Financial Accounting and Analysis of Financial

Statements

Lecture Notes
Introduction

Financial Accounting is the language of business. Its purpose is to

communicate financial information to interested parties. The information
includes disclosures about a firm’s profits, cash flows, assets, and obligations.
The interested parties are numerous and include employees, customers, the
government, communities, lenders, and investors.

2
 3

Accounting Discipline Overview

(1 of 3)

• Management accounting measures, analyzes, and reports

financial and nonfinancial information that helps managers
make decisions to fulfill organizational goals. Management
accounting need not be GAAP compliant.
• Managers use management accounting information to:
– Develop, communicate and implement strategies
– Coordinate product design, production, and marketing
decisions and evaluate a company’s performance
 4
Accounting Discipline Overview
(2 of 3)

• Financial accounting focuses on reporting financial

information to external parties such as investors,
governmental agencies, banks, and suppliers, based on GAAP.
• Cost Accounting measures, analyzes and reports financial and
nonfinancial information related to the costs of acquiring or
using resources in an organization.
 5
Accounting Discipline Overview
( 3 of 3)

• Today, most accounting professionals take the perspective

that cost information is part of the information collected to
make management decisions; therefore the distinction
between the two is not clear-cut and in your book and these
PowerPoint presentations, we often use the terms
interchangeably.
 Major Differences Between 6

Management and Financial

Accounting
EXHIBIT 1.1 Major Difference Between Management and Financial Accounting
 7
Strategic Decisions and the
Management Accountant- (1 of 2)
• Strategy specifies how an organization matches its own
capabilities with the opportunities in the marketplace
• There are two broad strategies: cost leadership and product
differentiation
• Strategic cost management describes cost management that
specifically focuses on strategic issues.
 8
Strategic Decisions and the
Management Accountant- (2 of 2)
Management accounting information helps managers formulate strategy by
answering questions such as the following:
• Who are our most important customers and what critical capability do we
have to be competitive and deliver value to our customers?
• What is the bargaining power of our customers?
• What is the bargaining power of our suppliers?
• What substitute products exist in the marketplace and how do they differ
from our product in terms of features, price, cost and quality?
• Will adequate cash be available to fund the strategy, or will additional
funds need to be raised?
Our Focus

Society

Public Private

Non-profit For-profit

Sole Proprietor Partnership Corporation

Private Public

9
International Standards

• In the US, the accounting rules are written by the Financial Accounting
Standards Board (FASB).

• The rules of the FASB constitute “Generally Accepted Accounting

Principles” (GAAP).

• Other countries have their own GAAP, which contrast in varying degrees to
US GAAP.

• The International Accounting Standards Board (IASB) is developing a set

of rules that will be used trans-nationally in order to facilitate comparisons
between and among firms in different countries.

• IASB GAAP is commonly referred to as International Financial Reporting

Standards (IFRS).

10
The Fundamental Accounting Equation

Assets = Liabilities + Owners’ Equity

11
Recording basic financial transactions

1. Assume a firm is just getting started and decides to borrow £100 in cash
from a bank. This would be recorded as follows:

Assets Liabilities Owners’ Equity

100 Cash 100 Note Payable

•Assets increase by £100 and liabilities increase by £100.

12
Recording basic financial transactions (cont’d)

2. Assume the firm needs more cash and decides to sell stock to investors,
rather than borrow from a bank. Suppose it sells stock valued at £100.

Assets Liabilities Owners’ Equity

100 Cash 100 Stock

•So the firm now has £200 in cash, half from debt and half from equity.

13
Recording basic financial transactions (cont’d)

3. In order to commence activities, the managers decide to use £80 of the

cash to buy a building.

Assets Liabilities Owners’ Equity

(80) Cash
80 Building

•Cash is reduced by £80. Building (also an asset) replaces the cash.

14
Recording basic financial transactions (cont’d)

4. The managers then decide to use £40 of the cash to buy key inputs for its
activities (inventory/raw materials/etc.).

Assets Liabilities Owners’ Equity

(40) Cash
40 Inventory

•Cash is reduced by £40 and inventory (also an asset) is increased by £40.

15
Journal Entries

• The four tables above are called journal entries.

• They record both sides of a transaction, so they always have at least two
parts.

• This system is called the double-entry system and was developed in 1494 in
Venice by an Italian monk, Friar Luca Pacioli.

• Journal entries are recorded in the “Journal”, which is a sort of financial

diary.

• The Journal is also called the “book of original entry”.

16
The Ledger

• Data from the journal entries are “posted” to individual accounts (Cash, Debt,
Stock, etc.) to accumulate the account balances.

