2. 1.Describe the purpose and content of an income statement. 2.Explain the purpose and content of a balance sheet. 3.Explain how viewing the income statement and balance sheets together gives a more complete picture of a firm’s financial position. 4.Use the income statement and balance sheets to compute a company’s cash flows. 5.Analyze the financial statements using ratios to see more clearly how decisions affect a firm’s financial performance. 10–2 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

3. Understanding Financial Statements Financial Statements (Accounting Statements)Financial Statements (Accounting Statements)  Reports of a firm’s financial performance and resources  Helps determine a startup’s financial requirements  Assesses the financial implications of a business plan Basic Financial StatementsBasic Financial Statements  Income statement  Balance sheet  Cash flow statement 10–3 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

4. Understanding the Income Statement Income StatementIncome Statement  A report showing the profit or loss from a firm’s operations over a given period of time.  “How profitable is the business?”  Sales (revenue) – Expenses = Profits (income) –Revenue from product or service sales –Costs of producing product/service (cost of goods sold) –Operating expenses (marketing, selling, general and administrative expenses, and depreciation) –Financing costs (interest paid) –Tax payments 10–4 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

5. The Income Statement (cont’d) Cost of Goods SoldCost of Goods Sold  The cost of producing or acquiring goods or services to be sold by a firm Gross ProfitGross Profit  Sales less the cost of goods sold Operating ExpensesOperating Expenses  Costs related to marketing and selling a firm’s product or service, general and administrative expenses, and depreciation Operating IncomeOperating Income  Earnings before interest and taxes are paid 10–5 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

6. The Income Statement (cont’d) Financing CostsFinancing Costs  The amount of interest owed to lenders on borrowed money Net Income Available To Owners (Net Income)Net Income Available To Owners (Net Income)  Income that may be distributed to the owners or reinvested in the company Depreciation ExpenseDepreciation Expense  Costs related to a fixed asset, such as a building or equipment, distributed over its useful life 10–6 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

7. 10–7 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Income Statement: An Overview 10.1

8. The Income Statement (cont’d) 10–8 Operating Activities Sales Revenue = = = Operating Income Earnings Before Taxes Net Income Available to Owners Cost of producing or acquiring product or service (cost of goods sold) Gross profit Marketing and selling expenses, general and administrative expenses and depreciation (operating expenses), – = – Financing Activities Operating Income Interest expense on debt (financing costs) – Taxes Earnings Before Taxes Income taxes – © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

9. 10–9 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 10.2 Income Statement for Houser & Associates, Inc., for the Year Ending December 31, 2013 35% –65% 100% Percent of Sales 12% –24% –2% 9% –2% 7% Gross profit margin Operating profit margin Net profit margin

10. The Balance Sheet Balance SheetBalance Sheet  A report showing a firm’s assets, liabilities, and owners’ equity at a specific point in time  Total Assets = Debt + Owner’s equity 10–10 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

11. 10–11 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 10.3 The Balance Sheet: An Overview

12. The Balance Sheet: Current Assets Current Assets (Working Capital)Current Assets (Working Capital)  Assets that can be converted to cash within the firm’s operating cycle  Cash  Currency and negotiable instruments  Accounts receivable  Amount of credit extended to customers that is currently outstanding  Inventory  Raw materials and products held in anticipation of sale 10–12 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

13. 10–13 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 10.4 The Working Capital Cycle

14. The Balance Sheet: Fixed Assets Fixed Assets (Plant, Property, and Equipment)Fixed Assets (Plant, Property, and Equipment)  Relatively permanent resources intended for use in the business (not for resale) Depreciable AssetsDepreciable Assets  Assets whose value declines (depreciates) over time Gross Fixed AssetsGross Fixed Assets  Original cost of depreciable assets before any depreciation expense has been taken Accumulated DepreciationAccumulated Depreciation  Total depreciation expense taken over the assets’ life 10–14 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

15. The Balance Sheet: Fixed Assets (cont’d) Net Fixed AssetsNet Fixed Assets  Gross fixed assets less accumulated depreciation Other AssetsOther Assets  Assets other than current assets and fixed assets, such as patents, copyrights, and goodwill that have an estimated value 10–15 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

16. The Balance Sheet: Debt DebtDebt  Business financing provided by a creditor Current Debt (Short-Term Liabilities)Current Debt (Short-Term Liabilities)  Accounts payable: trade credit payable to suppliers  Accrued expenses: short-term liabilities incurred but not paid  Short-term notes: Cash amounts borrowed that must be repaid within a short period of time Long-Term DebtLong-Term Debt  Loans and mortgages with maturities greater than one year 10–16 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

17. The Balance Sheet: Debt (cont’d) MortgageMortgage  A long-term loan from a creditor for which real estate is pledged as collateral. 10–17 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

