Chapter8

FinancialStatementsandFinancialStatementAnalysis8.1Financialstatements8.2Financialstatementanalysis28.1FinancialStatementsFinancialstatementsaretheprincipalmeansthroughwhichacompanycommunicatesitsfinancialinformationtostakeholders.Thischapterintroducesfourprimaryfinancialstatements:(1)theStatementofFinancialPosition(oftenreferredtoastheBalanceSheet),(2)theIncomeStatement;(3)theStatementofCashFlows;and(4)theStatementofChangesinOwners’Equity.Notedisclosuresareanintegralpartofeachfinancialstatement.38.1.1BalanceSheet1.ThePurposeofaBalanceSheetTheBalanceSheetisalsocalledtheStatementofFinancialPosition.Thepurposeofthisfinancialstatementistodemonstratewherethecompanystands,infinancialterms,ataspecificpointintime.Itreportstheassets,liabilities,andowners’equityofabusinessenterpriseattheendofaspecificdate.TheuseroftheBalanceSheetcanassessacompany’sliquidity,solvency,andfinancialflexibilitythroughtheinformationonassets,liabilities,and

Owners’equity.42.TheElementsofaBalanceSheetABalanceSheetincludesthreegeneralclassesofitems,assets,liabilities,andowners’equity.Assetscanbedividedintocurrentassetsandnon-currentassets.Currentassetsusuallyincludecash,short-terminvestments,receivables,andprepaidexpenses;convertingthemselvesintocashinoneyearorless.Non-currentassetsrequiremorethanoneyeartorealizetheirfullvaluetothecompany,suchaslong-terminvestments,property,plantandequipment,andintangibleassets.Liabilitiescanbedividedintocurrentliabilitiesandlong-termliabilities.Owners’equityincludescapitalstock,additionalpaid-incapital,and

retainedearnings.53.TheFormatofaBalanceSheetNormallytherearetwopresentationformatsofaBalanceSheet.Horizontalpresentation.Thispresentationformatlistsassets,bysections,ontheleftside,andliabilitiesandowners’equity,bysections,ontherightside.Withthisformat,asufficientlywidespaceisneededtopresenttheitemssidebyside.Itvisualizesthefactthatassetsequalliabilitiesplusowners’equity.Vertical

presentation.Thispresentationformatliststhesectionsoneabovetheother,onthesamepage.PleaserefertotheIllustration8-1showstheBalanceSheetofABCWineCompanyasofend-ofday,December31,2018.68.1.2IncomeStatement1.ThePurposeofanIncomeStatementAnIncomeStatementisafinancialstatementthatsummarizestheprofitabilityofabusinessentityforaspecifiedperiodoftime.Theprimarypurposeistohelpusersoffinancialstatements:(1)evaluatethepastperformanceofthecompany,(2)predictfutureperformance,and(3)assesstheriskoruncertaintyofachievingfuturecashflows.InformationintheIncomeStatementnotonlyhelpsusersevaluatepastperformance,butalsoprovidesinsightsintothelikelihoodofachievingaparticularlevelofcashflowsinthefuture.72.TheElementsofanIncomeStatementTheIncomeStatementclassifiesamountsintogrossprofitonsales,incomefromoperations,incomebeforetaxes,andnetincome.Netincomeresultsfromrevenue,expense,andgainandlosstransactions.Revenues,expenses,gains,andlossesarethemajorelementsoftheIncomeStatement.Revenuestakemanyforms,suchassales,interests,dividends,andrents.Expensesalsotakemanyforms,suchascostofgoodssold,depreciationexpenses,interests,salariesandwages,andtaxes.Gainsandlossesarealsoofmanytypes,resultingfromeventsthatarenotinthenormalcourseofbusiness,suchasthesaleofinvestmentsorplantassets,settlementofliabilities,write-offsofassetsduetoimpairmentsorcasualties.83.TheFormatofanIncomeStatementAsingle-stepIncomeStatementItconsistsofjusttwogroups:revenueandexpenses.Expensesaredeductedfromrevenuestoarriveatnetincomeornetloss.Theprimaryadvantage

