1. Understanding the Numbers: Essential for the Entrepreneur
A Student Tutorial

2. Ever thought or said:
“I did not do well in my accounting and finance classes . I just am not good with numbers”
“Finance scares me.”
“I try, but I just can’t get it.”
If not, great, but if so, you may try to avoid accounting and finance. Why is that a mistake?

3. Reasons to Learn Finance
There are things you cannot learn about a company any other way.
If you do not understand financial statements and what they tell you, you will be missing some critical information about the firm.
And hiring someone to do it for you, DOES NOT WORK!!

4. Understanding Financial Statements
Goal: Understand the financial consequences of decisions
There are three basic financial (or accounting) statements:
Income Statement
Balance Sheet
Cash Flow Statement
The Goal: Making Good Financial Decisions
3 types of financial statements

5. Income Statement (1)
Basic purpose and format of an income statement
Indicates the firm’s profits over a period of time
Usually monthly, quarterly or annually
Basic form:
Sales (Revenues)
Profits
Expenses

6. Income Statement (2)
Can you compute gross profits?
The Income Statement starts with sales (revenues).
= # of units sold X sales price per unit
Sales (Revenue)
minus
Cost of Goods Sold
From Sales, subtract the Cost of Goods Sold to obtain the Gross Profit
equals
Gross Profit

7. Income Statement (3) What is cost of goods sold?
Computing cost of goods sold
Cost of goods sold is determined by:
The cost of producing or acquiring a single unit of the firm’s products or services
The number of units sold
Cost of goods sold
number of units sold
cost per unit = X

8. Income Statement (4)
Can you compute operating income; also called earnings before interest and taxes (EBIT)?
Next compute operating income (earnings before interest & taxes)
From Gross Profits subtract Operating Expenses to obtain Operating Income
Sales Revenue
minus
Cost of Goods Sold
equals
Gross Profit
minus
Operating Expenses
equals
Operating Income

9. Income Statement (5) What are operating expenses?
In addition to the cost of goods sold, you need to convince someone to buy what you are selling. So, you will have;
Marketing expenses
And you have operating overhead—the light bill must be paid. So, you will have:
General & administrative expenses
And if you have equipment and buildings. You will have:
Depreciation expense
(More will be said about depreciation later.)
Operating expenses include marketing expenses, G&A, and deprecia- tion

10. Income Statement (6) A Comment on Operating Income
Operating Income is the total profit a firm makes from running the business before paying creditors (interest expense) for the use of debt, and paying income taxes to the government.
Operating income is the best profit indicator of how well a company is doing in its business.

11. Income Statement (7) Next we compute earnings before taxes (EBT)
Can you compute earnings before taxes?
From Operating Income, subtract Interest Expense to obtain Earnings Before Taxes
Operating Income
minus
Interest Expense
equals
Earnings Before Taxes

12. Income Statement (8) Interest Expense: The Cost of Borrowing Money
You have to pay the banker to use the bank’s money!!
A lender charges interest to loan money, which is shown as interest expense in the income statement of the borrower.
Interest expense is the result of the interest rate and the amount borrowed.
Interest Rate
Amount Borrowed
Interest Expense x

13. Income Statement (9) Computing Earning Before Taxes: An Illustration
Earnings Before Taxes:
= Operating Income – Interest Expense
= $15, ($50,000 X .06)
= $15, $3,000 = $12,000
Computing a firm’s earnings before taxes
If a firm has:
$15,000 in operating income and $50,000 in debt at a 6% interest rate, then:
Operating Income $ 15,000
Interest Expense $ 3,000
The Earnings before taxes is: $ 12,000

14. Income Statement (10) Finally, we calculate net income
Can you compute net income?
Finally, we calculate net income
Operating Income
From Earnings Before Taxes subtract Income Taxes to obtain the Net Income
minus
Interest Expense
equals
Earnings Before Taxes
minus
Income Taxes
equals
Net Income

15. Income Statement (11) Computing Net Income Illustrated
(Earnings before taxes)-(Tax rate)*(Earnings before taxes)
$12, (25%)*($12,000) =
$12, $3,000 = $9,000
Income Statement (11) Computing Net Income Illustrated
Computing income taxes to find net income
If a firm has:
Operating Income of $15,000
Earnings before taxes of $12,000
And pays 25% on income taxes.
The Net income is: $ 9,000

