1 Financial Accounting: Tools for Business Decision Making, 2nd Ed. Kimmel, Weygandt, Kieso ELS

Chapter 2

3 Chapter 2 A Further Look at Financial Statements zExplain the meaning of generally accepted accounting principles and describe the basic objective of financial reporting. zDiscuss the qualitative characteristics of accounting information. zIdentify two constraints in accounting. zIdentify sections of a classified balance sheet. After studying Chapter 2, you should be able to:

4 zIdentify and compute ratios for analyzing a company's profitability. zExplain the relationship between a retained earnings statement and a statement of stockholders' equity. zIdentify and compute ratios for analyzing a company's liquidity and solvency using a balance sheet. zIdentify and compute ratios for analyzing a company’s liquidity and solvency using a statement of cash flows. Chapter 2 A Further Look at Financial Statements

5 General Guide for Financial Accounting zGenerally zAccepted zAccounting zPrinciples

6 What is financial accounting supposed to accomplish? Provide the the most useful financial information for… Decision Making

7 Primary Accounting Setting Body in the U.S. zFinancial zAccounting zStandards zBoard

Remember… GAAP Are the Rules The FASB makes the rules.

9 Basic Terms zRelevance - information makes a difference in decisions zReliability - information must be free of error and bias zComparability - ability to compare information of different companies because they use same accounting principles zConsistency - use of same accounting principles and methods from year to year within same company

Characteristics of Useful Information

11 Constraints in Accounting Permits companies to modify GAAP without hurting the usefulness of information zMateriality - if item doesn’t make a difference, GAAP doesn’t have to be followed zConservatism - in “gray” areas choose guide which does not overstate assets or income

12 A Classified Balance Sheet... Generally contains the following standard classifications: yCurrent Assets yLong-Term Investments yProperty, Plant, and Equipment yIntangible Assets yCurrent Liabilities yLong-Term Liabilities yStockholders' Equity

13 Current Assets zAssets that are expected to be converted to cash or used in the business within a short period of time, usually one year. zCurrent assets are listed in order of liquidity. zExamples: yCash yShort-term investments yReceivables yInventories yPrepaid expenses

14 Long-Term Investments zAssets that can be converted into cash, but whose conversion is not expected within one year. zAssets not intended for use within the business. zExample: y investments of stocks and bonds of other corporations.

15 Property, Plant, and Equipment zAssets with relatively long useful lives. zAssets used in operating the business. zExamples: yland ybuildings ymachinery ydelivery equipment yfurniture and fixtures

16 Depreciation is... zPractice of allocating an asset’s full purchase price to a number of years instead of expensing full cost in year of purchase.

17 Accumulated Depreciation account... zShows the total amount of depreciation taken over the life of the asset.

18 Assets That A Company Depreciates... Should be shown at cost less accumulated depreciation CSU CORPORATION Balance Sheet December 31, 2001 Assets Cash$ 2,000 Accounts receivable 4,000 Supplies 1,800 Equipment24,000 Less: Accumulated Depreciation 8,000 16,000 Total assets $23,800

19 Intangible Assets have value because of the exclusive rights or privileges they possess. Intangible Assets zNoncurrent assets zHave no physical substance zExamples: ypatents ycopyrights ytrademarks or trade names yfranchise

20 Current Liabilities Obligations that are supposed to be paid within the coming year... zaccounts payable zwages payable zbank loans payable zinterest payable ztaxes payable zcurrent maturities of long-term bank loans payable

21 Long-Term Liabilities Debts expected to be paid after one year Examples… y bonds payable y mortgages payable y long-term notes payable y lease liabilities and yobligations under employee pension plans

22 Stockholders' Equity zCapital stock - investments in the business by the stockholders zRetained earnings - earnings kept for use in the business

HUMANA CORPORATION Balance Sheet December 31, 19XX (in millions ) Assets Current Assets Cash $ 272 Marketable securities (current) 609 Receivables 74 Other current assets 83 Total current assets 1,038 Property and equipment (net) 317 Marketable securities (long-term) 322 Other long-term assets 280 Total Assets $1,957 Liabilities and Stockholders’ Equity Liabilities Current Liabilities Medical costs payable$527 Accounts payable233 Income taxes payable 56 Total current liabilities816 Long-term debt 83 Total liabilities899 Stockholders’ equity Common stock 830 Retained earnings228 Total Liabilities and stockholders’ equity $1,957 Current

24 Ratios Analysis... êExpresses the relationship among selected items of financial statement data êRelationship can be expressed in term of… êpercentage êrate êproportion

25 Profitability Ratios... measure operating success of a company over a period of time. yReturn on Assets  Profit Margin

26 Profitability Ratios... measure operating success of a company over a period of time. yReturn on Assets  Profit Margin

27 Profitability Ratios... measure operating success of a company over a period of time. yReturn on Assets  Profit Margin

28 Return On Assets Ratio Reveals the amount of net income generated by each dollar invested Net Income Average Assets Return on Assets Ratio = Higher value suggests favorable efficiency.

29 Profit Margin Ratio Measures the percentage of each dollar of sales that results in net income Profit Margin Ratio = Net Income Net Sales Higher value suggests favorable return on each dollar of sales.

30 Statement of Retained Earnings Describes the events that caused changes in the retained earnings account for the period.

CSU CORPORATION Retained Earnings Statement For the Year Ended December 31, 1998 Retained earnings, January 1$ 0 Add: Net Income6,800 6,800 Less: Dividends 0 Retained earnings, December 31$ 6,800

32 Statement of Retained Earnings and Statement of Stockholders Equity Stockholders’ Equity: zRetained Earning zCommon Stock Since both of these parts affect stockholders’ equity… a statement of stockholders’ equity provides better information than a statement of retained earnings.

33 Financial Ratio Classifications zLiquidity Ratios - measures of short- term ability of the company to pay its maturing obligations and to meet unexpected needs for cash zProfitability Ratios -measures of the income or operating success of a company for a given period of time zSolvency Ratios - measures of the ability of a company to survive over a long period of time

34 Liquidity Ratios zWorking capital zCurrent ratio

35 Working Capital Measures short-term ability to pay liabilities Current Assets - Current Liabilities = Working Capital

36 Current Ratio Measure of short term ability to pay obligations Current Ratio = Current Assets Current Liabilities

37 Solvency Ratio Debt to Total Assets Ratio measures % of assets financed by creditors. Total Debts Total Assets Debt to Total Asset Ratio =

38 Purpose of Statement Of Cash Flows To provide information about zcash receipts zcash payments znet changes in cash

39 Changes Result From zOperating activities zFinancing activities zInvesting activities

40 Operating Activities Cash inflows and cash outflows associated with the primary operations of the business.

41 Financing Activities Cash inflows/ outflows come from sources funding the business… zSale of Stock/ Payment of Dividends zIssuing Debt/Repaying Debt

42 Investing Activities Cash inflows/ outflows result from changes in investments and long- term assets… zpurchasing/disposing of investment and long-lived assets using cash zlending money and collecting the loans

43 Current Cash Debt Coverage Ratio Cash Provided by Operating Activities Average Current Liabilities =

44 Cash Debt Coverage Ratio Cash Provided by Operating Activities Average Total Liabilities =