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Chapter 14

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COMM 200
Gary J Bissonette

COMM200 Readings - Week Jan 20 Chapter 14 Understanding Financial Statements The Role of Financial Statements - Analyzing and interpreting financial statements is what enables a management team to keep its “Fingers on the pulse” of the organization o FS keep managers up to date on the success of the organization’s sales and marketing initiatives, and on the ability of the organization to control its cost and maintain its operating margin and profitability margin - Three primary FS for analysis: o Income statement, balance sheet, and cash flow statement  Provides vital info to managers regarding an organization’s current liquidity and solvency position as well as overall financial capacity to respond to opportunities and/or challenges the organization may face in the near term  When assessed over a period of time – provides managers with info of organization’s overall growth and profitability trends + overall operating efficiency  Statements should be reviewed together Two Fundamental Types of Business Transactions - 1) Operational Transactions o Represent flow of money within the organization o E.g. Revenue and reoccurring expenses - 2) CapitalAsset Transactions o Decisions which managers make with respect to investment and divestment of capital assets (e.g. buildings, equipment) which may be needed, or are no longer needed, as part of the organization’s business system o Not directly related to current year’s profit but impact cash flow of the organization over the period of time being analyzed Liquidity, Solvency, Efficiency, & Financial Capacity - Liquidity: ability of the company, on the basis of the cash it has on hand and the cash it is generating within its operations, to meet its ongoing financial obligations - Solvency: a longer-term assessment of the financial stability of the organization o Focuses on the forward anticipated profitability of the firm and whether the firm has and/or can acquire sufficient capital in order to remain in business o Also takes into consideration future revenues, products/services under development, market position, and ability of company to acquire additional capital resources if necessary o In sum = ability of org. to meet long-term expense obligations and profitably grow company - Efficiency: how effective the organization is in deploying its resources and managing its operational processes in the delivery of goods and/or services to the marketplace o E.g. how quickly we’re collecting money owed from customers - Financial Capacity: an organization’s cash reserves and borrowing power o An assessment of an organization’s financial capacity will determine where and at what level the organization feels it can financially support its competitive position in the marketplace - We “read” these things through analyzing and interpreting financial statements THREE PRIMARY FINANCIALSTATEMETNSB Income Statement - Income statement: the financial statement which responds to the question: o “is our business earning a profit as a result of sales made versus expenses incurred?” o Reflects a specific period of time o Identifies revenue received o Subtracts expenses incurred o Residual amount = profit - Individual components of the income statement: o Sales Revenue: reflects dollar amount received as a result of sold goods/services o Cost of Goods Sold: expenses directly incurred in the manufacturing of a product and/or delivery of a service o Gross Profit Margin: difference between total revenue and direct expenses incurred o General Operating Expenses: indirect expenses incurred which must be paid from an organization’s gross profit margin  E.g. administrative expenses, operational overhead (R&D costs, insurance, etc.) o EBIT: earnings before interest and taxes  Determined by subtracting General Operating Expenses from GPM o Interest Expense: interest payments on the debt the organization has undertaken o Earnings before Income Taxes: amount of earnings the operation has produced prior to recognizing its federal and provincial tax obligations o Net Profit or Loss Balance Sheet - Financial statement which provides managers with an understanding of the resources the organization has at its disposal at a given point in time and the financial obligations which the business has incurred as a result of purchasing these resources - Three areas: o Assets: resources which the organization has at its disposal and which it can utilize in the generation of business activity and, ultimately, profit  “current” assets: resources that can be converted to cash and/or consumed within a short period of time (i.e. 1 year or less) • E.g. cash, marketable securities, accounts receivable, inventory  “non-current” assets: resources generally more fixed in nature and typically represent the capital assets of the organization • E.g. plant and equipment, land, value of intangible assets such as patents o Liabilities: an organization’s debts or financial obligations incurred  current liabilities (90 day bonds) versus long-term liabilities (ten-year bonds) o Owners’Equity (or shareholders’equity): the value of capital received from the owners of the business used to fund the start-up or ongoing operations of the business + value of organization’s retained earnings  Retained earnings: profits generated since the inception of the company’s operations • Owners’equity = owners’capital invested + retained earnings - ASSETS = LIABILITIES + OWNERS’EQUITY Cash Flow Statement - Cash flow statement: provides managers with a full understanding of the total movement of cash into and out of the business o Considered to be the best source of info relating to an organization’s liquidity situation Analyzing and Interpreting Financial Information - In conducting an analysis of an organization’s financial health, focus is generally in four specific areas: ratio, leverage, trend/comparative, and absolute analysis. RatioAnalysis - Ratios: seek to define relationship between critical components of information found on the financial statements o Analyzing ratios allows development of questions to which mgmt. can seek additional info to effectively manage organization  Ratio analysis -> used to get a feel for the operational efficiency in four fundamental areas • 1) Profitability • 2) Solvency & Liquidity • 3) Debt • 4)Activity Profitability Ratios o Focus on assessing the amount of income which the organization has earned in comparison to the operating activity which has taken place and the assets which have been used to support its income generation  E.g. of profitability ratios: • Return on Sales: o Identifies the percentage of sales which the company has generated that actually represents profit for the business • Return onAssets: o Identifies the relationship of Net Income to the total asset base of the organization • Return on Equity (ROE) o Computes the amount of Net Income which was earned no each dollar of invested capital provided by the business’owners • Earnings Per Share (EPS) o Reflects the return that individual investors would recognize for each share of stock they owned Solvency and Liquidity Ratios o Solvency and liquidity ratios compare financial obligations with the financial resources an organization has allowing managers to determine if the organization possesses sufficient capital resources to meet its upcoming needs • Current Ratio o Shows the relationship between an organization’s current assets and its current liabilities [maintaining a strong current ratio is a “best practice” for keeping an organization solvent and for meeting its liquidity needs] • Quick Ratio o Valuable tool when really concerned about current liquidity position o Looks to remove from the current ratio those assets not so easily converted into cash immediately [often limited to cash, marketable securities, and accounts receivables] o Quick assets than divided by total value of current liabilities to determine ability to meet current obligations strictly from
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