• The Ledger for our firm at this point in time is:

Total Liabilities &

Owners’ Equity

Owners’ Equity
Note Payable
Total Assets

Liabilities
Inventory

Building
Assets

Stock
Cash

Begin 0 0 0 0 0 0 0

1 100 100

2 100 100

3 (80) 80

4 (40) 40

End 80 40 80 200 100 100 200

17
Further transactions

5. Let’s say the firm sells half of its inventory (£20) for £80 in cash. Here we
have two pairs of accounts to track.

Assets Liabilities Owners’ Equity

80 Cash 80 Revenues
(20) Inventory (20) Cost of Goods
Sold

•Revenues could be called Sales or Turnover. Cost of Goods Sold can be

abbreviated as COGS or CGS.

18
Further transactions (cont’d)

6. Now the firm pays wages to its employees. Let’s assume it pays £10 in
cash.

Assets Liabilities Owners’ Equity

(10) Cash (10) Wage Expense

•Both Cost of Goods Sold and Wage Expense are deducted from Revenues in
order to get the firm’s Net Income.

19
Further transactions (cont’d)

7. Earlier the firm bought a building, which it must depreciate for general wear
and tear as it uses it. Assume the expected life of the building is 4 years.

Assets Liabilities Owners’ Equity

(20) Building (20) Depreciation
Expense

•If straight-line depreciation is adopted, the Building account is reduced

systematically over its expected life, i.e. £20 each year for the 4 years.

20
Further transactions (cont’d)

8. Earlier the firm borrowed money from a bank, for which it must pay interest.
Let’s assume the interest of £10 is due now but the bank has agreed for the
interest to be paid at a later date.

Assets Liabilities Owners’ Equity

10 Interest Payable (10) Interest Expense

•The Interest Expense must be booked in the current period, and the Interest
Payable must also be booked to indicate that it owes £10 to the bank and that
it will pay it in the future.

21
Further transactions (cont’d)

9. The firm has to pay tax on its profit to the government. Let’s assume the tax
rate is 35% so the total Tax Expense is £7. The firm will not pay the tax now
but at some point in the future.

Assets Liabilities Owners’ Equity

7 Taxes Payable (7) Tax Expense

•Similarly, the Tax Expense is booked in the current period and the Taxes
Payable indicate a liability (owed) to be paid in the future.

22
 9
8
7
6
5
5
4
3
2
1

End
Assets

Begin
0

80
Cash

150
100
100

(10)
(40)
(80)
0

20
40
Inventory

(20)
0

60
80
Building

(20)
0 Total Assets

230
Updated Ledger

Liabilities
0

Notes Payable

100
100
0

10
10
Interest Payable

7
7
0

Taxes Payable
0

Total Liabilities
117

Owners’ Equity
0

Stock
100
100

Retained
0

13
80

(7)
(10)
(20)
(10)
(20)

Earnings

Total Owners’
0

113

Equity

Total Liabilities
0

& Owners’
230

23

Equity
Retained Earnings

• Retained Earnings is an account in the Ledger (or Balance Sheet) that

collects all of the revenues and expenses of the firm.

• All of the changes in the Retained Earnings account correspond to the

individual items on the Income Statement.
Income Statement
Revenues £80

Cost of Goods Sold (20)

Wage Expense (10)

Depreciation Expense (20)

Interest Expense (10)

Pre-Tax Income 20

Tax Expense (7)

Net Income 13
24
Financial Statements

• The Balance Sheet, Income Statement, and Statement of Cash Flows are a
firm’s primary statements.

• The Statement of Cash Flows shows the cash into and out of the firm, i.e.
the Cash account from the Ledger (or Balance Sheet). The 3 categories of
Cash Flows are: operating cash flows, investing cash flows, and financing
cash flows.

• The 3 primary statements highlighted above plus the Statement of Owners’

Equity and the firm’s Note Disclosures are collectively referred to as the
firm’s “Financial Statements”.

25
Exercise 1
Journalize the below transactions for a firm that is just commencing business:

1.The firm borrows £50 cash.

2.The firm sells stock for £20 cash.

3.Buys a building for £30 cash.

4.Buys inventory for £10 cash.

5.Sells £8 of inventory for £30 cash.

6.Pays wages of £2 cash.

7.Depreciates the building by £6.

8.Books £4 of Interest Expense to be paid later.

9.Books £4 of Tax Expense to be paid later.

