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Financial Fundamentals

Introduction
Overview

Welcome to the Financial Fundamentals course.

This course introduces concepts, terms, and


procedures that provide a basic understanding of
financial fundamentals. An understanding of financial
information, reporting, and analysis is important
because management and other stakeholders
frequently use financial information to evaluate the
performance of the organization, functions within the
organization, and projects.

Additionally, a calculator will be useful with this course, as you will be asked to complete a series
of quantitative and qualitative activities.

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Financial Transactions
The flow of funds within an organization must be consistently monitored and reported to assure
adequate support related to business financial transactions. These flows must be tracked,
categorized, and reported in a timely manner. The company does not solely determine reporting
requirements related to cash flow. Taxing, securities, and accounting agencies, and non-
governmental organizations typically set many of the requirements for reporting the financial
information. There are many ways to categorize financial transactions, but only an essential few
are typically used.

The income statement, balance sheet and the statement of cash flows are the main financial
statements that are used to report the financial health and performance of an organization.
Without the use of these specific documents, a company would find it difficult to manage their
business financial activities.

The income statement and balance sheet are the sources of data for several measures of the
financial health and performance of the organization. They are used by company management,
owners, and outside analysts to communicate an entity's financial position at a certain point in
time and its results of operations for a period ended.

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Financial Transactions Continued
The income statement, also known as a profit and loss statement, is a
summary of a companys profit or loss during any given period of
time, typically a year. The income statement presents all revenues
and operating expenses for a company during the selected time
period.

The balance sheet is a snapshot of a companys financial situation at


a selected point in time, typically at the end of a companys
accounting period or fiscal year. A balance sheet includes company
assets, liabilities, and the owners or stockholders equity in the
business. Assets and liabilities are made-up of both short- and long-
term company financial obligations, including cash accounts.

The statement of cash flows shows the sources and uses of cash, which are a basis of cash flow
analysis for management. Cash flow plays an integral role in the financial success or failure of a
company.

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Course Outline

This training course will cover the essential financial elements of a business, such as financial
statements, material, labor, and overhead cost structures, financial data analysis, and other
financial topics. Click the arrow to see each component that will be covered in the Financial
Fundamentals training course.

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Course Objectives

The objectives of this course are to provide students with a basic understanding of financial
fundamentals as they relate to the operation of a business. Upon completion of this course,
students will be able to:

Recognize the elements of product cost and the typical categories of those costs.

Explain the general format, content, and use of the balance sheet, income statement, and
the statement of cash flows.

Understand how to construct a balance sheet and income statement using basic data.

Explain the importance of cash flow to a business.

Explain how profit margins relate to sales and cost of goods sold.

Explain the methods frequently used to analyze the financial statements that measure the
overall performance of an organization.

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Financial Data
Overview
Standard classifications of the financial data must be
used in preparing the three financial statements. There
are some variations in the forms of the statements and
the classifications of the data for specific types of
businesses and industry segments.

Standardization makes it simpler for individuals to


understand the financial reports and allows
comparisons of the performance of different
companies in the same industry segment. Determining
the health of an organization starts with an
understanding of the classification of financial information.

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Financial Information Concepts
Enter content hereFunds flowing into an organization, such as income from sales, and out of an
organization, such as payment of company bills, must be classified to facilitate the reporting and
analysis of a companys financial condition. Click on the arrow below to see a list of commonly-
used methods of classification.

Financial and professional accounting organizations, like other professional organizations, have
developed a specialized vocabulary to describe their activities. Throughout this course, from a
simplified perspective, you will be introduced to financial and accounting terms, and their given
explanations.

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Costs of Goods Sold

A key cost element in the analysis of a companys performance is the cost of the goods that were
sold, commonly referred to as the cost of goods sold (COGS) or cost of sales (COS), and are
included on the income statement. Cost of Goods Sold is defined as the direct materials, direct
labor and overhead associated with producing the goods or services of an organization. Note that
cost of goods sold does not include selling costs that are normally included in a separate
category called selling, general and administrative expenses, or SG&A for short.

The graphic below shows the components of costs of goods sold. Click on any of the boxes to
learn more details about COGS, or its components.

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Check Your Understanding

Based on the following financial information, calculate the cost of goods sold for 10 kitchen
blenders.

Cost of Goods Sold (per unit)

Item Cost
Direct Materials 2.80
Direct Labor 1.30
Overhead 0.65
SG&A 2.40

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Material, Labor, and Overhead Costs
In developing costs for manufactured products, three elements are used: material, labor, and
supporting activities. These are described as direct materials, direct labor, and overhead.
These three items appear in an income statement under Cost of Goods Sold.

Direct materials include those items that can be physically traced to a particular job or product.
Direct labor can be physically traced to a particular job or product.

The cost of operations support activities are classified as factory overhead and distributed to jobs
or operations. Additionally, indirect materials used for a particular job or product such as screws,
adhesive, and grease, and factory work not performed directly on a particular product such as
factory supervisors, janitors, inventory control, and material handlers would be included as a
component of manufacturing overhead. Overhead is also synonymous with burdened.

Composition of Cost of Goods Sold

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Check Your Understanding

For each of the cost categories below, identify whether they are examples of direct labor or
overhead.

