Understanding the Numbers: Essential for the Entrepreneur

A Student Tutorial

Ever thought or said:

I did not do well in my accounting and finance classes . I just am not good with numbers Finance scares me. I try, but I just cant get it. If not, great, but if so, you may try to avoid accounting and finance. Why is that a mistake?

Reasons to Learn Finance

There are things you cannot learn about a company any other way. If you do not understand financial statements and what they tell you, you will be missing some critical information about the firm. And hiring someone to do it for you, DOES NOT WORK!!

Understanding Financial Statements

Goal: Understand the financial consequences of decisions There are three basic financial (or accounting) statements: Income Statement Balance Sheet Cash Flow Statement
The Goal: Making Good Financial Decisions

3 types of financial statements

Income Statement (1)

Indicates the firms profits over a period of time Usually monthly, quarterly or annually Basic form:
Sales
(Revenues) Basic purpose and format of an income statement

Expenses

Profits

Income Statement (2)

The Income Statement starts with sales (revenues).
Sales (Revenue)
minus

= # of units sold X sales price per unit

Can you compute gross profits?

Cost of Goods Sold

equals

Gross Profit

From Sales, subtract the Cost of Goods Sold to obtain the Gross Profit

Income Statement (3)

What is cost of goods sold?
Cost of goods sold is determined by:
The cost of producing or acquiring a single unit of the firms products or services The number of units sold
Cost of goods sold
= cost per unit X
Computing cost of goods sold

number of units sold

Income Statement (4)

Next compute operating income (earnings before interest & taxes)
Sales Revenue
minus

Cost of Goods Sold

equals

Gross Profit
minus

Operating Expenses
equals

From Gross Profits subtract Operating Expenses to obtain Operating Income

Can you compute operating income; also called earnings before interest and taxes (EBIT)?

Operating Income

Income Statement (5)

What are operating expenses?
In addition to the cost of goods sold, you need to convince someone to buy what you are selling. So, you will have; Marketing expenses

And you have operating overheadthe light bill must be paid. So, you will have:
General & administrative expenses

Operating expenses include marketing expenses, G&A, and depreciation

And if you have equipment and buildings. You will have:

Depreciation expense

(More will be said about depreciation later.)

Income Statement (6)

A Comment on Operating Income
Operating Income is the total profit a firm makes from running the business before paying creditors (interest expense) for the use of debt, and paying income taxes to the government. Operating income is the best profit indicator of how well a company is doing in its business.

Income Statement (7)

Next we compute earnings before taxes (EBT) From Operating Income, subtract Interest Expense to obtain Earnings Before Taxes
Operating Income
minus

Can you compute earnings before taxes?

Interest Expense
equals

Earnings Before Taxes

Income Statement (8)

Interest Expense: The Cost of Borrowing Money
A lender charges interest to loan money, which is shown as interest expense in the income statement of the borrower. Interest expense is the result of the interest rate and the amount borrowed.
Interest Rate

You have to pay the banker to use the banks money!!

Amount Borrowed

Interest Expense

Income Statement Earnings Before Taxes: (9)

Computing Earning Before Taxes: = Operating Income Interest Expense An Illustration
= $15,000 - ($50,000 X .06) = $15,000 - $3,000 = $12,000 If a firm has: $15,000 in operating income and $50,000 in debt at a 6% interest rate, then: Operating Income $ 15,000 Interest Expense $ 3,000

Computing a firms earnings before taxes

The Earnings before taxes is:

$ 12,000

Income Statement (10)

Finally, we calculate net income
Can you compute net income?

