Management and Organizational Studies 2310A/B Study Guide - Midterm Guide: Financial Statement, Net Income, Retained Earnings
5 Nov 2018
School
Department
Professor
MOS 2310 – Finance
Chapter 3 – Working with Financial Statements
3.1 Cash Flow and Financial Statements: A Closer Look
- At base level, firms do two things:
o Generate cash by selling a product, an asset or a security
o Spend cash by paying for materials and labour, or purchasing assets
- Sometimes, if a company needs more cash than they can get by internal work, they
involve debt or equity
- *Addition to retained earnings = net income – dividends paid
Sources and Uses of Cash
- Activities that bring in cash are called
sources
o Decrease in asset account
o Increase in liability or equity
account
- Activities that involve spending cash are
called uses
o Increase in asset account
o Decrease in liability or equity
account
Statement of Cash Flows
- Statement of Cash Flows: A firm’s financial statement that summarizes its sources and
uses of cash over a specified period
- Three categories:
o Operating Activity
▪ Includes net income and changes in most current accounts
▪ Add back depreciation and other non-cash expenses to show true value
o Investment Activity
▪ Includes changes in fixed assets
o Financing Activity
▪ Includes changes in notes payable, long-term debt and equity accounts as
well as dividends
3.2 Standardized Financial Statements
- Sometimes beneficial to compare a company’s financial statements to other, similar
companies
o Hard to do this independently because companies vary in size
o Must standardize the financial statements
Common-Size Statements
- Common-Size Statement: A standardized financial statement presenting all items in
percentage terms. Statement of financial position is shown as a percentage of assets and
income statements as a percentage of sales
- Useful for comparing different businesses in similar industries and comparing internally
year to year
- Makes it easier to compare financial information, particularly as the company grows
1. Common-Size Statement of Financial Position
o Compute all accounts as a percentage of total assets
2. Common-Size Statement of Comprehensive Income
o Compute all line items as a percentage of sales
3. Common-Size Statements of Cash Flow
o Possible and useful
o No easy denominator, sometimes done as a percentage of total sources or total
uses
Common-Base-Year Financial Statements
- Express each line item as a multiple of the base year item
- Growth ratio
- Divide year 2 by year 1
Combined Common-Size and Base-Year Analysis
- Do this because as total assets grow, most of the other accounts must grow as well
- This helps us to eliminate the effect of this overall growth
3.3 Ratio Analysis
- Financial Ratios: Relationships determined from a firm’s financial information and used
for comparison purposes
- Eliminates the problems associated with comparing firms of different sizes
- Five categories of ratios:
o Short-term liquidity ratios
o Long-term solvency or financial leverage ratios
o Asset management or turnover ratios
o Profitability ratios
o Market value ratios
Short-term Liquidity Ratios
- Liquidity: Your ability to convert a non-cash asset into cash quickly, without losing value
- The results of these ratios often interest creditors
- One advantage to these ratios is the book value and market value of current accounts are
often quite similar
o It provides a well realistic view of the company
- Can be problematic because the company is constantly changing their balances of current
accounts
- Target benchmarks for ratios always depend on a number of factors such as the industry,
company size, company history, their most recent activities, etc.
Name
Formula
What Does it Tell us?
High/Low Meaning
Current Ratio
Current Assets /
Current Liabilities
The # of times that short-
term assets can cover
short-term debts. Indicates
an ability to meet short-
term obligations as they
become due.
Goal is 2:1
Too low = risk of
insolvency
Too high = inefficient
use of cash
*NOTE lenders want
high…Ex: if a firm
borrowed LT
recently, current
ratio would be high
because current
assets would
increase.
Quick Ratio
(Current Assets –
Inventory) / Current
Liabilities
Indicates the ability to meet
short-term payments using
only the most liquid assets.
Goal is 1:1
Cash Ratio
Cash + Cash
equivalents /
Current Liabilities
Useful for very short-term
creditors.
Higher = better
Net working
Capital to Total
Assets
NWC / Total Assets
NWC is referred to as the
among of short-term
liquidity a firm has
Low = low level of
liquidity
Interval Measure
Current assets /
Average daily
operating costs
(discluding interst
and non-cash
expenses)
Tells us how long the
business could keep
running of cash inflows
dried up
Higher = better
Long-Term Solvency Measures
- Solvency: How easy it is for us to cover our long-term debts
Document Summary
3. 1 cash flow and financial statements: a closer look. At base level, firms do two things: generate cash by selling a product, an asset or a security, spend cash by paying for materials and labour, or purchasing assets. Sometimes, if a company needs more cash than they can get by internal work, they involve debt or equity. *addition to retained earnings = net income dividends paid. Activities that bring in cash are called sources: decrease in asset account, increase in liability or equity account. Activities that involve spending cash are called uses: increase in asset account, decrease in liability or equity account. Statement of cash flows: a firm"s financial statement that summarizes its sources and uses of cash over a specified period. Includes net income and changes in most current accounts: add back depreciation and other non-cash expenses to show true value, investment activity. Includes changes in fixed assets: financing activity.
