Chapter Eight: Accounting Records and Financial Statements

Chapter Eight
Accounting Records
and Financial
Statements
Learning Objectives
• Discuss the importance and uses of

financial records to a small business
• Itemize the accounting records needed
for a small business
• Explain the 11 ratios used to analyze
financial statements
• Illustrate the importance of and
procedures for managing cash flow
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The Accounting Process
Starting the Accounting Process
• Purchase a simple accounting software

package
• Use the services of a professional who
specializes in small business

Accurate Information for Management
• Value of accounts receivable

• Age of each account
• How quickly the inventory is turning over
• Items that are not moving
• How much the firm owes
• When debt are due
• How much the business owes in taxes and
FICA

Banking and Tax Requirements
• Information on financial statements is

needed to prepare tax returns
• Bankers and investors use financial
statements to evaluate the condition of
the business

Small Business Accounting
Complete
Understandable Accurate
Easy to Use
Timely Dependable
Consistent

Double Accounting Systems
• Double-entry accounting – system in which every

business transaction is recorded in an asset
account and a liability or owner’s equity account in
order for the system to balance
• Asset – any resource that a business owns and
expects to use to its benefits
• Liability – debt owed by a business to another
organization or individual
• Owner’s Equity – amount of money the owner of a
business would receive if all of the assets were sold
and all of the liabilities were paid

Single Entry Accounting System
• Income and expenses are recorded in a

running log, basically like a checkbook
• Does not produce a balance sheet, an
income statement, or other financial
records
• Simple - but not a self-balancing system

Financial Statements & Accounting
Equations
• Balance Sheet:
– Assets =Liabilities + Owner’s Equity
• Income Statement:
– Profit = Revenue – Expenses
• Cash Flow Statement:
– Cash flow = Receipts – Disbursements

Two Methods of Accounting
Cash
Accrual

Generally Accepted Accounting
Principles (GAAP)
• GAAP – Standards are established so
that all businesses produce comparable
financial statements
• Flexibility in GAAP methods is
acceptable as long as consistency is
maintained within the business

Journal and Ledgers
• Journal – chronological record of all

financial transactions of a business
– Examples: Sales, purchases, cash receipts,
cash disbursements
• General Ledger – record of all financial
transactions divided into accounts and
usually compiled at the end of each month
– At the end of the accounting period or fiscal
year, you close and total each individual
account in the general ledger

Income Statement
• Income statement - shows the revenue

and expenses of a firm. Sections include:
– Net Sales
– Cost of Goods Sold
– Gross Margin
– Expenses
– New Income (or loss)
• Equation: Profit = Revenue – Expenses

Income Statement: Common-Size
Financial Statement
• Common-size financial statement –
financial statement that includes a
percentage breakdown/relationship of
each item of expense to sales
• Valuable tool for checking the efficiency
trends of the business by measuring
and controlling individual expense items

Stereo City
Income
Statement
Balance Sheet
• Provides an instant “snapshot” of the

business at any given moment.
Sections include:
– Assets
– Liabilities and owner’s equity (capital)
• Equation: Assets = Liabilities + Capital

Stereo City Balance Sheet
Current Asset: 3500/323500*100 = 1.08%

Stereo City Balance Sheet (continued)
Current Liabilities: 75000/323500 * 100 = 23.18%

Class Exercise
• For each of the following accounts,
indicate whether it belongs on a balance
sheet or an income statement.
– Rent – Salaries payable
– Cash – Purchase
– Patent – Delivery
– Mortgage equipment
payment – Sales
– Net income – Cost of goods
sold
– Common stock
Statement of Cash Flow
• Statement of cash flow – shows the

cash inflows and outflows of a business
• Equation:
– Cash flow = Receipts – Disbursements
• Forecasting cash flow is often more
critical to the survival of a business than
profits

Statement of Cash Flow

Estimating Financial Needs
for a New Business
• Pro forma financial statements – used
to project what a firm’s financial
condition will be in the future
• Based on estimates as to how much
money is needed, what expenses will
be at different sales levels, and how
much money you can expect to make

Analyzing Financial Statements
Four Common Financial Ratios
Liquidity
Activity Profitability
Leverage

Liquidity Ratios: Current Ratio
• Measures the number of times the firm can

cover its current liabilities with its current
assets
• Assumes that both accounts receivable and
inventory can easily be converted to cash
• Current ratios of 1.0 or less are considered low
and indicative of financial difficulties
• Current ratios of more than 2.0 often suggest
excessive liquidity that may be adverse to the
firm’s profitability

Liquidity Ratio: Quick Ratio
(Acid-Test)
• Measures the firm’s ability to meet
current obligations with the most liquid
of its current assets

Activity Ratios
• Measures the speed with which various

accounts are converted into sales or
cash
• Four major activity ratios include:
– Inventory turnover
– Average collection period
– Fixed asset turnover
– Total asset turnover

