business math

1

Business Math

Chapter 20:

Financial Statements

2Cleaves/Hobbs: Business Math, 7e Copyright 2005 by Pearson Education, Inc. Upper Saddle River, NJ 07458 All Rights Reserved

20.1 The Balance Sheet

Prepare the balance sheet

Prepare the vertical analysis of a balance sheet

Prepare a horizontal analysis of a balance sheet


20.1.1 Prepare a balance sheet

Owners, creditors and investors need to know the financial condition of a business before they can make decisions and plans.

Two important financial statements are the balance sheet and the income statement.

On the balance sheet, the assets = liability + equity, hence the name, balance sheet.


Key Terms Balance sheet: financial statement that

indicates the worth or financial condition of a business as of a certain date.

Assets: properties or anything of monetary value owned by the business.

Current assets: assets that are normally turned into cash within a year.

Plant and equipment: assets used in transacting business.


Cash: a current asset of money in the bank or cash on hand.

Accounts receivable: a current asset that is the money owed by customers.

Note receivable: a current asset that is a promissory note owed to the business.

Merchandise inventory: a current asset that is the value of merchandise on hand.

Key Terms


Liabilities: amounts the business owes.

Current liabilities: debts that must be paid in a short period of time.

Long-term liabilities: current liabilities that are paid over a long period of time.

Accounts payable: a current liability for merchandise or services that has not been paid.

Key Terms


Note payable: promissory notes that are owed.

Mortgage payable: a long-term liability for the building and land the business owns.

Owner’s equity or stockholder’s equity: the difference between the assets and the liabilities.

Capital, proprietorship or net worth: other terms for owner’s equity.

Key Terms


How to prepare a balance sheet1. Find and record the total assets, working by asset

category. (Total assets= total current assets + total plant and equipment.)

-(a) List the current assets and draw a single line underneath the last entry.

-(b) Add the entries and record total current assets, drawing a single line underneath the total.

-Repeat step (a) for plant and equipment and step (b) for total plant and equipment assets.

-Add the category totals and draw a double line underneath the grand total.


Prepare a balance sheet (cont.)

2. Find and record the total liabilities, working by liability category.

- Repeat step 1a for current liabilities and step 1b for total current liabilities.

- Repeat step 1a for long term liabilities and step 1b for total long term liabilities.

- Add the category totals and draw a single line underneath the total.

Total liabilities = total current liabilities + total long-term liabilities.


3. Find and list the total owner’s equity.

(a) List the equity entries and draw a single line underneath the last entry.

(b) Add the entries and draw a single line underneath the total.

4. Find and record the total liabilities and owner’s equity and draw a double line underneath the grand total.

Total liabilities and owner’s equity = total liabilities + total owner’s equity.

Prepare a balance sheet (cont.)


A = L + E

5. Confirm that the double line grand totals from step 1 (Total assets) and step 4 (Total liabilities + total owner’s equity) match up.

Assets = Liabilities + Owner's Equity


Look at this example Prepare a balance sheet using Figure 20-1 in

your text as a guide for Sander’s Woodworks for December 31st.

Assets include: cash ($1,973); AR ($2,118); merchandise inventory ($18,476); equipment ($18,951).

Liabilities include: AP ($2,317); wages payable ($684); mortgage note payable ($15,286).

Owner’s capital is $22,871.


Check your work.


20.1.2 Prepare a vertical analysis

A vertical analysis shows the ratio of each item on the balance sheet to total assets.

To find the ratios, use the formula of R= P/B

Each item on the balance sheet is a percentage (P) and the total assets are the base (B).

Their ratio “R” is expressed as a percent.


Look at Figure 20-2 What is the ratio between cash and total assets?

4.8%

What is the ratio between total plant and equipment and total assets?

45.2%

What is the ratio between the mortgage note payable and total assets?

37.1%


Look at the complete vertical analysis of Sander’s Woodworks


20.1.3 Prepare a horizontal analysis of the balance sheet

Another way to analyze information on a comparative balance sheet is to compare item by item in a horizontal analysis.

A horizontal analysis compares the same item for two different years, recording both the amount of increase (or decrease) and the increase (or decrease) as a percent of the earlier year’s amount.


Prepare a horizontal analysis

1. Prepare a balance sheet for two or more years; record each year’s amounts in separate columns.

2. Create an additional column labeled “amount of increase (decrease)” for each yearly item.

a) Subtract the smaller amount from the larger amount and record the difference.

b) If the earlier year’s amount is larger than the more recent year’s amount, record the difference in step 2a as a decrease using parentheses or a negative (minus) sign.


Prepare a horizontal analysis (cont.)

3. Create an additional column label percent increase (decrease); for each year item, divide the amount of increase (decrease) by the earlier year’s amount and record the difference as a percent.

Percent increase (decrease) =amount of increase (decrease) x 100% earlier year’s amount


Look at this example


Tip!

Which year is the base in the percent of increase?

In a horizontal analysis, the earlier year is always the base year in calculating percent increase or decrease.

It is possible to have a 0% change if there is no dollar change in the amounts.


20.2 Income statements

Prepare an income statement

Prepare a vertical analysis of an income statement

Prepare a horizontal analysis of an income statement


Income statement: a financial statement; the net income of a business over a period of time.

Total sales: earnings from the sale of goods or the performance of services.

Sales returns or allowances: refunds or adjustments for unsatisfactory merchandise or services.

Net sales: total sales minus sales returns or allowances.

Key Terms


Cost of goods sold: cost to the business for merchandise or goods sold.