26
Exercise 1 – Solution
1. The firm borrows £50 cash.
Assets Liabilities Owners’ Equity
50 Cash 50 Note Payable

1. The firm sells stock for £20 cash.

Assets Liabilities Owners’ Equity
20 Cash 20 Stock

1. Buys a building for £30 cash.

Assets Liabilities Owners’ Equity
(30) Cash
30 Building

1. Buys
Assets
inventory forLiabilities
£10 cash. Owners’ Equity
(10) Cash
10 Inventory

Assets Liabilities Owners’ Equity

1. Sells £8 of inventory for £30 cash.
30 Cash 30 Revenue
27
(8) Inventory (8) COGS
Exercise 1 – Solution

6. Pays wages of £2 cash.

Assets Liabilities Owners’ Equity
(2) Cash (2) Wage Expense

6. Depreciates
Assets the Building by £6.
Liabilities Owners’ Equity
(6) Building (6) Depreciation Expense

Assets Liabilities Owners’ Equity

6. Books £4 of Interest Expense(4)to

4 Interest Payable beExpense
Interest paid later.

Assets Liabilities Owners’ Equity

4 Taxes Payable (4) Tax Expense

6. Books £4 of Tax Expense to be paid later.

28
Exercise 2

Post the journal entries to the Ledger. The Beginning Balances (“Begin”) are
all 0 because the firm is just commencing its business.

29
 9
8
7
6
5
5
4
3
2
1

End
Assets

Begin
0

58
30
20
50
Cash

(2)
(10)
(30)

2
0

10
Inventory

(8)
0

24
30
Building

(6)
0

84
Total Assets

Liabilities
0

50
50

Notes Payable
Exercise 2 – Solution

4
4
0

Interest Payable

4
4
0

Taxes Payable
0

58
Total Liabilities

Owners’ Equity
0

20
20

Stock

Retained
6
0

30

(4)
(4)
(6)
(2)
(8)

Earnings

Total Owners’
0

26

Equity

Total Liabilities
0

84

& Owners’
30

Equity
Exercise 3

Create the Balance Sheet from the information in the Ledger.

31
 Exercise 3 – Solution
Company Name
Balance Sheet at December 31, X
Assets Liabilities
Current Assets Current Liabilities
Cash £58 Interest Payable £4
Inventory 2 Taxes Payable 4
Total Current Assets 60 Total Current Liabilities 8

Non-Current Assets Non-Current Liabilities

Property, Plant & Equipment 24 Note Payable 50
Total Assets £84 Total Liabilities £58

Owners’ Equity
Stock £20
Retained Earnings 6
Total Owners’ Equity £26
Total Liabilities & Owners’ Equity £84

32
Exercise 4

Create the Income Statement from the information in the Ledger.

33
Exercise 4 – Solution

Company Name
Income Statement for the period ended December 31, X

Revenues £30

Cost of Goods Sold (8)

Wage Expense (2)

Depreciation Expense (6)

Interest Expense (4)

Income Before Tax 10

Tax Expense (4)

Net Income £6

34
Exercise 5

Create the Statement of Cash Flows from the information in the Ledger.

35
Exercise 5 – Solution
Company Name
Statement of Cash Flows for the period ended December 31, X

Cash from Operating Activities

Cash received from customers £30
Cash paid to suppliers of inventory (10)
Cash paid to employees (2)
Total Cash from Operating Activities 18

Cash used in Investing Activities

Building (30)

Cash from Financing Activities

Cash received from the sale of stock 20
Cash received from new borrowing 50
Total Cash from Financing Activities 70

Total Change in Cash 58

Beginning Cash Balance 0
Ending Cash Balance £58 36
Recap Example
1. A firm issues £100 in stock for cash.

2. Borrows £10 from a bank by issuing a long-term note.

3. Buys Property, Plant, and Equipment (PP&E) for £40 by paying £15 in cash and issuing a
long-term note for the balance.

4. Buys inventory for £20 on credit.

5. Sells £15 of the inventory for £28 in a credit sale.

6. Collects one-half of the receivable booked in event 5.

7. Pays £10 to suppliers of inventory purchased in event 4.

8. Records wage expense for £3, which will be paid at a later date.

9. Records £2 of depreciation expense on the PP&E.

10. Due to interest on both notes, records interest expense of £3, to be paid at a later date.

11. At a tax rate of 40%, records tax expense of £2, which will be paid in the future.
37
Recap Example – Solution
1. A firm issues £100 in stock for cash.
Assets Liabilities Owners’ Equity
100 Cash 100 Stock