liesinitssimplepresentationandtheabsenceofanyimplicationthatonetypeofrevenueorexpenseitemhaspriorityoveranother.AMultiple-stepincomestatementThis

formatofstatementseparatesoperatingtransactionsfromnon-operatingtransactions,andmatchescostsandexpenseswithrelatedrevenues.Itcoverssomeorallofthefollowingsectionsorsubsections:(1)Operatingsection;(2)Non-operatingsection;(3)Incometaxsection;(4)Discontinuedoperationssection;(5)Extraordinaryitemssection;and(6)Earningspershare.98.1.3StatementofCashFlows1.ThePurposeofaStatementofCashFlowsTheprimarypurposeistoprovideinformationaboutcashreceiptsandcashpaymentsforabusinessentityduringtheaccountingperiod.Thetermcashflowsincludesbothcashreceiptsandcashpayments.Informationaboutcashreceiptsandcashpaymentsisclassifiedintermsofthecompany’soperating

activities,investingactivities,and

financingactivities.Reportingthesources,uses,andnetincreaseordecreaseincashhelpsinvestors,creditors,andothersknowwhatwashappeningtoacompany’smostliquidresource,including:(1)wheredidthecashcomefromduringtheperiod?(2)whatwasthecashusedforduringtheperiod?

(3)whatwasthechangeinthecashbalanceduringtheperiod?102.TheContentofaStatementofCashFlowsTheStatementclassifiescashreceiptsandcashpaymentsduringaperiodintooperating,investing,andfinancingactivities.Operatingactivitiesincludethecasheffectsoftransactionsthatcreaterevenuesandexpensesinnormalcourseofbusiness.Thiscategoryisthemostimportant.Itshowsthecashprovidedbycompanyoperations,whichisgenerallyconsideredtobethebestmeasureofacompany’sabilitytogeneratesufficientcashtocontinueasagoingconcern.InvestingactivitiesIncludethecasheffectsoftransactionsinvolvingplantassets,intangibleassets,andinvestments.Financingactivities

involveliabilityandowners’equityitems.Theyinclude:(1)obtainingresourcesfromownersandprovidingthemwithareturnontheirinvestments,and(2)borrowingmoneyfromcreditorsandrepayingtheamountsborrowed.113.DirectandIndirectMethodTherearetwomethodstopreparenetcashflowsfromoperatingactivities:directmethodandindirectmethod.(1)DirectmethodThedirectmethodreportscashreceiptsandcashpaymentsfromoperatingactivities.Thedifferencebetweenthetwoamountsisthenetcashflowsfromoperatingactivities.(2)IndirectmethodTheindirectmethodstartswithnetincomeandconvertsittonetcashflowsfromoperatingactivities.Tocomputenetcashflowsfromoperatingactivities,acompanyaddsbacknoncashchangesintheIncomeStatementtonetincomeanddeductsnoncashreductions.128.1.4StatementofChangesinOwners’EquityTheStatementreportsthechangesduringtheyearinalloftheowners’equityaccounts.Itincludes(1)thebeginningbalanceofeachmajorcategoryofowners’equity;(2)additions;(3)deductions;and(4)balanceattheendoftheperiod.Companiesmustdisclosechangesintheseparateaccountscomprisingowners’equitytomakethefinancialstatementssufficientlyinformative.138.1.5NotestotheFinancialStatementNotestothefinancialstatementsarethemeansofexplainingtheitemspresentedinthemainbodyoffinancialstatements.Notesdiscloseinformationusefulininterpretingthestatementsandareanintegralpartofthefinancialstatements.Notescanexplaininqualitativetermsinformationpertinenttospecificfinancialstatementitems.Theycanalsoprovidesupplementarydataofaquantitativenaturetoexpandtheinformationinthefinancialstatements.Inaddition,notes