Costs Direct Labor Overhead

Wages for the lathe operators


Insurance for the manufacturing facilities
Overtime premiums paid to production workers
Lease expense for manufacturing office space
Plastic bags for product packaging
Labels for the plastic bags
Wages for the plant supervisor

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Direct and Indirect Costs
When analyzing the cost of goods sold, both direct and indirect costs need to be considered.

Direct costs are those costs of operations directly incurred in the production of a product. The
wheel and tire assemblies and the effort to mount them on a bicycle frame would be one of the
direct costs of producing a bicycle. For accurate product costing, it is very important that a system
exists for the timely and accurate collection of direct cost data.

The indirect costs are split into two categories based on whether they support production or
support the business in general. These are the expenses that are necessary in running a
business, but in themselves cannot be traced directly to products.

Operating overhead. Cost of operations support activities that was just discussed
in prior screens. An example would be the use of adhesive or lubricant on a product.

Selling, general and administrative expenses. Often referred to as SG&A


expenses. Selling expenses are related to the sales and marketing function of an
organization and includes salaries, commissions, travel, advertising, and samples.
General and administrative expenses are non-sales and manufacturing related and
include payroll, legal expense, the cost of distributing the product, and research and
development (R&D).

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Variable and Fixed Costs

The analysis of costs from a manufacturing perspective is important in the establishment of


selling prices of the products being produced. Its also important from a purchasing perspective in
determining what a fair purchase price should be for an item being procured. Two types of costs
that enter into a cost analysis are variable and fixed costs.

Variable costs are those that are associated with the volume of product being produced or sold.
Costs increase in some direct proportion to the volume produced. Examples of variable costs
from a manufacturing perspective include direct material and direct labor. Whereas, variable cost
from a providing a service could be the commissions earned by sales force personnel.

An expenditure that does not vary with production volume is referred to as a fixed cost. The cost
of factory rent, property taxes, utilities, insurance, floor space, and factory supervision typically do
not vary with small changes in production volume and would be classified as fixed costs.

The total cost of a product is determined by variable and fixed costs. The total cost equals the
fixed cost plus the products variable cost per unit times the total number of units produced.

Total Cost = Fixed Cost + [(Variable Cost per Unit)x(Number of Units Produced)]

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Check Your Understanding

An organization has the following actual costs for producing a shovel:

Item Cost
Direct Materials per unit 3.00
Direct Labor per unit 1.00
Fixed production costs 100,000

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Actual Costs

Managers must know the cost of producing various products to determine which are profitable.
Therefore, they need to know the actual costs associated with a job, and the average cost per
unit.

Actual costs are typically associated with order driven production and include the direct labor,
direct material, and associated overhead costs that are charged against a job as it moves through
the production process.

Once the actual costs are determined, the average cost per unit is calculated. The average cost
per unit is found by dividing the actual cost of the job by the number of good finished units
produced in the job.

Total Manufacturing Cost for Job


Total Number of Good Finished Units

In a schedule-driven production environment, the costs for a period are accumulated and divided
by the total quantity produced to calculate the average cost per unit.

Click the icon to the right to see an example of how average cost per unit is calculated for a batch
of gears.

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Assets, Liabilities, and Owners Equity
One set of classifications includes assets, liabilities, and owners equity. Assets and liabilities can
be classified as either long or short-term and are an indication of what an organization owns and
owes. They are included on the balance sheet. The three components related to one another as
shown in the following equation:

Assets = Liabilities + Owners Equity

Assets

Economic resources that are owned by an organization and are expected to benefit future
operations. From a personal perspective, assets would include items such as bank accounts,
annuities, clothing, jewelry, automobiles, and real property, while business assets would include
cash, accounts receivables, inventory, and property, plant, and equipment.

Liabilities

Debts owed to outsiders, and are frequently described on the balance sheet with titles that
include payables. Personal liabilities would include credit card bills, personal loans, automobile
loans, and home mortgage. Whereas, business liabilities would include accounts payable, notes
payable, taxes payable, and bonds payable.

Owner's Equity

Identified as what is left after subtracting all the companys liabilities from its assets. Its the total
equity interest that all stockholders have in the company. Owners equity is also known as
stockholders equity. This is usually separated for legal and accounting reasons into three
categories:
Capital stock
Capital surplus
Accumulated retained earnings

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Check Your Understanding

Classify each item as an asset or liability by checking the appropriate column.

Item Asset Liability


Credit card debt

Equipment

Notes payable

Personal loan

Accounts receivable

Inventory

A home mortgage

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Revenue and Expense

Select the red and green lights below to read about the differences between a companys
revenues and expenses.

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Check Your Understanding

Identify the following items as either revenues or expenses by selecting the appropriate column.

Item Revenue Expense


Entertainment

An individuals payroll check

Cost of clothing

Direct material used

Interest received on savings

Overhead incurred

Royalties earned

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Topic Summary

Key ideas from this topic include the following:

The flow of funds into and out of an organization must be captured, categorized, and
reported.

Taxing, securities, and accounting agencies and non-government organizations set some
of the requirements for reporting financial information.

There are many ways to categorize financial transactions, but there are only a few that
are typically used. Click on the arrow below to the most frequently used categories.

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Essential Statements
Overview

The analysis of financial statements reveals important


information to management in regards to profit and loss, to
creditors in determining whether they should give a line of credit
or loan, and to present and prospective investors which use the
information to determine if they will buy, hold, or sell stocks and
bonds of publicly traded companies.

