Financial Accounting-1

(MFY 193)
Fall, 2020

Lecture 2
A Further Look at Financial Statements

Assistant Prof. Dr. Ibrahim MERT

Istanbul Aydin University 1
Agenda
• The Classified Balance Sheet
- Current Assets
- Long-Term Investments
- Property, Plant, and Equipment
- Intangible Assets
- Current Liabilities
- Long-Term Liabilities
- Stockholders’ Equity
• Using the Financial Statements
- Ratio Analysis
- Using the Income Statement
- Using the Statement of Stockholders’ Equity
- Using a Classified Balance Sheet
- Using the Statement of Cash Flows
• Financial Reporting Concepts
- The Standard-Setting Environment
- Cost Constraint

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1. The Classified Balance Sheet
A classified balance sheet groups similar assets and similar
liabilities by using some standard classifications and sections.
This is useful for analyses because items within a group have
similar economic characteristics.
Standard balance sheet classification:
Assets Liabilities and Stockholders’ Equity
Current assets Current (Short-term) liabilities
Long-term investments (assets) Long-term liabilities
- Property, plant, and equipment Stockholders’ equity
- Intangible assets
These groupings help financial statement readers determine:
(1) whether the company has enough assets to pay its debts as they
come due, and
(2) how much are the claims of short- and long-term creditors on the
company’s total assets.
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 XYZ Corporation

1. The Classified Balance SheetBalance Sheet

30-Nov-17
Asse ts
Current assets
Cash $6,600
Debt investments 2,000
Account receivable 7,000
Notes re ceivable 1,000
Inventory 3,000
Supplies 2,100
Prepaid insurance 400
Total curre nt assets $22,100
Long-te rm assets
Stock investments 5,200
Investment in real estate 2,000
Property, plant, and equipme nt
Land 10,000
Equipme nt 24,000
Less: Accumulated
Depreciat.-Equipment 5,000 19,000
Intangible asse ts
Patents 3,100
Total long-te rm assets $39,300
Total assets $61,400
Liabilitie s and Stockholde rs' Equity
Current liabilities
Note s payable $11,000
Accounts payable 2,100
Unearned sales revenue 900
Salaries and wages payable 1,600
Interest payable 450
Total curre nt liabilities 16,050
Long-te rm liabilities
Mortgage payable 10,000
Note s payable 1,300
Total curre nt liabilities 11,300
Total liabilities 27,350
Stockholders' equity
Common stock 14,000
Retained earnings 20,050
Total stockholders' equity 34,050
Total liabilities and stockholders' equity 61,400

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1. The Classified Balance Sheet
CURRENT ASSETS: CAs are assets that a company
expects to convert into cash or consume (use up)
within one year or its operating cycle, whichever is
longer.
XYZ Corporation
Balance Sheet
30-Nov-17
Assets
Current assets
Cash $6,600
Debt investments 2,000
Account receivable 7,000
Notes receivable 1,000
Inventory 3,000
Supplies 2,100
Prepaid insurance 400
Total current assets $22,100

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1. The Classified Balance Sheet
LONG-TERM ASSETS: LTAs are assets that a company
expects to convert into cash or consume (use up) more than
one year.
Long-term investments:
(1) Stocks and bonds of other corporations that are held for
more than one year,
(2) Lands or buildings that are NOT currently in use for a
company’s operating activities, and
(3) Long-term notes receivables.

Property, plant, and equipment: PPEs are assets with

relatively long useful lives that are currently used in
operating the business. This category includes land,
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buildings, equipment, delivery vehicles, and furniture.
LONG-TERM ASSETS:
Depreciation is the allocation of the cost of an asset to a number of years.
The accumulated depreciation shows the total amount of
depreciation that the company has expensed in the asset’s life.
Intangible Assets: IAs do NOT have physical substance but may be
very valuable (e.g. goodwill).