18. The Balance Sheet: Types of Financing Owners’ EquityOwners’ Equity  Money that the owners invest in the business  Owners are “residual owners” of the firm.  Creditors have first claim on the assets of the firm. Retained earningsRetained earnings  Profits less withdrawals (dividends) over the life of the business 10–18 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Owners’ equity = Owners’ investment – Cumulative dividends paid to owners Cumulative profits + Owners’ equity = Owners’ investment + Earnings retained within the business

19. 10–19 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 10.5 Balance Sheets for Houser & Associates, Inc., for December 31, 2012 and 2013

20. 10–20 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Fit of the Income Statement and Balance Sheet 10.6

21. The Cash Flow Statement Cash Flow StatementCash Flow Statement  A financial report showing a firm’s income (cash) when it is received and expenses when they are paid.  Cash flows from normal operations (operating activities)  Cash flows related to the investment in or sale of assets (investment activities)  Cash flows related to financing the firm (financing activities) 10–21 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

22. Profits Versus Cash Flows Accrual-Basis AccountingAccrual-Basis Accounting  Matches revenues when they are earned against the expenses associated with those revenues.  Sales reflect both cash and credit (noncash) sales.  Inventory purchased on credit is a noncash expense.  Depreciation is a noncash expense.  Income tax is accrued and not entirely expensed. Cash-Basis AccountingCash-Basis Accounting  Reports transactions only when cash is received or a payment is made. 10–22 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

23. Measuring Cash Flows Cash Flows from Daily OperationsCash Flows from Daily Operations  Net cash flows generated from operating a business  Calculated by adding back to operating income depreciation, deducting income taxes, and factoring in any changes in net working capital. Adjusted IncomeAdjusted Income  After-tax cash flow Net Working CapitalNet Working Capital  Money invested in current assets less accounts payable and accruals 10–23 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

24. Measuring Cash Flows (cont’d) Cash Flows from Investment ActivitiesCash Flows from Investment Activities  Cash inflows and outflows resulting from the sale or purchase of equipment or another depreciable asset Cash Flows from Financing ActivitiesCash Flows from Financing Activities  Cash inflows and outflows resulting from:  Paying dividends and interest expense.  Increasing or decreasing short-term and long-term debt.  Issuing or repurchasing stock. 10–24 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

25. Computing Cash Flows from Assets 10–25 After-Tax Cash Flows from Operations Cash Flows from Assets Changes in Operating Working Capital Changes in Long-Term Assets After-tax cash flows from operations Investments in operating working capital Investments in long-term assets Cash flows from assets = © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

26. Computing Other Cash Flows After-Tax Cash Flows From OperationsAfter-Tax Cash Flows From Operations 10–26 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Net income Depreciation expense Interest Expense After-tax cash flows from operations = + + Operating Working CapitalOperating Working Capital Current assets Operating Working Capital = – Account payable and accruals

27. 10–27 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Cash Flow Statement for Houser & Associates, Inc., for the Year Ending December 31, 2013 10.7

28. Cash Flows from Financing 10–28 Cash Flows from Financing Interest and Dividends Paid to Investors Increase in Debt (firm issues new debt) Increase in Equity (firm issues new stock) Decrease in Debt (firm repays debt) Decrease in Equity (firm repurchases outstanding stock) Increases in Cash Flows from Financing Decreases in Cash Flows from Financing © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

29. Evaluating a Firm’s Financial Performance Factors Impacting the Firm’s Financial SituationFactors Impacting the Firm’s Financial Situation  The firm’s ability to pay its debt as it comes due.  The firm’s profitability from assets.  The amount of debt the business is using.  The rate of return earned by the owners on their equity investment. Financial LeverageFinancial Leverage  The impact (positive or negative) of financing with debt rather than with equity. 10–29 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

30. 10–30 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Financial Ratio Analysis for Houser & Associates, Inc. 10.8

31. 10–31 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Return on Assets: An Overview 10.9

32. Looking Ahead: Financial Forecasting Pro Forma Financial StatementsPro Forma Financial Statements  Statements that project a firm’s financial performance and condition  Purposes of pro forma statements:  How profitable can the firm be expected to be, given the projected sales levels and the expected sales expense relationships?  What will determine the amount and type of financing (debt or equity) to be used?  Will the firm have adequate cash flows? If so, how will they be used; if not, where will the additional cash come from? 10–32 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

33. Key Terms accounts payable (trade credit) accounts receivable accrual-basis accounting accrued expenses accumulated depreciation balance sheet cash cash-basis accounting cash flow activities cash flow statement common stock cost of goods sold current assets (working capital) current debt (short-term liabilities) current ratio debt debt ratio depreciable assets depreciation expense dividend financial leverage financial statements (accounting statements) fixed assets (property, plant and equipment [PPE]) gross fixed assets gross profit 10–33 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

34. Key Terms income statement (profit and loss statement) interest expense inventory liquidity long-term debt long-term notes mortgage net fixed assets net profits operating expenses operating profit margin operating profits other assets owners’ equity profit margins profits before taxes (taxable profits) retained earnings return on assets return on equity short-term notes total asset turnover working capital cycle 10–34 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.