The three essential financial statements are the:

Income statement
Balance sheet
Statement of cash flow

To effectively use financial statement information, it is helpful to know a few simple concepts and
to be familiar with some of the fundamental characteristics of basic financial statements. This
topic of the course will provide more detail on each of these statements. Knowledge of these
financial statements is a prelude to being able to analyze the data to determine the financial
health and operating performance of an organization.

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Knowledge of Financial Statements

These three financial statements (income statement, balance sheet, and statement of cash flow)
and the knowledge of how to use them are essential in being able to manage a company
properly. Each of the statements will be explored in some detail, but lets start with a quick
overview of all three. Click the below links for details on each of the financial statements.

Income statements

Used to track revenues and expenses so companies and investors can see the operating
performance of a company. The income statement provides important information about how
effectively management is controlling expenses and allows investors to calculate financial ratios
that reveal the rate of return the business is earning on shareholders retained earnings and
assets.

Balance Sheet

Main purpose is to indicate whether a company is financially strong and economically efficient. A
balance sheet provides a snapshot of a business' health at a point in time. It is a summary of
what the business owns (assets) and owes (liabilities). Balance sheets are usually prepared at
the close of an accounting period such as month-end, quarter-end, or year-end. New business
owners should not wait until the end of 12 months or the end of an operating cycle to complete a
balance sheet. Savvy business owners see a balance sheet as an important decision-making
tool.

Statement of Cash Flows

Provides insight into the sources and uses of funds and the timing of fund flows. The major
operating cash flows are:

Cash received from customers


Cash paid to suppliers and employees
Interest and dividends received
Interest paid
Income taxes paid

These cash flows are computed by converting income statement amounts for revenue, cost of
goods sold, and expenses from the accrual basis to the cash basis. This is done by adjusting the
income statement amounts for changes occurring over the period in the related balance-sheet
accounts.

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The Income Statement

An income statement can show a variety of entries. This course will use only a basic form,
however, to illustrate the key essentials of any income statement.

An income statement is a summary of a companys profit or loss during one given period of
time, such as a month, a quarter, or a year. The income statement records all revenues for a
business during this given period, as well as the operating expenses for the business in the same
period. Since the statement shows both revenues and expenses, income can be calculated as:

Income = Revenues Expenses.

Since it is important not to intermingle the cost of goods sold and the SG&A expenses, each must
be tracked separately on the income statement to provide an awareness of how well they are
conforming to budgets. Cost of goods sold is further shown as being comprised of the elements
that make it up, direct material, direct labor, and overhead.

The amount of revenue left after subtracting the cost of goods sold has many names, such as
profit margin, gross profit, gross income, gross profit margin, and operating profit margin. We will
call it profit margin to reflect revenues achieved after subtracting the manufacturing or
operations costs of direct material, direct labor, and factory overhead.

Net profit margin is then obtained by subtracting SG&A expenses from the operating profit
margin. Net profit margin is also known as net income before corporate or company taxes. If the
net profit margin is positive, then the firm will report a gain, thus realizing an increase in its
owners equity for the period. However, a negative profit margin will indicate the company has
sustained a loss in the period being reported.

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Sample Income Statement

The following is a sample income statement from an automotive manufacturer. Click on each of
the underlined financial terms if you would like to see a reminder hint on what they cover.

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Check Your Understanding

The following data has been recorded by a company for its operations over the last quarter.

Item Cost
Revenue 1,250,000
Direct material per unit 250,000
Direct labor 500,000
Overhead; 250,000
SG&A 125,000

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The Balance Sheet
The balance sheet is one of the most important financial statements of a company. It is prepared
and reported to management, owners, and company stockholders at least once a year, although
it may also be prepared and presented semiannually, quarterly, or monthly. The balance sheet
provides information on what the company owns (assets), what it owes (liabilities), and the
value of the business to its stockholders (owners equity). The balance sheet name is derived
from the fact that its accounts must always be in balance.

Assets must always equal the sum of liabilities and owners equity.

Assets = Liabilities + Owners Equity

The balance sheet is the fundamental report of a companys possessions, debts, and invested
capital. It can be analyzed to determine if the company can meet financial obligations, the amount
of funds invested in the company, and the types and amount of assets the company acquired with
its financing.

The balance sheets components consist of the following:

Assets Liabilities Owners Equity


Accounts receivable Accounts payable Capital

Inventory Notes payable Retained Earnings

Fixed assets Long-term debt

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Sample Balance Sheet
As you can see from the sample balance sheet:

Total Assets = Liabilities + Owners Equity

or 1,900,000 = 525,000 + 1,375,000

Assets
Cash 100,000
Accounts receivable 300,000
Inventory 500,000
Fixed assets 1,000,000
Total assets 1,900,000

Liabilities
Notes payable 5,000
Accounts payable 20,000
Long-term debt 500,000
Total liabilities 525,000

Owners equity
Capital 1,000,000
Retained earnings 375,000
Total owners equity 1,375,000

Total Liabilities and Owners Equity 1,900,000

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Check Your Understanding

A company has closed its books for the fiscal year and has determined that its total assets are
2,350,000 and its total liabilities are 725,000.

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The Statement of Cash Flows
An income statement shows how much money passes through a company, the profit margin, and
how much of that profit was apportioned out to shareholders versus the amount retained. The
statement of cash flows, or the sources and applications of funds statement provides further
insights on the flow of funds, by showing where funds were provided from and where funds were
used.