16. Income Statement (12) What have we learned about the income statement?
DO NOT continue until you know and understand the format and content of an income statement.
Financing Activities
Operating Activities
Sales Revenue
Operating Income
minus
minus
Cost of Goods Sold
Interest Expense
equals
equals
Gross Profit
Earnings Bef Taxes
minus
minus
Operating Expenses
Income Taxes
equals
equals
Operating Income
Net Income

17. Income Statement (13) An Example
The Income Statement for Trimble & Associates:
Sales $850
Cost of Goods Sold
Gross Profit on Sales $300
Operating Expenses:
Marketing Expenses
General & Admin Expenses
Depreciation
Total Operating. Expenses $200
Operating Income
Interest Expense
Earnings Before Tax
Income Tax (25%)
Net Income
Cost of borrowing
Income from operating the business
Income after \paying interest

18. Income Statement (14) Summary
The Income Statement answers the question:
“How profitable is the business?”
The Income Statement reports on five broad areas:
Sales (Revenue)
Costs of producing or acquiring the firm’s goods or services
Operating Expenses
Financing costs (interest expense)
Tax payments

19. Income Statement (15) Can You Put It Together?
Gross Profit on Sales $
Operating Expenses:
Total Op. Exp. $
Operating Income $
Earnings Before Taxes $
Net Income $
Put the pieces where they go!!
4. Good judgment
Organize this Income statement
Cost of Goods Sold $250
Admin. &Sales Exp. $ 18
Depreciation $ 8
Interest Expense $ 6
Sales $290
Income Taxes(25%) $ 2

20. Here You Go! Gross Profit on Sales $ Operating Expenses: 40
Total Op. Exp. $
Operating Income $
Earnings Before Taxes $
Net Income $
Cost of Goods Sold $250
Cost of Goods Sold $250 40
Admin. &Sales Exp. $ 18
Admin. &Sales Exp. $ 18
Depreciation $ 8
Depreciation $ 8 26
Interest Expense $ 6
Interest Expense $ 6 14
Sales $290
Sales $290 8
Income Taxes(25%) $ 2
Income Taxes(25%) $ 2 6

21. Income Statement (16) A Concluding Thought
Congratulations!! You should be able to understand the income statement and what it is telling you.
We are now ready to examine the balance sheet, which measures the firm’s current financial position.
Let’s continue.

22. Balance Sheet (1)
A Snapshot of a company’s financial position at a specific point in time
The Income Statement covers a period in time (Jan 1 – Dec 31, 2007)
The Balance Sheet represents a specific moment (December 31, 2007)
In its simplest form, the Balance Sheet is:
Total assets always equal debt plus equity.
Total Assets
Owner’s Equity
Outstanding Debt
Debt & Equity

23. Balance Sheet (2) Three main parts
Basic pieces of the balance sheet
Assets
What the company owns
Liabilities (Debt)
What the company owes
Owner’s Equity (Net Worth)
The amount invested by the owners (stockholders)
The difference between Assets and Liabilities
Continue

24. Balance Sheet (3) Three main parts
Total Assets, the sum of:
Current Assets (Cash, A/R, Inventory)
Fixed Assets (Machinery and equipment, Buildings, Land)
Other Assets (Long-term investments, Patents)
Debt and Equity, the sum of:
Total Debt, including:
Current debt (Accounts payable, Accrued expenses, Short-term notes)
Long-term debt (Long-term notes, Mortgages)
Owner’s equity: owner’s investment in the company
A look inside the balance sheet
-Cash Flow
2. Forecast
3. Determine and evaluate
4. Good judgment

25. Balance Sheet (4) Assets: Current Assets
Current assets: the firm’s “liquid” assets; includes cash and assets that can soon be converted into cash
Current assets are also called gross working capital
Current assets comprise the assets that are relatively liquid
Cash
Accounts Receivable
Inventories
Other current assets
(e.g., prepaid expenses)

26. Balance Sheet (5) Assets: Fixed Assets
Fixed assets may also be called plant & equipment
Fixed assets include:
Machinery and Equipment
Buildings and Land
The cost of a fixed asset is recorded in the balance sheet and depreciated over its useful life.
The Income Statement reports the depreciation expense for each year.
The Balance Sheet reports the accumulated depreciation—depreciation taken on an asset over all its life.

