Chapter 3

Firms Financial Operations

 1-2

Focus areas

• Financial statements
 Balance sheet
 Income statement
 Statement of retained earnings
 Statement of cash flows
 Relationship among financial statements
• Financial analysis

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies

 The Accounting System

Managers
(internal)

Reports
information
to decision
Collects and processes makers Investors
financial information and
Creditors
(external)
 The Accounting System
Accounting System

Financial Accounting System Managerial Accounting System

Periodic financial statements and Detailed plans and continuous
related disclosures performance reports

External Decision Makers Internal Decision Makers

Investors, creditors, Managers throughout the
suppliers, customers, etc. organization
1. The Basic Financial Statements
Financial statements summarize the financial activities of the
business.
Financial statements paint a picture of the transactions that flow
through the business.

Statement of Cash Flows Statement of Retained Earnings

Balance Sheet Income Statement

 2 Balance Sheet Capital Supplied 1

ASSETS LIABILITIES

• Current • Current Debt

(Short-term) • Long-term)
• Fixed
(long-term)
Shareholder’s
• Other Stock
EQUITY
Cash Flow

The System
Retain Return

Sell Equity
Issue Debt
3 <Buy Assets>
<Buy Inventory> 4
Retain profits or
Make Sales! “repay” debt-
<Pay Costs> holders (with
<Pay Taxes> interest) and
stockholders
<Pay Interest> (with dividends)
<Pay Dividends>
 Purpose of Financial Statements
To inform the following parties of the financial
performance and position of the entity:
1) Management – for reviewing their performance during
the reporting period
2) Shareholders – for assessing the worth of their
investments and reviewing the effectiveness of the
Management
3) Investors – for judging the worth of the entity before
deciding to invest
4) Suppliers and Lenders – for judging the creditworthiness
of the entity before deciding to extend credit
5) Government – for calculating the amount of tax to be
collected
 Let’s look at
Addis-Matador
CORP.’s
financial
statements.
1) Balance Sheet
Owns Owes

Assets Liabilities and Equity

• Current assets: • Current liabilities:
 Cash & securities  Payables
 Receivables  Short-term debt
 Inventories • Long-term liabilities
• Fixed assets: • Shareholders' equity
 Tangible assets
 Intangible assets
1. Name of entity Addis-Matador CORP.
2. Title of statement Balance Sheet
3. Specific date At December 31, 2006
4. Unit of measure (in thousands of dollars)
Assets
Cash $ 4,895
Accounts receivable 5,714
The Inventories 8,517
Balance Plant and equipment
Land
7,154
981
Sheet Total assets $ 27,261
reports the Liabilities and Stockholders' Equity
financial Liabilities

position of Accounts payable $ 7,156

Notes payable 9,000
an entity at Total liabilities $ 16,156
a particular Stockholders' Equity
point in Contributed capital $ 2,000
time. Retained earnings 9,105
Total stockholders' equity 11,105
Total liabilities and stockholders' equity $ 27,261
 The Balance Sheet

