Understanding Financial Statements and

Cash Flows
Chapter No.3
The Income Statement
Income statement:
An income statement or Profit and loss statement
indicates the amount of profits generated by a firm
over a given time period, such as 1 year.
Most basic form of income statement is
Sales – expenses = profits
Sales Revenue: Which is equal to selling price of
products or services to be sold times the number of
units sold (selling price*units sold= total sales).
Cost of goods sold: Which is the cost of producing
or acquiring goods or services that were sold.
Continued…
Gross profit: Sales or revenues minus the cost of
goods sold.
Operating expenses: Which include:
a. Marketing and selling expenses ( the expenses
related to marketing, selling and distributing
the products and services.
b. General and administrative expenses ( firm’s
overhead expenses, such as executive salaries
and rent expenses.
Also include depreciation expenses ( a non
cash expense to allocate the cost of depreciable
assets, such as plant and equipment, over the
life of asset.
Continued…
Operating income: also called operating profit or
earning before interest and taxes or EBIT.
Sales less the cost of goods sold less operating
expenses.
Earning before taxes (EBT or Taxable income):
operating income minus interest expense.
Net income (Net profit or earnings available
to common stockholder): Which represents
income that may be reinvested in the firm or
distributed to its owners, provided of course
the cash is available to do so.
Continued…

Earning per share: is net income on per share

basis. As firm’s owners( Common stockholders) like
to know how much income firm made for each
share of stock outstanding.
It is calculated as net income divided by number of
common shares of stock outstanding.
Dividend per share: the amount of dividends a
firm pays for each share outstanding.
It is calculated as total dividend divided by shares
outstanding.
The Income Statement
The Balance Sheet
Balance sheet: The balance sheet provides a
snapshot of a firm’s financial position at a particular
date.
• It includes three main items: assets, liabilities, and
owner-supplied capital (shareholders’ equity).
– Assets are resources owned by the firm.
– Liabilities and owner’s equity indicate how those
resources are financed:
Total Assets = Total debt (Liabilities) + Total
Shareholder equity
 The transactions in balance sheet are recorded
at cost price, so the book value of a firm may
be very different from its current market value.
The Balance Sheet: Assets

Current Assets: comprise assets that are relatively

liquid, or expected to be converted into cash within
12 months. Current assets typically include:
– Cash
– Accounts Receivable (payments due from
customers who buy on credit)
– Inventory (raw materials, work in process, and
finished goods held for eventual sale)
– Other assets (ex.: Prepaid expenses are items
paid for in advance)
The Balance Sheet: Assets

Long-Term Assets: Fixed Assets and Other Assets

• Fixed Assets
– Include assets that will be used for more than
one year. Fixed assets typically include:
• Machinery and equipment, buildings, land

• Other Long term Assets

– Assets that are neither current assets nor fixed
assets. They may include long-term investments
and intangible assets such as goodwill etc.
The Balance Sheet: Liabilities

Debt (Liabilities):
– Money that has been borrowed from a creditor
and must be repaid at some predetermined
date.
– Debt could be current (must be repaid within
twelve months) or long-term (repayment time
exceeds one year).
The Balance Sheet: Liabilities
Short-Term Debt (Current Liabilities):
– Accounts payable (Credit extended by suppliers
to a firm when it purchases inventories)
– Accrued expenses (Short-term liabilities incurred
in the firm’s operations but not yet paid for)
– Short-term notes (Borrowings from a bank or
lending institution due and payable within 12
months)
Long-Term Debt
– Borrowings from banks and other sources for
more than one year
The Balance Sheet: Equity

Equity:
Shareholder’s investment in the firm in the form of
preferred stock and common stock. Preferred
stockholders enjoy preference with regard to
payment of dividend and seniority at settlement of
bankruptcy claims.
Retained Earnings:
Cumulative profits retained in a business up to the
date of the balance sheet.
The Balance Sheet