FINANCIAL MANAGEMENT_INCOME STATEMENT.pptx

FINANCIAL MANAGEMENT FINANCIAL STATEMENTS Financial Statements Understanding the financial health of a business by reviewing its financial statements is also important to the financial manager, whose goal is to determine how to increase the value of the firm. Basic Financial Statements The accountin...

FINANCIAL MANAGEMENT FINANCIAL STATEMENTS Financial Statements Understanding the financial health of a business by reviewing its financial statements is also important to the financial manager, whose goal is to determine how to increase the value of the firm. Basic Financial Statements The accounting and financial regulatory authorities mandate that firms provide the following four types of financial statements: 1. Income Statement—includes the revenues the firm has earned, the expenses it has incurred to earn those revenues, and the profit it has earned over a specific period of time, usually a quarter of a year or a full year. 2. Balance Sheet—contains information as of the date of its preparation about the firm’s assets (everything of value the company owns), liabilities (the company’s debts), and stockholders’ equity (the money invested by the company owners). As such, the balance sheet is a snapshot of the firm’s assets, liabilities, and stockholders’ equity for a particular date. 3. Cash Flow Statement—reports cash received and cash spent by the firm over a specific period of time, usually a quarter of a year or a full year. 4. Statement of Shareholders’ Equity—provides a detailed account of activities in the firm’s common and preferred stock accounts and its retained earnings account and of changes to shareholders’ equity that do not appear in the income statement Why Study Financial Statements? Analyzing a firm’s financial statements can help managers carry out three important tasks: assess current performance, monitor and control operations and plan and forecast future performance. 1. Financial statement analysis. The basic objective of financial statement analysis is to assess the financial condition of the firm being analyzed. In a sense, the analyst performs a financial analysis so he or she can see the firm’s financial performance the same way an outside investor would see it. 2. Financial control. Managers use financial statements to monitor and control the firm’s operations. The performance of the firm is reported using accounting measures that compare the prices of the firm’s products and services with the estimated costs of providing them to buyers. Moreover, the board of directors Why Study Financial Statements? Analyzing a firm’s financial statements can help managers carry out three important tasks: assess current performance, monitor and control operations and plan and forecast future performance. 3. Financial forecasting and planning. Financial statements provide a universally understood format for describing a firm’s operations. Consequently, financial planning models are typically built using the financial statements as a prototype. What Are the Accounting Principles Used to Prepare Financial Statements? Accountants use three fundamental principles when preparing a firm’s financial statements: the revenue recognition principle, the matching principle, and the historical cost principle. Understanding these principles is critical to a full and complete understanding of what information is reported in a firm’s financial statements and how that information is reported. Much of the accounting fraud that has occurred in the United States can be traced back to violations of one or more of these basic principles of accounting. What Are the Accounting Principles Used to Prepare Financial Statements? 1. The revenue recognition principle. This principle provides the basis for deciding what revenues—the cumulative dollar/peso amount of goods and services the firm sold to its customers during the period—should be reported in a particular income statement. The principle states that revenues should be included in the firm’s income statement for the period in which (a) its goods and services were exchanged for either cash or accounts receivable (credit sales that have not yet been collected) or (b) the firm completed what it had to do to be entitled to the cash. As a general rule, a sale can be counted only when the goods sold leave the business’s premises en route to the customer. The revenue recognition principle guides accountants when it is difficult to determine whether revenues should be reported in one period or another What Are the Accounting Principles Used to Prepare Financial Statements? 2. The matching principle. This principle determines what costs or expenses can be attributed to a specific period’s revenues. Once the firm’s revenues for the period have been determined, its accountants then determine the expenses for the period by letting the expenses “follow” the revenues, so to speak. For example, employees’ wages aren’t recognized when the wages are paid or when their work is performed but when the product produced as a result of that work is sold. Therefore, expenses are matched with the revenues they helped to produce What Are the Accounting Principles Used to Prepare Financial Statements? 3. The historical cost principle. This principle provides the basis for determining the dollar/peso values the firm reports on the balance sheet. Most assets and liabilities are reported in the firm’s financial statements on the basis of the price the firm paid to acquire them. This price is called the asset’s historical cost. This may or may not equal the price the asset might bring if it were sold today. The Income Statement An income statement, also called a profit and loss statement, measures the amount of profits generated by a firm over a given time period (usually a month or year or a quarter). In its most basic form, the income statement can be expressed as follows: Revenues (or Sales) - Expenses = Profits Revenues represent the sales for the period. Profits are the difference between the firm’s revenues and the expenses it incurred in order to generate those revenues for the period. Recall that revenues are determined in accordance with the revenue recognition principle and expenses are then matched to these revenues using the matching principle. The Income Statement H.J. Boswell, Inc. Income Statement For the Year Ended December 31, 2016 (in $ Millions) The Income Statement 1. Revenues (or Sales). Boswell’s revenues totaled $2,700 million for the 12-month period ended December 31, 2016. 2. Cost of Goods Sold. Next, we see that the various expenses the firm incurred in producing revenues are broken down into various subcategories. For example, the firm spent $2,025 million on cost of goods sold, the cost of producing or acquiring the products or services that the firm sold during the period. 3. Gross Profit. Subtracting cost of goods sold from revenues produces the firm’s gross profit of $675 million. 4. Operating Expenses. Next, we examine Boswell’s operating expenses (this includes the salaries paid to the firm’s administrative staff, the firm’s electric bills, and so forth). One of the operating expense categories is depreciation expense ($135 million for Boswell in 2016). Depreciation expense is a noncash expense used to allocate the cost of the firm’s long-lived assets (such as its plant and equipment) over the useful lives of these assets. For example, suppose that, during 2016, Boswell built a new distribution facility in Temple, Texas, at a cost of $10 million. The firm would not expense the full $10 million against 2016 revenues; instead, it would spread out the costs over many years to match the revenues created with the help of the facility. 5. Net Operating Income. After deducting $292.50 million in operating expenses, Boswell’s net operating income is $382.50 million. The firm’s net operating income shows us the firm’s ability to earn profits from its ongoing operations—before it makes interest payments and pays its taxes. For our purposes, net operating income will be synonymous The Income Statement 6. Interest Expense. To this point, we have calculated only the profit resulting from operating the business, without regard for any financing costs, such as the interest paid on money the firm might have borrowed. In this instance, Boswell incurred interest expense equal to $67.50 million during 2016. 7. Earnings Before Taxes. Now we can subtract Boswell’s interest expense of $67.50 million from its net operating income of $382.50 million to determine its earnings before taxes (also known as taxable income). Boswell’s earnings before taxes are $315 million. 8. Income Taxes. Next, we determine the firm’s income tax obligation. We will show how to calculate the tax obligation later in this chapter. For now, note that Boswell’s income tax obligation is $110.25 million. 9. Net Income. The income statement’s bottom line is net income, which is calculated by subtracting the firm’s tax liability of $110.25 million from its earnings before taxes of $315 million. This leaves net income of $204.75 million Constructing an Income Statement STEP 1: Picture the problem The income statement can be visualized as a mathematical equation using Equation as follows: Revenues - Expenses = Profit Constructing an Income Statement Constructing an Income Statement