Basic Accounting Equation

Assets = Liabilities + Stockholders’ Equity
 Addis-Matador CORP.
Balance Sheet
At December 31, 2006
(in thousands of dollars)
Assets are Assets
economic Cash $ 4,895
Accounts receivable 5,714
resources Inventories 8,517
owned by the Plant and equipment 7,154
business as a Land 981
result of past Total assets $ 27,261
Liabilities and Stockholders' Equity
transactions. Amount of cash in the company’s bank
Cash Liabilities
accounts.
Accounts payable $ 7,156
Accounts
Notes payable Amounts owed by customers from prior
9,000
Assets are receivable sales.
Total liabilities $ 16,156
listed by their Parts andEquity
Stockholders' completed but unsold
Inventories
ease of products.
Contributed capital $ 2,000
Retained earnings
Plant and 9,105
conversion into Factories and production machinery.
Total stockholders' equity 11,105
cash. equipment
Total liabilities and stockholders' equity $ 27,261
Land Land on which factories are built.
 Addis-Matador CORP.
Balance Sheet
At December 31, 2006
(in thousands of dollars)
Assets
Cash $ 4,895
Liabilities are Accounts receivable 5,714
debts or Inventories 8,517
obligations of Plant and equipment 7,154
the business Land 981
Total assets $ 27,261
that result from Liabilities and Stockholders' Equity
past Liabilities
transactions. Accounts payable $ 7,156
Notes payable 9,000
Total liabilities $ 16,156
Stockholders' Equity
Accounts Amounts owed to suppliers for prior
Contributed capital $ 2,000
payable purchases.
Retained earnings 9,105
Notes Amounts owed Totalon written debt
stockholders' equity 11,105
payable contracts.Total liabilities and stockholders' equity $ 27,261
 Addis-Matador CORP.
Balance Sheet
At December 31, 2006
Equity is the (in thousands of dollars)
Assets
amount of
Cash $ 4,895
financing Accounts receivable 5,714
provided by Inventories 8,517
owners of the Plant and equipment 7,154
Land 981
business and Total assets $ 27,261
earnings. Liabilities and Stockholders' Equity
Liabilities
Contributed Amounts invested in the business by
Accounts payable $ 7,156
capital stockholders.
Notes payable 9,000
Retained Past earnings not distributed to
earnings stockholders.Total liabilities $ 16,156
Stockholders' Equity
Contributed capital $ 2,000
Retained earnings 9,105
Total stockholders' equity 11,105
Total liabilities and stockholders' equity $ 27,261
 Addis-Matador CORP.
Balance Sheet
At December 31, 2006
(in thousands of dollars)
Assets
Cash $ 4,895
Use $ on the
Accounts receivable 5,714
first item in a Inventories 8,517
group Plant and equipment 7,154
and on the Land 981
Total assets $ 27,261
group total.
Liabilities and Stockholders' Equity
Liabilities
Accounts payable $ 7,156
Notes payable 9,000
Assets = LiabilitiesTotal
+ Stockholders’
liabilities Equity $ 16,156
Stockholders' Equity
Contributed capital $ 2,000
Retained earnings 9,105
Total stockholders' equity 11,105
Total liabilities and stockholders' equity $ 27,261
 Addis-Matador CORP.
Income Statement
For the Year Ended December 31, 2006
(in thousands of dollars)

Revenues
1. Name
Sales of entity
revenue $ 37,436
2. Title of statement
Expenses
3. Specific
Cost of goodsdate
sold(Unlike the balance sheet, this
$ 26,980
statement
Selling, generalcovers a specified period
and administrative of time.)
3,624
4. Unit ofand
Research measure
development 1,982
Interest expense 450
Total expenses 33,036
Pretax income $ 4,400
Income tax expense 1,100
Net income $ 3,300
 Addis-Matador CORP.
The Income Statement reports the
Income Statement
revenues less expenses of
For the Year Ended December 31, 2006
the
accounting
(in thousands ofperiod.
dollars)

Revenues
Sales revenue $ 37,436
Expenses
Cost of goods sold $ 26,980
Selling, general and administrative 3,624
Research and development 1,982
Interest expense 450
Total expenses 33,036
Pretax income $ 4,400
Income tax expense 1,100
Net income $ 3,300
 Addis-Matador CORP.
Income Statement
For the Year Ended December 31, 2006
(in thousands of dollars)

Revenues
Sales revenue $ 37,436
Expenses
Revenues are earnings from the sale of goods
Cost of goods sold $ 26,980
or services to customers.
Selling, general and administrative 3,624
Research and development 1,982
Interest expense 450
Total expenses 33,036
Pretax income $ 4,400
Income tax expense 1,100
Net income $ 3,300
 Addis-Matador CORP.
Expenses are theIncome
dollar amount of resources used
Statement
up by the
Forentity to earn
the Year Ended revenues
Decemberduring a period.
31, 2006
(in thousands of dollars)

Revenues
Sales revenue $ 37,436
Expenses
Cost of goods sold $ 26,980
Selling, general and administrative 3,624
Research and development 1,982
Interest expense 450
Total expenses 33,036
Pretax income $ 4,400
Income tax expense 1,100
Net income $ 3,300
 Addis-Matador CORP.
Income Statement
For the Year Ended December 31, 2006
(in thousands of dollars)

Revenues
Cost of The cost to produce products sold this
goods
Sales sold period. Production costs: direct$costs
revenue 37,436
Expenses
Selling,
Operating expenses not directly related
Cost of goods
general and sold $ 26,980
to production.
Selling, general and administrative
administrative 3,624
Research and development 1,982
Research and Expenses incurred to develop new
Interest expense
development products. 450
Total expenses 33,036
Interest
Pretax income The cost of using borrowed funds.
$ 4,400
expense
Incometax
Income tax expense 1,100
Income taxes on current period’s pretax
Netexpense
income income. $ 3,300
 Addis-Matador CORP.
Income Statement
For the Year Ended December 31, 2006
(in thousands of dollars)