From Earnings Before Taxes subtract Income Taxes to obtain the Net Income

Operating Income
minus

Interest Expense
equals

Earnings Before Taxes

minus

Income Taxes
equals

Net Income

Net Income:

Income Statement (11) (Earnings before taxes)-(Tax rate)*(Earnings Computing Net Income Illustrated before taxes)
$12,000 - (25%)*($12,000) =

$12,000 - $3,000 = $9,000

If a firm has:
Computing income taxes to find net income

Operating Income of $15,000 Earnings before taxes of $12,000 And pays 25% on income taxes. The Net income is: $ 9,000

Income Statement (12)

What have we learned about the income statement?
Sales Revenue
Operating Activities
Financing Activities

Operating Income
minus

minus

Cost of Goods Sold

equals

Interest Expense
equals

Gross Profit
minus

Earnings Bef Taxes

minus

DO NOT continue until you know and understand the format and content of an income statement.

Operating Expenses
equals

Income Taxes
equals

Operating Income

Net Income

Income Statement (13) An Example

The Income Statement for Trimble & Associates:
Sales Cost of Goods Sold Gross Profit on Sales Operating Expenses: Marketing Expenses 90 General & Admin Expenses 80 Depreciation 30 Total Operating. Expenses Operating Income Interest Expense Earnings Before Tax Income Tax (25%) Net Income $850 550 $300

Cost of borrowing Income from operating the business Income after \paying interest

$200 100 20 80 20

60

Income Statement (14) Summary

The Income Statement answers the question: How profitable is the business? The Income Statement reports on five broad areas: Sales (Revenue) Costs of producing or acquiring the firms goods or services Operating Expenses Financing costs (interest expense) Tax payments

Income Statement (15) Can You Put It Together?

Organize this Income statement
Gross Profit on Sales Operating Expenses: $
Cost of Goods Sold $250 Admin. &Sales Exp. $ 18

Put the pieces where they go!!

4. Good judgment

Depreciation

$
$

8
6

Total Op. Exp. Operating Income

$ $

Interest Expense Sales

$290 2

Earnings Before Taxes $ Net Income $

Income Taxes(25%) $

Here You Go!

Cost of Goods Sold $250 Admin. &Sales Exp. $ 18

Gross Profit on Sales Operating Expenses:

$ 40

Depreciation

$
$

8
6

Total Op. Exp. Operating Income

$ 26 $ 14 8 6

Interest Expense Sales

$290 2

Earnings Before Taxes $ Net Income $

Income Taxes(25%) $

Income Statement (16) A Concluding Thought

Congratulations!! You should be able to understand the income statement and what it is telling you. We are now ready to examine the balance sheet, which measures the firms current financial position. Lets continue.

Balance Sheet (1)

A Snapshot of a companys financial position at a specific point in time
The Income Statement covers a period in time (Jan 1 Dec 31, 2007) The Balance Sheet represents a specific moment (December 31, 2007) Total assets always equal debt plus equity.

In its simplest form, the Balance Sheet is:

Total Assets Outstanding Debt
Owners Equity

Debt & Equity

Balance Sheet (2)

Three main parts Assets
What the company owns
Basic pieces of the balance sheet

Liabilities (Debt)
What the company owes

Owners Equity (Net Worth)

The amount invested by the owners (stockholders) The difference between Assets and Liabilities
Continue

Balance Sheet (3)

Three main parts
Total Assets, the sum of:
Current Assets (Cash, A/R, Inventory) Fixed Assets (Machinery and equipment, Buildings, Land) Other Assets (Long-term investments, Patents)

A look inside the balance sheet

-Cash Flow 2. Forecast 3. Determine and evaluate 4. Good judgment

Debt and Equity, the sum of:

Total Debt, including:
Current debt (Accounts payable, Accrued expenses, Short-term notes) Long-term debt (Long-term notes, Mortgages)

Owners equity: owners investment in the company

Balance Sheet (4)

Assets: Current Assets
Current assets are also called gross working capital Current assets comprise the assets that are relatively liquid
Cash Accounts Receivable Inventories Other current assets (e.g., prepaid expenses)
Current assets: the firms liquid assets; includes cash and assets that can soon be converted into cash

Balance Sheet (5)

Assets: Fixed Assets
Fixed assets include:
Machinery and Equipment Buildings and Land
Fixed assets may also be called plant & equipment

The cost of a fixed asset is recorded in the balance sheet and depreciated over its useful life.
The Income Statement reports the depreciation expense for each year. The Balance Sheet reports the accumulated depreciationdepreciation taken on an asset over all its life.