27. Balance Sheet (6) Depreciating Fixed Assets
Remember that
When a fixed asset is purchased, the firm pays cash, and so:
Fixed assets increase in the balance sheet.
Cash decreases in the balance sheet.
But the depreciation expense is NOT a cash event.
Depreciation expense is recorded in the income statement
Accumulated depreciation increases in the balance sheet
There is NO cash involved!!
Depreciation expense is NOT a cash expense!!!

28. Balance Sheet (7) Gross Versus Net Fixed Assets
So:
net fixed assets = gross fixed assets – accumulated depreciation
Gross Fixed Assets is the original amount paid for a firm’s fixed assets.
Net Fixed Assets is the gross fixed assets minus the total depreciation (accumulated depreciation) taken on the fixed assets. That is,
Gross fixed
assets
accumulated
depreciation
net fixed
assets - =

29. Balance Sheet (8) An Example of Depreciation
You purchase equipment for $10,000 with an expected life of 5 years. How much will the depreciation expense be each year, as reported in the income statement?
$2,000 ($10,000 ÷ 5 years = $2,000)
What will the balance sheet look like over the 5 years?
End of Year
Gross fixed assets $10K $10K $10K $10K $10K
Accumulated depre 2K 4K 6K 8K 10K
Net fixed assets $8K $6K $4K $2K $0K

30. Balance Sheet (9) Assets: Other Assets
The firm’s other assets
Other assets includes intangibles, such as:
Patents
Copyrights
Goodwill
And for a start-up company:
Organizational costs

31. Balance Sheet (10) Debt And Equity
Remember
Total assets MUST equal total debt plus owner’s equity
Total Assets
Owner’s Equity
Outstanding Debt
Debt & Equity

32. Balance Sheet (11) Debt or Liabilities
Debt is financing provided by a creditor
Debt is divided in two parts:
Current debt or short-term liabilities
Long-term debt
Where does debt come from?

33. Balance Sheet (12) Short-term Liabilities
Short-term liabilities is debt that must be repaid within 12 months
-Cash Flow
2. Forecast
3. Determine
4. Good judgment
Liabilities due within 12 months
Accounts Payable or Trade Credit:
Credit extended by suppliers for the purchase of inventories
Usually given days to pay
Accrued Expenses:
Operating expenses that are owed but not yet paid
Short-term Notes:
Short-term loans from banks or other financial institutions

34. Balance Sheet (13) Long-term Liabilities
Long-term liabilities (debt)
Loans that come due after 12 months
Loans from banks or other sources that that come due after 12 months
Usually loans to finance long-term capital investments, such as machinery and equipment.

35. Balance Sheet (14) Owners’ Equity
Owners have 2 ways to invest in a business:
Buy stock
Reinvest all or part of the firm’s profits
Owner’s Equity is the money invested by the owners
Note: They are residual owners, because in a liquidation, stockholders are paid last
Equity consists of:
Amount invested when purchasing ownership in the business
Retained Earnings: All the profits retained in the company (profits not paid out in dividends to the owners)

36. Balance Sheet (15) Owners’ Equity
Retained earnings: A concept that many students fail to understand. Do you?
Retained Earnings is the accumulated profits (gains-losses) of the business, less the dividends paid to stockholders since the firm was created
Owners’ Equity
Cumulative Profits
Owners’ Investment
Cumulative Dividends
Retained Earnings
Owners’ Equity
Owners’ Investment

38. Balance Sheet (16) An Example
The Balance Sheet for Trimble & Associates:
ASSETS DEBT AND EQUITY
Current Assets Current Liabilities:
Cash $50 Accounts payable $20
Accounts receiv Short-term notes 80
Inventories Total current debt $100
Total current assets $350 Long-term debt 200
Fixed assets: Total debt: $300
Gross fixed assets $960 Common stock $300
Accum depreciation Retained earnings 320
Net fixed assets $570 Total common equity $620
TOTAL ASSETS $920 TOTAL DEBT AND EQUITY $920