Revenues
Sales revenue $ 37,436
Expenses
Cost of goods sold $ 26,980
Selling, general and administrative 3,624
Research and development 1,982
Interest expense 450
Total expenses 33,036
Pretax income $ 4,400
IncomeIf tax
expenses
expense exceed revenues, 1,100
Net income we report net loss. $ 3,300
 Addis-Matador CORP.
Statement of Retained Earnings
For the Year Ended December 31, 2006
(in thousands of dollars)

Retained earnings, January 1, 2006 $ 6,805

1. Name
Net of entity
income for 2003 3,300
2. Title of statement
Dividends for 2003 (1,000)
3. Specificearnings,
Retained date (LikeDecember
the income
31,statement, this
2006 $ 9,105
statement covers a specified period of time.)
4. Unit of measure
 Addis-Matador CORP.
Statement of Retained Earnings
For the Year Ended December 31, 2006
(in thousands of dollars)

Retained earnings, January 1, 2006 $ 6,805

Net income for 2006 3,300
Dividends for 2006 (1,000)
Retained earnings, December 31, 2006 $ 9,105

The Statement of Retained Earnings reports the way

that net income and the distribution of dividends affect
the financial position of the company during a period.
Statement of Cash Flows

Because . . . and expenses

revenues reported reported do not
do not always equal always equal
cash collected. . . cash paid . . .

net income is
usually not equal
to the change
in cash for
the period.
 Addis-Matador CORP.
Statement of Cash Flows
For the Year Ended December 31, 2006
(in thousands of dollars)

Cash flows from operating activities:

Cash collected from customers $ 33,563
1. Name
Cash ofsuppliers
paid to entity and employees (30,854)
Cash
2. paid
Title offorstatement
interest (450)
Cash paid for taxes (1,190)
3. Specific date (Like the income statement$ and
Net cash flow from operating activities 1,069
Cash statement of retained
flow from investing activities: earnings, this
Cash paid to purchase
statement covers equipment $
a specified period (1,625)
of time.)
Net cash flow from investing activities (1,625)
4. Unit of measure
Cash flow from financing activities:
Cash received from bank loan $ 1,400
Cash paid for dividends (1,000)
Net cash flow from financing activities 400
Net decrease in cash during the year $ (156)
Cash at beginning of the year 5,051
Cash at end of the year $ 4,895
 Addis-Matador CORP.
The Statement of Cash Flows reports the inflows
Statement of Cash Flows
and outflows
For the of
Yearcash
Endedduring
Decemberthe31,period
2006 in the
categories of operating, investing,
(in thousands of dollars) and financing.

Cash flows from operating activities:

Cash collected from customers $ 33,563
Cash paid to suppliers and employees (30,854)
Cash paid for interest (450)
Cash paid for taxes (1,190)
Net cash flow from operating activities $ 1,069
Cash flow from investing activities:
Cash paid to purchase equipment $ (1,625)
Net cash flow from investing activities (1,625)
Cash flow from financing activities:
Cash received from bank loan $ 1,400
Cash paid for dividends (1,000)
Net cash flow from financing activities 400
Net decrease in cash during the year $ (156)
Cash at beginning of the year 5,051
Cash at end of the year $ 4,895
 “Natural” Cash flow statement
Cash Flows Classifications

Sell Equity Sell Equity

Issue Debt Issue Debt Financing
<Pay Dividends>
<Buy Assets>
<Buy Inventory>
<Buy Assets> Investing
Make Sales!
<Pay Costs>
<Pay Taxes>
Make Sales!
<Pay Interest> <Buy Inventory>
<Pay Dividends> <Pay Costs> Operating
<Pay Taxes>
<Pay Interest>

=NET CASH FLOW

 Addis-Matador CORP.
Statement of Cash Flows
For the Year Ended December 31, 2006
(in thousands of dollars)

Cash flows from operating activities:

Cash collected from customers $ 33,563
Cash paid to suppliers and employees (30,854)
Cash paid for interest (450)
Cash paid for taxes (1,190)
Net cash flow from operating activities $ 1,069
Cash flows directly related
Cash flow from investing activities:
Cash paid to purchase equipment $ (1,625)
to
earning income are shown in the
Net cash flow from investing activities
Cash flow from financing activities:
(1,625)

operating
Cash received from bank loan section.
$ 1,400
Cash paid for dividends (1,000)
Net cash flow from financing activities 400
Net decrease in cash during the year $ (156)
Cash at beginning of the year 5,051
 Addis-Matador CORP.
Statement of Cash Flows
For the Year Ended December 31, 2006