XYZ Corporation
Balance Sheet
30-Nov-17
Long-term assets
Stock investments 5,200
Investment in real estate 2,000
Property, plant, and equipment
Land 10,000
Equipment 24,000
Less: Accumulated
Depreciat.-Equipment 5,000 19,000
Intangible assets
Patents 3,100
Total long-term assets $39,300
Total assets $39,300
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1. The Classified Balance Sheet- Total Assets

XYZ Corporation
Balance Sheet
30-Nov-17
Assets
Current assets
Cash $6,600
Debt investments 2,000
Account receivable 7,000
Notes receivable 1,000
Inventory 3,000
Supplies 2,100
Prepaid insurance 400
Total current assets $22,100
Long-term assets
Stock investments 5,200
Investment in real estate 2,000
Property, plant, and equipment
Land 10,000
Equipment 24,000
Less: Accumulated
Depreciat.-Equipment 5,000 19,000
Intangible assets
Patents 3,100
Total long-term assets $39,300
Total assets $61,400

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1. The Classified Balance Sheet
CURRENT LIABILITIES: CLs are obligations that
the company is to pay within one year or its
operating cycle, whichever is longer.
XYZ Corporation
Balance Sheet
30-Nov-17
Liabilities and Stockholders' Equity
Current liabilities
Notes payable $11,000
Accounts payable 2,100
Unearned sales revenue 900
Salaries and wages payable 1,600
Interest payable 450
Total current liabilities 16,050
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1. The Classified Balance Sheet
LONG-TERM LIABILITIES: LTLs are
obligations that a company expects to pay more than
one year later.
XYZ Corporation
Balance Sheet
30-Nov-17
Liabilities and Stockholders' Equity
Long-term liabilities
Mortgage payable 10,000
Notes payable 1,300
Total long-term liabilities 11,300
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1. The Classified Balance Sheet-TOTAL
LIABILITIES
XYZ Corporation
Balance Sheet
30-Nov-17
Liabilities and Stockholders' Equity
Current liabilities
Notes payable $11,000
Accounts payable 2,100
Unearned sales revenue 900
Salaries and wages payable 1,600
Interest payable 450
Total current liabilities 16,050
Long-term liabilities
Mortgage payable 10,000
Notes payable 1,300
Total long-term liabilities 11,300
Total liabilities 27,350
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1. The Classified Balance Sheet
SHAREHOLDERS’ EQUITY: SE consists of two parts:
Paid-in Capital (Common stock) is the investments of assets
into the business by the stockholders (investors, owners).
Retained earnings are the income (profit) retained for use
in the business.

XYZ Corporation
Balance Sheet
30-Nov-17
Liabilities and Stockholders' Equity
Stockholders' equity
Common stock 14,000
Retained earnings 20,050
Total stockholders' equity 34,050
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1. The Classified Balance Sheet
LIABILITIES and STOCKHOLDERS’ EQUITY:

XYZ Corporation
Balance Sheet
30-Nov-17
Liabilities and Stockholders' Equity
Current liabilities
Notes payable $11,000
Accounts payable 2,100
Unearned sales revenue 900
Salaries and wages payable 1,600
Interest payable 450
Total current liabilities 16,050
Long-term liabilities
Mortgage payable 10,000
Notes payable 1,300
Total long-term liabilities 11,300
Liabilities and Stockholders' Equity
Stockholders' equity
Common stock 14,000
Retained earnings 20,050
Total stockholders' equity 34,050
Total liabilities and stockholders' equity 61,400

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2. Using the Financial Statements
2.1. Ratio Analysis
A ratio expresses the mathematical relationship between one
quantity and another.
RA expresses the relationship among selected items of financial
statement data.
1) Profitability Ratios: Measure the income or operating
success of a company for a given period of time.
2) Liquidity Ratios: Measure short-term ability of the
company to pay its maturing obligations and to meet
unexpected needs for cash.
3) Solvency Ratios: Measure the ability of the company to
survive over a long period of time, meaning, the ability of
paying all debts.
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2.1.1) Profitability Ratios:
Margin Ratios: MRs represent the company’s
ability to convert revenues into profits
(income):
Main Ratios:
• Gross Profit (income) Margin,
• Operating Profit (income) Margin, and
• Net Profit (income) Margin,
Other Ratios: Cash Flow Margin, EBIT Margin, EBITDA
Margin, EBITDAR, NOPAT, Operating Expense Ratio,
and Overhead Ratio.
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2.1.1) Profitability Ratios-Margin Ratios
Net Revenues $14,500 Gross Income Margin=
COGS (8,400) Gross Income / Net Revenues x 100
Gross Income 6,100 6,100 / 14,500 = 42.0%
Selling, General &Adm. Exp. (1,850)
Research & Development Exp. (950) Operating Income Margin=
Depreciation/Amortization (300) Operating Income / Net Revenue x 100
Extraordinary (Unusual) Exp. (150) 2,850 / 14,500 = 19,7%
Other Operating Exp. 0 .
Operating Income 2,850 Net Income Margin=
Interest Expense (100) Net Income / Net Revenue x 100
Income Before Tax 2,750 2,063 / 14,500 = 14.2%
Income Tax 687
Income After Tax (Net Income) 2,063

