Financial Statements

Income Statements—Discussion Guide

Slide #1 THINK ABOUT IT - Each of the three core financial statements provides its own set of information that might be useful to external users. Of these three, the income statement is widely regarded as the most important financial statement. It shows a business’s “bottom line,” or whether a business is generating profit.

KEY CONCEPTS

Slide #2 An income statement, sometimes called a profit and loss statement, is a financial statement that records the amount of a business’s revenues and expenses over a specified amount of time, usually a single accounting period.

• • By listing and comparing the balances of the expense and revenue accounts, the income statement arrives at an amount of net profit or net loss for the accounting period.
  • This net profit or loss is often called “the bottom line” because of where it appears on the income statement.

• • The income statement displays a business’s profitability, and a business that routinely displays a net profit will likely be able to repay a debt or offer a return on investment.

• • The income statement, like the other core financial statements (cash flow statement and balance sheet) is best considered in conjunction with other information to best evaluate a business’s finances.
  • For example, just because a business is profitable, doesn’t mean that its cash flow is well managed.

Slide #3 The format of income statements is not defined by accounting standards or frameworks like the GAAP.

• • The different variations of income statements can range from very simple and condensed to complex and highly detailed.

• • Revenues (many businesses either only have one revenue account or combine all revenues into one line on the income statement)
  • A listing of expense accounts and their balances
  • A sum total of expense account balances
  • Profit before tax
  • Income tax
  • Net profit or net loss after tax

Slide #4 More detailed income statements might include additional lines for income tax expense, post-tax profits, or additional calculations for different amounts that might be useful for the financial statement users.

These additional calculations may include:

• • Gross profit (revenue – cost of goods sold)
  • Operating income (gross profit – operating expenses)
  • Non-operating income (non-operating revenues – non-operating expenses)
  • Comprehensive income (operating income + non-operating income)

Discussion #1: Ask students to discuss what extra information might be obtained by listing the information on an income statement alongside the same information from previous accounting periods. What could this information be used for?

Balance Sheets—Discussion Guide

THINK ABOUT IT

Slide #1 - Financial statement users who are interested in the current state of a company’s finances frequently want to know how much the company owns in comparison to how much it owes. This information can be found in a report called a balance sheet.

KEY CONCEPTS

Slide #2 A balance sheet is a financial statement that reports the balances of a business’s asset, liability, and equity accounts at a specific moment in time.

Balance sheets are prepared second during the financial statements stage of the accounting cycle (between the income statement and the cash flow statement), before temporary account balances are transferred to the permanent accounts through closing entries.

• • Only permanent accounts (also called balance sheet accounts) that do not have a zero balance appear on the balance sheet.
  • Because only the balances from asset, liability, and equity accounts appear on the balance sheet, it is a perfect representation of the basic accounting equation (Assets = Liabilities + Equity), and should therefore always balance.

Unlike the balances of temporary revenue and expense accounts that accumulate over the entire accounting period, the balances of permanent accounts can increase and decrease with each transaction.

• • Therefore, a balance sheet only provides information about a single moment in time.
  • If viewed on the previous or following day, for example, these balances might give an entirely different impression about what the business owns and owes.

The balance sheet, therefore, is often called a “snapshot” of a business’s finances.

• • It is used by creditors, lenders, and investors to evaluate a business’s short-term financial stability.

A number of important ratios are calculated using the information in a balance sheet including the debt-to-equity ratio (D/E ratio) that is one of many factors used by lenders to determine if the business should be given credit.

• • The ratios calculated in the balance sheet can be useful on their own.
  • However, in order to make predictions about a business’s future or any determinations about trends, this information must be used in conjunction with the other core financial statements or with additional balance sheets that cover a range of accounting periods.

Slide #3 Accounting standards do not require a specific format for balance sheets.