Balance Sheet (6)

Depreciating Fixed Assets
Remember that
When a fixed asset is purchased, the firm pays cash, and so:
Fixed assets increase in the balance sheet. Cash decreases in the balance sheet.
Depreciation expense is NOT a cash expense!!!

But the depreciation expense is NOT a cash event.

Depreciation expense is recorded in the income statement Accumulated depreciation increases in the balance sheet There is NO cash involved!!

Balance Sheet (7)

Gross Versus Net Fixed Assets
Gross Fixed Assets is the original amount paid for a firms fixed assets. Net Fixed Assets is the gross fixed assets minus the total depreciation (accumulated depreciation) taken on the fixed assets. That is,
Gross fixed assets accumulated depreciation net fixed = assets
So: net fixed assets = gross fixed assets accumulated depreciation

Balance Sheet (8)

An Example of Depreciation
You purchase equipment for $10,000 with an expected life of 5 years. How much will the depreciation expense be each year, as reported in the income statement? $2,000 ($10,000 5 years = $2,000) What will the balance sheet look like over the 5 years?
End of Year 1 2 3 4 5 Gross fixed assets $10K $10K $10K $10K $10K Accumulated depre 2K 4K 6K 8K 10K Net fixed assets $8K $6K $4K $2K $0K

Balance Sheet (9)

Assets: Other Assets
Other assets includes intangibles, such as: Patents Copyrights Goodwill And for a start-up company: Organizational costs
The firms other assets

Balance Sheet (10)

Debt And Equity
Remember
Total Assets Outstanding Debt Owners Equity Total assets MUST equal total debt plus owners equity

Debt & Equity

Balance Sheet (11)

Debt or Liabilities
Debt is financing provided by a creditor Debt is divided in two parts: Current debt or short-term liabilities Long-term debt
Where does debt come from?

Balance Sheet (12)

Short-term Liabilities
Liabilities due within 12 months
Accounts Payable or Trade Credit: Credit extended by suppliers for the purchase of inventories Usually given 30-60 days to pay Accrued Expenses: Operating expenses that are owed but not yet paid Short-term Notes: Short-term loans from banks or other financial institutions
Short-term liabilities is debt that must be repaid within 12 months
-Cash Flow 2. Forecast 3. Determine 4. Good judgment

Balance Sheet (13)

Long-term Liabilities
Loans from banks or other sources that that come due after 12 months Usually loans to finance long-term capital investments, such as machinery and equipment.
Long-term liabilities (debt) Loans that come due after 12 months

Balance Sheet (14)

Owners Equity
Owners Equity is the money invested by the owners
Note: They are residual owners, because in a liquidation, stockholders are paid last Owners have 2 ways to invest in a business: Buy stock Reinvest all or part of the firms profits

Equity consists of:

Amount invested when purchasing ownership in the business Retained Earnings: All the profits retained in the company (profits not paid out in dividends to the owners)

Balance Sheet (15)

Owners Equity
Retained Earnings is the accumulated profits (gains-losses) of the business, less the dividends paid to stockholders since the firm was created
Owners Investment Cumulative Profits Cumulative Dividends Retained earnings: A concept that many students fail to understand. Do you?

Owners Equity

Owners Equity

Owners Investment

Retained Earnings

Balance Sheet (16)

An Example
The Balance Sheet for Trimble & Associates:
ASSETS
Current Assets Cash Accounts receiv Inventories Total current assets Fixed assets: Gross fixed assets Accum depreciation Net fixed assets TOTAL ASSETS

DEBT AND EQUITY

Current Liabilities: $50 Accounts payable 80 Short-term notes 220 Total current debt $350 Long-term debt Total debt: $960 Common stock -390 Retained earnings $570 Total common equity $920 TOTAL DEBT AND EQUITY $20 80 $100 200 $300 $300 320 $620 $920

