Analyzing and Interpreting Financial Statements

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This paper will demonstrate my understanding of financial accounting and why generally accepted accounting principles (GAAP) are important. I will discuss how financial statements are used in the marketplace. I will describe each financial statement and tell what it reveals about the business. I will explain how the statements are linked and show examples. I will explain the notes to the financial statements. I will also explain why ratios are used and why they are important. Keiser UniversityDr. Bunney SchmidtACG 501| Monica Holmes| 4/14/2013| INTRODUCTION Financial statements are the output of the accounting cycle. Financial statements are a way to communicate financial information that can be used to make decisions in regards to where the company is heading. Financial statements are a way to help organizations know whether to invest, lend, or grant credit to a company. The stakeholders of a business use financial statement information for planning, and evaluating business activities.
The results reported in the financial statement may help companies determine certain decisions from a human resource prospective such as benefits, bonuses, hiring, and downsizing. Financial statements serve as a critical role in organizations because it tells a story of a company’s life cycle. Financial reporting provides information that is useful in making investments for company growth as well as credit decisions. Financial reporting provides material that is valuable in obtaining cash flow projections. Financial reporting provides facts regarding assets of an organization, the claims to those resources, and changes in those resources.
There are several questions that financial statements can answer such as is the business profitable, is the operating activities of the business generated sufficient cash flow, and has the business grown since the previous year. This paper will discuss the importance of financial statements and how they are used in the marketplace. The paper will explain all aspects of financial statements in detail and why it is critical to companies to know what information are in these statements to make vital decisions on moving their company to success.
FINANCIAL STATEMENTS IN THE MARKETPLACE Balance Sheet Kramer and Johnson stated, “Companies use several financial statements which are the balance sheet, income statement, the statement of owner’s equity, and the statement of cash flow to total and present financial data to internal and external stakeholders” (Kramer, Johnson, 2009). Berry stated in his book, “the balance sheet presents the assets, liabilities, and residual equity of the owner or owner of a business” (Berry, 2006). Assets are the economic resources.
The balance sheet is a picture of the organization which demonstrates the position of the organization at a specific time (Kramer, Johnson, 2009). Assets are economic resources for a business. Assets can be tangible, which is something the company can touch. Assets can also be what they may represent rights the company possesses. Income Statement Berry stated in his book, “the purpose of the income statement is to compute a company’s net profit of loss for a given period, whether a year, a quarter or any other time frame” (Berry, 2006).
Berry stated “income statements start by adding total revenues for the period, which includes the capital gains and interest income in addition to sales revenue” (Berry, 2006). Berry stated, “Income statements compute and subtract the cost of goods sold to arrive at the organization’s gross profit” (Berry, 2006). Berry stated, “Gross profit signify the profit made on inventory sales and other income over the cost of goods sold, before additional company expenses” (Berry, 2006).
Berry stated, “Income statements calculate and subtract additional expenses, including the overhead, administrative expenses, and interest payments to arrive at a company’s net income” (Berry, 2006). Owner’s Equity Berry stated, “Owners’ equity statements are less commonly found in small business accounting than in corporate accounting” (Berry, 2006). Berry also stated, “That corporate owners’ equity statements go into detail about stock sales, retained earnings and long term investments held by the company” (Berry, 2006).
Financial statements also investigate into pension liabilities and capital gains/losses on liquid investments (Berry, 2006). Berry stated “small business owners’ equity statements are much less complicated than their corporate counterparts” (Berry, 2006). According to Berry (2006), a statement for a small business can detail any changes in the balance of cash accounts on which company owners have the right to withdrawal, showing the net increase or decrease in the balance for the period in question (Berry, 2006). Statement of Cash Flow
Kramer talked about the statement of cash flows and how they serve as much the same purpose as the income statement, with the major difference being the cash flow statement’s exclusion of non-cash income and expenses (Kramer, Johnson, 2009). According to Kramer and Johnson (2009), accountants commonly begin with the net income figure from the income statement when developing a statement of cash flows. According to Kramer, and Johnson (2009), accountants adjust net income by adding back non-cash expenses and subtracting non-cash income, arriving at a net increase or decrease in cash.