1. Borrows £10 from a bank by issuing a long-term note.

Assets Liabilities Owners’ Equity
10 Cash 10 Note Payable

1. Buys Property, Plant, and Equipment (PP&E) for £40 by paying £15 in cash and issuing a
long-term note for the balance.
Assets Liabilities Owners’ Equity
40 PP&E 25 Note Payable
(15) Cash

1. Buys inventory for £20 on credit.

Assets Liabilities Owners’ Equity
20 Inventory 20 A/P

1. Sells £15 of the inventory for £28 in a credit sale.

Assets Liabilities Owners’ Equity
28 A/R 28 Sales
(15) Inventory (15) Cost of Goods Sold
38
Recap Example – Solution
6. Collects one-half of the receivable booked in event 5.
Assets Liabilities Owners’ Equity
14 Cash
(14) A/R

6. Pays £10 to suppliers of inventory purchased in event 4.

Assets Liabilities Owners’ Equity
(10) Cash (10) A/P

6. Records wage expense for £3, which will be paid at a later date.
Assets Liabilities Owners’ Equity
3 Wages Payable (3) Wage Expense

6. Records £2 of depreciation expense on the PP&E.

Assets Liabilities Owners’ Equity
(2) A/D (2) Depreciation Expense

6. Due to interest on both notes, records interest expense of £3, to be paid at a later date.
Assets Liabilities Owners’ Equity
3 Interest Payable (3) Interest Expense

6. At a tax rate of 40%, records tax expense of £2, which will be paid in the future.
Assets Liabilities Owners’ Equity
39
2 Taxes Payable (2) Tax Expense
 9
8
7
6
5
5
4
3
2
1
in

11
10
Assets

Beg

End
0

99
14
10
Cash

100

(10)
(15)
Accounts

14
28

(14)
Receivable

5
0

20
Inventory

(15)
0

40
40
Building
The Ledger

0 Accumulated

(2)
(2)
Depreciation
0

Total Assets

156
Liabilities

Accounts
0

10
20

(10)
Payable

3
3
0

Wages Payable

3
3
0

Interest Payable

2
2
0

Taxes Payable
0

35
25
10

Note Payable
0

53

Total Liabilities

Owners’ Equity
0

Stock
100
100

Retained
3
0

28

(2)
(3)
(2)
(3)
(15)

Earnings

Total Owners’
0

103

Equity
Total Liabilities
0

& Owners’
156

40

Equity
 Creating the Balance Sheet
Company Name
Balance Sheet at December 31, X
Assets Liabilities
Current Assets Current Liabilities
Cash £99 Accounts Payable £10
Accounts Receivable 14 Wages Payable 3
Inventory 5 Interest Payable 3
Total Current Assets 118 Taxes Payable 2
Total Current Liabilities 18
Non-Current Assets
Property, Plant & Equipment 40 Non-Current Liabilities
Accumulated Depreciation (2) Note Payable 35
Net Property Plant & Equipment 38 Total Liabilities £53
Total Assets £156
Owners’ Equity
Stock £100
Retained Earnings 3
Total Owners’ Equity £103
Total Liabilities & Owners’ Equity £156

41
Creating the Income Statement

Company Name
Income Statement for the period ended December 31, X

Sales £28

Cost of Goods Sold (15)

Wage Expense (3)

Depreciation Expense (2)

Interest Expense (3)

Tax Expense (2)

Net Income £3

42
Creating the Statement of Cash Flows
Company Name
Statement of Cash Flows for the period ended December 31, X

Cash from Operating Activities

Cash received from customers £14
Cash paid to suppliers of inventory (10)
Total Cash from Operating Activities 4

Cash used in Investing Activities

Capital expenditures (15)

Cash from Financing Activities

Cash received from the sale of stock 100
Cash received from new borrowing 10
Total Cash from Financing Activities 110

Total Change in Cash 99

Beginning Cash Balance 0
Ending Cash Balance £99
43
Some Important Concepts – Gains and Losses

• Gains are similar to revenues, but they are the result of peripheral activities
that are not central and ongoing activities of the firm, like revenues.

• For example, a firm sells a piece of equipment for £1,000 cash. The firm
used the equipment to manufacture products (inventory) that it sells. The
equipment is listed on the firm’s Balance Sheet at £800.
Assets Liabilities Owners’ Equity
1,000 Cash 200 Gain
(800) Equipment

• If the firm had been in the business of selling the equipment, rather than
using it, then it would record the transaction as revenue.
Assets Liabilities Owners’ Equity
1,000 Cash 1,000 Revenue
(800) Equipment (800) COGS

44
Some Important Concepts – Gains and Losses

• Losses are mirror images of Gains.