However, they typically contain the following categories:

• • Current assets—assets which are planned to be converted into cash within one year. They include things like inventory, receivables, and cash.
  • Non-current assets—those assets that will not be used or converted into cash within one year. These include fixed assets (e.g., buildings or machinery) and long-term investments.
  • Current liabilities—liabilities meant to be paid within one year. These include payables, short-term debt, utilities, and tax.
  • Non-current liabilities—long-term liabilities not intended to be paid within one year. These include long-term debt and some employee benefit liabilities.
  • Equity—the total amount of money invested in a business by its owners or shareholders.

Within each of these main categories, accounts are listed in the order of their liquidity (the amount of time required to convert an item to cash).

After all of the accounts are listed with their balances, a total is calculated for each category.

• • Total assets and the combined liabilities and equity balances should equal each other.
    • Any errors in these totals is likely to have been discovered during the preparation of trial balances in a previous step in the accounting cycle.

For more information, including a sample balance sheet, click here: https://www.accountingtools.com/articles/2017/5/17/the-balance-sheet.

Cash Flow Statements—Discussion Guide

Slide #1 THINK ABOUT IT

After completing the income statement and balance sheet, accountants prepare the last of the three core financial statements: the cash flow statement.

KEY CONCEPTS

Slide #2 The movement of money into and out of a business is called cash flow.

Monitoring cash flow can provide some important insights into how well a business is performing.

• • For example, if a business routinely brings in more money than it sends out, that business is probably in a strong financial position and may continue to be successful into the short-term future.
  • If, however, a business routinely sends out more money than it is bringing in, this could point to a troubling pattern.

The amount of difference between incoming and outgoing cash during a set period of time is called net cash flow.

• • A positive net cash flow means that more money came into a business than went out.
  • A negative cash flow means more money went out than came in.
  • Because net cash flow can fluctuate a lot from one accounting period to the next, it is usually best to look at the cash flow across multiple accounting periods to best evaluate a business’s strength.

Investors and creditors can learn a lot about a company by looking at the money that comes in and comparing it to the money that goes out.

• • However, net cash flow does not paint a complete picture of a company’s health.

Information about cash flow should be evaluated along with other information about a company in order to arrive at a more complete financial picture.

• • For example, a company that is experiencing rapid growth may well show a negative net cash flow because the upfront costs associated with investments in machinery or new buildings can easily outpace the inflow of cash from sales.
  • In this case, a negative net cash flow may actually hint toward a positive future for the business.

Slide #3 A cash flow statement is a financial statement that summarizes how much money flowed into and out of a business during a specific accounting period.

Cash flow statements allow financial statement users such as investors or creditors to evaluate how a company’s day-to-day operations are running, and whether cash flows are sufficient for the business’s short-term success.

Many investors feel that cash flow statements provide the clearest picture of any of the financial statements.

• • They are widely used to evaluate whether a business has sufficient sources and frequency of incoming cash and that cash outflows are used appropriately and in balance with inflows.
  • This information can help an investor determine if a company is in a strong financial position and is worth investing in.

Creditors also use cash flow statements to help make decisions about whether a business is likely to have the necessary cash available to pay its bills on time.

Discussion #1: Ask students to discuss why the cash flow statement is considered to be the “clearest” picture of a business’s finances. The theory is that businesses can hide information in the other statements. What might be hidden in the other statements that cannot be hidden in a cash flow statement?

Slide #4 Cash flow statements almost always list inflows and outflows pertaining to three

main types.

They are:

• • Cash flow from operating activities
    • Inflows include: product sales, collected receivables, etc.
    • Outflows include: payroll, taxes, interest paid on loans, etc.
  • Cash flow from investing activities
    • Inflows include: sale of fixed assets, collected loan interest, etc.
    • Outflows include: purchase of fixed assets (e.g. machinery), loans provided, etc.
  • Cash flow from financing activities
    • Inflows: loans obtained, sale of stocks, donations received, etc.
    • Outflows: loan repayments, stock buybacks, owner draws, etc.
  • Net cash flow (positive or negative)

A net total is provided for each of the first three categories, and these balances are used to calculate the final net change in cash from the opening cash balance to the closing cash balance.