The main source of funds is net income. In addition, depreciation provides additional funding, to
the extent there are assets that are undergoing depreciation. Depreciation is listed as an
expense in an income statement but a source of income in the funds flow statement. This is
acceptable accounting practice since it represents a companys recovery of the cost of an asset
that was previously expensed. Depreciation allows the recovered funds to be shown on the asset
side of books. The combination of net profit and depreciation is known as cash flow.

Uses of funds include the payment of dividends on both preferred and common stock, for:

Plant and equipment. Might include the purchase of a new piece of production
equipment.

Sundry assets. Might include a new company car, for example.

It is imperative to understand the total amounts of cash inflow and outflow, as they are used to
determine how a company is managing its cash position. By subtracting total funds used from
total cash flow, company management can determine whether the company has increased or
decreased its networking capital during the year.

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Statement of Cash Flows Example

The following shows an example of a statement of cash flows.

Funds were provided by:


Net income 535,000
Depreciation 300,000
Total 835,000

Funds were used for:


Dividends on preferred stock 30,000
Dividends on common stock 120,000
Plant and equipment 305,000
Sundry assets 10,000
Total 465,000

Net increase in working capital 370,000

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Topic Summary

Key points to remember from this topic include:

Financial statements provide information for the managers and owners of an


organization and for outsiders to evaluate the financial health and performance of the
organization.

The income statement, balance sheet, and the statement of cash flows are essential
financial statements.

The income statement shows the revenue, expenses, and profit or loss for an
organization for a period of time.

The balance sheet provides a picture of the value of the assets an organization owns,
the liabilities that it owes at a specific point of time, and owners equity.

The statement of cash flows shows the flow of cash in and out of the organization.

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Analysis of Performance
Overview
It is important to understand how the management, owners, and others use
data from the financial statements to assess the performance of an
organization. Managers get financial reports on a regular basis and judge
the performance of the organization by looking at specific entries such as
revenue, cost of goods sold, profit margin, and net profit.

They may do further analysis using information from the financial reports
and other sources. Individual owners or stockholders also get financial
reports on a regular basis. Their focus is typically on understanding the
security of and the return from their investment in the organization.
Securities analysts use published financial reports and other information to
make recommendations on the stock of an organization. Bankers use data
from financial statements in determining whether to loan funds to the organization and bond
rating agencies and bond purchasers use the same information to evaluate bond offerings of an
organization.

There are several means that can be utilized to analyze the financial statements of an
organization; however, we will focus on the two major methods:

Financial ratios
Comparative financial statements

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Working with Financial Ratios

Fundamental business analysis is a method of using numerical ratios to evaluate the


performance of a company and to allow it to be compared to the performances of other
companies in the same industry. Analysis utilizes the information provided by the income
statement and the balance sheet in the preparation of specific financial ratios.

Ratio analysis occurs when two or more figures from different categories are compared, with the
result being an absolute number or percentage. Click on the arrow below to see what the results
of ratio analysis will enable you to do:

Classifications of commonly used ratios include liquidity, leverage, profitability, and efficiency.
Each of these classifications will be explored briefly and some measurement examples in each
category will be introduced.

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Liquidity Ratios
Liquidity is the companys ability to satisfy its maturing short-term financial obligations. It relates
to short-term, typically a period of year or less. Liquidity is crucial to carrying out the business,
especially during times of adversity. Poor liquidity might lead to higher cost of financing and
inability to pay bills and dividends.

Liquidity is measured using ratios, which are financial tools to measure the companys capacity to
pay its debts as they come due.

Examples of liquidity ratios include the following. Click on each for details.

Current Ratio

Regarded as a measure of the short-term debt paying ability of the organization.

Current Assets
Current Liabilities

For example, if current assets are 900,000 and Current Liabilities are 25,000, the current ratio
would be 900,000/25,000 or 36.

Quick Ratio

Also known as Acid Test. Ratio between all assets quickly convertible into cash and all current
liabilities; specifically excludes inventory.

Cash + Accounts Receivable


Current Liabilities

For example, if cash is 50,000, accounts receivable is 22,000 and Current Liabilities are 56,000,
the quick ratio would be 72,000/56,000 or 1.29. The result should be higher than 1.0.

Net Working Capital Ratio

More accurately referred to as a measure of cash flow, as opposed to a ratio. The result must be
a positive number.

Working Capital = Total Current Assets Total Current Liabilities

For example, if current assets are 124,000 and current liabilities are 56,000, the net working
capital ratio would be 124,000 minus 56,000 or 68,000. The result should be a positive number.

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Check Your Understanding

A company has the following balances for the accounts shown at the end of a fiscal period.

Item Balance
Cash 61,000
Accounts Receivable per unit 25,000
Current Assets 76,000
Current Liabilities 48,000
SG&A 125,000

Indicate whether each of the following statements is true or false.

Statement True False


The current ratio is .63

The quick ratio is .59

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Leverage Ratios

Leverage is opposite of liquidity, as it is the companys ability to satisfy long-term debt as it


becomes due. Leverage is measured by a ratio that gives some indication of how highly
leveraged a company is. If the ratio is highif assets far exceed stock equitythen the company
is quite leveraged. This can be lucrative during good times, when borrowed assets earn more
than they cost, but if things go bad the company could have trouble servicing the debt implied by
all this leverage.