canexplainrestrictionsimposedbyfinancialarrangementsorbasiccontractualagreements.14Manyitemsaredisclosedinnotesaccompanyingthefinancialstatements.Amongthemostusefularethefollowings:(1)Accountingpoliciesandmethods;(2)Unusedlinesofcredit;(3)Significantcommitmentsandlosscontingencies;(4)Dividendsinarrears;(5)Assetspledgedtosecurespecificliabilities;and(6)Changesinaccountingpoliciesandmethods.158.2FinancialStatementAnalysisFourbasictoolsinfinancialstatementanalysistohighlightthesignificanceoffinancialstatementdata:(1)percentagechangeanalysis;(2)trendchangeanalysis;(3)componentspercentageanalysis;and(4)ratioanalysis.168.2.1PercentageChangeAnalysisPercentagechangeanalysisisusedtoevaluateandcomparecompanies.The

percentagechangeiscomputedbydividingthedollaramountofchangefromabaseyeartoacomparisonyearbytheamountforthebaseyear.Themeasurementofchangefromperiod-to-periodinpercentageindicatestheproportionatechangeoveraperiodoftime.Itisespeciallyusefulinevaluatingtrendsasabsolutechangesareoftendeceptive.178.2.2TrendChangeAnalysisTrendchangesarethechangesinfinancialstatementitemsfromabaseyeartothefollowingorprecedingyears.Tocomputetrendchange,abaseyearisfirstlyselectedandeachiteminthefinancialstatementsforthebaseyearisgivenaweightof100percent.Then,eachiteminthefinancialstatementsforthefollowingorprecedingyearsisexpressedasapercentageofthebase-yearamount.188.2.3ComponentPercentageAnalysisComponentpercentageanalysisistheproportionalexpressionofeachfinancialstatementiteminagivenperiodtoabaseamountwithinthefinancialstatement.198.2.4RatioAnalysisRatioanalysisisawidelyusedmethodtoevaluatethefinancialhealthandperformanceofacompany.Aratioisanumberexpressedasapercentageofarelatednumber.Ratioscanbeclassifiedinto:(1)liquidityandsolvencyratios;(2)profitabilityratios;and(3)efficiencyratios.201.LiquidityandSolvencyRatiosLiquidityratiosmeasureacompany’sshort-termabilitytopayitsmaturingobligations.Short-termcreditorsandpotentialcreditors,suchasbankersandsuppliersareparticularlyinterestedinassessingliquidity.Solvencyratiosmeasureacompany’sabilitytosurviveoveralongerperiodoftime.Long-termcreditorsandpotentialcreditorsareinterestedinacompany’s

long-runsolvency.21Liquidityratiosincludeworkingcapital,currentratio,quickratio,andcurrentcashdebtcoverageratios.Solvencyratiosincludedebtratio,timesinterestearned,cashdebtcoverageratio,andfreecashflow.

(1)Workingcapital(adollaramount,notaratio)Workingcapitalistheexcess(orshortage)ofcurrentassetsneededtopaycurrentliabilities.Itexpressestherelationshipbetweencurrentassetsandcurrentliabilities,andmeasuresacompany’sabilitytosatisfyitscurrentliabilitiesfromitsexisting,liquidassets.22(2)CurrentratioItisawidelyusedratiotomeasureacompany’sshort-termdebt-payingability.Itiscomputedbydividingtotalcurrentassetsbytotalcurrentliabilities.23(3)Quickoracid-testratioItiscomputedbydividingquickassetsbytotalcurrentliabilities.Quickassetsincludecash,marketablesecurities,andreceivablesduewithinoneyear.

