Chapter 3-Income Statements and Balance Sheets

Understanding Financial

Statements

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Agenda

● Review accounting basics to understand

the information on your financial statements

● Understand how to read and analyze your:

● Income statement

● Balance sheet

“ No one can advise you on how to manage

your business without first reviewing and
understanding your financial statements.”

What are financial statements?

The summarized results of your business
financial transactions over a designated period
of time.

They will show total income, expenses, cash
balances, level of debt, and much more.
But where does this information come from?

Multiple Choice

This document is known as what?

• Account Equation

• Balance Sheet

• Income Statement

• Bank Statement

Multiple Choice

This document communicates what the entity owns in terms of assets, what it owes in the terms of liabilities, and the difference between those two which represents what the owners of the company are entitled to.

• Income Statement

• Balance Sheet

Accounts

Accounts are the categories into which the

effects of transactions are recorded, and from

which financial reports are created.

5 major account categories:

Income

Proceeds
from sales

Expenses

Costs of
operation

Assets

What you

own

Liabilities

What you

owe

Equity

Net worth /

level of

investment

Operations

Financial Position

Multiple Choice

Savings accounts and a home are examples of

• liabilities

• assets

• net worth

• cash outflow

Multiple Choice

Which one is right?

• Asset = Owner's equity + Liability

• Asset = Owner's equity - Liability

• Asset + Owner's equity = Liability

• Asset + Owner's equity = expense

Multiple Choice

Examples of assets include:

• Real Property, Car, and credit cards

• Car, Jewelry, and Checking account

• Art collection, Jewelry, and unpaid taxes

• Real Property, Car loan, Jewelry

Multiple Choice

Examples of Liabilities include which of the following:

• Loans, credit cards, and real property

• Loans, mortgage, and credit cards

• Loans, Art collection, and savings account

• Mortgage, credit card, and real property

Multiple Choice

Current Assets are cash or other assets that are expected to be converted to cash within a year

• True

• False

Chart of Accounts

Sample Income accounts

● Sales revenue

● Other income

Sample Expense accounts

● Rent

● Cost of Goods Sold (COGS)

● Marketing

● Office supplies

● Payroll

● Professional fees

Sample Asset accounts
Current assets

● Cash

● Inventory

● Accounts receivable

Fixed assets

● Equipment

● Property

Sample Liability
accounts

● Accounts payable

● Credit card payable

● Loan payable

Sample Equity
accounts

● Owner’s equity

● Retained earnings

Financial Statements

Income Statement*

Balance Sheet*

Statement of Cash Flow

* today’s class will focus on the income statement and

balance sheet

Income Statement /
Profit & Loss Statement (P&L)

My company Income Statement
For the month of August 2008
Income

Sales revenue

$2,000

Expenses

rent

$ 850

utilities

75

payroll

400

insurance

25

marketing 250

Total expenses

1,600

Profit/Loss

$400

• Shows the performance of your
business over a period of time

• Resets at the beginning of each
new accounting period

• Summarizes all revenue generated
by the business

• Summarizes all expenses incurred
by the business (by category)

• Calculates the net profit or loss, or
“bottom line” = Income – Expenses

• Tells you how well your business is
operated

Multiple Choice

The Income Statement lists a business

• Assets and Expenses

• Owner's Equity and Revenue

• Revenue and Expenses

• Expenses and Net Assets

Multiple Choice

Examples may include salaries, utilities, rent, insurance, and office supplies.

• Revenue

• Expense

• Net Income

• Net Loss

Reviewing your income
statement

● How is your revenue trending?

●
Month-to-month

●
Against same period last year (considers seasonality)

● How are your expenses trending?

● What are your highest categories of expenses?

● Which expenses are fixed vs. variable?

● What is your cost of goods sold?

● How do your expenses (as a % of sales) compare to

others in your industry?

Multiple Choice

Which of the following means money received?

