Hobbs: Business Math, 7e Copyright 2005 by Pearson Education, Inc. Upper Saddle River, NJ 07458 All Rights Reserved 29 Example (cont.) Net sales = gross sales – returns and allowances ($25,283 - $492 ) Net sales = $24,791 COGS = cost of beginning inventory + purchases – cost of ending inventory (COGS = $5,384 + $18,923 -$5,557 = $18,750) Gross profit = net sales – COGS Gross profit = $24,791 - $18,750 = $6,041 Net income = gross profit – operating expenses Net income = $6,041- $3,750 = $2,291 Net income = $2,291

30. Cleaves/Hobbs: Business Math, 7e Copyright 2005 by Pearson Education, Inc. Upper Saddle River, NJ 07458 All Rights Reserved 30 Income statement for Corner Grocer

31. Cleaves/Hobbs: Business Math, 7e Copyright 2005 by Pearson Education, Inc. Upper Saddle River, NJ 07458 All Rights Reserved 31 20.2.2 Prepare a vertical analysis of an income statement Just as you do with a vertical analysis of a balance sheet, to make a vertical analysis of an income statement you use the percentage formula R = P/B P = each entry on the income statement as a percentage B = net sales R= expressed as a percent, it is the ratio between P and B.

32. Cleaves/Hobbs: Business Math, 7e Copyright 2005 by Pearson Education, Inc. Upper Saddle River, NJ 07458 All Rights Reserved 32 Prepare a vertical analysis 1.Prepare an income statement. 2.Create an additional column labeled percent of net sales for each item. Divide the amount of the item by the net sales and record the result as a percent. Percent of net sales = amount of item x 100% net sales

33. Cleaves/Hobbs: Business Math, 7e Copyright 2005 by Pearson Education, Inc. Upper Saddle River, NJ 07458 All Rights Reserved 33 Try these examples Suppose net sales are $839,056. What is the percent of cost of goods sold if that amount is $516,019? 61.5% What is the percent of total operating expenses if that amount is $126,305? 15.1%

34. Cleaves/Hobbs: Business Math, 7e Copyright 2005 by Pearson Education, Inc. Upper Saddle River, NJ 07458 All Rights Reserved 34 Vertical Analysis of The Seventh Inning’s Income Statement

35. Cleaves/Hobbs: Business Math, 7e Copyright 2005 by Pearson Education, Inc. Upper Saddle River, NJ 07458 All Rights Reserved 35 20.2.3 Horizontal analysis of an income statement Comparative income statement: an income statement that includes data from two or more years. Horizontal analysis of an income statement: comparison of like entries for two years. The amount of increase or decrease and the percent of increase or decrease are determined.

36. Cleaves/Hobbs: Business Math, 7e Copyright 2005 by Pearson Education, Inc. Upper Saddle River, NJ 07458 All Rights Reserved 36 Prepare a horizontal analysis 1.Prepare an income statement for two or more years; record each year’s amounts in separate columns. 2.Create an additional column labeled amount of increase (decrease). For each yearly item: (a) Subtract the smaller amount from the larger amount and record the difference. (b) If the earlier year’s amount is larger than the later year’s amount, record the difference from step 2a as a decrease using parentheses. (continue on next slide)

37. Cleaves/Hobbs: Business Math, 7e Copyright 2005 by Pearson Education, Inc. Upper Saddle River, NJ 07458 All Rights Reserved 37 Prepare a horizontal analysis (cont.) 3.Create an additional column labeled percent increase (decrease). For each yearly item, record the difference as percent: Percent increase (decrease) = amount of increase (decrease) x 100% earlier year’s amount

38. Cleaves/Hobbs: Business Math, 7e Copyright 2005 by Pearson Education, Inc. Upper Saddle River, NJ 07458 All Rights Reserved 38 Look at this example Davis Company 20062005 Amount Percent of net sales Net sales$242,897$239,528$3,3691.4 Cost of goods sold 116,582115,3511,2311.1 Gross profit $126,315$124,1772,1381.7 Operating Expenses 38,72537,9827432.0 Net Income $87,590$86,195$1,3951.6

39. Cleaves/Hobbs: Business Math, 7e Copyright 2005 by Pearson Education, Inc. Upper Saddle River, NJ 07458 All Rights Reserved 39 20.3 Financial Statement Ratios Find and use financial ratios Financial ratio: analysis of financial data to compare a business’s performance with other businesses. Working capital: current assets minus current liabilities. Current ratio or working capital ratio: the ratio of the current assets to the current liabilities.

40. Cleaves/Hobbs: Business Math, 7e Copyright 2005 by Pearson Education, Inc. Upper Saddle River, NJ 07458 All Rights Reserved 40 How to find a financial ratio 1.Write one amount as the numerator of a fraction and a second amount as the denominator. 2.Write the fraction in decimal form (or for some ratios, in percent form). Example: Current assets Current liabilities

41. Cleaves/Hobbs: Business Math, 7e Copyright 2005 by Pearson Education, Inc. Upper Saddle River, NJ 07458 All Rights Reserved 41 Look at this example Compare the current ratio for Aaron’s Air Conditioning with Zelda’s Zeppelins. Aaron: CR = $11,000 ÷ $5,000 = 2.2 Zelda: CR = $615,000 ÷ $609,000 = 1.01 What does this mean? Aaron has more than $2 in assets for every $1 in liabilities. Zelda has about $1 in assets for each $1 in liabilities. What could you possibly infer from this information?

42. Cleaves/Hobbs: Business Math, 7e Copyright 2005 by Pearson Education, Inc. Upper Saddle River, NJ 07458 All Rights Reserved 42 Additional financial ratios The acid test: also called the quick ratio, it measures the relationship between quick current assets to current liabilities. Find the acid-test ratio if the balance sheet shows the following amounts: Cash: $17,342; Marketable securities: 0; and Accounts receivable: $10,345; and Current Liabilities = $26,345 The acid test ratio is 1.05 to 1.

43. Cleaves/Hobbs: Business Math, 7e Copyright 2005 by Pearson Education, Inc. Upper Saddle River, NJ 07458 All Rights Reserved 43 Operating ratio Operating ratio = COGS + operating expenses net sales This ratio indicates the amount of sales dollars that are used to pay for the cost of goods sold and administrative expenses. A ratio of less than 1:1 is desirable. The lower the operating ratio, the more income there is to meet financial obligations.

44. Cleaves/Hobbs: Business Math, 7e Copyright 2005 by Pearson Education, Inc. Upper Saddle River, NJ 07458 All Rights Reserved 44 Other financial ratios Asset turnover ratio compares the net sales to the average total assets. Total debt to total assets ratio compares the total liabilities to the total assets. The gross profit margin ratio shows the average spread between cost of goods sold and the selling price.

45. Cleaves/Hobbs: Business Math, 7e Copyright 2005 by Pearson Education, Inc. Upper Saddle River, NJ 07458 All Rights Reserved 45 Interpreting financial ratios The mere calculation of a ratio is meaningless unless the business owner, financial analyst, creditor or investor is able to interpret them. Industry standards are an important base. Historical performance also adds perspective. Industry-specific ratios also help one interpret performance within a field of similar firms.