Kramer and Johnson stated that another way to construct a cash-flow statement is to begin from scratch, calculating and adding/subtracting cash flows from operating activities, investing activities and financing activities (Kramer, Johnson, 2009). According to Moseley (2009), you have to ensure that the whole organization is prepared to carry out strategic initiatives, and every aspect of the organization must be align with those initiatives. Auditors, and financial managers must know the basis for measuring the performance and success of strategies for companies (Moseley, 2009).
Moseley stated “companies have to have necessary capital funds to support the chosen plans the company set for moving the company to success” (Moseley, 2009). According to Moseley (2009), this means ensuring the whole organization’s financial performance is satisfied with the demands of equity and debt to stakeholders. Organizations have to ensure available capital is owed among planned initiatives according to standards that maintain solvency and maximize the value created by the company’s operations (Moseley, 2009).
Moseley stated, “Companies use financial statements to track financial performance of new plans as they are applied to make sure they meet financial goals, and to forestall any developing issues (Moseley, 2009). Moseley stated, “If an organization had no planning goals, and was completely satisfied with its current operations of the business for the predictable future the company would need to be worried only that the revenues from those operations were suffice to cover the expenses of running the operations” (Moseley, 2009).
According to Kramer and Johnson (2009), organizations must make certain decision in regards to regular capital investments in order to succeed and where payers carefully inspect every bill they pay, it is necessary to pay much more attention to potential sources of strategic capital financing. According to Kramer and Johnson (2009), this is how financial statements are utilized in the marketplace. It is necessary for companies to practice financial management regardless if they are large or small. This also goes for profit and non-profit organizations (Kramer, Johnson, 2009).
Kramer and Johnson stated “Financial management can be handled by one well trained financial expert” (Kramer, Johnson, 2009). The financial expert of the company responsibility is to ensure that there is sufficient funding for the organization’s strategic initiatives (Kramer, Johnson, 2009). Many companies contain internal funds and generous donations in the equity group, the term pronounces an ownership interest in the organization (Moseley, 2009). Stakeholders invest their money in the shares of a business because they want to see the value of their investment grow (Moseley, 2009).
Moseley stated, “This can happen in two ways, one the business pays them dividends on their shares or the value of those shares in the markets where they are traded goes up” (Moseley, 2009). The business has complete control over whether dividends are paid on its stock, though it will not have the money to do so unless the business is doing well in selling its product and services (Moseley, 2009). Moseley stated “The major alternative to equity financing is debt financing because debt is a lower cost source of capital than equity, many businesses try to keep their overall cost of capital as low as possible by sing as much debt as possible” (Moseley, 2009). In fact, any earnings over and above the interest accrue to the benefit of equity, many businesses try to keep their overall cost if capital as low as possible by using as much debt as possible (Moseley, 2009). According to Moseley (2009), a popular form of debt financing is a bond issued directly by the organization requiring the funds. Under a bond agreement, the issuing company promises to make regular interest payments up until the bond maturity date when it will pay off the principal in one lump sum (Moseley, 2009).
The result of an organization’s decision about its use of debt and equity financing is called capital structure which is essentially the right hand side of the balance sheet (Kramer, Johnson, 2009). According to Kramer and Johnson (2009) no company will be able to get the capital it needs for its planning at the cost and under the circumstances that it would like. Critical planning needs to be in synch with the realities of the capital markets and the business credit standing. The only way to accomplish this is through the full participation with the financial management in the strategy making procedure (Kramer, Johnson, 2009).
Debt capacity are measures of how fully the business is using its ability to raise and pay for debt capital (Kramer, Johnson, 2009). Cash flow measures how liquid an organization is, and how much cash is easily available to meet debt service obligations (Kramer, Johnson, 2009). According to Kramer and Johnson (2009) profit margins After the accounts payable have been paid and accounts receivable received this interpret into cash flow that can be used to satisfy debt obligations (Kramer, Johnson, 2009).
The reliability of capable financial management requires that capital resource distribution to be followed by a mechanism for checking the operation and performance of the chosen plans, and making necessary adjustments (Kramer, Johnson, 2009). There are good reasons for an organization’s financial manager to monitor financial metrics in three different areas (Kramer, Johnson, 2009). The long term financial goals, financial criteria, and financial targets are the areas that a financial manager must monitor.
