Business Finance
University of Missouri Chapter 22 A Closer Look at Financial Statements Discussion

University of Missouri

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I’m studying for my Accounting class and don’t understand how to answer this. Can you help me study?

Chapter 22 takes another look at financial statements, adding more detail to the initial coverage in Chapter 4. Read Finkler, Chapter 22.

You’ve already used the balance sheet to find the book value per share. Another way of using accounting data to estimate value is to look at the statement of earnings. The price or value per share is based on the future stream of earnings a company can generate. An analyst may apply a multiplier to the current earnings per share if he or she believes the company capable of sustaining this level of earnings into the future.

You can see the earnings multipliers that are reflected in current stock prices by calculating the Price-to-Earnings ratio (PE for short). This is done by taking the current market price and dividing by the most recent annual earnings per share. If we do this for Stanley using the $50 market price and $3.55 basic earnings per share from continuing operations from 2006, it results in a PE of 14.1. The common way of talking about this is to say "Stanley Works is trading at 14 times earnings."

A rough rule of thumb for mature U.S. Corporations is that a PE ratio exceeding 10 implies some expected earnings growth in the future. This comes from the finance equation which expresses the earnings multiplier as [ 1 / k - g ] where k is the expected annual yield on equity and g is the long run future growth rate in earnings. If current earnings are expected to persist in the long run ( g=0.0) and an expected yield on equity is approximately 10% (k=0.10) the expression becomes [ 1 / .10 ] or 10.

To see if Stanley deserves some expected growth, go to the Income Statement tab on your worksheet and input the Sales figures for the 3 years, and the basic earnings per share from continuing operations. As you can see, Stanley, although a mature company, has exhibited growth in sales and earnings per share, so a PE of 14 may be reasonable.