Activity Ratio: Inventory Turnover
• Measures the liquidity of a firm’s
inventory – how quickly goods are sold
and replenished
• Higher the inventory turnover, the more
times the firm is selling, or “turning
over,” its inventory
• High inventory ratio generally implies
efficient inventory management

Activity Ratio: Average Collection
Period
• A measure of how long it takes a firm to
convert a credit sale into a usable form
• All firms that extend credit must compute this
ratio to determine the effectiveness of their
credit-granting and collection policies
• High average collection periods usually
indicate many uncollectible receivables
• Low average collections periods usually
indicate overly restrictive credit-granting
policies

Activity Ratio: Fixed Asset Turnover
• Measures how efficiently a firm is using

its assets to generate sales
• Higher the ratio, the more effectively the
firm is using its assets to generate sales
• Low ratio often indicates that marketing
efforts are ineffective or that the firm’s
core business areas are not currently
feasible

Activity Ratio: Total Asset Turnover
• Measures how efficiently a firm uses all

of its assets to generate sales
• High generally reflects good overall
management
• Low ratio may indicate flaws in the
firm’s overall strategy, poor marketing
efforts, or improper capital
expenditures.

Leverage Ratios
• Measures the extent to which a firm uses debt as a

source of financing and its ability to service that
debt
• Leverage refers to the magnification of risk and
potential return that comes with using other
people’s money to generate profit
• More debt a firm uses, the more financial leverage it
has
• Two important leverage ratios are:
– Debt ratio
– Times interest earned ratio

Leverage Ratios: Debt Ratio
• Measures the proportion of a firm’s total

assets that is acquired with borrowed funds
• Total debt includes short-term debt, long-term
debt, and long-term obligations such as leases
• High ratio indicates a more aggressive
approach to financing and is evidence of a
high risk, high-expected – return strategy
• Low ratio indicates a more conservative
approach to financing

Leverage Ratio: Times Interest Earned
• Calculates the firm’s ability to meet its interest

requirements
• Shows how far operating income can decline
before the firm will likely have difficulties
servicing its debt obligations
• High ratio indicates a low-risk situation but may
also indicate an inefficient use of leverage
• Low ratio indicates that immediate action
should be taken to ensure that no debt
payments will go into default status

Profitability Ratios
• Measure the ability of a company to turn

sales into profits and to earn profits on
assets committed
• Allow for some insight into the overall
effectiveness of the management team
• Three important profitability ratios are:
– Net Profit Margin
– Return on Assets
– Return on Equity

Profitability Ratio: Net Profit Margin
• Measures the percentage of each sales

dollar that remains as profit after all
expenses, including taxes, have been
paid
• Widely used as a gauge of management
efficiency
• Although net profit margins vary greatly
by industry, a low ratio indicates that
expenses are too high relative to sales

Profitability Ratio: Return on Assets
• Also known as return on investment

• Indicates the firm’s effectiveness in
generating profits from its available
assets
• Higher shows effective management
and good chances for future growth

Profitability Ratio: Return on Equity
• Measures the return the firm earned on its

owner’s investment in the firm
• Higher this ratio is, the better off the
owner is
• This ratio is highly affected by the amount
of financial leverage (borrowed money)
used by the firm and may not be an
accurate measure of management
effectiveness

The Use of Financial Ratios
• Financial ratios by themselves tell us

very little. For purposes of analysis,
ratios are useful only when compared
with other ratios
• Two types of ratio comparisons can be
made:
Cross-Sectional
Cross-Sectional Time
TimeSeries
Series
Analysis
Analysis Analysis
Analysis

The Use of Financial Ratios
• Cross-Sectional Analysis – Ratio comparison

that compares different firm’s financial ratios
at the same point in time. Is often done by
comparing an individual firm’s ratios against
the standard ratios for the firm’s industry
• Time Series Analysis – Ratio comparison that
compares a single firm’s present performance
with its own past performance. Is used to
uncover trends in the firm’s financial
performance

Comparing Company and
Industry Ratios
* Uses pretax profits.

Source: Financial Studies of the Small Business, 17th ed. (Winter Haven, FL: Financial Research Associates, 1994).
Managing Cash Flow
• Cash Flow – sum of net income plus any

noncash expenses, such as depreciation and
amortization
– or the difference between the actual amount of cash
a company brings in and the actual amount of cash
a company disburses in a given time period
• Goal of good cash-flow management is to have
enough cash on hand when you need it
• Basic strategy is to maximize your use of cash

Cash Flow Fundamentals
• The first step in cash flow management is to

understand the purpose and nature of cash flows.
We can do this by understanding:
– Why do we need cash flow?
– How is cash flow generated?
– How do firms become insolvent even though they are
profitable?
• To answer these questions we need to look at:
– Motives for having cash
– Cash-to-cash cycle
– Timing of cash inflows and outflows

Motives for Having Cash
• Make transactions
• Protect against unanticipated problems
• Invest in opportunities as they arise
• Primary Motive: Make transactions – the
ability to pay the bills incurred by the
business.
• If a business cannot meet its obligations – it
is insolvent. Continued insolvency leads
directly to bankruptcy

