Unit 2: Financial Statements and Financial Analysis
Completing this unit should take you approximately 16 hours.
Upon successful completion of this unit, you will be able to:
- explain how financial managers use the income statement, the balance sheet, and the statement of cash flows to make better informed decisions;
- compute the major financial ratios in order to evaluate a company's performance;
- analyze pro-forma financial statements in order to evaluate the future performance of a company; and
- prepare an analysis of a company's financial statements.
2.1: Balance Sheets and Income Statements
This lesson will introduce you to financial statements, their uses, and their limitations. This broad overview will help frame the upcoming lessons on each individual statement.
This lesson focuses on the elements and limitations of the income statement and the effects of GAAP on the income statement. It will also discuss noncash items.
This video introduces income statements. An income statement is an account of a company's revenues (net sales), costs, expenses, and taxes during a given period. The goal of an income statement is to compute a company's net profits.
This lesson will introduce the balance sheet, a representation of a firm's financial position at a single point in time. The balance sheet is one of the four major financial statements. You will be able to identify assets, liability, and shareholder's equity, and learn how to compute the balance sheet equation. You will also be able to create a balance sheet.
This video introduces balance sheets. A balance sheet statement is an account of the value of assets, liabilities, and net worth of a company. It records these values on a certain date, and as such, it is a snapshot of a company's financial position at a single point in time. Assets are things that a company owns, while liabilities are things that a company owes. Assets minus liabilities results in the net worth of a company.
This video discusses the relationship between balance sheets and income statements.
This lesson exposes you to the impact of taxes on firms. You will learn how different forms of corporate organization affect the tax obligations for the firm and the individual owners. You will be able to compute tax liability using the tax rate. This section defines the various types of taxes and discusses the impact of depreciation on taxable income. It also compares a tax credit with a tax deduction, and demonstrates multiple methods of computing depreciation.
2.2: Cash Flow and Other Statements
This video introduces cash accounting. While most businesses use accrual accounting, some small companies may use cash accounting. Even companies that use accrual accounting must also account for all of their cash flows through the cash flow statement. Thus, all businesses need to understand cash accounting.
This section exposes you to one of the four major financial statements, the "Statement of Cash Flows". It explains how to create and interpret the statement and discusses the three major activities that produce cash for a firm – operating, investing, and financing.
In this section, you will learn about less commonly used financial statements such as the Statement of Equity and the Free Cash Flow Statement (which is different from The Statement of Cash Flows) and their uses in finance. It also explains the difference between economic value and market value.
2.3: Analyzing Financial Statements
This section provides more insight into the standard elements included in all balance sheets and income statements. It provides a listing of common accounts on each statement and the order in which those accounts are listed.
This section provides a general overview of what a financial ratio is, how they are used, and the relevant categories of financial ratios.
An overview of the financial ratios is presented in this section. The manager or student may well ask the question, "Why are financial ratios important to understanding the activities of the business?" This question is addressed in this section. Pay particular attention to the following topics: (1) Sources of financial ratios, (2) Purpose and types of ratios, (3) Accounting methods and principles, (4) Abbreviations and terminology, and (5) A summary of all ratios used to analyze financial statements. Try to remember some of the basic formulas presented in this section.
After reading this section, you will have been exposed to the different types of profitability ratios, their formulas, how to compute them, and which financial statements contain the information needed to calculate the ratios. You will also learn how to interpret the ratios and apply those interpretations to understanding the firm's activities.
After reading this section, you will have been exposed to the different types of asset management ratios, their formulas, how to compute them, and which financial statements contain the information needed to calculate the ratios. You will also learn how to interpret the ratios and apply those interpretations to understanding the firm's activities.
After reading this section, you will have been exposed to the different types of liquidity ratios, their formulas, how to compute them, and which financial statements contain the information needed to calculate the ratios. You will also learn how to interpret the ratios and apply those interpretations to understanding the firm's activities.
After reading this section, you will have been exposed to the different types of market value ratios, their formulas, how to compute them, and which financial statements contain the information needed to calculate the ratios. You will also learn how to interpret the ratios and apply those interpretations to understanding the firm's activities.
As you read this section, you will learn about special ratios that address dividend growth, return on assets, and equity. You will be exposed to their formulas, how to compute them, and which financial statements contain the information needed to calculate the ratios. You will read about the DuPont Equation (also known as the strategic profit model), which comprises multiple financial ratios. You will also learn how to interpret the ratios and apply those interpretations to understanding the firm's activities.
An overview of how financial ratios are used to aid in company analysis is presented in this lesson. Financial ratios are used for industry comparisons, benchmarking, and trend analysis. This section also presents some limitations of financial ratio analysis to consider when evaluating firms.
This section presents financial ratios and their analysis. Why are financial ratios and their analysis important? To answer this question, you should pay particular attention to the firm's profitability, and allow comparisons between the firm and its industry. By the end of this section, you will be able to summarize how an interested party would use financial ratios to analyze a company's financial statement.
This lesson describes what inflation is and the various categories of inflation. It discusses the effect that inflation in an economy has on a firm's earnings and financial statements.
This section mentions other items that can distort the true value or representation of information on financial statements. It provides information about two primary examples of distortions – accounting errors and unusual one-time gains or losses.
2.4: Forecasting Financial Statements
After reading this section, you will understand how to create a forecast of the income statement, using assumptions for the future growth of expenses and sales by category. A forecasted financial statement is called a "pro forma" statement. Pro Forma financial statements help value a firm in preparation for its sale, comparing the impacts of proposed financial transactions, or estimating future costs and expenses under specific business scenarios. By the end of this section, you will be able to draft a pro forma income statement. Businesses in all industries use Pro Forma income statements to make managerial decisions that affect their sustainability.
This section discusses the Pro Forma balance sheet. The question "why should the Pro Forma balance sheet be used in a business?" is relevant as the economy changes. Possible uses of the Pro Forma balance sheet include mergers and acquisitions, warranties, and negotiating a commercial lending relationship to support growth. A pro forma balance sheet summarizes the projected future status of a company after a planned transaction, based on the current financial statements. By the end of this section, you will be able to prepare a pro forma balance sheet.
This section emphasizes the importance of cash and good cash management to a business. You will learn how to analyze cash inflows and outflows to better forecast a firm's cash budget. When you have completed this section, you will be able to describe the direct and indirect methods of cash flow forecasting. Cash flow is often used as a determinant providing financing to firms. A cash budget is used along with pro forma financial statements to assess the result of financial transactions.
When you have completed this section, you will be able to use ratio analysis to assess a firm's performance to compare its performance to itself, its competitors, its industry, and across time. You will learn the categories of ratios, how to compute ratios and how to interpret the numeric values of a ratio as a comment on the firm's performance. Ratio analysis is used to consider the impact of certain financial transactions on a firm.
Read this section and pay close attention to the summary of pro- forma financial statements as follows: (1) the Pro-forma income statement, (2) the Pro-forma balance sheet, (3) assessment of Pro-forma statements, (4) the bigger picture, and (5) end of chapter problems. Attempt the practical exercises at the end of this section to check your understanding of the uses of Pro-forma financial statements. Note that the images in this resource are broken.
This section discusses financial modeling and pro forma analysis. The five key takeaways include: (1) Introduction - financial goals and long-term planning, (2) Percent of sales method, (3) Forecasting a planned expansion, (4) The planned expansions value, and (5) Growth and firm value. Managers and executives use these financial tools regularly to make internal decisions and present them to external partners such as banks and investors.
Unit 2 Practice and Assessment
Complete these exercises and problems and then check your work.