For a sample cash flow statement, click here: https://corporatefinanceinstitute.com/resources/knowledge/accounting/cash-flow-statement%E2%80%8B/.

Annual Reports—Discussion Guide

Slide #1 THINK ABOUT IT

At the end of each fiscal year, businesses collect the financial information from the previous year and compile it into an annual report of the company’s financial data.

KEY CONCEPTS

Slide #2 A fiscal year is a 12-month period identified by an organization as a single year for accounting purposes.

While the start of a fiscal year can be chosen as any date in the calendar year, they typically begin at the start of a quarter (such as January, April, July, or October 1st) and tend to coincide with the completion of that organization’s business cycle.

An annual report is a publication prepared at the end of each fiscal year that serves as a record of an organization’s financial activities during that time period.

• • It is a collection of multiple documents that provide details, narratives, and analyses of a business’s finances.
  • These documents are compiled and presented to the business’s internal management, shareholders, creditors, and potential lenders and investors so that they can evaluate the company’s financial position over the past year and make determinations about likely future performance.

Discussion #1: Ask students to discuss why companies choose different fiscal years. Why doesn’t every company just use the calendar year? If they had to choose a start date for the fiscal year for a high school, when would it be? Why?

Slide #3 The specific sections and contents of annual reports will vary by organization and industry.

Most annual reports include:

• • A letter to the shareholders written by the CEO
  • A narrative of the year’s highlights including photos
  • A compilation of the year’s financial highlights, including graphs, charts,
    and tables
  • The Management’s Discussion and Analysis (MD&A)
  • The three core financial statements (balance sheet, income statement, cash flow statement)
  • Notes on the financial statements
  • Independent auditor’s report
  • General corporate information

To view the 2018 annual report for Maryland’s own Under Armour, click here: https://about.underarmour.com/investor-relations/financials/annual-reports.

Slide #4 In addition to the production of an annual report, all public corporations must also file a more detailed report called a Form 10-K with the Securities and Exchange Commission (SEC).

Form 10-K reports are famously long, dense, and complicated documents filled with legal and high-level financial language.

• • The Form 10-K must contain a long list of items, including certain sections from the annual report.

The five main sections of a 10-K are:

• • Business—overview of the business’s products, services, and general operations
  • Risk factors—information about risks facing the business in order of importance
  • Selected financial data—the business’s financial information from the previous five years
  • MD&A—management’s narrative of the business operations of the previous fiscal year
  • Financial statements and supplementary data—audited versions of the financial statements

For the SEC’s detailed list of Form 10-K contents, click here: https://www.investor.gov/news-alerts/investor-bulletins/how-read-10-k.

Interpret Financial Statements—Discussion Guide

Slide #1 THINK ABOUT IT

Financial statements contain a lot of data, but these facts and figures alone may not be enough for users to make decisions. Knowing how to turn the financial data into useful financial information is an important step for gaining as much insight as possible from the core financial statements.

KEY CONCEPTS

Slide #2 Each of the three core financial statements (income statements, balance sheets, and cash flow statements) is a report of raw financial data and numbers.

The real value for financial statement users comes from the information that can be calculated and interpreted from this raw data.

• • Working with the data provided in financial statements, savvy users can determine a number of ratios, percentages, and trends that provide deeper insight into the past, present, and future of a business.

There are two basic approaches to interpreting financial statements: vertical and horizontal.

• • Vertical analysis allows users to calculate ratios and percentages to arrive at useful information that pertains to a specific accounting period.
    • This information helps measure the short-term financial strength and position of a business.
  • Horizontal analysis requires the information from financial statements over a number of accounting periods.
    • When this information is lined up, comparing financial data from different periods horizontally allows users to analyze trends in the data over a longer period of time than one accounting period.
    • This is how trends are recognized and can help users assess the effectiveness of business management or make predictions about a business’s financial future.
  • Comparing statements over time by horizontal analysis offers both advantages and disadvantages, however.
    • A direct comparison of data horizontally will not always show any changes that happened in the structure of the business or any one-time charges or activities that may have occurred.
    • Comparing these numbers without an understanding of the circumstances that produced them may lead to inaccurate analysis.