• For example, assume the firm sells the same piece of equipment for £600
cash and the firm used the equipment to manufacture products (inventory)
that it sells. The sale would be recorded as follows:

Assets Liabilities Owners’ Equity

600 Cash (200) Loss
(800) Equipment

• Peripheral activities are reported on a “net” basis while central activities are
reported on a “gross” basis (Revenue less COGS).

• Net Income can sometimes be “propped up” or distorted by one-time gains

or losses. Therefore, earnings that do not include gains and losses are of
“higher quality”.

45
Some Accounting Principles – The Revenue
Principle
• The Revenue Principle stipulates that one books (records, recognizes,
journalizes) revenue when it is earned and it is realized or realizable. By
realizable, it means that the receivable will likely turn into cash.

• Even if a customer has paid cash, the firm cannot book it as a sale if it has
not earned the revenue. For example, an upfront payment for a service or a
gift card.

• It is recorded under Liabilities as Unearned Revenue, Deferred Revenue, or

Advances from Customers.

46
Some Accounting Principles – The Expense
Principle
• This is also called the Matching Principle.

• It is similar to the Revenue Principle, in respect that a firm can book an

expense when the benefit is received regardless of the timing of the cash
flow. For example, rent or insurance.

• If cash is paid before the benefit is received, it is recorded under Assets as

Prepaid Expense.

• These two principles, the Revenue principle and the Expense Principle, are
the basis of Accrual Accounting.

47
Fair Value Accounting

• It is also called Mark-to-Market Accounting.

• Fair Value Accounting is an accounting system that is “bolted on” to the

Accrual Accounting system. It requires the recognition of unrealized losses
and unrealized gains for certain select assets and liabilities.

• It is “non-transactions based” since the gains and losses are from changes in
value and not from transactions with independent parties.

• The purpose of Fair Value Accounting is to show current market values,

because they are deemed relevant even though they may not be very
reliable and go against general conservative accounting principles.

• It has become very controversial, being partly blamed for the global financial
crisis 2007/8.

48
Fair Value Accounting – Example

• Assume a firm buys an investment for £100 and that the investment is the
stock of another company. Subsequently, the stock price of the investment
increases from £100 to £120.

• Under fair value accounting, the firm would book the investment and the
subsequent gain.
Assets Liabilities Owners’ Equity
100 Investment
(100) Cash

Assets Liabilities Owners’ Equity

20 Investment 20 Unrealized Gain

• One can see how quickly and easily this can contribute to bubbles!

49
Exercise 1
Theobald Ltd is a new company that has just started business. Journalize its
following transactions:

1.It issues (sells) its own stock for £100 cash.

2.It borrows £50 cash.

3.Buys a building for £100 cash.

4.Buys inventory for £50. It pays £40 cash and the remainder is on account.

5.Sells inventory costing £20 for £60. The sale is a credit sale.

6.Collects £50 cash from the above Accounts Receivable.

7.Records wage expense of £5.

8.Depreciates the building by £5.

9.Records £5 (or 10%) interest expense on the borrowing in 2. Will pay the interest later.

10.Calculates tax expense as £10 (or 40%) of pre-tax profit. Will pay the tax later.
50
Exercise 1 – Solution
1. It issues (sells) its own stock for £100 cash.
Assets Liabilities Owners’ Equity
100 Cash 100 Stock

1. It borrows £50 cash.

Assets Liabilities Owners’ Equity
50 Cash 50 Note Payable

1. Buys a building for £100 cash.

Assets Liabilities Owners’ Equity
(100) Cash
100 PP&E

1. Buys inventory for £50. It pays £40 cash and the remainder is on account.
Assets Liabilities Owners’ Equity
50 Inventory 10 Accounts Payable
(40) Cash

1. Sells inventory costing £20 for £60. The sale is a credit sale.
Assets Liabilities Owners’ Equity
60 Accounts Receivable 60 Sales
51
(20) Inventory (20) COGS
Exercise 1 – Solution
6. Collects £50 cash from the above Accounts Receivable.
Assets Liabilities Owners’ Equity
50 Cash
(50) Accounts Receivable

6. Records wage expense of £5.

Assets Liabilities Owners’ Equity
(5) Cash (5) Wage Expense

6. Depreciates the building by £5.

Assets Liabilities Owners’ Equity

(5) Accumulated (5) Depreciation Expense
Depreciation

6. Records £5 (or 10%) interest expense on the borrowing in 2. Will pay the interest later.
Assets Liabilities Owners’ Equity
5 Interest Payable (5) Interest Expense

6. Calculates tax expense as £10 (or 40%) of pre-tax profit. Will pay the tax later.
Assets Liabilities Owners’ Equity
10 Taxes Payable (10) Tax Expense
52
Exercise 2

Post the journal entries to the Ledger.