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2.1.1) Profitability Ratios-Return Ratios
Return Ratios: RRs represent the company’s ability
to generate returns to its shareholders.
Main Return Ratios:
• Return-on assets (ROA)
• Return-on equity (ROE),
Other Ratios: cash return on assets, return on debt, return on
retained earnings, return on revenue, risk-adjusted return, return
on invested capital (ROIC), and return on capital employed.

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2.1.1) Profitability Ratios-Return Ratios
Return-on assets (ROA)
Net Income $10,000
Assets at the beginning of the period 14,000
Assets at the end of the period 16,000
Average Assets 15,000
ROA = Net Income / Average Assets = 10,000 / 15,000 = 67%

Return-on equity (ROE)

Net Income $20,000
Equity at the beginning of the period 15,000
Equity at the end of the period 21,000
Average Equity 18,000
ROE = Net Income / Average Shareholders’ Equity = 20,000 / 18,000 = 111%

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2. Using the Financial Statements
2.2. Using the Income Statement
 The income statement reports how successful
a company is at generating a profit from its
revenues.

 The income statement reports the amount

earned during the period (revenues) and the
costs incurred during the period (expenses).

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2.2. Using the Income Statement
Earnings per share (EPS), measures the net income
earned on each share of common stock .
(in million) 2011 2010
Net Income $1,300 $1,500
Preferred dividends 0 0
Shares outstanding at the beginning of year 420 410
Shares outstanding at the end of year 390 420
Earnings per Share (EPS)=
(Net Income – Preferred Dividends) / Average Common Shares Outstanding
2011 2010 .
($1,300-$0)/((420+390)/2) = 3.2 ($1,500-$0)/((410+420)/2) = 3.6

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2.3. Using the Statement of Stockholders’
Equity
 Stockholders’ equity is comprised of two parts: paid-in
capital and retained earnings.
 Paid-in capital is concluded with common stock and
preferred stock (capital invested by the investors).
 The retained earnings statement describes the changes in
retained earnings during the year.
 This statement adds net income to beginning retained
earnings and then subtracts dividends to arrive at ending
retained earnings.

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2.3. Using the Statement of Stockholders’
Equity
XYZ Corporation
Changes on stockholders’ Statement of Stockholders' Equity

equity: (in millions)

Nr. of Common Retained
 Common stock increased in Stock Earnings
the first year as the result of Balances at February 28, 2015 246 $4,397
Issuance of common stock 237
an issuance of shares.
Net income 1,317
 Common stock decreased Dividends -234
In the second year. Other Adjustments 1,001
Balances at February 28, 2016 483 $6,481
Even though it had an
Issuance of common stock 303
issuance of common stock Repurcchase of common stock -729
that increase was much Net income 1,277
smaller than the decrease Dividends -238
Other Adjustments -285
caused by a stock Balances at February 28, 2017 57 $7,235
repurchase.
 XYZ paid dividends each year. 22
2.4. Using a Classified Balance Sheet
Balance Sheet: XYZ Corp. Balance Sheet as of Feb 26, 2011

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2.4. Using a Classified Balance Sheet
Liquidity
A company’s ability to pay obligations expected to become
due within the next year or operating cycle.
Liquidity ratios measure the short-term ability of the
company to pay its maturing obligations and to meet
unexpected needs for cash.

Bankers to give credit, or suppliers to sell products would look

closely at the relationship of its current assets and current
liabilities.

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2.4. Using a Classified Balance Sheet-
Liquidity
Working Capital: One measure of liquidity is working capital,
which is the difference between current assets and current liabilities:
Working Capital = Current Assets – Current Liabilities

When current assets exceed current liabilities, working capital is

positive. When this occurs, there is greater likelihood that the company
will pay its liabilities.

