1. The Purpose of Financial Statements
Financial Analysis

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3. Purposes of Financial Statements
Presents financial position of the business
Shows effectiveness of management
Can be an indicator of future performance when compared to past performance
Financial statements are the main source of information to be used in analysis. The general purpose of the financial statements is to present the financial position of the business. They can also show the effectiveness of management and can be an indicator of future performance if compared to past performance.
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4. Types of Financial Statements
Balance Sheet
Income Statement
Statement of Changes in Owner’s Equity
Cash Flow Statement
There are four main financial statements: the Balance Sheet, the Income Statement, the Statement of Changes in Owner’s Equity, and the Cash Flow Statement.
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5. Balance Sheet
Also called Statement of Financial Position
Based upon the Accounting Equation:
Assets = Liabilities + Owner’s Equity
Provides a “snapshot” of a company’s position on a particular date in time
Shows what a company owns (assets), owes (liabilities), and the difference between them (stockholder’s or owner’s equity)
The Balance Sheet is also called the Statement of Financial Position. It is based upon the Accounting Equation of Assets = Liabilities + Owner’s Equity. It provides a “snapshot” of a company’s position on a particular date. It shows what a company owns (the assets), owes (the liabilities), and the difference between them (stockholder’s or owner’s equity).
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6. Condensed Balance Sheet
ABC Corporation
Condensed Balance Sheet
October 31, 20--
Cash
$ 2,000
Current Liabilities
$ 12,000
Accounts Receivable
6,000
Long-term Liabilities
40,000
Inventory
50,000
Total Liabilities
52,000
Buildings
100,000
Owner’s Equity
106,000
Total Assets
$ 158,000
Total Liabilities and Owner’s Equity
This is a shortened version of a balance sheet including the main components of assets, liabilities, and owner’s equity.
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7. Income Statement Also called a Profit and Loss Statement
Shows gains and losses for an accounting period
Takes into account different revenue and expense items during the period
General calculation of net income/loss:
Sales- Cost of Goods Sold = Gross Profit
Gross Profit- Expenses = Net Income/Loss
The Income Statement shows the effect that the operating (and other) expenses have on the revenues of the business. Once this is calculated, the net income or net loss can be determined.
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8. Condensed Income Statement For the Month Ended October 31, 20--
ABC Corporation
Condensed Income Statement
For the Month Ended October 31, 20--
Net sales
$ 95,000
Cost of goods sold
(55,000)
Gross profit
$ 40,000
Expenses
(25,000)
Net Income
$ 15,000
Dividends
(3,000)
Retained Earnings
$ 12,000
This is an example of a basic income and expense statement including the revenue and expense (costs) components.
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9. Revenue Relationships
Relationship among total revenue, marginal revenue, output, and profit:
Marginal revenue is the addition to total revenue due to the sale of another unit of output that maximizes profit.
Calculation of marginal revenue example:
If the first item brings $20 in revenue and an additional item sold brings $15, the marginal revenue is $5:
Change in total revenue / the number of additional units of output sold
20 – 15 = 5 so 5 / 1 additional unit = $5
Understanding revenue relationships is important to the sales component of the income statement. Marginal revenue is the addition to total revenue due to selling another unit. This attempts to maximize profit.
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10. Statement of Changes in Owner’s Equity
Also called Statement of Retained Earnings
Shows the balance of stockholder’s equity from the beginning of an accounting period to the end of the period and the changes that took place in the account during that time
The Statement of Changes in Owner’s Equity basically shows the activities that affect the retained earnings or capital account during an accounting period.
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11. Statement of Changes in Owner’s Equity
ABC Corporation
Statement of Changes in Owner’s Equity
For the Year Ended December 31, 20--
Beginning Capital
$ 17,000
Add: Contributions by owner
15,000
Net Income
20,000
Subtotal
$ 52,000
Less: Withdrawals by owner
$ 7,000
Dividends
2,000
Ending Capital (or Retained Earnings)
$ 43,000
This shows the major parts of the Statement of Changes in Owner’s Equity.
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12. Cash Flow Statement
Examines the sources and uses of cash as a result of the following activities:
Operating activities- associated with delivering goods for sale or providing services for sale; includes receipts from sales as well as payments for inventories and wages and other common operating expenses
Investing activities- includes sale of predominantly long-term assets and interest received from loans or vice versa, i.e., buying long-term assets as investments and making loans with other companies
Financing activities- selling securities as well as paying out dividends to investors
The Cash Flow Statement shows the cash that was acquired by the business and what it was used for. Uses of the cash include operating activities (providing goods for sale, wages, etc.), investing activities (sale of long-term assets), and financing activities (selling investments and paying dividends to investors).
