Foundations of Finance: Financial Statements Analysis Essay

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Foundations of Finance
Lecture 2 (Part 1)

Dr. Alcino Azevedo

Financial Statements Analysis

Learning Objectives

Compute firms’ profits as reflected by its income statement.
Determine firms’ financial position at a point in time based on its balance sheet.
Measure a firms’ cash flows.


The Income Statement

It is also known as Profit/Loss Statement
It measures the results of a firm’s operation over a specific period.

The bottom line of the income statement shows the firm’s profit or loss for a period.
(Sales – Expenses) = Profit or Loss


Income Statement Terms

Revenue (Sales)

Cost of goods sold

Expenses related to marketing and distributing the product or service and administering the business

Financing costs

The cost of producing or acquiring the goods or services to be sold

Operating expenses

Money derived from selling the company’s product or service

The interest paid to creditors and the dividends paid to preferred stockholders Tax expenses

Amount of taxes owed, based upon taxable income

Income Statement Form
Revenue (Sales)
Less cost of goods sold

= Gross profit
Less operating expenses

= Operating income
Less interest expenses

= Earnings before taxes (EBT)
Less income taxes

= Net income (earnings available for shareholders)



Common-size Income Statement

Common-size income statement:

Restates the income statement items as a percentage of sales.
Makes it easier to compare trends over time and across firms in the industry.


Common-size Income
Statement for Davies, Inc.
Cost of Goods Sold
Gross Profit
Operating Expenses

Selling Expenses
General & Admn. Exp.
Depreciation Expense

Total Operating Expenses
Operating Income
Interest Expense
Earnings before taxes
Income taxes
Net income






Profit-to-Sales analysis from
Common-size income statement

Gross profit margin: (or percentage of sales going towards gross profit) is 23.3%
Operating profit margin: (or percentage of sales going towards operating profit) is 12.5%
Net profit margin (or percentage of sales going towards net profit) is 7%


Balance Sheet

Provides a snapshot of firm’s financial position at a particular date.
It includes three main parts: assets, liabilities and equity. 

Assets (A): are resources owned by the firm
Liabilities (L) and owner’s Equity (E) indicate how those resources are financed

The items are recorded at historical cost, so the book value of a firm may be very different from its market value. 10

Balance Sheet Terms: Assets

Current assets or gross working capital comprise assets that are relatively liquid, or expected to be converted into cash within 12 months. Current assets typically include:

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) 11

Balance Sheet Terms: Assets

Fixed Assets: include assets that are held for more than one year. Fixed assets typically include:

Machinery and equipment

Other Assets: assets that are neither current assets nor fixed assets. They may include intangible assets such as patents, copyrights, and goodwill.


Balance Sheet Terms: 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)


Balance Sheet Terms: Liabilities

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