Examples of leverage ratios include the debt ratio and the debt to equity ratio.

Debt ratio. Reveals how much money a company owes to its creditors.

Total Liabilities
Total Assets

If total liabilities are 159,000 and total assets are 237,000, the debt ratio is
159,000/237,000 or .67.

Debt to equity ratio. Will show whether a firm has a lot of debt in its capital structure.

Total Liabilities
Stockholder's Assets

If total liabilities are 159,000 and stockholders equity is 78,000, the debt to equity ratio
is 159,000/78,000 or 2.03.

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Profitability Ratios

Profitability ratios measure performance, showing how much the firm is earning compared to its
sales, assets, or equity. These ratios can tell you how well the company is managed compared to
the industry average. Poor earnings will have an adverse effect on market price of stock and
dividends. High earnings have little meaning unless there is a thorough understanding of how the
profit was generated.

Examples of liquidity ratios include the profit margin ratio, return on investment (ROI), and
earnings per share. Select the links below to read about each ratio.

Profit Margin Ratio


Shows the earnings generated from revenue and is a key indicator of operating performance.

Net Income
Net Sales

For example: If net sales are 100,000 and net income is 25,000, the profit margin ratio
25,000/100,000 or 25%.

Return on Investment (ROI)


Broad measure of the financial returns resulting from an investment in some business or some
revenue-generating asset. It is usually expressed as a percentage of earnings produced by an
asset to the amount invested in the asset.

Net Profit after Taxes


Total Assets

Earnings Per Share


Shows the net income per common share owned and measures the return to the shareholder.

Net Income - Preferred Dividends


Number of Common Shares Outstanding

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Check Your Understanding

A restaurant manager has developed a plan to increase sales and profits by replacing the tables
with more comfortable booths. The cost associated with the new booths is 20,000, and they are
projected to increase profits by 4,000.

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Efficiency Ratios

Efficiency ratios measure how well the company uses its assets to obtain revenue and profit. One
example would be collecting receivables more quickly than the industry standard. The higher the
ratio, the more efficiently the firm manages its assets.

Examples of liquidity ratios include the inventory turnover ratio, sales to inventory, and accounts
receivable turnover ratio.

Inventory Turnover Ratio

Shows the number of times that inventory is being turned on an annual basis.

Cost of Goods Sold


Average Inventory for the Period

Remember: The average inventory for the period is calculated as inventory at the beginning of
the period plus inventory at the end of the period divided by two. For example, if the cost of goods
is 250,000 and average inventory for the period is 100,000, the inventory turnover ratio is
250,000/100,000, or 2.5.

Sales to Inventory Ratio

Measures how long it will take to convert the current inventory into revenue.

Sales
Total Inventory

Accounts Receivable Turnover Ratio

Measures the number of times that trade receivables turnover in a one-year period.

Net Sales
Average Accounts Receivable

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Check Your Understanding

Company ABC has annual sales of 900,000 with the associated cost of goods sold at 445,000,
beginning inventory of 250,000, and ending inventory of 350,000.

Based on this information, indicate whether each of the following statements is true or false.

Statement True False


The inventory turnover ratio is 1.48

The sales to inventory ratio is .39

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Comparative Financial Statements

A comparative financial statement is the second tool that can be utilized to analyze financial
statements. The entries in income statements and balance sheets are normally shown in
monetary units. To facilitate the comparison of an organizations performance over time, the
monetary units can be converted to percentages, which indicate the relative size of an item in
proportion to the whole. This is referred to as comparative statement analysis and is performed
on a common-size financial statement. Showing the financial data in percentages also allows
easy comparisons of two or more organizations of different sizes or the comparison of a
companys current situation to its new situation after a significant change has been made.

Click the arrow to see a list of scenarios in which the situation would be analyzed using a
common-size financial statement.

The following examples will guide you through the process of analyzing common-size financial
statements.

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Common-size Income Statement

Common-size income statements express revenue and expenses as a percentage of sales


revenue.

Revenue 1,000,000 (100%)


Cost of goods sold
Direct labor 200,000 (20%)
Direct material 400,000 (40%)
Factory overhead 200,000 (20%)
Total cost of goods sold (80%)
800,000
Operating profit margin 200,000 (20%)
General & administrative expenses 100,000 (10%)
Net profit margin (net income 100,000 (10%)

All items have been converted to a percentage of revenue in which revenue is shown as 100%.

200,00
For example, direct labor as a percentage of revenue = = 20%.
1,000,000

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Common-size Income Statement

Common-size balance sheets show assets, liabilities, and owners equity as a percentage of
total assets.

Assets
Cash 100,000 (05.26%)
Accounts receivable 300,000 (15.79%)
Inventory 500,000 (26.32%)
Fixed assets 1,000,000 (52.63%)
Total assets 1,900,000 (100.00%)

Liabilities
Notes payable 5,000 (00.26%)
Accounts payable 20,000 (01.05%)
Long-term debt 500,000 (26.32%)
Total liabilities 525,000 (27.63%)

Owners Equity
Capital 100,000 (52.63%)
Retained earnings 375,000 (14.74%)
Total owners equity 1,375,000 (72.37%)

Total Liabilities and Owners Equity 1,900,000 (100.00%)

All items have been converted to a percentage of total assets that equals 100%.

