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Learn how to analyze income statements and balance sheets to make informed financial decisions. Calculate ratios, ROI, and perform same-size analysis.
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Entrepreneurship and Small Business Management Chapter 13 Using Financial Statements to Guide a Business
Ch. 13 Performance Objectives • Understand an income statement. • Examine a balance sheet to determine a business’s financing strategy. • Use the balance sheet equation for analysis. • Perform a financial ratio analysis of an income statement.
Ch. 13 Performance Objectives(continued) • Calculate return on investment. • Perform same-size (common-size) analysis of an income statement. • Use quick, current, and debt ratios to analyze a balance sheet.
Financial Statements • Entrepreneurs use three basic financial statements: • Income statement • Balance sheet • Cash flow statement • Together, these financial reports show the health of a business at a glance.
Income Statement • Shows profit or loss over a particular time period • Revenues > Expenses = Positive Balance • Expenses > Revenues = Negative Balance • Prepared monthly • Serves as a scorecard; helps reveal problems
Parts of an Income Statement • Revenue • COGS/COSS • Gross profit • Other variable costs • Contribution margin • Fixed operating costs • Earnings before interest and taxes • Pre-tax profit • Taxes • Net profit/(loss)
Balance Sheet • Called a “point-in-time” financial statement because it shows the state of a business at a given moment • Typically prepared quarterly and at the end of the fiscal year (12-month accounting period chosen by the firm)
Parts of a Balance Sheet • Assets—things the company owns that are worth money • Liabilities—the company’s debts that must be paid (including unpaid bills) • Owner’s Equity (OE)— • Assets – Liabilities = OE • Also called “net worth” • The amount of capital in the company
Types/Examples of Assets • Current assets—cash, items easily turned into cash, and items used within one year • Accounts receivable • Inventory • Supplies • Long-term assets—items that would take the business more than one year to use • Equipment • Furniture • Machinery • Real estate
Types/Examples of Liabilities • Current liabilities—debts scheduled for payment within one year (includes portion of long-term debt due within the year) • Long-term liabilities—debts to be paid over a time period longer than one year • Examples of liabilities: • Accounts payable (bills) • Loans from banks, family, or friends • Mortgages • Lines of credit
The Balance Sheet Equation Assets – Liabilities = Owner’s Equity (OE) or Assets = Liabilities + Owner’s Equity or Liabilities = Assets – Owner’s Equity (Net worth and capital are other names for OE.)
Total Assets Must Equal (“Balance”) Total Liabilities + Owner’s Equity • If an item was financed with debt, the loan is a liability. • If an item was purchased with the owner’s (or shareholders’) money, it was financed with equity. • Liabilities and owner’s equity pay for all assets.
Analyzing Balance Sheet Data • Compare balance sheets from two different points in time to see progress. • Calculate the percentage of change between the reports for each line item. • An increase in owner’s equity is one way to measure success.
Income Statement Ratios Express each line item as a percentage of sales to see the relationship between items.
Return on Investment (ROI) • Entrepreneurs “invest” time, energy, and money because they expect a “return” of money or satisfaction. • Return on investment (ROI) measures return as a percentage of the original investment. (Net Profit ÷ Investment) X 100 = ROI%
Things Needed to Calculate ROI • Net profit—amount the firm has earned beyond what it has spent to cover costs • Total investment—start-up investment plus any additional money invested later • Period of time for which you are calculating ROI—typically one month or one year
Return on Sales (ROS) • ROS is also called the “profit margin” because it is an important measure of business profitability. • Net income ÷ sales = ROS • To express this ratio as a percentage, multiply it by 100.
Common-Sized (“Same-Size”) Analysis • Lets you compare income statements, even if sales amounts vary. • Compare your expenses with those incurred by other businesses in your industry, or for your own company at different points in time. • Operating ratio—expresses what percentage of sales dollars a particular expense item is using up
Quick and Current Ratios Quick Ratio: • (Cash + Marketable Securities) ÷ Current Liabilities • Marketable securities—investments such as certificates of deposit or Treasury bills • If the quick ratio is greater than one, there is enough cash to cover all bills (but not loans) within 24 hours. Current Ratio: • Current Assets ÷ Current Liabilities • If the current ratio is greater than one, the business could sell some assets to pay off its debts.
Debt Ratios Debt-to-Equity Ratio: Total Debt ÷ Equity • Indicates how many dollars in the business were provided by owners/investors • Example: A ratio of 1-to-1 means for every $1 of debt, the company owns $1 of assets. Debt Ratio: Total Debt ÷ Total Assets • Indicates how many dollars in the business were provided by creditors • Example: A ratio of 0.5 means the company is in debt for 50% of its assets.
Operating Efficiency Ratios • Collection-period ratio—measures the average number of days that sales are going uncollected • Receivable turnover ratio—measures the efficiency of your company’s efforts to collect receivables • Inventory turnover ratio—measures how quickly inventory is being sold
Formulas for Calculating Operating Efficiency Ratios • Collection-Period Ratio: Average Accounts Receivable (Balance Sheet) Average Daily Sales (Income Statement) • Receivable Turnover Ratio: Total Sales (Income Statement) Average Accounts Receivable (Balance Sheet) • Inventory Turnover Ratio: Cost of Goods Sold (Income Statement) Average Inventory (Balance Sheet) = # of days = # of times = # of times