Gross profit or gross margin: net sales minus the cost of goods sold.

Operating expenses: overhead or cost incurred in operating a business.

Net income or net profit: gross profit or gross margin minus the operating expenses.

Key Terms


Prepare an income statement1. Find and record net sales.

(a) Record gross sales

(b) Record sales returns and allowances

(c) Subtract sales returns and allowances from gross sales

2. Find and record the cost of goods sold.• Record cost of beginning inventory• Record cost of purchases• Record cost of ending inventory• Add cost of beginning inventory and cost of

purchases and subtract cost of ending inventory.


Prepare an income statement (cont.)

COGS = cost of beginning inventory + cost of purchases – cost of ending inventory

3. Find and record gross profit from sales = net sales – cost of goods sold.

4. Find and record total operating expenses: list the operating expenses and add the entries.

5. Find and record net income = gross profit from sales –operating expenses.


Look at this exampleComplete the income statement for Corner Grocery using the following information:

Gross sales: $25,283

Returns and allowances: $492

Cost of beginning inventory: $5,384

Cost of purchases: $18,923

Cost of ending inventory: $5,557

Total operating expenses: $3,750


Example (cont.) Net sales = gross sales – returns and allowances

($25,283 - $492 ) Net sales = $24,791 COGS = cost of beginning inventory + purchases – cost

of ending inventory(COGS = $5,384 + $18,923 -$5,557 = $18,750)

Gross profit = net sales – COGSGross profit = $24,791 - $18,750 = $6,041

Net income = gross profit – operating expensesNet income = $6,041- $3,750 = $2,291

Net income = $2,291


Income statement for Corner Grocer


20.2.2 Prepare a vertical analysis of an income statement

Just as you do with a vertical analysis of a balance sheet, to make a vertical analysis of an income statement you use the percentage formula R = P/B

P = each entry on the income statement as a percentage

B = net sales

R= expressed as a percent, it is the ratio between P and B.


Prepare a vertical analysis

1. Prepare an income statement.

2. Create an additional column labeled percent of net sales for each item. Divide the amount of the item by the net sales and record the result as a percent.Percent of net sales =amount of item x 100%net sales


Try these examples

Suppose net sales are $839,056.

What is the percent of cost of goods sold if that amount is $516,019?

61.5%

What is the percent of total operating expenses if that amount is $126,305?

15.1%


Vertical Analysis of The Seventh Inning’s Income Statement


20.2.3 Horizontal analysis of an income statement

Comparative income statement: an income statement that includes data from two or more years.

Horizontal analysis of an income statement: comparison of like entries for two years. The amount of increase or decrease and the percent of increase or decrease are determined.


Prepare a horizontal analysis1. Prepare an income statement for two or more years;

record each year’s amounts in separate columns.

2. Create an additional column labeled amount of increase (decrease). For each yearly item:

(a) Subtract the smaller amount from the larger amount and record the difference.

(b) If the earlier year’s amount is larger than the later year’s amount, record the difference from step 2a as a decrease using parentheses.

(continue on next slide)


Prepare a horizontal analysis (cont.)

3. Create an additional column labeled percent increase (decrease). For each yearly item, record the difference as percent:

Percent increase (decrease) = amount of increase (decrease) x 100%earlier year’s amount


Look at this example

Davis

Company2006 2005 Amount

Percent of net sales

Net sales $242,897 $239,528 $3,369 1.4

Cost of goods sold

116,582 115,351 1,231 1.1

Gross profit

$126,315 $124,177 2,138 1.7

Operating Expenses

38,725 37,982 743 2.0

Net Income

$87,590 $86,195 $1,395 1.6


20.3 Financial Statement Ratios

Find and use financial ratios

Financial ratio: analysis of financial data to compare a business’s performance with other businesses.

Working capital: current assets minus current liabilities.

Current ratio or working capital ratio: the ratio of the current assets to the current liabilities.


How to find a financial ratio

1. Write one amount as the numerator of a fraction and a second amount as the denominator.

2. Write the fraction in decimal form (or for some ratios, in percent form).Example: Current assets

Current liabilities


Look at this example Compare the current ratio for Aaron’s Air Conditioning

with Zelda’s Zeppelins. Aaron: CR = $11,000 ÷ $5,000 = 2.2 Zelda: CR = $615,000 ÷ $609,000 = 1.01 What does this mean? Aaron has more than $2 in assets for every $1 in

liabilities.

Zelda has about $1 in assets for each $1 in liabilities. What could you possibly infer from this information?


Additional financial ratios

The acid test: also called the quick ratio, it measures the relationship between quick current assets to current liabilities.

Find the acid-test ratio if the balance sheet shows the following amounts:

Cash: $17,342; Marketable securities: 0; and Accounts receivable: $10,345; and Current Liabilities = $26,345

The acid test ratio is 1.05 to 1.


Operating ratio

Operating ratio = COGS + operating expenses net sales

This ratio indicates the amount of sales dollars that are used to pay for the cost of goods sold and administrative expenses.

A ratio of less than 1:1 is desirable.

The lower the operating ratio, the more income there is to meet financial obligations.


Other financial ratios

Asset turnover ratio compares the net sales to the average total assets.

Total debt to total assets ratio compares the total liabilities to the total assets.

The gross profit margin ratio shows the average spread between cost of goods sold and the selling price.


Interpreting financial ratios

The mere calculation of a ratio is meaningless unless the business owner, financial analyst, creditor or investor is able to interpret them.

Industry standards are an important base.

Historical performance also adds perspective.

Industry-specific ratios also help one interpret performance within a field of similar firms.

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