1. Understanding a Firm’s Financial Statements
PART 3 Developing the New Venture Business Plan

2. Looking Ahead After studying this chapter, you should be able to:
Describe the purpose and content of an income statement.
Describe the purpose and content of a balance sheet.
Explain how viewing the income statement and balance sheets together gives a more complete picture of a firm’s financial position.
Use the income statement and balance sheets to compute a company’s cash flows.
Analyze the financial statements using ratios to see more clearly how decisions are affecting a firm’s financial performance.

3. Understanding Financial 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 Statements
Income statement
Balance sheet
Cash flow statement

4. Understanding the Income 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

5. The Income Statement (cont’d)
Cost of Goods Sold
The cost of producing or acquiring goods or services to be sold by a firm
Gross Profit
Sales less the cost of goods sold
Operating Expenses
Costs related to marketing and selling a firm’s product or service, general and administrative expenses, and depreciation
Operating Income
Earnings before interest and taxes are paid

6. The Income Statement (cont’d)
Financing Costs
The amount of interest owed to lenders on borrowed money
Net Income Available To Owners (Net Income)
Income that may be distributed to the owners or reinvested in the company
Depreciation Expense
Costs related to a fixed asset, such as a building or equipment, distributed over its useful life

7. Exhibit 10.1 The Income Statement: An Overview

8. The Income Statement (cont’d)
Operating Activities
Financing Activities
Taxes
Sales Revenue
Operating Income
Earnings Before Taxes –
Cost of producing or acquiring product or service
(cost of goods sold) –
Interest expense on debt (financing costs) –
Income taxes =
Net Income Available =
to Owners =
Gross profit
Earnings Before Taxes –
Marketing and selling expenses, general and administrative expenses and depreciation (operating expenses) , =
Operating Income

9. Exhibit 10. 2. Income Statement for Gilbert & Associates Leasing, Inc
Exhibit 10.2 Income Statement for Gilbert & Associates Leasing, Inc., for the Year Ending December 31, 2009

10. The Balance Sheet Balance Sheet
A report showing a firm’s assets, liabilities, and owners’ equity at a specific point in time
Total Assets = Debt + Owner’s equity

11. Exhibit 10.3 The Balance Sheet: An Overview

12. The Balance Sheet: Current Assets
Current Assets (Gross 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

13. The Balance Sheet: Fixed Assets
Relatively permanent resources intended for use in the business (not for resale)
Depreciable Assets
Assets whose value declines (depreciates) over time
Gross Fixed Assets
Original cost of depreciable assets before any depreciation expense has been taken
Accumulated Depreciation
Total depreciation expense taken over the assets’ life

14. The Balance Sheet: Fixed Assets (cont’d)
Net Fixed Assets
Gross fixed assets less accumulated depreciation
Other Assets
Assets other than current assets and fixed assets, such as patents, copyrights, and goodwill that have an estimated value

15. The Balance Sheet: Debt
Business financing provided by a creditor
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 Debt
Loans and mortgages with maturities greater than one year

16. The Balance Sheet: Debt (cont’d)
Mortgage
A long-term loan from a creditor for which real estate is pledged as collateral

17. The Balance Sheet: Types of Financing
Owners’ 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 earnings
Profits less withdrawals (dividends) over the life of the business
Owners’ equity =
Owners’ investment –
Cumulative dividends paid to owners
Cumulative profits +
Earnings retained within the business

18. Exhibit 10. 4. Balance Sheets for Gilbert & Associates Leasing, Inc
Exhibit 10.4 Balance Sheets for Gilbert & Associates Leasing, Inc., for December 31, 2008 and 2009

19. Exhibit 10.5 The Fit of the Income Statement and Balance Sheet

20. The Cash 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)

21. Profits Versus Cash Flows
Accrual-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 Accounting
Reports transactions only when cash is received or a payment is made.

22. Cash Flows from Daily Operations
Measuring Cash Flows
Cash 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 Income
After-tax cash flow
Net Working Capital
Money invested in current assets less accounts payable and accruals

23. Measuring Cash Flows (cont’d)
Cash Flows from Investment Activities
Cash inflows and outflows resulting from the sale or purchase of equipment or another depreciable asset
Cash 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.

24. Computing Cash Flows from Assets
After-Tax Cash Flows from Operations
Cash
Changes in Operating Working Capital
Changes in Long-Term Assets
Flows
from Assets
After-tax cash flows
from operations
Investments in
operating
working capital
Investments
in long-term
assets
Cash
flows from assets =

25. Computing Other Cash Flows
After-Tax Cash Flows From Operations
Net income
Depreciation expense
Interest Expense
After-tax cash
flows from operations = +
Operating Working Capital
Current assets
Operating Working Capital = –
Account payable and accruals

26. Exhibit 10.6 Cash Flow Statement for Gilbert & Associates Leasing, Inc., for the Year Ending December 31, 2009

27. Cash Flows from Financing
Increase in Debt
Increase in Equity
(firm issues new debt)
(firm issues new stock)
Increases in Cash Flows from Financing
Cash Flows
from Financing
Decreases in Cash Flows from Financing
Interest and Dividends
Decrease in Equity
Decrease in Debt
(firm repurchases outstanding stock)
Paid to Investors
(firm repays debt)

28. Evaluating a Firm’s Financial Performance
Factors 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.

29. Exhibit 10.7 Financial Ratio Analysis for Gilbert & Associates Leasing Company

30. Exhibit 10.8 Return on Assets: An Overview

31. Financial Forecasting
Pro 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?

32. Key Terms financial statements (accounting statements)
income statement (profit and loss statement)
cost of goods sold
gross profit
operating expenses
operating profits
profits before taxes (taxable profits)
net profits
depreciation expense
balance sheet
current assets
accounts receivable
inventory
fixed assets
depreciable assets
gross fixed assets
accumulated depreciation
net fixed assets
other assets
debt
current debt (short-term liabilities)
accounts payable (trade credit)
accrued expenses

33. Key Terms short-term notes long-term debt mortgage ownership equity
retained earnings
cash flow statement
accrual-basis accounting
cash-basis accounting
liquidity
current ratio
return on assets
operating profit margin
total asset turnover
debt ratio
return on equity