Cash-To-Cash Cycle
• Period of time from when money is spent on raw
materials until it is collected on the sale of a
finished good
• Cash-to-cash cycle:
– Firm will normally take some time to manufacture or
otherwise hold finished goods until they sell
– As sales are made, cash is replenished immediately
by cash sales, but accounts receivable are credit by
credit sales
– Firm must collect the receivable in order to secure
cash

Cash-to-Cash Cycle

Cash Flow Management Tools
Cash Budgets Float
Aging Schedules

Cash Flow Management: Cash Budget
• Allow the firm to plan short-term cash needs,

with particular attention to periods of surplus and
shortage
– When the firm is likely to experience a cash surplus, it
can plan to make a short-term investment
– When the firm is expected to experience a cash
shortage, it can plan to arrange for a short-term loan
• Typically covers a one-year period that is divided
into smaller intervals.
– Number of intervals is dictated by the nature of the
business.

Cash
Budget
Format
Aging Schedules
• Aging Schedules – listing of a firm’s

accounts receivable according to the
length of time they are outstanding
• Macro-aging Schedule:
– list of accounts receivable by age category
– list of accounts receivable showing each
customer, the amount owed, and the
amount that is past due

Macro Aging Schedule

Micro Aging Schedule

Strategies for Cash Flow Management
• Accounts receivable
• Inventory
• Banks
• Other areas of cash flow concern

Strategies for Cash Flow Management:
Accounts Receivable
• Establish sound credit practices
• Process orders quickly
• Prepare the invoice the same day as the
order is received
• Mail the invoice the same day it is prepared
• Offer discounts for prompt payment
• Aggressively follow up on past due
accounts

Accounts Receivable (continued)
• Deposit payments promptly
• Negotiate better terms from suppliers
and banks
• Keep a tight control on inventory
• Review and reduce expenses
• Pay bills on time, but not before they
are due
• Be smart in designing your invoice

Managing Inventory
• Compute inventory turnover ratio to
determine how much inventory is
needed
• Commit just enough cash to inventory to
meet demand

Strategies for Cash Flow
Management: Banks
• Request an account analysis to
determine:
– Banking services used, bank charges for
each service, balances in all accounts,
minimum balances required
– Excess account balances on deposit
– How quickly checks deposited become
available as cash

Strategies for Cash Flow
Management: Other Areas
Compensation
Borrowing Insurance Supplies
Deliveries

Chapter Eight: Accounting Records and Financial Statements

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Chapter Eight

• Discuss the importance and uses of

Copyright © Houghton Mifflin Company. All rights reserved. 8–2

• Purchase a simple accounting software

Copyright © Houghton Mifflin Company. All rights reserved. 8–4

• Value of accounts receivable

Copyright © Houghton Mifflin Company. All rights reserved. 8–5

• Information on financial statements is

Copyright © Houghton Mifflin Company. All rights reserved. 8–6

Copyright © Houghton Mifflin Company. All rights reserved. 8–7

• Double-entry accounting – system in which every

Copyright © Houghton Mifflin Company. All rights reserved. 8–8

• Income and expenses are recorded in a

Copyright © Houghton Mifflin Company. All rights reserved. 8–9

Copyright © Houghton Mifflin Company. All rights reserved. 8–10

Copyright © Houghton Mifflin Company. All rights reserved. 8–11

Copyright © Houghton Mifflin Company. All rights reserved. 8–12

• Journal – chronological record of all

Copyright © Houghton Mifflin Company. All rights reserved. 8–13

• Income statement - shows the revenue

Copyright © Houghton Mifflin Company. All rights reserved. 8–14

Copyright © Houghton Mifflin Company. All rights reserved. 8–15

• Provides an instant “snapshot” of the

Copyright © Houghton Mifflin Company. All rights reserved. 8–17

Copyright © Houghton Mifflin Company. All rights reserved. 8–18

Current Liabilities: 75000/323500 * 100 = 23.18%

Copyright © Houghton Mifflin Company. All rights reserved. 8–19

• Statement of cash flow – shows the

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• Measures the number of times the firm can

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• Measures the speed with which various

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• Measures how efficiently a firm is using

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• Measures how efficiently a firm uses all

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• Measures the extent to which a firm uses debt as a

Copyright © Houghton Mifflin Company. All rights reserved. 8–32

• Measures the proportion of a firm’s total

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• Calculates the firm’s ability to meet its interest

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• Measure the ability of a company to turn

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• Measures the percentage of each sales

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• Also known as return on investment

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• Measures the return the firm earned on its

Copyright © Houghton Mifflin Company. All rights reserved. 8–38

• Financial ratios by themselves tell us

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• Cross-Sectional Analysis – Ratio comparison

Copyright © Houghton Mifflin Company. All rights reserved. 8–40

* Uses pretax profits.

• Cash Flow – sum of net income plus any