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Chapter 22 A Closer Look at Financial Statements We now turn our attention to trying to get as much useful information as possible from a set of financial statements. There are a variety of reasons for wanting to be able to do this. First and foremost is to enable us to manage our firm better. Second, we want to be able to review the financial statements of close competitors to evaluate our performance as compared to theirs. Third, we may want to evaluate the financial statements of a firm in which we wish to invest. Fourth, we want to evaluate the financial statements of firms we are considering extending credit to. We may be looking for different types of information in each case. Before extending credit, we want to assess a firm’s liquidity and solvency. Before investing in a firm, we wish to know about its potential profitability. The goal of financial statement analysis is to derive from financial statements the information needed to make informed decisions. We do this primarily through examination of the financial statements themselves, the notes that accompany the financial statements, and through the use of a technique called ratio analysis. Generally accepted accounting principles (GAAP), in recognition of many of the limitations of financial numbers generated by accounting systems, require that clarifying notes accompany financial statements. The information contained in these notes may be more relevant and important than the basic statements themselves. Ratio analysis is a method for examining the numbers contained in financial statements to see if there are relationships among the numbers that can provide us with useful information. Chapter 23 focuses on the notes to the financial statements. Chapter 24 discusses ratio analysis. In the remainder of this chapter we will present a hypothetical set of financial statements to use as a basis of discussion for Chapters 22-24. THE BALANCE SHEET Exhibit 22-1 presents the balance sheet for the hypothetical Pacioli Wholesale Corporation (PW) that will be the subject of our analysis. The information is provided for two years. In recognition of the fact that information in a vacuum is not very useful, accountants generally provide comparative data. In the case of PW, the financial statements present the current fiscal year ending June 30, 2018 and the previous fiscal year ended June 30, 2017. Many financial reports contain the current year and the two previous years for comparison. EXHIBIT 22-1 Pacioli Wholesale Corporation Statement of Financial Position As of June 30 2018 and June 30, 2017 All the numbers on the PW financial statements are rounded to the nearest thousand dollars. For large corporations, it is not uncommon to round numbers to the nearest hundred thousand or even million dollars. Current Assets The first assets listed on the balance sheet are the current assets. These are the most liquid of the firm’s resources. The current assets are presented on the balance sheet in order of liquidity. Cash, the most readily available asset for use in meeting obligations as they become due, is listed first. Cash includes amounts on deposit in checking and savings accounts as well as cash on hand. The next item is marketable securities that are intended to be liquidated in the near term. They can be converted to cash in a matter of a few days. Marketable securities that the firm intends to hold as long-term investments shouldn’t be listed with current assets, but instead under a long-term investment category, after fixed assets. The next current asset listed is accounts receivable, net of uncollectible accounts. It is usually the case that we do not expect to collect what is due us from all of our customers. Credit policies, discussed in Chapter 15, may have an impact on the level of bad debts. Inventory is not as liquid as receivables because we first have to sell the goods in order to generate receivables. Prepaid expenses are generally small, relative to the rest of the balance sheet. They include such items as prepaid rent or insurance. Prepaid expenses are grouped with current assets even though they will not usually generate any cash to use for paying current liabilities. Long-Term Assets All assets the firm has that are not current assets fall into the general category of long-term assets. Prominent among the long-term assets are fixed assets, which include the property, plant, and equipment used to process or produce the firm’s product or service. A variety of other long-term assets may appear on the balance sheet. There would be a category for investments if we had marketable securities that we anticipated keeping for more than one year. In the case of PW, there is an asset called goodwill. Goodwill is an intangible asset that may arise through the acquisition of another company. Most firms have some goodwill: They have customer loyalty and a good relationship with their suppliers. However, goodwill is an intangible asset that accountants usually leave off the balance sheet because of the difficulty in measuring it. When one company takes over another, if it pays more for the company it is acquiring than can reasonably be assigned as the fair market value of the specific identifiable assets that it is buying, then the excess is recorded on the balance sheet of the acquiring company as goodwill. This follows the accountant’s philosophy that people are not fools. If we pay more for a company than its other assets are worth, then there is a presumption that the various intangibles we are acquiring that can’t be directly valued must be worth at least the excess amount we paid. Liabilities The firm’s current liabilities are those that exist at the balance sheet date, which have to be paid in the next operating cycle—usually considered to be one year. Common current liabilities include wages payable, accounts payable, and taxes payable. The taxes payable include only the portion to be paid in the near term, not the taxes that have been deferred more than one year beyond the balance sheet date. Long-term liabilities include any recorded liabilities that are not current liabilities. There may be a variety of commitments that the firm has made that will not be included with the liabilities. For example, if the firm signed a contract to buy equipment but has neither paid for nor received the equipment, it will not show a liability, even though the contract may legally obligate the firm to make large payments into the future. The notes to the financial statements are especially important in disclosing material commitments such as this. Stockholder’ Equity The stockholders’ equity section of the balance sheet contains a number of elements. Instead of simply having contributed capital and retained earnings, there are a number of separate items that comprise contributed capital. There are two general classes of stock—common stock and preferred stock. Both types of