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13. Condensed Cash Flow Statement For the Year Ended October 31, 20--
ABC Corporation
Condensed Cash Flow Statement
For the Year Ended October 31, 20--
Operating cash flow
$ 17,000
Investing cash flow
(25,000)
Financing cash flow
20,000
Net change in cash
$ 12,000
Cash balance, January 1, 20--
$ 7,000
Cash balance, December 31, 20--
$ 19,000
This is a simplified version of a Cash Flow Statement that demonstrates the presence of the operating, investing, and financing cash flows and the resulting cash balance at the end of a period.
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14. Budget vs. Financial Statements
Budgets
Use estimated numbers to make predictions
Compares estimated to actual to determine variances
Usually short term (less than one year)
Includes mainly income and expenses
Financial statements
Use actual numbers
Use analysis methods to make forecasts
Budgets are an important part of planning for any business, but they are different than financial statements. Budgets use estimated figures to anticipate income and expenses. Financial statements use actual numbers to analyze a company’s performance.
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15. Financial Statement Relationships
Statement of Changes in Owner’s Equity
Beginning Capital (Retained Earnings)
$ 35,000
+ Net Income
- Dividends
4,000
(2,000)
Ending Capital Balance
$37,000
Income Statement
Revenues
$ 35,000
- Expenses
31,000
Net Income
$4,000
Balance Sheet
Cash
$ 7,000
+ All other Assets
39,000
Total Assets
$46,000
Liabilities
$9,000
+ Capital
37,000
Total Liabilities & Stockholder’s Equity
Statement of Cash Flows
Cash Flow from operating activities
Cash Flow from investing activities
Cash Flow from financing activities
$ (2,000)
1,000
3,000
Change in Cash
2,000
Cash at Beginning of period
5,000
Cash at End of period
$7,000
Financial statements are all inter-connected. The net income or loss on the Income Statement transfers to the Statement of Changes in Owner’s Equity. The ending capital balance on this statement is the number used as the capital on the Balance Sheet. The cash at the end of the period on the Statement of Cash Flows is the cash used on the Balance Sheet.
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16. Footnotes to Financials
Includes explanations for items that are not typical in financial statements
May explain how certain items are accounted for
Occasionally includes an explanation of depreciation methods or goodwill
The footnotes to financial statements are found on a company’s annual report. The footnotes can include explanations such as how items are accounted for if it is not a standard method, which method for depreciation is used, or an explanation of goodwill.
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17. Analyzing Financial Statements
Horizontal, or trend analysis- compares the same accounts across different time periods
Vertical analysis, or common-size analysis-compares different accounts to a total within the same time period
Ratio analysis- a comparison of different accounts on a statement and typically compared over different time periods
There are several different ways to analyze financial statements. Horizontal, or trend, analysis compares the same accounts over different time periods, usually from three to five periods, to see if there are trends. Vertical analysis, or common-sized analysis, compares different accounts to a total within the same accounting period. Ratio analysis consists of comparing different accounts to each other and comparing the ratios over several accounting periods to see if there are trends in the results.
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18. Limitations of Financial Statements
No right or wrong numbers to compare to
Finding accurate competitors to compare to can be difficult due to differences even between similar companies
Making future predictions based on the past is not an exact science
Management expertise is difficult to quantify but should be an important factor in analyzing company performance.
Using specific numbers to create measurable statistics can assess a company’s performance. However, factors such as the capability of management is not so easily calculated; this can be very important when addressing the performance of a company. Analysis also does not include an “answer key,” which is why trends in numbers must also be considered. In addition, comparing analysis findings to other companies in the same industry can only provide general results—no two companies are exactly the same, so a margin of error should be included to allow for differences.
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19. Independent Practice Assignments
Financial Statement Venn Diagram Assignment #1
Have students create a Venn diagram, either on paper or using a diagram feature on the computer, containing any three of the four main financial statements: Balance Sheet, Income Statement, Statement of Changes in Owner’s Equity, and/or Cash Flow Statement. They should list the component accounts found on each statement, and where the circles overlap, list the accounts that are found on more than one financial statement.
Financial Statement Acrostic Assignment #2
Students will select one of the four financial statements and create an acrostic for that statement. They should use phrases or sentences related to the chosen statement that show the student thoroughly understands what that financial statement is all about. For example, for Balance Sheet, the ‘B’ could say “Balances of Total Assets should equal the balances of Liabilities plus Owner’s Equity.”
Financial Statement Interrelationships Assignment #3
In pairs, students will create each of the four financial statements in condensed form with fictitious numbers. This will show that students understand the Accounting Equation of Assets = Liabilities + Owner’s Equity, and they must show how the statements relate to each other as they did in the presentation. They should create these on a small poster or flip chart paper.
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