1

Lecture 11:UnderstandingFinancial Statements

61.068 Agribusiness ManagementDr. Jared Carlberg

TodayThe Importance of Financial StatementsThe Accounting ProcessFinancial Statements

The Balance SheetThe Income StatementStatement of Owners’ EquityStatement of Cash Flows

Pro Forma StatementsImportant Accounting Principles

Financial Statementsneed financial info. for 2 main reasons:

used internally for decision makingmanagerial accounting

used for financial reporting to stockholders, lenders, authorities, etc.

financial accounting

two most important financial statements:(1) balance sheet(2) income statement (also sometimes called profit & loss statement or operating statement)

2

Financial Statementsgood info. required for good managementfinancial records system should be:

simple & easy to understandreliable, accurate, consistent, timelybased upon the business’ uniquenesscost-effective to implement & maintain

need professional help to design systemmost agribus. hire bookkeepers/accountants

The Accounting Systemthe accounting system helps prevent errors and safeguard the business’ resources

need accurate, honest records to do this!system of checks and balances requiredauditors verify proper record keeping

if the accounting system is built properly, there is little reason to suspect impropriety!

Accounting System Usesgood financial records provide the basis for:

determining the business’ successshowing the financial health of the businesspredicting the ability of the business to meet the demands of creditors, change, and expansionrelating performance to managers’ decisionschoosing among alternative courses of action for the future

3

The Accounting Processbased largely on original documents

sales slips, bills, cheques, invoices

transactions recorded in the “journal”also called “book of original entry”records all of the business’ transactionsinfo. then transferred into other fin. statementsalso have “ledger” with classes of receipts and expenses grouped together

(1) The Balance Sheetshows the financial makeup and condition of a business at a specific point and time

shows what a business owns, what it owes, and what the owners have investeddetails the “balance” between assets and claims against them (liabilities and owners’ equity)assets: things of value owned by the businessliabilities: amounts that must be paidowners’ equity: amount invested by owners

The Balance Sheetthe balance sheet always balances

assets = liabilities + owners’ equityfor each thing of value (asset), the business owes somebody for it (liability) or an investor has a claim on it (owners’ equity)if the balance sheet doesn’t balance, you’ve done something wrong!

4

Assetsare sources of value the business owns

note: only corporations can “own” assets, but we do this for all types of businesses anyway

three usual types of business assets:current assetsfixed assetsother assets

Current Assetscash or assets that will be converted to cash within one operating cycle (usually a year)

reflect the firm’s ability to generate cash

there are several types of current assetscash: immediately available fundsaccounts receivable: amounts owed for salesinventory: items to be sold/used in productionprepaid expenses: paid for but not yet utilizedother current assets: e.g. marketable securities

Fixed Assetsassets that have a relatively long life

typically used to produce or sell goods/services

there are three main types of fixed assets:land: real estate owned by the business

land is usually valued at the purchase price

buildings: facilities the business ownsequipment: used for any aspect of operations

have to recognize that assets depreciateshow this on balance sheet to ensure accuracy!

5

Other Assetsmiscellaneous assets that aren’t exactly current or fixed

many things don’t fit into those categorieslonger life than current assetsusually nondepreciable in natureexamples of “other assets” include:

bonds held for longer than one year“intangible” assets such as patents, copyrights, and goodwill

Liabilitiesconsist of money the business owes to “outsiders” (not original investors)are claims against the business’ assets

but not usually against specific assets

two main types of liabilitiescurrent liabilitieslong-term liabilities

Current Liabilitiesclaims against the business that will fall due within one business cycle

show the business’ short-term obligationstypes of current liabilities include:

accounts payable: payment for things purchased on creditnotes payable: loans due within one yearaccrued expenses: day-to-day expenses accrued but not yet paid e.g. wages, taxes payableadvances: payment for goods in advance

6

Long-term Liabilitiesoutsiders’ claims not due within one operating cycle

those liabilities that are not “current”

examples of long-term liabilities include:bonded indebtedness: issued by the firmmortgages: taken out on certain assetslong-term loans: to banks or individuals

Owners’ Equityclaims of owners against firm assets

summary of accounts showing contributions

two usual accounts for owners’ equity:common stock: appears on books at original valueretained earnings: net gain on initial investment

represent net profit left in the business as capital

proprietorship/partnership often shows only one account for owners’ equity instead of two

(2) The Income Statementshows revenues & expenses for a specific period of time & profit/loss from operations

gives a measure of profit and performanceprovides insight into managerial efficiencyshows how changes in the balance sheet came aboutshows revenue taken in and money spent to generate that revenue