1,000,00
For example, fixed assets as a percentage of total assets = = 52.63%.
1,900,000

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Analyzing Changes in Business Revenues

Common-size financial statements can be used to perform various levels of sensitivity analysis
related to changes to the business within or between operating periods. The result of the analysis
will determine the overall effect that the proposals or business changes have to the financial
statements of the organization.

For example, in the following scenario, the sales and marketing group has developed a proposal
to increase revenue by 25%, while maintaining a status quo level for SG&A. Additionally, labor,
material, and overhead would increase proportionally to revenue. As previously noted, the
percentages are based on revenue. For example, direct labor is 200,000 and is 20% of revenue
1,000,000.

A common size income statement has been prepared to show the effects of the proposal. This
income statement shows that when overall revenue is increased by 25%, or 250,000, operating
profit margin is increased by 50,000. Thus, the net profit margin is increased by 50,000. Also, you
will see that SG&A are now 8% of revenue and the net profit margin is 12%.

Original Scenario New Scenario


Revenue 1,000,000 (100%) 1,250,000 (100%)
Cost of goods sold
Direct labor 200,000 (20%) 250,000 (20%)
Direct material 400,000 (40%) 500,000 (40%)
Factory overhead 200,000 (20%) 250,000 (20%)
Total cost of goods sold 800,000 (80%) 1,000,000 (80%)
Operating profit margin 200,000 250,000 (20%)
SG&A expenses 100,000 (10%) 100,000 (8%)
Net profit margin (net
100,000 (10%) 150,000 (12%)
income)

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Check Your Understanding

A company is planning the re-launch of a product to the market, with a projected increase in
revenue of 50% and an increase to SGA of 25,000. A common-size income statement for the
current situation is shown below.

Original Scenario
Revenue 1,000,000 (100%)
Cost of goods sold
Direct labor 200,000 (20%)
Direct material 400,000 (40%)
Factory overhead 200,000 (20%)
Total cost of goods sold 800,000 (80%)
Operating profit margin 200,000
SG&A expenses 100,000 (10%)
Net profit margin (net income) 100,000 (10%)

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Check Your Understanding

A company is planning the re-launch of a product to the market, with a projected increase in
revenue of 50% achieved by increasing the selling price. Assume that the selling, general and
administrative, and cost of goods sold expenses remain constant, from a real currency
perspective. A common size income statement for the current situation is shown below.

Original Scenario
Revenue 1,000,000 (100%)
Cost of goods sold
Direct labor 200,000 (20%)
Direct material 400,000 (40%)
Factory overhead 200,000 (20%)
Total cost of goods sold 800,000 (80%)
Operating profit margin 200,000
SG&A expenses 100,000 (10%)
Net profit margin (net income) 100,000 (10%)

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Check Your Understanding

An organization has calculated its average inventory for a year to have a value of 500,000 and its
cost of goods sold for the year as 800,000. The resulting inventory turnover ratio is 1.6 and the
company wants to increase it by 50%.

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Check Your Understanding

An organization has calculated its average inventory for a year to have a value of 500,000 and its
cost of goods sold for the year as 800,000. The resulting inventory turnover ratio is 1.6, and the
company has set a target of increasing the inventory turnover ratio to 2.4 by the end of the year.
The cost of goods sold for the next year is projected to be the same as for the past year.

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Topic Summary

This topic focused on the two major methods used to analyze the financial statements of an
organization:

Using financial ratios. Ratio analysis is an excellent method for determining the overall
financial condition of a firm. It puts the information from a financial statement into
perspective, helping to spot financial patterns that may threaten the health of a company.
Ratios are also very useful for making comparisons between one business and other
businesses in the same industry. For example, comparing ratios can indicate whether a
business is holding too much inventory or collecting receivables too slowly. The
comparison provides a window into ways in which any business can improve its
operations.

Classifications of ratios include liquidity, leverage, profitability, and efficiency.

Developing comparative financial statements. The use of common-size financial


statements will allow for comparison within or between organizations. By converting
financial statements to ratios, rather than using actual currency figures, it is easier to
compare performances of:
o An organization over time
o Two or more organizations of the same or different size
o An organization before and after major improvements have been made

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Operational Effects
Overview

A companys sales and operations plan identifies the companys products that are forecasted to
be sold in a future period of time, from one to three years for example, and the manufacturing
strategies for producing the items to satisfy the forecast. To the extent that the forecasts are
reasonable and the manufacturing strategies are realistic, the associated financial plans and
goals should reflect a strategy that can be executed. Considering that manufacturing has a
significant influence on the cost of goods sold, its performance can affect company profits
positively or negatively.

In that regard a companys operations department plays a key role in assuring that specific tasks
are completed. Please click on the arrow below to see a list of the processes that are overseen
by the operations department.

To the extent that all of this is in place and process variability is minimized, financial performance
of the company should be relatively on target.

In order to ensure that a company is considered world class, priority planning and capacity
planning need to occur at each level of the organizational hierarchy. An organization should have
a successful total quality management (TQM) program established, which is a solid ground that
the entire firm is committed to meeting or exceeding the expectations of the customer.

We will review scenarios where financial statements have been affected by the behavior of the
organization and analyze the overall results of these actions.

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Change in Cost of Goods Sold

An organization has implemented an engineering change resulting in an increase in direct


material. The accounting department has been requested to perform an analysis using common-
size financial statements. The overall cost associated with the material change is 50,000, while
revenue and all other expenses will remain constant.