Financial statements should contain information that is useful, relevant, reliable, comparable, and consistent. Relevant information is important because it helps to make predictions of future company performance on the basis of past information and provides feedback about past predictions. Reliable information can be verified and biased in favor of the business, and represents the substance of the underlying events. Consistent financial information is presented in the same manner from one period to the next for a particular company.
Consistency helps ensure that the financial statements of one company are comparable from period to the next. Financial management needs to include a foundation to prevent potential overspending, wasting available capital, damaging creditworthiness. According to Berry (2006) an organization that is not cautious and logically manage the sizes of different types of debt and equity in its capital structure is quite likely to pay higher costs for the capital it ingests and have less access to the quantities that it strategies require.
Berry stated, “organization’s that do not have effective mechanism for monitoring financial performance there is a good chance that companies can have fraudulent information on their financial statements, profits will suffer, invested capital will be wasted, strategies of the company will fail to achieve their objectives, and financial weakness will develop” (Berry, 2006). HOW STATEMENTS ARE LINKED Financial statements are interrelated although they represent different things on each statement. Net income links to both the balance sheet and the cash flow statement.
Both the income statement and the balance sheet links into the stockholder’s equity via retained earnings (Kramer, Johnson, 2009). Kramer and Johnson stated, “The retained earnings is equivalent to the previous period’s retained earnings plus the net income from current period less the dividends from current period” (Kramer, Johnson, 2009). Kramer, and Johnson stated, “in terms of the cash flow statement, net income is the first line as it is used to calculate cash flows from operations” (Kramer, Johnson, 2009).
Kramer and Johnson stated, “Any non-cash expenses or non-cash income from the income statement (depreciation and amortization) flow into the cash flow statement and adjust net income to arrive at cash flow from operations” (Kramer, Johnson, 2009). Kramer and Johnson stated, “Any balance sheet items that have a cash impact (working capital, financing, PP&E) are linked to the cash flow statement since it is either a source or use of cash” (Kramer, Johnson, 2009). Kramer and Johnson stated, “The net change in cash on the cash flow statement and cash from the previous period’s balance sheet comprise cash for the current period” Kramer, Johnson, 2009). NOTES TO THE FINANCIAL STATEMENT Berry stated, “Notes (footnotes) to the financial statements are included to meet standards of full disclosure” (Berry, 2006). Berry stated, “Notes to the financial statement signifies certain items included in the main body” (Berry, 2006). Berry stated, “They are used to help users of the financial statements understand some of the more difficult items and are considered an essential part of the financial statements” (Berry, 2006). Berry stated, “Notes summarizes the accounting principles and methods of applying those principles” (Berry, 2006).
Berry stated, “encompass important judgment as to valuation, recognition, and allocation of assets, liabilities, expenses, revenues and other financing sources” (Berry, 2006). Berry stated, “Discloses any significant changes in the composition of the reporting entity or significant changes in the manner in which the information is combined for financial reporting purposes” (Berry, 2006). WHY ARE RATIOS IMPORTANT AND EXAMPLES OF RATIOS Debt to equity ratio compares a company’s total debt to shareholders’ equity (Easton, Halsey, McNally, Hartgraves, Morse, 2013).
Easton, Halsey, McNally, Hartgraves, Morse stated, “Both of these numbers can be found on a company’s balance sheet” (Easton, et. al, 2013). Easton, Halsey, McNally, Hartgraves, Morse stated, “If a company has a debt-to-equity ratio of 2 to 1, it means that the company has two dollars of debt to every one dollar shareholders invest in the company” (Easton, et. al, 2013). The company is taking on debt at twice the rate that its owners are investing in the company (Easton, et. al, 2013). Debt to Equity Ratio = Total Liabilities / Shareholders’ Equity (Easton, et. al, 2013)
Inventory turnover ratio compares a company’s cost of sales on its income statement with its average inventory balance for the period (Easton, et. al, 2013). If a company has an inventory turnover ratio of 2 to 1, it means that the company’s inventory turned over twice in the reporting period. Inventory Turnover Ratio = Cost of Sales / Average Inventory for the Period (Easton, et. al, 2013) Operating margin compares a company’s operating income to net revenues. Both of these numbers can be found on a company’s income statement (Easton, et. al, 2013). Operating margin is expressed as a percentage.