Cash flows related to the

(in thousands of dollars)

acquisition
Cash flows from operatingor sale
activities:
Cash collected from customers
of productive
$ 33,563
assets are shown
Cash paid to suppliers and employees
Cash paid for interest
in the
(30,854)
(450)
investing
Cash paid for taxes
section.
Net cash flow from operating activities
(1,190)
$ 1,069
Cash flow from investing activities:
Cash paid to purchase equipment $ (1,625)
Net cash flow from investing activities (1,625)
Cash flow from financing activities:
Cash received from bank loan $ 1,400
Cash paid for dividends (1,000)
Net cash flow from financing activities 400
Net decrease in cash during the year $ (156)
Cash at beginning of the year 5,051
Cash at end of the year $ 4,895
 Addis-Matador CORP.
Statement of Cash Flows
For the Year Ended December 31, 2006
(in thousands of dollars)

Cash flows from operating activities:

Cash collected from customers $ 33,563
Cash paid to suppliers and employees (30,854)
Cash paid for interest (450)
Cash flows from or to investors
Cash paid for taxes (1,190)
Net cash flow from operating activities
$ 1,069
or creditors are shown in the
Cash flow from investing activities:
Cash paid to purchase equipment
$ (1,625)
financing section.
Net cash flow from investing activities
(1,625)
Cash flow from financing activities:
Cash received from bank loan $ 1,400
Cash paid for dividends (1,000)
Net cash flow from financing activities 400
Net decrease in cash during the year $ (156)
Cash at beginning of the year 5,051
Cash at end of the year $ 4,895
 Addis-Matador CORP.
Statement of Cash Flows
For the Year Ended December 31, 2006
(in thousands of dollars)

Cash flows from operating activities:

Cash collected from customers $ 33,563
Cash paid to suppliers and employees (30,854)
Cash paid for interest (450)
Cash paid for taxes (1,190)
Net cash flow from operating activities $ 1,069
Cash flow from investing activities:
Cash paid to purchase equipment $ (1,625)
Net cash flow from investing activities (1,625)
The statement ends with a
Cash flow from financing activities:
Cash received from bank loan $ 1,400
Cash paidreconciliation
for dividends of Cash.
(1,000)
Net cash flow from financing activities 400
Net decrease in cash during the year $ (156)
Cash at beginning of the year 5,051
Cash at end of the year $ 4,895
 Relationship Among the Financial
Statements
Addis-Matador CORP.
Income Statement
For the Year Ended December 31, 2006
Net income from the
(in thousands of dollars) income statement
Revenues
Sales revenue $ 37,436
increases ending
Expenses
Cost of goods sold $ 26,980 retained earnings on the
Selling, general and administrative 3,624
Research and development 1,982 statement of retained
Interest expense 450
Total expenses 33,036 earnings.
Pretax income $ 4,400
Income tax expense 1,100
Net income $ 3,300 Addis-Matador CORP.
Statement of Retained Earnings
For the Year Ended December 31, 2006
(in thousands of dollars)