stock were discussed in Chapter 5. In addition, there is a distinction between amounts paid in exchange for stock that represent par value and amounts in excess of par. Par value is a legal concept. In many states, firms are required to set an arbitrary amount as the par value of their stock. As was discussed in Chapter 5, one of the primary reasons many firms incorporate is to achieve a limited liability for their owners. Limited liability assumes that the corporation’s stock was originally issued for at least its par value. If stock is issued below the par value—let’s say that $10 par value stock is issued for $7—then the owner would be liable for the difference between the issue price and the par value should the firm go bankrupt. Given that situation, the par value of a corporation’s stock is generally set low enough so that all stock is issued for at least the par value. Par value is an arbitrary value set by the firm. There is no connection between the par value and any underlying value of the firm. There is no reason to believe that the arbitrarily selected par value is a good measure of what a share of stock is worth. In fact, because most firms are very careful to set par low enough so that there is no extra liability for the corporation’s owners, par value has become almost meaningless. Therefore, some states now allow corporations to issue stock without assigning a par value. From an accounting perspective, we wish to be able to show the user of financial statements whether there is some potential additional liability to the stockholders. To accomplish this, the accountant will have one account to show amounts received for stock up to the par value amount. Anything paid above par for any share will go into a separate account with a name such as “excess paid over par” or “additional paid-in capital.” In the case of PW, we see that it has 1,000 shares of $1 par value common stock. The balance in the common stock par account is $ 1,000, meaning that all 1,000 shares were issued for at least $1 each, the par value. There are 100 shares of $100 par value preferred stock and the balance in the preferred stock par account is $10,000, indicating that each of the 100 shares was issued for at least $100. Therefore, we know that the stockholders of PW have limited liability. They can lose everything they’ve paid for their stock, but if the firm goes bankrupt, the creditors cannot attempt to collect additional amounts from the stockholders personally. As is quite commonly the case, PW’s stockholders have paid more than the par value for at least some of the stock issued by the corporation. The common stock excess over par account has a balance of $24,000. Together with the $1,000 in the common stock par account, this indicates the investors paid $25,000 (or gave the firm resources worth $25,000) for 1,000 shares of stock. On average, investors have paid $25 per share for the common stock. There is no excess over par account for the preferred stock. Therefore, we know that the preferred stockholders each paid exactly $100 per share for the preferred stock. The preferred stock is referred to as 10 percent, $100 par stock, indicating that the annual dividend rate on the preferred stock is 10 percent of the $100 par value. Each preferred share must receive a $10 dividend before the firm can pay any dividend to the common stock shareholders. The retained earnings, as discussed earlier in the book, represent the profits that the firm earned during its existence not been distributed to the stockholders as dividends, and therefore have been retained in the firm. Remember that this category, like the others on the liability and owners’ equity side of that have the balance sheet, represents claims on assets. There is no pool of money making up the retained earnings. Rather, the profits earned over the years and retained in the firm have likely been invested in a variety of fixed and current assets. Excel Exercise You may use Template 20 to prepare a Balance Sheet for your organization. The template is included at https://www.CCHGroup.com/FANM2017 along with all other supplemental material. THE INCOME STATEMENT The income statement of PW (Exhibit 22-2) does not overtly raise as many new concepts and issues as the balance sheet did. PW uses the common multiple-step statement in which various expenses are shown separately. For instance, product costs are all grouped under the heading “Cost of Goods Sold.” The gross profit or gross margin provides information about the margin of profitability when sales are compared to the direct product costs of the firm. Subtracting the various other day-to-day operating costs from the gross profit results in operating income. By operating costs, we mean the various selling, administrative, and general costs of the firm. These costs include everything except product costs, financing costs, and taxes. Financing costs are isolated as a separate figure because of the specific financial leverage decisions (see Chapter 9) the firm makes. There is a much greater degree of control over whether interest expense exists than, say, selling expenses. Management can decide whether money is to be borrowed, thus generating interest expense, or whether money should be raised through the issuance of stock. Management can choose to use a single-step statement in which far less information is given about individual types of expenses. In this latter case, less information is provided to stockholders and creditors. On the other hand, less information is also given to competitors. The single-step approach cannot be used if it would mask information that the auditor believes is necessary for a fair representation of the firm’s position and results of operations. EXHIBIT 22-2 Pacioli Wholesale Corporation Income Statement and Analysis of Retained Earnings For the Years Ending June 30, 2018 and June 30, 2017 2018 $297,000 162,000 $135,000 Sales Less Cost of Goods Sold Gross Profit 2017 $246,000 143,000 $103,000 Operating Expenses Selling Expenses $30,000 $25,000 General Expenses 12,000 10,000 Administrative Expenses 49,000 40,000 Total Operating Expenses Operating Income Interest Expense Income Before Taxes Income Taxes Net Income Earnings Per Share Common 91,000 $ 44,000 12,000 $ 32,000 13,000 $ 19,000 $ 18.00 75,000 $ 28,000 10,000 $ 18,000 7,000 $ 11,000 $ 10.00 Less Dividends 2018 and 2017 5,000 3,000 Addition to Retained Earnings $ 14,000 $ 8,000 Retained Earnings July 1, 2017 and 2016 19,000 11,000 Retained Earnings June 30, 2018 and 2017 $ 33,000 $ 19,000 The accompanying notes are an integral part of these statements. The line following net income in Exhibit 22-2 contains earnings per share data. GAAP require inclusion of information on a per-share basis for common stock. It is felt that this type of information may be more relevant than net income for many users of financial information. Consider an individual who owns 100 shares of common stock of a large