Income Statement

Original Scenario Material Cost Increased


Revenue 1,000,000 (100%) 1,000,000 (100%)
Cost of goods sold
Direct labor 400,000 (40%) 450,000 (45%)
Direct material 200,000 (20%) 200,000 (20%)
Factory overhead 200,000 (20%) 200,000 (20%)
Total cost of goods sold 800,000 (80%) 850,000 (85%)
Operating profit margin 200,000 (20%) 150,000 (15%)
SG&A expenses 100,000 (10%) 100,000 (10%)
Net profit margin (net
100,000 (10%) 50,000 (5%)
income)

Based on this scenario, the results show that net income dropped from 100,000 to 50,000 or from
10% to 5%, a 50% decrease. This illustrates the impact material costs have on the income
statements bottom line: net profit margin.

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Check Your Understanding

An organization has implemented a total quality management initiative and labor costs have
decreased by 60,000, all else remaining the same. The following income statement is for the
period before the initiative was implemented.

Inventory Statement

Original Scenario
Revenue 1,000,000 (100%)
Cost of goods sold
Direct labor 400,000 (40%)
Direct material 200,000 (20%)
Factory overhead 200,000 (20%)
Total cost of goods sold 800,000 (80%)
Operating profit margin 200,000 (20%)
SG&A expenses 100,000 (10%)
Net profit margin (net income) 100,000 (10%)

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Change in Revenue

Next, based on the previous example related to an increase in direct material, determine what
increase in revenues would be required to bring the net income back up to 100,000. Assume
revenues increased by raising selling prices and not by increasing sales volume.

Income Statement

Original Scenario Revenues Increased


Revenue 1,000,000 (100%) 1,050,000 (100%)
Cost of goods sold
Direct labor 450,000 (45%) 450,000 (43%)
Direct material 200,000 (20%) 200,000 (19%)
Factory overhead 200,000 (20%) 200,000 (19%)
Total cost of goods sold 850,000 (85%) 850,000 (81%)
Operating profit margin 150,000 (15%) 200,000 (19%)
SG&A expenses 100,000 (10%) 100,000 (9.5%)
Net profit margin (net
50,000 (5%) 100,000 (9.5%)
income)

To achieve the same profit margin of 100,000 as originally attained, revenues would have to
increase by 50,000, or 5%. This would increase the net profit margin from 5% to 9.5%.

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Check Your Understanding

An organization has implemented a total quality management initiative and labor costs have
decreased by 60,000, all else remaining the same. The following income statement is for the
period before the initiative was implemented.

Inventory Statement

Original Scenario
Revenue 1,000,000 (100%)
Cost of goods sold
Direct labor 400,000 (40%)
Direct material 225,000 (23%)
Factory overhead 200,000 (20%)
Total cost of goods sold 825,000 (83%)
Operating profit margin 175,000 (17%)
SG&A expenses 100,000 (10%)
Net profit margin (net income) 750,000 (7.5%)

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Example: Effect of Inventory Increase on Balance Sheet

Based on an initiative to increase customer service, it has been determined that a higher level of
inventory will be maintained. This change in management direction has resulted in a 50,000
increase in inventory. The follow balance sheets will show the overall effect of this directive.

Balance Sheet

Assets Before After


Cash 100,000 100,000
Accounts receivable 300,000 300,000
Inventory 500,000 550,000
Fixed assets 1,000,000 1,000,000
Total assets 1,900,000 1,950,000

Liabilities
Notes payable 5,000 5,000
Accounts payable 20,000 70,000
Long-term debt 500,000 500,000
Total liabilities 525,000 575,000

Owners Equity
Capital 100,000 100,000
Retained earnings 375,000 375,000
Total owners equity 1,375,000 1,375,000
Total liabilities and owners equity 1,900,000 1,950,000

Notice that the inventory and accounts payable increased by 50,000.

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Note: interactive elements such as activities, quizzes and assessment tests are not available in printed form.
Check Your Understanding

The following balance sheet is for an organization at the end of the fiscal year. Management has
determined that the inventory will increase by 75,000 over the next year.

Balance Sheet

Assets
Cash 100,000
Accounts receivable 200,000
Inventory 300,000
Fixed assets 1,200,000
Total assets 1,800,000

Liabilities
Notes payable 5,000
Accounts payable 20,000
Long-term debt 475,000
Total liabilities 500,000

Owners Equity
Capital 1,000,000
Retained earnings 300,000
Total owners equity 1,300,000
Total liabilities and owners equity 1,800,000

Copyright (c) 2004 Accenture. All rights reserved. You may only use and print one copy of this document for
private study in connection with your personal, non-commercial use of a Supply Chain Academy course
validly licensed from Accenture. This document, may not be photocopied, distributed, or otherwise
duplicated, repackaged or modified in any way.
Note: interactive elements such as activities, quizzes and assessment tests are not available in printed form.
Topic Summary

Operations is considered one of the most important functions within a company, since its the
area where significant material, labor, and overhead costs occur. External or internal issues can
drive the overall fluctuation in operating costs. From an external perspective, there could be a
supplier quality issue or raw material shortage. Whereas, internal factors could result from
inefficiently managed operations department which would result in cost overruns, excessively
long production times, and ultimately, dissatisfied customers. Additionally, these environments
could implement initiatives that most likely would improve material, labor, and overhead. For
example, operations could implement a process improvement initiative that will reduce overall
labor by 20%.