Retained earnings, January 1, 2006 $ 6,805

Net income for 2006 3,300
Dividends for 2006 (1,000)
Retained earnings, December 31, 2006 $ 9,105
 Relationship Among the Financial
Statements
Addis-Matador CORP.
Balance Sheet
At December 31, 2006
Ending retained earnings
(in thousands of dollars)
Assets from the statement of
Cash $ 4,895
Accounts receivable 5,714 retained earnings is one
Inventories 8,517
Plant and equipment 7,154 of the components of
stockholders’ equity on
Land 981
Total assets $ 27,261
Liabilities and Stockholders' Equity
Liabilities the balance sheet.
Accounts payable $ 7,156
Notes payable 9,000
Addis-Matador CORP.
Total liabilities $ 16,156
Stockholders' Equity Statement of Retained Earnings
Contributed capital $ 2,000 For the Year Ended December 31, 2006
Retained earnings 9,105
(in thousands of dollars)
Total stockholders' equity 11,105
Total liabilities and stockholders' equity $ 27,261
Retained earnings, January 1, 2003 $ 6,805
Net income for 2003 3,300
Dividends for 2003 (1,000)
Retained earnings, December 31, 2003 $ 9,105
 Relationship Among the Financial
Statements
Addis-Matador CORP. Addis-Matador CORP.
Balance Sheet Statement of Cash Flows
At December 31, 2006
For the Year Ended December 31, 2006
(in thousands of dollars)
(in thousands of dollars)
Assets
Cash $ 4,895
Accounts receivable 5,714 Cash flows from operating activities:
Inventories 8,517 Cash collected from customers $ 33,563
Plant and equipment 7,154 Cash paid to suppliers and employees (30,854)
Land 981 Cash paid for interest (450)
Cash paid for taxes (1,190)
Total assets $ 27,261
Net cash flow from operating activities $ 1,069
Liabilities and Stockholders' Equity
Cash flow from investing activities:
Liabilities Cash paid to purchase equipment $ (1,625)
Accounts payable $ 7,156 Net cash flow from investing activities (1,625)
Notes payable 9,000 Cash flow from financing activities:
Total liabilities $ 16,156 Cash received from bank loan $ 1,400
Stockholders' Equity Cash paid for dividends (1,000)
Contributed capital $ 2,000 Net cash flow from financing activities 400
Retained earnings 9,105 Net decrease in cash during the year $ (156)
Total stockholders' equity 11,105 Cash at beginning of the year 5,051
Total liabilities and stockholders' equity $ 27,261 Cash at end of the year $ 4,895

The change in cash on the statement of cash flows added to

the beginning of the year balance in cash equals the ending
balance in cash on the balance sheet.
 2. Financial Analysis

• Assessment of the firm’s past, present

and future financial conditions
• Done to find firm’s financial strengths
and weaknesses
• Primary Tools:
 Financial Statements
 Comparison of financial ratios to past,
industry, sector and all firms
 Should analyze ratios based upon standards of comparison such
as

i. Industry ratios and standards

ii. Similar businesses in the same industry (competition)

iii. Past performance ratios.

iv. Prior years operating results

 Ratio Analysis

• Liquidity: Can we make required

payments?
• Debt management: Right mix of debt and
equity?
• Asset management: Right amount of
assets vs. sales?
• Profitability: Do sales prices exceed unit
costs?
 a) Liquidity Ratios

• An asset that can be converted to cash

quickly without having to reduce asset’s
price very much.
• Current Ratio:

Current assets
Current ratio 
Current liabilitie s
 Liquidity Ratios (cont’d)

• Quick, or Acid Test Ratio:

Is calculated by deducting inventory
from current assets as a proportion of
current liabilities

Current assets - Inventories

Current ratio 
Current liabilitie s
 b) Leverage Ratios (cont’d)

• Debt Ratio
The ratio of total debts to total assets:
measures the percentage of funds
provided by creditors

Total Debt
Debt Ratio 
Total Assets
 Leverage Ratios (cont’d)

• Times-Interest-Earned (TIE) Ratio

The ratio of earnings before interest and
taxes (EBIT) to interest charges; a
measure of the firm’s ability to meet its
annual interest payments.

EBIT
Interest coverage ratio 
Interest charges
 c) Asset Management Ratios
(Turnover)
The asset management ratios measures
how effectively the firm is managing its
assets

• Inventory turnover ratio

This ratio is calculated by dividing sales by
inventories
Sales
Inventory turnover ratio 
Inventories
 Asset Management Ratios
(Cont’d)

• Total Asset turnover ratio

Measures how efficiently assets are employed

Sales
Total Asset turnover ratio 
Total Assets
• Fixed Asset turnover ratio
Measures how efficiently fixed assets are
employed

Sales
Fixe Asset turnover ratio 
Net fixed assets
 d) Profitability Ratios
• A group of ratios that show the combined
effects of liquidity, asset management, and
debt on operating results.
• Gross profit margin
This ratio shows the margin left after
meeting production costs. It measures the
efficiency of production and pricing.
Gross profit
Gross profit margin 
Income
 Profitability Ratios (cont’d)
• Return on Capital Employed
A measure of how efficiently the capital is employed. A key
indicator of profitability of a firm. Firms that are efficiently
using their assets have a relatively high return. Less
efficient firms have a lower return.

Net profit
Return on capital employed 
Current Assets
• Return on Equity
Profit indicator to shareholders. The ratio indicates the
degree to which the firm is able to convert equity to
generate net profit that eventually can be claimed by
shareholders
Net profit
Return on equity 
Total equity