Balance Sheet (17)

Putting it together
Given the information below, can you ASSETS arrange theFIRST: balance sheet?
Remember: ASSETS = LIABILITIES + EQUITY
Assets: Current Assets
Gross Fixed Assets Inventories Net Fixed Assets Cash $2,500 $ 310 $2,200 $ 70

Fixed Assets

Accumulated Depreciation $(300) Total Current Assets Accounts Receivable $ 600 $ 220

TOTAL ASSETS

$ 2,800

Balance Sheet (18)

Putting it together
NEXT: DEBT & EQUITY
Liabilities: Current Liabilities:

Total Current Liabilities Total Owners Equity Accounts Payable Common Stock

$ 250 $1,750 $ 230 $ 900 $ 20

Owners Equity:

Short-term Notes Total Debt Long-term debt

$1,050 $ 800

TOTAL DEBT&EQUITY $ 2,800

Retained Earnings

$ 850

Balance Sheet (19)

All Together
The complete balance sheet is as follows
Assets: Current Assets
Cash $ 70

Liabilities: Current Liabilities:

Accounts Payable Short-term Notes $ 230 $ 20

Accounts Receivable
Inventories Total Current Assets

$ 220
$ 310 $ 600 $2,500

Total Current Liabilities

Long-term debt Total Debt

$ 250
$ 800 $1,050 $ 900 $ 850 $1,750

Fixed Assets
Gross Fixed Assets Accumulated Depreciation $ 300 Net Fixed Assets $2,200

Owners Equity:
Common Stock Retained Earnings Total Owners Equity

TOTAL ASSETS

$ 2,800

TOTAL DEBT&EQUITY $ 2,800

Balance Sheet (20)

Income Statement and Balance Sheet
The Income Statement and Balance Sheet complement each other
January 1 December 31 Balance Sheet on December 31, 2007

Income Statement for 2007

YEAR 2007 Balance Sheet on December 31, 2006

Balance Sheet (21)

Concluding Thought
A balance sheet indicates a firms financial position in terms of the assets owned and how these assets have been financed by debt and owners equity. With an understanding of the income statement and the balance sheet, we can now look at the Cash Flow Statement.
DONT CONTINUE if you do not fully understand the balance sheet!! Go back until you have grasped all the parts of the balance sheet.

Cash Flow Statement (1)

Cash is King!!
Cash flow problems is a major reason for small firms failingeven at times when the business is profitable. Run out of cash

CASH IS KING is not some clich, but a principle you cannot afford to violate!

and your business will fail!

Cash Flow Statement (2)

Accrual versus Cash Accounting
You must understand the difference between accrual-basis accounting and cash-basis accounting. With the exception of very small businesses, the income statement and the balance sheet are based on accrual accounting. When accrual accounting is used, profits and cash flows will not be equal.

Cash Flow Statement (3)

Accrual and Cash Accounting Again
Recording income and expenses:
Accrual-basis: When there is a commitment Cash-basis: When money changes hands

Income earned Cash received Expense incurred Expense paid Accrual-basis accounting Cash-basis accounting

Cash Flow Statement (4)

Why Profits and Cash Flow are NOT the Same
The differences between profits and cash flows can result from:
Sales reported on the Income Statement include cash and credit sales Some purchases are financed by creditso no cash is involved Depreciation expense is a non-cash expense. Income tax on the income statement may be accrued and paid in later periods.
Profits will never tell you how much cash you generated!!

Cash Flow Statement (5)

Accrual vs. Cash Again
Which type of accounting would record the following?
Accrual Income tax expense that has not been paid Insurance premium paid in advance Customer pays for a good to be delivered Equipment is sold, with a 30 day note Customer pays and takes equipment sold Customer receives a service estimate Payment of last months utility bill Cash

Cash Flow Statement (6)

The Cash Flow Statement answers a very important question:

Where did the cash come from and where did the cash go?