corporation. The corporation reports that its profits have risen from $25,000,000 to $30,000,000. On the surface, we would presume that the stockholder is better off this year. What if, however, during the year the firm issued additional shares of stock, thereby creating additional owners. Although total profits have risen $5,000,000 or 20 percent, because of the additional shares of stock outstanding, investors will find that their share of earnings increased by less than 20 percent. In fact, it is quite possible that the profits attributable to each individual share may have fallen, even though the total profit for the firm has increased. Therefore, we must show not only net income for the firm, but also net income per share of common stock. Although there are 1,000 shares of common stock for PW, and the net income was $19,000, the earnings or income (the two terms are used interchangeably) per share is $18.00, rather than the expected $19.00. This is because $1,000 has to be paid as a 10 percent dividend to the preferred shareholders. This portion of the income of the firm doesn’t belong to the common shareholders. The remaining $18,000 does. Many corporations have outstanding securities that can be converted to common stock. For example, convertible debt represents loans that give the lender the option of taking shares of common stock instead of a cash repayment. This potential increase in the number of common shares outstanding can reduce the portion of total earnings owned by each of the current shareholders. If PW had such potential conversions, the earnings per share (EPS) of $18.00 would have been called basic EPS and the potential lower amount would also be shown and would be called diluted EPS. For PW, the balance in the common and preferred stock accounts didn’t change during the year (Exhibit 22-1). However, upon looking at the stockholders’ equity section of the balance sheet, we see that the retained earnings has changed. Furthermore, the change is not exactly equal to the firm’s income for the year. Somewhere in the financials we need some way of reconciling this change. In PW’s case it has chosen one of the most common approaches—retained earnings are reconciled as part of the income statement. In order to accomplish this reconciliation, the first step is to subtract any of this year’s dividends from this year’s net income. The difference is the amount of this year’s earnings that are being retained in the firm. This year’s earnings that are retained in the firm plus the balance of retained earnings at the start of the year gives us the retained earnings balance at year-end. This number should, and does, reconcile directly with the number that appears on the balance sheet as the yearend retained earnings. Excel Exercise You may use Template 21 to prepare an Income Statement and Analysis of Retained Earnings for your organization. The template is included at https://www.CCHGroup.com/FANM2017 along with all other supplemental material. THE STATEMENT OF CASH FLOWS The statement of cash flows focuses on financial rather than operating aspects of the firm. Where did the money come from, and how did the firm spend it? While the major concern of the income statement is profitability, the statement of cash flows is very concerned with viability. Is the firm generating and will it generate enough cash to meet both short-term and long-term obligations? The statement of cash flows shows where the firm got its cash and how it used it over the entire period covered by the financial statement. This feature is similar to the income statement, which shows revenues and expenses for the entire accounting period, and is different from the balance sheet that shows the firm’s financial position at a single point in time. The statement of cash flows is divided into three major sections: cash from operating activities, cash from investing activities, and cash from financing activities. The operating activities are those that relate to the ordinary revenue- and expense-producing activities of the firm. Firms tend to be particularly interested in how their day-to-day revenues and expenses affect cash balances. These activities include items such as payments to employees and suppliers and collections of cash from customers. The investing activities of the firm relate to the purchase and sale of fixed assets and securities. It is clear that the purchase of stocks and bonds represents an investing activity. The accounting rule-making body determined that the purchase of property, plant, and equipment also represents an investment, and should be accounted for in this category. Lending money (and receiving repayments) also represents an investing activity. The financing activities of the firm are concerned with borrowing money (or repaying it), issuance of stock, and the payment of dividends. Note that when a firm lends money, it is investing. However, borrowing money relates to getting the financial resources the firm needs to operate. Thus, borrowing is included in the financing category, along with issuance of stock. PW’s statement of cash flows is presented in Exhibit 22-3. The first element of the statement is cash flows from operating activities. This is a key focal point, because it provides information on whether the routine operating activities of the firm generate cash, or require a cash infusion. If the operating activities generate a surplus of cash, the firm is more financially stable and viable than if they consume more cash than they generate. This does not mean that negative cash from operating activities is bad. It may be indicative of a growing, profitable firm that is expanding inventories and receivables as it grows. However, it does provide a note of caution. Overly rapid expansion, without other adequate cash sources, can cause financial failure. EXHIBIT 22-3 Pacioli Wholesale Corporation Statement of Cash Flows For the Years E ...
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Template 20

Balance Sheet (Statement of Financial Position)
See Chapter 22 for a discussion of this topic.
Replace the heading with the name of your company and the years your Balance Sheet covers.
Replace each of the xxx's with your values OR zero, and your Balance Sheet will be calculated automatically.
Pacioli Wholesale Corporation
Statement of Financial Position and Common Size Ratios
As of June 30, 2018 and June 30, 2017
2018

2017

$8,000
12000

$7,000
9000

22000
49000
0
3000
$94,000

30000
40000
0
2000
$88,000

$150,000

$120,000

40000

30000

$110,000
50000
0
$160,000

$90,000
50000
0
$140,000

ASSETS
Current Assets
Cash
Marketable Securities
Accounts Receivable,
Net of Uncollectible
Accounts
Inventory
Other
Prepaid Expenses
Total Current Assets
Fixed Assets
Buildings and Equipment
Less Accumulated
Depreciation
Net Buildings and
Equipment
Land
Other
Total Fixed Assets

2018...

AccountsChamp (1007)
Purdue University

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