CBF Exam Review Financial Statements Part 2 Tom Shimko, CCE 1 Income Statement Represents estimates for revenues and costs using accrual accounting. Accrual and cash accounting differ Net income not equal to cash profits 2 Disclosure of Items Net sales - cost of goods sold Gross profit -Selling & administrative expenses -Depreciation and amortization expenses - Other operating expenses Operating profit - Income taxes Net earnings 3
Items requiring Separate Disclosure 1. Discontinued operations * Gains/losses resulting from sale of a portion of the business 2. Extraordinary transactions * Unusual in nature * Not expected to recur * Temporary 3. Cumulative effect of accounting changes 4. Each item is shown after operating income 4 Net Sales Net Sales = Gross sales sales returns and allowances 5 Cost of Goods Sold Beginning inventory + purchases - ending inventory Costs of goods sold 6
Gross Profit Gross profit= Net sales cost of goods sold Gross profit / sales = Gross profit margin 7 Operating Expenses Many expenses simply aggregated into General, Selling and Administrative expenses * Salaries * Depreciation * Advertising * Taxes * Operating lease expenses.. 8 Depreciation Represents a non-cash charge to allocate a portion of an asset to the income statement as an expense. 9
Operating Profit Operating profit = Net sales cost of goods sold operating expenses Operating profit margin percent = Operating profit / net sales 10 Other Income & Expenses Revenue and costs not considered part of operations Examples - Dividend and interest income - Gains/losses from investments - Gains/losses from sale of assets - Interest expense 11 Net Earnings Earnings before taxes = Operating profit + income other other expenses Net earnings = Earnings before taxes taxes income Net profit margin = Net earnings / net sales 12
Statement of Cash Flows Shows changes in the cash account over a period of time Takes the perspective that all transactions are run through the cash account. Shows which activities contributed to cash and which activities reduced cash. 13 Parts of Statements of Cash Flow Operating activities Investing activities Financing activities Sum of these activities equals the change in the cash account on the balance sheet. 14 Two Formats of SCF Direct approach income statement format. Indirect approach starts with income and makes adjustments. Most firms use the indirect approach. 15
Preparation of SCF Rules 1. Increase in asset is a use (outflow) and decrease is a source (inflow). 2. Increase in a liability or equity account is a source (inflow) and a decrease is a use (outflow) of cash. 3. Treat revenues as sources (inflows and expenses as uses (outflows) of cash. Exceptions: non-cash expense such as depreciation. Total sources = Total uses 16 Examples of Cash Flow *Operating activities - sale of goods and services - normal course of business activities *Investing activities - purchase or sale of plant and equipment *Financing activities - borrowing from creditors 17 Key Financial Ratios Activity ratios *measure the liquidity of specific assets and the efficiency of managing assets Liquidity ratios *Measure short-term term solvency Leverage ratios *Measure how the firm is financed and its ability to cover interest and other fixed charges Profitability ratios *Measure overall performance 18
Activity Ratios Measured as turnover ratios or days outstanding ratios Higher turnover (lower days outstanding) is generally considered better. 19 Working Capital Current Assets Current Liabilities = WC 20 Liquidity Ratios Current Ratio Current Assets/Current Liabilities Quick or Acid Test Ratio Cash + Receivables/Current Liabilities 21
Leverage Ratios Measure the extent of debt financing Ratios allow an assessment of financial risk Ratios from the balance sheet fail to show off-balance sheet financing: *Operating leases *Contingency obligations *Under-funded pension plans 22 Debt Ratio Debt ratio = Total liabilities/total assets *Measures the proportion of assets that are debt financed. *Does not show the use of long-term versus short-term term debt financing 23 Debt to Equity Debt-to to-equity ratio = Total liabilities/equity *Indicates how many dollars of debt financing are used for each $1 of equity financing *The equity base is perceived as providing a safety-net for creditors. 24
Times Interest Earned Times interest earned = Earnings before interest & taxes/ Interest *Indicates the number of times interest payments can be covered from operating earnings. *Problem: Earnings do not represent cash flows 25 Fixed Charge Coverage Fixed Charge Coverage = (Earnings before interest and lease expense)/(interest +Lease expense) *Attempts to measure the firm s s ability to make interest and operating lease payments 26 Profitability Ratios Measure *Earning power of assets *Efficiency of operations *Returns to investors Gross profit margin =Gross profit/net sales Operating profit margin =Earnings before interest and taxes/net sales Net profit margin = Net earnings/net 27
DuPont Return on Assets The net profit margin, the total asset turnover and the return on assets being reviewed together. All components have a direct influence on the return on assets. 28 DuPont Return on Assets Formula Net Income/Total Assets=Net Income/Net Sales X Net Sales/Total Assets 29 The End Good Luck to All! 30