When working capital is negative, a company might NOT be able to

pay short-term creditors, and the company might ultimately be
forced into bankruptcy.
XYZ had working capital in 2011 of $1,810 million ($10,473 million - $8,663
million). 25
2.4. Using a Classified Balance Sheet-Liquidity
Current Ratio: CR is computed as current assets divided
by current liabilities .
Current Ratio = Current Assets / Current Liabilities

The CR is a more dependable indicator of liquidity than working capital.

XYZ Corp. ($ in millions) ABC Corp. Industry Average

Meanings of results: XYZ’s 2011 current ratio of 1.21:1 means that for every dollar of
current liabilities, XYZ has $1.21 of current assets.

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2.4. Using a Classified Balance Sheet
Solvency Ratios
Solvency: Solvency is the ability of a company to meet its
long-term financial obligations.
Long-term creditors and stockholders are interested in a
company’s solvency—its ability to pay interest as it comes
due and to repay the balance of a debt due at its maturity.
Solvency ratios measure the ability of the company to survive
over a long period of time.

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2.4. Using a Classified Balance Sheet
Solvency
DEBT-TO-ASSETS RATIO: The DTAR is one measure of
solvency.
It is calculated by dividing total liabilities (both current and
long-term) by total assets.
It measures the percentage of total financing provided by
creditors rather than stockholders.
Debt financing is more risky than equity financing because
debt must be repaid at specific points in time, whether the
company is performing well or not.
The higher the percentage of debt financing, the riskier the
company.
Debt-to-Assets Ratio = Total Debt / Total Assets
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2.4. Using a Classified Balance Sheet-Solvency
DEBT TO ASSETS RATIO
XYZ Corp. ($ in millions) ABC Corp.
Industry Avrg.

The 2011 ratio of 59% means that every dollar of assets was financed by 59
cents of debt.
XYZ’s ratio exceeds the industry average of 57% and is significantly higher
than ABC’s ratio of 42%.
The higher the ratio, the more reliant the company is on debt financing. This
means the company has a lower equity “buffer” available to creditors if the
company becomes insolvent. Thus, from the creditors’ point of view, a high
ratio of debt to assets is undesirable.
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2.5. Using Cash Flow Statement
 In the statement of cash flows, net cash provided by operating
activities is intended to indicate the cash-generating capability of the
company.
 However, net cash provided by operating activities fails to take
into account that a company must invest in new property, plant, and
equipment (capital expenditures) just to maintain its current level of
operations.
 Companies also must at least maintain dividends at current levels to
satisfy investors.
Free cash flow describes the net cash provided by operating activities
after adjusting for capital expenditures and dividends paid.

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2.5. Using Cash Flow Statement
Free Cash Flow = Net Cash Provided by Operating
Activities –Capital Expenditures – Cash Dividends

For example: A company produced and sold 10,000 pc.

It reported $100,000 net cash provided by operating activities.
 In order to maintain production at 10,000 pc, the company
invested $15,000 in equipment.
 It also decided to pay $5,000 in dividends.
Its free cash flow was $80,000 (=$100,000 - $15,000 - $5,000).
Net cash provided by operating activities $100,000
Less: Expenditures on property, plant, and equipment -10,000
Less: Dividends paid -5,000
Free cash flow $85,000
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3. Financial Reporting Concepts
3.1. The Standard-Setting Environment
- The type of financial information to disclose?
- What format to use?
- How to measure assets, liabilities, revenues, and expenses?
 The International Accounting Standards Board (IASB) issues
standards called International Financial Reporting Standards (IFRS),
 All companies in Turkey get guidance from a set of accounting
standards that have authoritative support, referred to as generally
accepted accounting principles (GAAP).
 The Capital Markets Board (CMB) is the agency of Turkey that
oversees Turkish financial markets and accounting standard-setting
bodies.
 The Accounting and Auditing Standards Board (AASB) is the
primary accounting standard-setting body in Turkey.
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3.2. Cost Constraint
 Providing information is costly.
 Cost constraints means that the cost of the information
shouldn’t be more than the expected benefit.
 In deciding whether companies should be required to
provide a certain type of information, accounting standard-
setters consider the cost constraint.
 It weighs the cost that companies will incur to provide the
information against the benefit that financial statement users
will gain from having the information available.

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