53
 9
8
7
6
5
5
4
3
2
1
in

10
Assets

Beg

End
0

55
50
50
Cash

(5)
100

(40)
(100)
Accounts

10
60

(50)
Receivable

30
50
Inventory

(20)
0
PP&E

100
100
Accumulated
0

(5)
(5)
Depreciation
0

Total Assets

190
Liabilities
Exercise 2 – Solution

Accounts
0

10
10

Payable

5
5
0

Interest Payable
0

10
10
Taxes Payable
0

50
50

Note Payable
0

75

Total Liabilities

Owners’ Equity
0

Stock
100
100

Retained
0

15
60

(5)
(5)
(5)

(10)
(20)

Earnings

Total Owners’
0

115

Equity
Total Liabilities
0

& Owners’
190

Equity
54
Exercise 3

Create the Balance Sheet from the information in the Ledger.

55
 Exercise 3 – Solution
Theobald Ltd
Balance Sheet at December 31, X
Assets Liabilities
Current Assets Current Liabilities
Cash £55 Accounts Payable £10
Accounts Receivable 10 Wages Payable 0
Inventory 30 Interest Payable 5
Total Current Assets 95 Taxes Payable 10
Total Current Liabilities 25
Non-Current Assets
Property, Plant & Equipment 100 Non-Current Liabilities
Accumulated Depreciation (5) Note Payable 50
Net Property Plant & Equipment 95 Total Liabilities £75
Total Assets £190
Owners’ Equity
Stock £100
Retained Earnings 15
Total Owners’ Equity £115
Total Liabilities & Owners’ Equity £190

56
Exercise 4

Create the Income Statement from the information in the Ledger.

57
Exercise 4 – Solution

Theobald Ltd
Income Statement for the period ended December 31, X

Sales £60

Cost of Goods Sold (20)

Wage Expense (5)

Depreciation Expense (5)

Interest Expense (5)

Income Before Tax 25

Tax Expense (10)

Net Income £15

58
Exercise 5

Create the Statement of Cash Flows from the information in the Ledger.

59
Exercise 5 – Solution
Theobald Ltd
Statement of Cash Flows for the period ended December 31, X

Cash from Operating Activities

Cash received from customers £50
Cash paid to suppliers of inventory (40)
Cash paid to employees (5)
Total Cash from Operating Activities 5

Cash used in Investing Activities

Property, Plant & Equipment (100)

Cash from Financing Activities

Cash received from the sale of stock 100
Cash received from new borrowing 50
Total Cash from Financing Activities 150

Total Change in Cash 55

Beginning Cash Balance 0
Ending Cash Balance £55 60
Exercise 6

A firm sells a car for £100 cash. The cost of the car is £80.

A)If the firm is a car dealer and the sale of cars is its central activity, journalize
the transaction.

B)If the firm does not normally sell cars but rather simply uses cars to visit its
customers, journalize the transaction. Assume that £80 is the car’s net book
value (i.e. cost less any accumulated depreciation).

61
Exercise 6 – Solution

A firm sells a car for £100 cash. The cost of the car is £80.

A)If the firm is a car dealer and the sale of cars is its central activity, journalize
the transaction.

Assets Liabilities Owners’ Equity

100 Cash 100 Sale
(80) Inventory (80) COGS

A)If the firm does not normally sell cars but rather simply uses cars to visit its
customers, journalize the transaction. Assume that £80 is the car’s net book
value (i.e. cost less any accumulated depreciation).
Assets Liabilities Owners’ Equity
100 Cash 20 Gain
(80) PP&E

62
Contents

• Reasons for financial analysis

• Review of financial statements
• Effects of financial leverage
• Financial ratios
• DuPont system

63
Financial analysis can be achieved through
different methods
Methods Description

• Financial analysis Financial • The most common way to performing

refers to the financial analysis by going through
ratios ratios that concentrate on leverage,
analysis of the
accounts and the liquidity, efficiency, profitability and
economic firm value
prospects of a firm
• Valuation through the use of cash
• It also provides a Valuation flows and other “comparables”
tool for evaluating
the viability, stability
and profitability of
a business, sub-
business or project • Benchmarking other comparable
Competition firms
• There are different
methods to do so:

64
Financial ratios is the most common method used
for financial analysis

• Understand the significance of accounting data by comparing:

• Across time
• Financial • Across the industry/sector
analysts
calculate • Ratios can help normalise and facilitate meaningful
ratios to:
comparisons

• Taking apart a ratio can help develop insights

65
Financial ratios are ways of comparing and
investigating the relationship between pieces of
financial information
Aspects Description

• Financial ratios are measures of relative values of key financial

Definition information

• Ratio analysis involves methods of calculating and interpreting

Use financial ratios to assess a firm’s performance

• Ratio analysis comes in various measurements such as

Measurements  Percentages [“%”]
 Times or multiples [“x”]
 Number of days [“days”]

• Ratios are of interest as key indicators of financial health to

Use  Management team of the company
 Creditors
 Shareholders
66  Prospective investors
There
Types
are twoDescription
main types of ratio comparison

1
• Cross-sectional analysis involves the comparison of different firms
Cross-sectional at the same point of time
analysis • Benchmarking firm performance against industry averages is very
popular

Price-Earning ratio
2004A
Barclays 9.1x
HBOS 8.9x
HSBC 4.2x
Lloyds 9.9x

9 UK Banks 10.7x

67
There are two main types of ratio comparison
(cont’d)
Types Description

2
• Time-series analysis evaluates performance over time, allowing
Time-series comparisons of current and past ratio values to take place
analysis

Price-Earning ratio
2004A 2005E 2006E
Barclays 9.1x 9.6x 8.8x

• Combined analysis mixes both features of cross-sectional and

Combination time-series analysis

Price-Earning ratio
2004A 2005E 2006E
Barclays 9.1x 9.6x 8.8x
HBOS 8.9x 9.5x 8.9x
HSBC 4.2x 4.6x 5.1x
Lloyds 9.9x 10.5x 9.7x

9 UK Banks 10.7x 10.5x 9.7x

68
Contents

• Reasons for financial analysis

• Review of financial statements
• Effects of financial leverage
• Financial ratios
• DuPont system

69
Important information can be obtained from the 3
financial statements
Statements Description

1
• The balance sheet is a snapshot of the firm. It is a convenient
Balance means of organising and summarising what a firm owns (its
Sheet assets), what a firm owes (its liabilities), and the difference
between the two (the firm’s equity) at a given point in time
• The main components are:
 Current assets
 Fixed assets
 Current liabilities
 Long-term debt
 Shareholders’ equity

Income • The income statement measures performance over some period

of time, usually a quarter or a year
statement
• If the balance sheet is a snapshot, the income statement is a
video recording covering the period between before and after
pictures
• The importance of EBITDA
70
Important information can be obtained from the 3
financial statements (cont’d)
Statements Description

3
• The cash flow statement shows how money is sourced and how it
Cash flow is spent
statement • Total sources of funds are the activities that bring in cash
 Net income + depreciation + new issues of long-term debt +
new issues of equity
• Total uses of funds
 Investment in working capital + capital expenditure +
dividends paid to shareholders

71
Contents

• Reasons for financial analysis

• Review of financial statements
• Effects of financial leverage
• Financial ratios
• DuPont system

72
Contents

• Reasons for financial analysis

• Review of financial statements
• Effects of financial leverage
• Financial ratios
• DuPont system

73
There are five broad categories of ratios, each revealing different aspects
Types Description

1
• Leverage ratios address a firm’s long-term ability to meet its
Leverage obligations and financial leverage

2
• Liquidity ratios refer to a firm’s abilities to satisfy its short-term
Liquidity obligations as they come due
• The primary concern is the firm’s ability to pay its bills over the
short-run without undue stress
3

Efficiency/ • Efficiency or activity ratios measure how efficiently and intensively

a firm uses its assets to generate sales
Activity

4 • Profitability ratios measure how efficiently a firm uses its assets

Profitability and how efficiently a firm manages its operations
• The focus is on the bottom line (i.e. net income)
5

Market-to- • Market-to-value ratios measure how the market views the

performance of a firm
value

74
 Leverage ratios address a firm’s long-term
1 ability to meet its obligations and financial
leverage
Types Description Equation
1
• Takes into account all debts of all Long-term debt
Debt ratio maturities to all creditors
• Sometimes, value of leases are Long-term debt + Equity
counted as long-term debt
because they resemble long-term
debt
• Can be expressed in “x”, “%” or
“:”

Debt-equity • The proportion of equity and Long-term debt

debt the company is using to
ratio finance its assets Equity
• Again, sometimes, value of
leases are counted as long-term
debt because they resemble
long-term debt
• Can be expressed in “x”, “%” or
“:”