• net loss

• net gain

• insurance

• income

Multiple Choice

An accounting report that is used to show revenue and expenses is the

• Loss and Profit Statement

• Reveune and Expenses Statement

• The Profit or Loss Statement

• The Income Statement

Multiple Choice

The Qualitative characteristics that need to be considered when preparing an Income Statement are...

• comparability and understandability

• relevance and reliability

• relevance and understandability

• comparability and relevance

Reviewing your income
statement will tell you…

● Are you profitable?

● What’s your profit margin?

● Profit / Sales

● What’s your gross profit margin?

● (Sales – COGS) / Sales

Multiple Choice

Profitability is....

• Revenue less expenses

• When a business makes a profit

• a comparison of profit earned with an investment made

• when revenue is higher than expenses

Multiple Choice

COGS stands for

• cost of goods sales

• cost of goods serviced

• cost of goods sold

Multiple Choice

The difference between sales and Gross profit is

• cost of sales

• cost of goods sold

• adjusted gross profit

• gross profit

Multiple Choice

Gross profit is calculated by...

• Revenue - Total Costs

• Revenue + Variable Costs

• Revenue - Cost of Sales

• Revenue - Fixed Costs

Multiple Choice

Cost of sales is calculated by...

• Opening stock + purchases - closing stock

• Opening stock + purchases + closing stock

• Adding up all of the stock bought during the year

• Opening stock - closing stock

Multiple Choice

An Income Statement is

• A formal way of listing sales and expenses for the year.

• Another word for 'Gross Profit'

• Same as the Cash Flow Statement

• None of the above.

Multiple Choice

Net profit is

• Assets less Liabilities

• Revenue less Expenses

• Revenue less Liabilities

• Liabilities less Assets

Multiple Choice

The Income Statement lists a businesses:

• Assets and Expenses

• Owner's Equity and Revenue

• Revenue, cost of goods and Expenses

• Expenses and Net Assets

Multiple Choice

What is the purpose of an income statement?

• calculate the bank balance

• calculate net assets

• calculate sales

• calculate net profit

Balance sheet

My company Balance Sheet

As of August 31, 2011

Assets:
Cash 5,000
Accounts Receivable 600
Inventory 900
Equipment 1,000

Total Assets 7,500

Liabilities:
Accounts Payable 900
Loan Payable 3,500

Total Liabilities 4,400

Equity:
Owner’s equity 2,700
Retained earnings 400

Total Equity 3,100

• Shows a snapshot of your business at a point in time

• Accumulates over the lifetime of your business

• Shows the net worth of your business

• The balance sheet always balances ASSETS – LIABILITIES = EQUITY

Multiple Choice

What is a balance sheet?

• A financial statement

• An annual overview

• A bank slip

• All of these

Multiple Choice

What do liabilities tell us?

• How much of the company's wealth does not belong to us

• None of the mentioned

• How many assets we have

Multiple Choice

What is balance sheet?

• A balance sheet is a financial statement that reports a company's assets, liabilities and shareholders' equity at a specific point in time, and provides a basis for computing rates of return and evaluating its capital structure.

• A Balance sheet is one of a company's core financial sheet that shows their profit and lossProfit and Loss

Multiple Choice

Property owned by an individual

• Liability

• Asset

• Property

• Net Worth

Multiple Choice

Examples of Liabilities include which of the following:

• Loans, credit cards, and real property

• Loans, mortgage, and credit cards

• Loans, Art collection, and savings account

• Mortgage, credit card, and real property

Multiple Choice

Select the item which is not a component of a balance sheet.

• Fixed Assets

• Current Assets

• Current Liabilities

• Expenses

Multiple Choice

What period of time does a balance sheet cover?

• One quarter

• One moment in time

• One year

• One tax year

Link between balance sheet
and income statement

Profit or loss is taken from the bottom line of the income statement and
recorded on the balance sheet in the Retained Earnings equity account.
Retained earnings accumulate over the life of the business.

●When a business operates at a profit, it increases in equity (is worth more)

●When a business operates at a loss, it decreases in equity (is worth less)

Reviewing your balance sheet

●
Liquidity: Can your company meet its payment obligations?