7

The Income Statementthe basic format of the income statement is:

Sales

- Cost of Goods Sold (COGS)Gross Profit (sometimes called gross margin)

- ExpensesNet Income Before Taxes

-Income TaxesNet Profit After Taxes

Cash Accounting Vs. Accrual Accounting

two different approaches to preparing the income statement can be takencash-basis approach: says revenue and expenses occur when cash is paid/received

can under-or-overstate true net profit

accrual-basis approach: says revenue and expenses exist when they first take place

this approach more accurately reflects reality

Salestotal dollar value of goods and services sold during the income statement period

include cash and credit salesmay include special lines for items such as returns and/or discounts & allowancesoften broken down into different products

this provides best information but also takes up more space on the income statement

8

Cost of Goods Sold(COGS)

gives the total cost to the business of goods sold during the reporting period

what it cost the business to purchase the goods it later re-sold

more complicated for a processing or manufacturing firm than a retailing firm

should provide details as to cost breakdownsincludes raw materials costs and direct labourhave to factor inventory changes into COGSfreight and transportation charges are in COGS

Gross Profit (or Gross Margin)shows difference between sales and COGS

money available to cover operating expenses

important to retail agribusinessesthey have very little control over COGS

changes in output price have big impact on gross margins for retailers

because COGS stay the same regardless

manufacturers can try to reduce COGS to increase margins

Operating Expensescosts incurred as a result of business operations during the reporting period

have to pay for things to conduct business

can break them down into major categories:marketing: wages, salaries, commissionsadministrative: mgr. salaries, office, travelgeneral: depreciation, insurance, taxes, rent, repairs, utilities

all these expenses are operating expenses

9

Net Operating Profitamount left over when operating expenses are deducted from gross marginaffected by same factors that influence gross margins

output price, COGS

can influence net operating profit by controlling operating expenses

cost-cutting measures can make the firm more profitable

Net Profit Before Taxesamount remaining after taking account of any non-operating revenue or expensesnon-operating revenue includes things like interest or dividends received

for a local co-op, this could include patronage refunds from the regional/federated co-op

non-operating expenses include items such as interest expense

interest paid on borrowed money

Net Profit After Taxes(or Net Income)

what is left after business taxes are paidtax rates vary by jurisdiction and by profit level

this is the so-called “bottom line”appears on the bottom line of the income statement

can also be a “net loss”yes, businesses sometimes lose money!

10

Statement of Owners’ Equityshortest & least complicated of the financial statements

shows changes to owners’ equity accounts over a period of time

most common change: retained earningsif the business makes a profit, retained earnings increases unless all profit is paid in dividends and/or withdrawals by firm owners

can also increase or decrease common stockthis is only done very occasionally

Statement of Cash Flowsshows a business’ cash inflows and outflows for a period of time

can be used to report what happened to cashconstructed at end of reporting period

can be used to help budget cash flowsconstructed at beginning of period (pro forma)

cash flow statement always “balances”, too!sources of cash = uses of cash

Statement of Cash Flowsthree primary categories for this statement:

cash flows from operationscash flows from investments/disinvestmentscash flows from financing transactions

contributions from owners, borrowing from lenders, repaying debt, etc.

11

Pro Forma Statementsfinancial statements usually reflect history

but sometimes want to assess future plans!

can use “pro forma” statements to do thisthey are statements prepared for a future periodoften used to estimate the impact of potential courses of action upon the business

often have to do pro forma statements to borrow money for a new/existing business

Important Accounting Principles

important things about financial accounting:only facts that can be recorded in monetary terms should be on balance sheet/inc. statementkeep personal & business transactions separateaccounting methods assume ongoing operation of the businessassets are usually recorded at the lower of their actual cost or market value

this is the “cost basis” of valuationbook value does not always equal market value!

Important Accounting Principles

more important fin. accounting principles:every accounting event has to balance: a change in assets necessarily requires a change in either liabilities or owners’ equity, or bothmost accounting is done on an accrual basisthe format of the income statement should reflect the unique needs of the organizationfin. statement format can evolve to meet needsthe purpose of fin. statements is to provide info!

necessary for informed decision making

12

Next Classtopic: Analyzing Financial Statementsreading: Chapter 13Using Statements to Evaluate PerformanceRatio Analysis

profitability ratiosliquidity ratiossolvency ratiosoperating/efficiency ratios

Discussion question: What are the advantages of ROE as a tool of analysis for agbus. managers?