It shows, for each dollar of sales, what percentage was profit. Operating Margin = Income from Operations / Net Revenues (Easton, et. al, 2013) P/E ratio compares a company’s common stock price with its earnings per share. If a company’s stock is selling at $20 per share and the company is earning $2 per share, then the company’s P/E Ratio is 10 to 1. The company’s stock is selling at 10 times its earnings. P/E Ratio = Price per share / Earnings per share (Easton, et. al, 2013) The working capital is defined as the money leftover if a company paid its current liabilities from its current assets.
Working Capital = Current Assets – Current Liabilities (Easton, et. al, 2013) GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (GAAP) According to Kramer and Johnson (2009) generally accepted accounting principles is a framework of accounting standards, rules and procedures defined by the professional accounting industry, which has been adopted by nearly all publicly traded U. S. companies Kramer, Johnson, 2009). Kramer and Johnson stated, “GAAP rules and procedures are what govern corporate accountants when they present the details of a company’s financial operations” (Kramer, Johnson, 2009).
GAAP, requires that discontinued operations be shown separately on the income statement after income from continuing operations is computed. Discontinued operations will not affect net income in the future in either a positive or a negative direction (Kramer, Johnson, 2009). According to Kramer and Johnson (2009), when auditors makes opinions on financial statements they follow the generally accepted accounting principles (GAAP) in all material aspects. According to Kramer and Johnson (2009), the auditors are given this opinion without any qualifications.
That is why the opinion is given the name unqualified. A qualification is a discovery by the auditors of some kind of problem (Kramer, Johnson, 2009). CONCLUSION According to Berry (2006) no matter if an organization is for profit or not for profit there is always someone designated to manage finances. Berry stated, “This person plays a leadership role in pushing for full integration of strategic financial planning” (Berry, 2006). Berry stated, “The person has to assume a role for full management of all the financial statements which means the financial management activities” (Berry, 2006).
This person has to maintain integrity of the balance sheet and the creditworthiness of the organization (Berry, 2006). According to Berry (2006) this person has to manage the capital structure of the organization to ensure maximum capital availability at the minimum cost. This person has to oversee the interplay among strategic plans, capital markets access and capital structure decisions, and capital allocation decisions (Berry, 2006). According to what I read with Kramer and Johnson (2009) the financial manager must enforce the application of a rigorous, systematic, evidence based, unbiased assessment of capital investments opportunities.
According to Kramer and Johnson (2009) it is important for the financial manager to also monitor and measure the financial performance of the total company. Moseley stated, “That financial statements helps organizations to make vital decisions on the growth of the company success” (Moseley, 2009). Moseley stated, “Financial statements are used to provide information that is useful in making investment and credit decisions” (Moseley, 2009). Financial statements is to provide information that is useful in assessing cash flow prospects (Moseley, 2009).
Financial statements provide information about the resources of a business, claims to those resources, and changes to them (Moseley, 2009). During the course I was able to understand the relationship between the four basic statements and the importance of these statements. During the year, the business engages in many activities. The operating activities of the business is summarized and presented in the income statement which shows the revenue earned, the expenses incurred, and the resulting net income.
Cash receipts and payments arising from operating activities are summarized and presented in the statement of cash flows. According to Moseley (2009) the company also engages in other activities, including borrowing and repaying loans, purchasing equipment, the owner’s contribution of additional equipment to be used by the business, and a withdrawal of cash by the owner. The cash receipts and payments from these investing and financing activities are presented in the statement of cash flows, along with disclosure of the investing and financial activities that do not affect cash.
RESOURCES 1. Moseley, G. B. (2009). Managing Health Care Business Strategy. Sudbury, Massachusetts: Jones and Bartlett Publishers 2. Easton, P. D. , Halsey, R. F. , McNally, M. L. , Hartgraves, A. , & Morse, W. J. (2013). Financial & Managerial Accounting for MBAs (3rd ed. ). Chicago, IL: Cambridge Business Publishers. 3. Berry, L. E. (2006). Management Accounting: Self Teaching Guide. Emeryville, CA: McGraw-Hill Companies. 4. Kramer, B. K. , Johnson, C. W. (2009). Financial Statements: A Self Teaching Guide. New York, NY: McGraw-Hill Companies.

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