●
Cash balance

●
Working capital: Current assets – Current liabilities

●
Current ratio: Current assets / Current liabilities

●
Cash flow management

●
How much inventory do you have? How fast are you selling it?

Is your inventory on the shelf collecting dust and interest?
Are you doing physical inventories monthly, annually, never?

▪Inventory turns: (COGS / Inventory balance)

●
How high is your accounts receivable balance?
How quickly are you collecting it?

▪Days sales outstanding: (AR / Sales) * # of days in period

Multiple Choice

Which ONE of the following relates to the ability of a business to pay its debts as they fall due?

• growth

• liquidity

• efficiency

• profitability

Multiple Choice

State the following statement is True or False.

Ratios help in comparisons of a firm’s results over a number of accounting periods as well as with other business enterprises.

• True

• False

Multiple Choice

The _________ of business firm is measured by its ability to satisfy its short term obligations as they become due:

• Activity

• Liquidity

• profitability

• Solvency

Multiple Choice

The two basic measures of liquidity are:

• inventory turnover and current ratio

• current ratio and acid test ratio

• gross profit Ratio and operating ratio

• current ratio and average collection period

Reviewing your balance sheet

● Debt management

● What are your total debt obligations?

● What is your total equity in the business?

● How leveraged is your company?

● Debt-to-equity ratio: Total liabilities / Total equity

Double-entry accounting

Every business transaction will affect at least two
accounts. If only one side of the entry is done, the
accounting system will become out-of-balance.

Example: You write a check to the newspaper for $100
to place an advertisement.

●
Your cash account is reduced by $100

●
Your marketing expense account is increased by $100

Multiple Choice

Customers that buy goods from us on credit are referred to as __________.

• Debtors

• Creditors

• Customers

• None of the above

Accounting methods

Cash-based accounting

●
You record transactions when payment is made or received
(cash exchanges hands), not when the business event
occurs

Accrual-based accounting

●
You record transactions when the business event occurs,
regardless of whether payment has yet been made or
received

●
Accounts payable and accounts receivable accounts are
used

Multiple Choice

Term to describe the amount of an expense due in an accounting period which is unpaid at the end of that period

• Prepayment

• Expense

• Accrual

• Unpaid income

Multiple Choice

Accrual Basis

• Method of accounting in which all bills and debts are paid on the same day every month

• Method of accounting that recognizes revenue and expenses when they are earned, rather than when collected

• Method of accounting that recognizes recurring revenue and expenses for the year as one cumulative transaction within the first quarter

Multiple Choice

Liability

• Having money or goods that belong to another entity in one’s possession

• Funds that a borrower must keep on deposit as required by a bank

• Debts or obligations owed by one entity (debtor) to another entity (creditor) payable in money, goods, or services

Multiple Choice

GAAP

• Generally accepted accounting principles

• General accounting acumen practice

• Global accounting asset performance

Multiple Choice

Captial

• The ratio of net income to total assets

• The specific, pre-determined amount needed to open a contra account

• The amount invested in a proprietorship, partnership or corporation by its owners

Multiple Choice

Fiscal year

• 12 consecutive months chosen by an entity as its annual accounting period

• The period between January 1 and December 31 by which all organizations must keep their accounting cycle

• The first year a going concern turns a profit

Multiple Choice

A cash flow statement shows an overview of money flowing in and out of a company

• True

• False

Analyzing financial statements

To obtain optimal management information from the
numbers on your financial statements, they should not just
be looked at alone, but compared against other numbers.

To know if your numbers are “good,” you must compare
them to:

●
Your expectations and needs (budget-to-actual)

●
Your competitors and industry norms (benchmarking)

●
Historical performance (trending)

●
Each other (ratios)

Other management reports

There are many other management and financial reports you
may find useful for managing your business that provide more
detail for income statement and balance sheet accounts, such
as:

●
Sales revenue by customer

●
Sales revenue by product

●
Unpaid invoices

●
Accounts receivable by customer

●
Accounts receivable aging

●
Expenses by vendor