75
 Leverage ratios address a firm’s long-term
1 ability to meet its obligations and financial
leverage (cont’d)
Types Description Equation
3

Interest • The extent to which interest is EBIT

covered by EBIT [plus
coverage depreciation] Interest
• Usually expressed in “x”
or
EBIT + Depreciation
Interest

76
 Liquidity ratios refer to a firm’s abilities to
2 satisfy its short-term obligations as they
come due
Types Description Equation
1
• Current ratio measures the Current assets
Current ratio margin liquidity – how assets can
readily be turned into cash Current liabilities
• Can be expressed in “x” or “:”

2
Quick • Quick ratio measures the margin
(acid-test) the liquidity, taking into Cash + marketable
ratio consideration certain current securities + receivables
assets are not readily convertible
into cash Current liabilities
• Can be expressed in “x” or “:”

3
• Cash ratio measures a company’s Cash + marketable
Cash ratio most liquid assets – cash – securities
against current liabilities
• Can be expressed in “x” or “:” Current liabilities

77
 Efficiency or activity ratios measure how
3 efficiently and intensively a firm uses its
assets to generate sales
Types Description Equation
1

Sale-to- • Sales-to-assets or asset

turnover ratio shows how hard a Sales
assets firm’s assets are being put to Average total assets
use
• Usually expressed in “x”
• Average of the figures at the
beginning and the end of the year
• Average is necessary when income
statement and balance sheet
information are used
simultaneously in the same ratio
Example

2014 2015 ∆

Turnover £1,110,678 £697,720 59.19%

Average total assets £315,528 £171,160 84.35%

Asset turnover 3.52x 4.08x N/A

78
 Efficiency or activity ratios measure how
3 efficiently and intensively a firm uses its
assets to generate
Types Description
sales (cont’d)
Equation
2

Inventory • Inventory turnover shows how Cost of goods sold

many times a company’s
turnover inventory is sold and replaced Average inventory
over a period
• Usually expressed in “x”
3

Days in • Days in inventory measures the Average inventory

speed with which a company
inventory turns over its inventory (i.e. Cost of goods sold ÷ 365
number of days that a firm
takes to produce and sell the
goods to be produced and sold)
• Expressed in “days”

Example
2014 2015 ∆
COGS £830,126 £505,738  64.14%
Inventory £52,437 £51,482  1.86%
79 Days in inventory 23.06 days 37.42 days
 Efficiency or activity ratios measure how
3 efficiently and intensively a firm uses its
assets to generate
Types Description
sales (cont’d)
Equation

4
Average • Average collection period Average receivables
collection measures how quickly
customers pay their bills Sales ÷ 365
period
• The industry average was 60
days
• Expressed in “days”

80
 Profitability ratios measure how efficiently a
4 firm uses its assets and how efficiently a firm
manages its operations
Types Description Equation
1

Net profit • Net profit margin shows the

proportion of sales that finds its EBIT - Tax
margin way into profits
Sales
• Usually expressed in “%”
• It is useful to compare net profit
margin with gross profit margin
• Example 1
Premium Low-cost
Product Product
Gross profit margin 5.62% 27.46%
Net profit margin 4.05% 10.87%

• Example 2

Software Business
Gross profit margin 89.55%
Net profit margin 27.15%

81
 Profitability ratios measure how efficiently a
4 firm uses its assets and how efficiently a firm
manages its operations (cont’d)
Types Description Equation

Return on • Return on assets measures EBIT - Tax

how profitable a company is
assets relative to its assets Average total assets
• Expressed in “%”

Return on • Return on equity shows how Net income

much profit a company
equity generates with the money Average equity
shareholders have invested
• Expressed in “%”

4
• Payout ratio measures the
Payout ratio proportion of earnings that is Dividends
paid out as dividends Earnings
• Can be expressed in “%” or
“x”
82
5
Market-to-value ratios measure how the market
views the performance of a firm
Types Description Equation
1
• Price-earning ratio measures Share price
Price-
the price that investors are
earning ratio prepared to pay each pound of Earnings per share
earnings
• Can be expressed in “x”

2
• Dividend yield shows the
Dividend
proportion of dividend
Dividend per share
yield embedded in the stock price Share price
• Can be expressed in “%” or “x”
Share price
3

Market-to- • Market-to-book ratio shows the

ratio of the share price to book Market value per share
book ratio value per share
Book value per share
• Can be expressed in “x”

Book equity divided by number of

shares outstanding

83