39. Balance Sheet (17) Putting it together
Given the information below, can you arrange the balance sheet?
Remember: ASSETS = LIABILITIES + EQUITY
FIRST: ASSETS
Assets:
Current Assets
Fixed Assets
TOTAL ASSETS $ 2,800
Gross Fixed Assets $2,500
Gross Fixed Assets $2,500
Inventories $ 310
Inventories $ 310
Net Fixed Assets $2,200
Net Fixed Assets $2,200
Cash $ 70
Cash $ 70
Accumulated Depreciation $(300)
Accumulated Depreciation $(300)
Total Current Assets $ 600
Total Current Assets $ 600
Accounts Receivable $ 220
Accounts Receivable $ 220

40. Balance Sheet (18) Putting it together
NEXT: DEBT & EQUITY
Liabilities:
Current Liabilities:
Owners’ Equity:
TOTAL DEBT&EQUITY $ 2,800
Total Current Liabilities $ 250
Total Current Liabilities $ 250
Total Owners’ Equity $1,750
Total Owners’ Equity $1,750
Accounts Payable $ 230
Accounts Payable $ 230
Common Stock $ 900
Common Stock $ 900
Short-term Notes $
Short-term Notes $
Total Debt $1,050
Total Debt $1,050
Long-term debt $ 800
Long-term debt $ 800
Retained Earnings $ 850
Retained Earnings $ 850

41. Balance Sheet (19) All Together The complete balance sheet is as follows
Assets:
Current Assets
Fixed Assets
TOTAL ASSETS $ 2,800
Liabilities:
Current Liabilities:
Owners’ Equity:
TOTAL DEBT&EQUITY $ 2,800
Cash $ 70
Accounts Payable $ 230
Accounts Receivable $ 220
Short-term Notes $
Inventories $ 310
Total Current Liabilities $ 250
Total Current Assets $ 600
Long-term debt $ 800
Total Debt $1,050
Gross Fixed Assets $2,500
Accumulated Depreciation $ 300
Common Stock $ 900
Net Fixed Assets $2,200
Retained Earnings $ 850
Total Owners’ Equity $1,750

42. Balance Sheet (20) Income Statement and Balance Sheet
The Income Statement and Balance Sheet complement each other
December 31
January 1
Income Statement for 2007
YEAR 2007
Balance Sheet on December 31, 2006
Balance Sheet on December 31, 2007

43. Balance Sheet (21) Concluding Thought
DON’T CONTINUE
if you do not fully understand the balance sheet!! Go back until you have grasped all the parts of the balance sheet.
A balance sheet indicates a firm’s financial position in terms of the assets owned and how these assets have been financed by debt and owner’s equity.
With an understanding of the income statement and the balance sheet, we can now look at the Cash Flow Statement.

44. and your business will fail!
Cash Flow Statement (1)
CASH IS KING is not some cliché, but a principle you cannot afford to violate!
“Cash is King!!
Cash flow problems is a major reason for small firms failing—even at times when the business is profitable.
Run out of cash
and your business will fail!

45. Cash Flow Statement (2) Accrual versus Cash Accounting
You must understand the difference between accrual-basis accounting and cash-basis accounting.
With the exception of very small businesses, the income statement and the balance sheet are based on accrual accounting.
When accrual accounting is used, profits and cash flows will not be equal.

46. Cash Flow Statement (3) Accrual and Cash Accounting Again
Recording income and expenses:
Accrual-basis: When there is a commitment
Cash-basis: When money changes hands
Income earned
Expense incurred
Cash received
Expense paid
Accrual-basis accounting
Cash-basis accounting

47. Cash Flow Statement (4) Why Profits and Cash Flow are NOT the Same
Profits will never tell you how much cash you generated!!
The differences between profits and cash flows can result from:
Sales reported on the Income Statement include cash and credit sales
Some purchases are financed by credit—so no cash is involved
Depreciation expense is a non-cash expense.
Income tax on the income statement may be accrued and paid in later periods.

48. Cash Flow Statement (5) Accrual vs. Cash Again
Which type of accounting would record the following?
Accrual
Cash
Income tax expense that has not been paid
Insurance premium paid in advance
Customer pays for a good to be delivered
Equipment is sold, with a 30 day note
Customer pays and takes equipment sold
Customer receives a service estimate
Payment of last month’s utility bill

49. “Where did the cash come from and where did the cash go?”
Cash Flow Statement (6)
The Cash Flow Statement answers a very important question:
“Where did the cash come from and where did the cash go?”