Inventoryandprepaidexpensesarenotquickassets.(4)CurrentcashdebtcoverageratioTheratioindicatesacompany’sabilitytopayoffitscurrentliabilitiesfromitsnormaloperationsinagivenyear.Thisratioiscomputedasthenetcashprovidedbyoperatingactivitiesdividedbyaveragecurrentliabilities.Averagecurrentliabilitiesarecomputedbyaddingthebeginningandendingvaluesofcurrentliabilitiesanddividingthetotalbytwo.24(5)DebtratioDebtratioisameasureofcreditors’long-termrisk.Fromthecreditors’pointofview,acompanywithalowerdebtratioisconsideredlessriskybecauseitisobligatedtorepaysmalleramountsofdebts,henceitsfinancialpositionissafer.Debtratioiscomputedbydividingtotalliabilitiesbytotalassets.2526(6)TimesinterestearnedItisameasureofrisktolong-termcreditors.Itindicatesacompany’sabilitytomeetitsinterestpaymentsastheycomedue.Itiscomputedbydividingincomebeforeincometaxesandinterestexpensebyinterest.(7)CashdebtcoverageratioTheratioindicatesacompany’sabilitytopayoffitstotalliabilitiesfromitsnormaloperationsinagivenyear.Itisusedtodeterminehowlongitwilltakeacompanytorepayitsdebtsifitdevotesallofitscashflowstodebtrepayment.Itiscomputedasthenetcashprovidedbyoperatingactivitiesdividedbyaveragetotalliabilities.Averagetotalliabilitiesarecomputedbyaddingthebeginningandendingvaluesoftotalliabilitiesanddividingthetotalbytwo.27(8)Freecashflow(adollaramount,notaratio)Freecashflowisausefulratiotomeasureacompany’sfinancialflexibility.Itdescribesthecashremainingfromoperatingactivitiesafterthedeductionsforcapitalexpendituresandcashdividendspaid.282.ProfitabilityRatiosProfitabilityratiosmeasurethedegreeofsuccessorfailureofacompanyinagivenyear.Equityinvestorsandmanagementaregreatlyinterestedinthemeasuresofacompany’sprofitabilityratios.Usuallythekeyratiosincludegrossprofitratio,profitmarginonsales,returnonassets,returnonequity,return

oninvestment,earningspershare,price-earningsratio,andpayoutratio.29(1)GrossprofitratioGrossprofitratioiscomputedbydividinggrossprofitbynetsales.Gross

profit(alsoknownasgrossmargin)isthedifferencebetweennetsalesandthecostofgoodssold.3031(2)ProfitmarginonsalesProfitmarginonsalesiscomputedasdividingnetincomebynetsales.Net

incomeisthedifferencebetweennetsalesandallexpenses(includingcostofgoodssold).Acompanycanimproveitsprofitmarginonsalesbyincreasingitsgrossprofitrateand/orbycontrollingitsoperatingexpenseandotherexpenses.(3)Returnonassets(ROA)ROAistherateofreturnacompanyachievesthroughtheuseofitsassets.Thisisanoverallmeasureofacompany’sprofitability,indicatingtheamountofnetincomegeneratedbyeachdollarofassets.AhigherROAindicatesacompanywithbetterprofitability.ROAiscomputedbydividingnetincomebyaveragetotalassets.Averagetotalassetsarecomputedbyaddingthebeginningandendingvaluesoftotalassetsanddividingthetotalbytwo.32(4)Returnoncommonowners’equity(ROE)ROEisawidelyusedratethatmeasuresacompany’sprofitabilityfromcommonstockholders’viewpoint.Itshowstheamountofdollarsinnetincomethatacompanyearnedforeachdollarinvestedbycommonowners.ROEequalsnetincomelesspreferreddividends,dividedbyaveragecommonowners’equity.Averagecommonowners’equityiscomputedbyaddingthebeginningandendingvaluesoftotalcommonowners’equityanddividingthetotalbytwo.33(5)Earningspershare(EPS)EPSisoneofthemostwidelyusedfinancialratiosanditshowsthedollarsearnedbyeachshareofcommonstock.EPSequalsnetincomelesspreferreddividends,dividedbyweighted-averagenumberofsharesoutstandinginthesameyear.Theweighted-averagenumberofsharesoutstandingfortheyearisdeterminedbymultiplyingthenumberofsharesoutstandingbythefractionoftheyearinwhichthenumberofsharesoutstandingremainedunchanged.34(6)Price-earningsratio(P/Eratio)Theprice-earningsratio(P/Eratio)showsinvestors’assessmentofacompany’sfutureperformance.Ifinvestorsareoptimisticaboutacompany’sfutureearnings,the

ratiowillbehigher.Astockpricebyitselfisnotusefultocomparetoothercompanies.But,theP/Eratioisavalidwaytocomparecompanies.P/Eratioiscomputedbydividingthecurrentmarketpricepershareofacompany’sstockbyitsannualEPS.35(7)PayoutratioPayoutratioistheratiothatmeasuresthepercentageofearningsacompanydistributesinthe