Slide #3 One of the most important places to start when interpreting financial statements is the business’s profitability.

To do this, analysts begin to calculate the business’s margins with information from the income statement.

In financial accounting, a business’s margins are the percentages of sales revenue that amount to gross profit, operating income, and net profit.

• • These margins amount to three different ways to measure the company’s profit-making.

A business’s gross profit margin shows how well management is controlling costs.

• • To calculate gross profit margin, start with gross profit (revenue – cost of goods sold) and divide it by revenue.
  • Gross Profit Margin = Gross Profit / Total Revenue

Operating profit margin is a measure of the business’s quality of operation.

• • A high operating profit margin means fewer costs are required to generate more gross profit.
  • To calculate operating profit margin, start with operating income (gross profit – operating expenses) and divide it by revenue.
  • Operating Profit Margin = Operating Income / Total Revenue

Net profit margin shows how much profit is generated from each dollar of a business’s revenue.

• • To calculate net profit margin, start with net profit after taxes are removed.
  • Net Profit Margin = Net Profit / Total Revenue

To display these margins as percentages, multiply calculated margin amounts by 100.

Discussion #1: Ask students to discuss situations in which each of these margins would be useful. If they were investors, would they prefer one over the other? Why? What if they were lenders?

Slide #4 Balance sheets are used to asses a business’s working capital and other indications of its financial strength and liquidity.

Working capital is calculated as the difference between a business’s current assets and its current liabilities.

• • Working capital is used as a measurement of a business’s liquidity, which is the ability to convert its assets into cash.
    • Low working capital can lead to increased borrowing and an inability to pay its bills on time.
    • Investors and creditors use this information to assess whether they want to invest or extend credit to a business.
  • Working Capital = Current Assets – Current Liabilities

In addition to working capital, the balance sheet can be used to calculate a number of ratios that measure a business’s liquidity, such as the current ratio, quick ratio, and debt-to-equity ratio.

The current ratio is a measure of a business’s ability to pay its current liabilities.

• • It compares the value of current assets (such as cash, receivables, and inventory) to the value of current liabilities (such as short-term debt, payables, utilities, and tax).
    • It is essentially a way to express working capital as a ratio.
  • Depending on the industry, a 1:1 current ratio or less could mean liquidity problems.
    • 2:1 indicates good management of liquidity.
    • 3:1 or higher may suggest that management is not investing its excess funds properly.
  • Current Ratio = Current Assets / Current Liabilities

The quick ratio (sometimes called the acid-test ratio) is a measure of how much of a business’s assets can be converted into cash immediately.

• • This is a good measure of liquidity for a business that has a lot of inventory that cannot be quickly converted into cash.
    • The quick ratio is similar to the current ratio, except it only counts the current assets that are not inventory.
  • Quick Ratio = (Current Assets – Inventory) / Current Liabilities

A business’s debt-to-equity ratio or D/E ratio is a measure of what amount of the business is indebted.

• • A high D/E ratio means a business is highly dependent on borrowed money to finance its operations.
    • This tells investors how much money a business should safely be able to borrow over a long period of time.
  • Debt-to-Equity Ratio = Total Liabilities / Equity

Slide #5 A business’s cash flow statement contains a lot of useful information for shareholders regarding stock values and the paying of dividends.

This can be of great use to investors who are curious about a potential return on their investment.

In addition to shareholder information, the amount of net cash flow from operating activities can be used along with the amount of revenue listed on the income statement to arrive at the operating cash flow-to-sales ratio, which is a measure of how much cash is generated from every dollar from sales.

• • This number is useful for comparing different companies in the same industry.
  • Operating Cash Flow-to-Sales Ratio = Net Operating Cash Flow / Revenue