50. Cash Flow Statement (7) Data Needed to Compute Cash Flows
From the income statement:
Depreciation expense
Operating income
Interest expense
Income tax expense
Changes in the balance sheet at the beginning of the year (end of last year) and the balance sheet for the current year end.

51. Cash Flow Statement (8) Changes in the Balance Sheet that Affect Cash Flows
Changes in the balance sheet affect cash flows.
Cash increases if:
Reduce assets
Borrow more money (increase debt)
Owners invest more in the business
Cash decreases if:
Increase assets
Repay (decrease) debt
Owners withdraw money from the company

52. Cash Flow Statement (9)
Three activities cause cash to increase or decrease
Cash inflows and outflows result from three activities:
Operating Activities:
Cash flow from normal operations
Investment Activities:
Cash flow related to the investment in or sale of assets
Financing activities:
Cash flow related to financing the firm

53. Cash Flow Statement (10) Operating Activities
Cash flow from operations consists of the net flow of cash from day-to-day business activities
What is cash flow from opera- tions?
Start with Operating income
Add back Depreciation expense
(a non-cash expense)
Subtract income taxes
(to work on an after-tax basis)
Subtract increase in net working capital
Which consists of:
Increase in A/R (a use of cash)
Increase in inventories (a use of cash)
Decrease in A/P (a source of cash)

54. Cash Flow Statement (11) Investment Activities
What is cash flow from investment activities?
Investment activities consist of
The purchase or sale of fixed assets (change in gross fixed assets)
The purchase or sale of other long-term assets (changes in goodwill, patents, etc.)

55. Cash Flow Statement (12) Financing Activities
Financing activities include:
Paying dividends and interest expense
Increasing or decreasing short-term and long-term debt
Increase: borrowing more money
Decrease: paying off debt
Owners invest more or less in business
Buy more stock
Company buys owner’s stock back
What is cash flow from financing activities?

56. Cash Flow Statement (13) Cash Flow Statement for Trimble Associates
Operating Activities
Operating income $ 100
Plus depreciation
Less income taxes (20) $ 110
Change in net working capital:
Less increases in A/R $ (5)
Less increases in inventories (40)
Plus increases in A/P (40)
Cash flows from operations $ 100
Investment Activities
Less increase in gross fixed assets $ (100)
Financing Activities
Less interest expenses $ (20)
Less dividends paid (15)
Plus incr in short-term notes 20
Plus incr in long-term notes 50
Total Financing Activities $
Increase (Decrease) in cash $ 5
Change in net working capital

57. Cash Flow Statement (14) Can You Arrange this Cash Flow Statement?
Interest expenses $(30)
Operating activities:
Plus
Less
Cash flows from operations:
Investment activities
Financing activities
Total financing activities
Increase (Decrease) in cash
Operating Income $120
Taxes $(30)
Increase in gross fixed assets $(90)
Increases in long-term notes $ 30
$100
Depreciation $ 40
Increases in short-term notes $ 15
$ 100
$ (90)
$ 5
Increases in accts receivable $(20)
Increases in accounts payable $ 5
$ 15
$ 5
Increases in inventories $(10)
Dividends paid $(10)

58. Cash Flow Statement (15) Interpreting the Cash Flow Statement
To understand what the cash flow statement is saying, look at the signs (+ or -) of the three cash flow activities:
Is cash flow from operations positive or negative?
Is cash flow from investment activities positive or negative?
Is cash flow from financing activates positive or negative?
Want to under-stand the cash flow state-ment? Look at the three cash flow activities.

59. Cash Flow Statement (16) Examples of Cash Flow Patterns
Operations
Financing
Investments
Some of the more important
cash flow patterns are:
Using cash flows from operations and financing to invest in long-term assets (fixed assets)
Using cash flows from operations to expand the business and repay creditors and/or owners
Negative cash flow from operations funded by selling long-term assets and additional financing
Sustaining negative cash flows and investment to expand the business through financing
(Could be a start-up that has yet to break even)

60. CONGRATULATIONS!! You have completed the task!
Go Celebrate!
You have completed the task!
Hopefully, your persistence has paid off and you understand financial statements much more fully and any fear of financial statements has been reduced.
Way to go!!!