Also, this topic demonstrated how a firm could change revenue, and most likely could offset
these issues, while maintaining a constant net profit margin. For example, depending on the root
cause of the issue, either the forecast would need to be adjusted or an adjustment to the selling
price could be implemented. The overall intent of the topic was to provide scenarios that
illustrated the overall effects of certain situations, such as change in direct material, labor, and
overhead, and how these changes were accounted for within the income statement and balance
sheet.

From an operational perspective, it is imperative to ensure that a company is considered world


class. Therefore, priority planning and capacity planning need to occur at each level of the
organizational hierarchy. An organization should have a successful total quality management
(TQM) program established, which is a solid ground that the entire firm is committed to meeting
or exceeding the expectations of the customer.

Copyright (c) 2004 Accenture. All rights reserved. You may only use and print one copy of this document for
private study in connection with your personal, non-commercial use of a Supply Chain Academy course
validly licensed from Accenture. This document, may not be photocopied, distributed, or otherwise
duplicated, repackaged or modified in any way.
Note: interactive elements such as activities, quizzes and assessment tests are not available in printed form.
Conclusion
Conclusion

The Financial Fundamentals course was intended to introduce concepts, terms, and procedures
that provide a basic understanding of business finances. Now that you have completed the
course you should have a thorough understanding of financial terminology and concepts and the
importance of information reporting and analysis. Also, you now have the tools to understand the
basics of financial statements that include the income statement, balance sheet, and statement of
cash flows, the components within those statements such as revenue, expenses, assets,
liabilities, and owners equity, and how they can affect the operations of a firm.

Key points to remember from this training course include the following.

Topic 2 Financial Data


The most common method of categorizing financial transactions are as follows.

Cost of goods sold and SG&A


Cost of goods sold include the direct materials, direct labor and overhead associated with
producing the goods or services of an organization. Selling, general, and administrative (SG&A)
covers all selling expenses associated with a company.

Material, labor, and overhead


Components of cost of goods sold. Direct materials are items that can be physically traced to a
particular job or product. Direct labor is work that can be physically traced to a particular job or
product. Overhead encompasses the costs of operations support activities.

Direct and indirect costs


Direct costs are those costs of operations directly incurred in the production of a product. Indirect
costs are the expenses that are necessary in running a business, but in themselves cannot be
traced directly to products (operating overhead and SG&A).

Fixed and variable costs


Fixed costs are expenditures that do not vary with production volume. Variable costs are those
that are associated with the volume of product being produced or sold.

Actual costs
Associated with order driven production and include the direct labor, direct material, and
associated overhead costs that are charged against a job as it moves through the production
process.

Assets, liabilities, and owners equity


Assets are economic resources that are owned by an organization and are expected to benefit
future operations. Liabilities are debts owed to outsiders, and are frequently described on the
balance sheet with titles that include payables. Owners equity is identified as what is left after
subtracting all the companys liabilities from its assets.

Topic 3 Essential Statements


The three essential financial statements are the:

Copyright (c) 2004 Accenture. All rights reserved. You may only use and print one copy of this document for
private study in connection with your personal, non-commercial use of a Supply Chain Academy course
validly licensed from Accenture. This document, may not be photocopied, distributed, or otherwise
duplicated, repackaged or modified in any way.
Note: interactive elements such as activities, quizzes and assessment tests are not available in printed form.
Income statement
A balance sheet provides a snapshot of the health of a business at a point in time.

Balance sheet
A balance sheet provides a snapshot of a business' health at a point in time. It is a summary of
what the business owns (assets) and owes (liabilities).

Statement of cash flow


Provides insight into the sources and uses of funds and the timing of fund flows.

Topic 4 Analysis of Performance


Companies frequently use financial information to evaluate the performance of the organization,
functions within the organization, and projects. Evaluation tools that were utilized in this course to
assess the overall state of the business included:

Financial ratios
Uses numerical ratios to evaluate the performance of a company and to allow it to be compared
to the performances of other companies in the same industry. Ratios used include liquidity,
leverage, profitability, and efficiency.

Comparative financial statements


Can also be utilized to analyze financial statements. The entries in income statements and
balance sheets are normally shown in monetary units. To facilitate the comparison of an
organizations performance over time, the monetary units can be converted to percentages, which
indicate the relative size of an item in proportion to the whole.

Topic 5 Operational Effects


Manufacturing has a significant influence on the cost of goods sold, thus its performance can
affect company profits positively or negatively. In this topic, you learned the financials can be
severely impacted by:

Change in cost of goods sold


Change in revenue
Inventory increase

Operations can strive to achieve high financial performance by ensuring that:

Necessary facilities and production equipment are in place


Production lines are operating lean
Workers are trained
Material is available
Need for six sigma quality is understood by all employees
Production problems are minimal
Customer satisfaction is the key driver

This course emphasized that the knowledge of financial fundamentals, among all functions, is
integral to the success of the organization, as everyone on the team can help drive the business
to the next level.

Copyright (c) 2004 Accenture. All rights reserved. You may only use and print one copy of this document for
private study in connection with your personal, non-commercial use of a Supply Chain Academy course
validly licensed from Accenture. This document, may not be photocopied, distributed, or otherwise
duplicated, repackaged or modified in any way.
Note: interactive elements such as activities, quizzes and assessment tests are not available in printed form.