Cash Flow Statement (7)

Data Needed to Compute Cash Flows
From the income statement:
Depreciation expense Operating income Interest expense Income tax expense

Changes in the balance sheet at the beginning of the year (end of last year) and the balance sheet for the current year end.

Cash Flow Statement (8)

Changes in the Balance Sheet that Affect Cash Flows
Cash increases if: Reduce assets Borrow more money (increase debt) Owners invest more in the business
Changes in the balance sheet affect cash flows.

Cash decreases if:

Increase assets Repay (decrease) debt Owners withdraw money from the company

Cash Flow Statement (9)

Cash inflows and outflows result from three activities:
Operating Activities: Cash flow from normal operations Investment Activities: Cash flow related to the investment in or sale of assets Financing activities: Cash flow related to financing the firm Three activities cause cash to increase or decrease

Cash Flow Statement (10)

Operating Activities
Cash flow from operations consists of the net flow of cash from day-today business activities
Start with Add back Subtract Subtract capital
Which consists of:

Operating income Depreciation expense income taxes increase in net working

What is cash flow from operations?

(a non-cash expense) (to work on an after-tax basis)

Increase in A/R (a use of cash) Increase in inventories (a use of cash) Decrease in A/P (a source of cash)

Cash Flow Statement (11)

Investment Activities
Investment activities consist of
The purchase or sale of fixed assets (change in gross fixed assets) The purchase or sale of other long-term assets (changes in goodwill, patents, etc.)
What is cash flow from investment activities?

Cash Flow Statement (12)

Financing Activities
Financing activities include: Paying dividends and interest expense Increasing or decreasing short-term and long-term debt Increase: borrowing more money Decrease: paying off debt Owners invest more or less in business
Buy more stock Company buys owners stock back

What is cash flow from financing activities?

Cash Flow Statement (13)

Cash Flow Statement for Trimble Associates
Operating Activities Operating income $ 100 Plus depreciation 30 Less income taxes (20) $ 110 Change in net working capital: Less increases in A/R $ (5) Less increases in inventories (40) Plus increases in A/P 5 (40) Cash flows from operations $ 100 Investment Activities Less increase in gross fixed assets $ (100) Financing Activities Less interest expenses $ (20) Less dividends paid (15) Plus incr in short-term notes 20 Plus incr in long-term notes 50 Total Financing Activities $ 35 Increase (Decrease) in cash $ 5

Change in net working capital

Cash Flow Statement (14)

Can You Arrange this Cash Flow Statement?
Interest expenses $(30) $120 $(30)

Operating activities: Plus Less Less Less Plus Cash flows from operations: Investment activities Less Financing activities Less Less Plus Plus Total financing activities Increase (Decrease) in cash

Operating Income Taxes

Increase in gross fixed assets $(90) Increases in long-term notes $ 30 $ 40

$100

Depreciation

Increases in short-term $ 100 notes $ 15

$ receivable (90) Increases in accts

$(20)

$ 5 Increases in accounts payable $ 5

$ 5
Increases in inventories Dividends paid

$ 15

$(10) $(10)

Cash Flow Statement (15)

Interpreting the Cash Flow Statement To understand what the cash flow statement is saying, look at the signs (+ or -) of the three cash flow activities:
Is cash flow from operations positive or negative? Is cash flow from investment activities positive or negative? Is cash flow from financing activates positive or negative?
Want to understand the cash flow statement? Look at the three cash flow activities.

Cash Flow Statement (16) Examples of Cash Flow Patterns

Some of the more important cash flow patterns are:
Using cash flows from operations and financing to invest in long-term assets (fixed assets) Using cash flows from operations to expand the business and repay creditors and/or owners Negative cash flow from operations funded by selling long-term assets and additional financing Sustaining negative cash flows and investment to expand the business through financing (Could be a start-up that has yet to break even)

CONGRATULATIONS!!
Go Celebrate!

You have completed the task! Hopefully, your persistence has paid off and you understand financial statements much more fully and any fear of financial statements has been reduced. Way to go!!!