1. The Role of Financial Statements
Businessman analyzing financial report data on large screen including balance sheet,
income statement, equity statement, and cash flow statement.
We often hear that we should eat healthier and exercise daily. Experts tell us that
we should keep our weight under control and monitor our body systems. If we
manage our life well, we will have more energy, lower blood pressure, lower
cholesterol, and we will feel better overall. In the same sense, as managers and
owners of companies, we should regularly monitor the systems that reflect the
financial health of our company. This is the role that financial statements play.
https://www.accountingtools.com/articles/2017/5/10/financial-statements
The three primary financial statements we will discuss in this course are:
1- The balance sheet shows us an organization’s financial position at a point in time based
on its assets, liabilities, and shareholders’ equity (Keown, Martin, & Petty, 2017).
2- Conversely, an income statement reflects the profit or loss results of a firm’s operations
over a specified period of time (Keown et al., 2017).
3- A statement of cash flows shows the amount of cash available from operations
after an organization pays for its operations and fixed asset costs (Keown et al.,
2017).
Production make an accordion interactive. Make it expandable
Understanding financial statements helps us to identify potential problem areas and
make better decisions to improve the company’s financial health. This active
management potentially benefits both the stockholders of the company and all other
stakeholders. The assets reflected on the financial statements of a company are
based on cost and are called book values. The actual market value of these assets
(what a disinterested buyer will pay for the assets) may be more than the book
value. This difference benefits a company if it sells an asset in the normal course of
business (Keown et al., 2017).
Take the opportunity to watch the video Financial Statements on the
Investopedia.com website that contains an explanation of financial statements:
https://www.investopedia.com/video/play/financial-statements/
This video expands upon the four sections to a company’s package of financial statements.
Now that you have watched the video, take the opportunity to consider the use of financial
statements and how they impact your workplace. Then watch the following two videos,
which contain explanations of both balance sheets and income statements:

This video provides an example of how to read an income statement.

This video provides an example of how to read an income statement.
You should now have a solid understanding of the importance of both income
statements and balance sheets. Consider how these might be used to properly
manage finances within an organization.
Understanding the difference between cash flow and profit is also critical to the
organization’s financial health. Cash flow is the lifeblood of a company. A company
can be profitable and still go out of business by not properly managing cash flow. In
the Dell example (in the next interactive), they would recognize the potential profit
when they invoiced you for the computer. They would not benefit from the cash
until you paid the invoice. While the profit from the sale is nice, the cash received
has more benefit to the financial health of the company (Keown et al., 2017).
As an example, imagine you have placed an order with Dell to build a computer for
you…
The book value for the computer before the sale is the actual cost that Dell incurred
to make the computer.
The market value is the price you pay for the computer. If Dell is managing this
transaction properly, the price you pay (market value) is more than the book value.
The difference is the profit Dell makes on this sale.
Watch the following video to learn how to read the statement of cash flows:

This video provides an example of how to read a statement of cash flows.
After reviewing the video, consider the importance of cash flow and the role it plays
on the success of an organization.
2. Global Financial Statements Standards
Financial document with a pen and a calculator
From a global perspective, there are currently two primary standards for financial
reporting: GAAP and IFRS (KPMG, 2017). As our world continues to evolve into a
single global economic environment, the importance of establishing consistent
international financial standards continues to increase. Table 1 provides a brief
comparison of the two established standards.
Table 1
General Comparison between GAAP and IFRS
Notes. Adapted from “IFRS compared to U.S. GAAP: An overview” (KPMG, 2017).
* some exceptions may apply
** other comprehensive income
*** “Fair value” is the price that would be received to sell an asset, or paid to
transfer a liability in an orderly transaction between market participants at the
measurement date.
The table data reflect more common practices than exceptions between the two
standards. According to KPMG (2017), the Securities and Exchange Commission
(SEC) that controls the reporting standards for U.S. businesses has indicated that
movement toward IFRS standards is being considered. This transition may take
several years.
According to IFRS (2015): “Currently the Saudi Arabian Monetary Authority (SAMA)
requires banks and insurance companies in Saudi Arabia report under IFRS. SOCPA
standards apply to all other companies…” (p. 1). SAMA is the central bank of Saudi
Arabia, and SOCPA is the Saudi Organization for Certified Public Accountants.
References
IFRS. (2017). IFRS application around the world: Jurisdictional profile: Saudi Arabia.
Retrieved from https://www.ifrs.org/use-around-the-world/use-of-ifrs-standards-byjurisdiction/saudi-arabia/#participant
Keown, A. J., Martin, J. D., & Petty, J. W. (2017). Foundations of finance: The logic and
practice of financial management (9th ed.). Upper Saddle River, NJ: Prentice Hall.
KPMG. (2017). IFRS compared to U.S. GAAP: An overview. Retrieved from
http://www.kpmg.com/CN/en/IssuesAndInsights/ArticlesPublications/Documents/IFR
S-compared-to-US-GAAP-An-overview-O-201411.pdf
Module 2 Critical Thinking Assignment
Understanding Financial Statements and Cash Flow
Problem 2-1: Preparing Financial Statements
Information below is for Buraydah Manufacturing, Inc. for the
year ended December 31, 20×1 except where beginning of year
numbers indicated. All amounts in SAR unless otherwise stated.
Accumulated depreciation
Sales
Accounts receivable
Interest expense
Cost of goods sold
Short term notes payable
Income taxes
Inventories
Common stock
Dividends paid
Cash
Marketing, general and administrative expenses
Long term debt
Fixed assets (property & equipment)
Accounts payable
Other assets
Depreciation expense
Retained earnings at beginning of year
Number of shares of common stock
Using the information above:
1. Prepare an income statement in good form
2. Prepare end of year balance sheet in good form
3. Calculate net working capital
4. Calculate the debt ratio
Using an additional column for each financial statement:
5. Prepare a common sized income statement
6. Prepare a common sized balance sheet
2,817,000
5,826,000
233,000
237,000
2,672,000
195,000
366,600
967,000
428,000
120,000
986,500
1,678,500
5,844,000
7,218,000
395,000
862,000
422,000
419,600
1,000
Problem 2-2 Preparing Statement of Cash
Flows
Given the following information, prepare a statement of cash
flows.
Dividends
Increase in common stock
Decrease in accounts receivable
Increase in inventories
Operating income
Increase in accounts payable
Interest expense
Depreciation expense
Increase in long term debt
Increase in fixed assets
Income taxes
Beginning cash balance
Assume all amounts are in 000’s SAR.
15
22
24
35
80
25
25
12
48
33
17
20
Chapter 3
Understanding
Financial
Statements
and Cash Flows
Learning Objectives
• Compute a company’s profits as reflected by its
income statement.
• Determine a firm’s financial position at a point in
time based on its balance sheet.
• Measure a company’s cash flows.
• Explain the difference between GAAP and IRFS.
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Learning Objectives
• Compute taxable income and income taxes owed.
• Describe the limitations of financial statements.
• Calculate a firm’s free cash flows and financing
cash flows.
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THE INCOME
STATEMENT
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The Income Statement
• It is also known as Profit/Loss Statement
• It measures the results of 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 = Profits
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Income Statement Terms
Revenue (Sales)
– Money derived from selling the company’s product or service
Cost of Goods Sold (COGS)
– The cost of producing or acquiring the goods or services to be
sold
Operating Expenses
– Expenses related to marketing and distributing the product or
service, general administrative expenses and depreciation
expense
Financing Costs
– The interest paid to creditors
Tax Expenses
– Amount of taxes owed, based upon taxable income
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Common-Sized
Income Statement
• Common-sized income statement restates
the income statement items as a percentage
of sales.
• Common-sized income statement makes it
easier to compare trends over time and
across firms in the industry.
• See Table 3.1
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Profit-to-Sales Analysis from
Common-Sized Income Statement
See Table 3.1
• Gross profit margin (or percentage of
sales going towards gross profit) is 61.1%
• Operating profit margin (or percentage
of sales going towards operating profit) is
21.1%
• Net profit margin (or percentage of sales
going towards net profit) is 15.4%
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THE BALANCE SHEET
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The 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 (A) are resources owned by the firm.
– Liabilities (L) and owner’s equity (E) indicate how those
resources are financed:
A=L+E
• 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.
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Balance Sheet Terms: 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)
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Balance Sheet Terms: 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 Assets
– Assets that are neither current assets nor fixed assets.
They may include long-term investments and intangible
assets such as patents, copyrights, and goodwill.
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Balance Sheet Terms: 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).
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Balance Sheet Terms: 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
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Balance Sheet Terms: 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.
• Treasury Stock: Stock that have been repurchased by the
company.
• Retained Earnings: Cumulative total of all the net income
over the life of the firm, less common stock dividends that
have been paid out over the years.
Note that retained earnings are not equal to hard cash!
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Balance Sheet: A = L + E
• ASSETS (A)
– Current Assets
– Fixed Assets
Total Assets
• LIABILITIES (L)
– Current Liabilities
– Long-Term Liabilities
Total Liabilities
• OWNER
S EQUITY (E)
– Preferred Stock
– Common Stock
– Retained Earnings
Total Owner s Equity
Total Liabilities + Equity
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Table 3-2
• Total assets exceeded $90 billion (1/3
current assets, 2/3 long-term assets)
• 1/4 of assets were held in cash
• Small accounts receivable and inventory
• 1/3 of assets are intangible
• Nearly 2/3 of financing came from debt
(debt ratio = 67%)
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Debt Ratio
– Debt ratio is the percentage of assets that are
financed by debt.
– Debt ratio is an indication of financial risk.
Generally, the higher the ratio, the more risky
the firm is, as firms have to pay interest on debt
regardless of the earnings or cash flow situation.
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Net Working Capital
Net Working Capital
= Current assets – current liabilities
– The larger the net working capital, the better the firm’s
ability to repay its debt.
– Net working capital can be positive or zero or negative. It
is generally positive.
– An increase in net working capital may not always be good
news. For example, if the level of inventory goes up,
current assets will increase and thus net working capital
will also increase. However, increasing inventory level may
well be a sign of inability to sell.
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MEASURING
CASH FLOWS
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Measuring Cash Flows
• Profits in the financial statements are
calculated on accrual basis rather than
cash basis (see next slide for accrual
basis accounting).
• Thus, profits are not equal to cash.
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Accrual Basis Accounting
• Accrual basis is the principle of recording revenues
when earned and expenses when incurred, rather
than when cash is received or paid.
– Thus, sales revenue recorded in the income statement
includes both cash and credit sales. Similarly, inventory
purchases may not be entirely paid for in cash as suppliers
may extend credit for some of the purchases.
• Treatment of long-term assets: Asset acquisitions
(that will last more than one year, such as
equipment) are not recorded as an expense but are
written off every year as depreciation expense.
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Three Sources of Cash Flows
•
Cash flows from Operations
(ex. Sales revenue, labor expenses)
•
Cash flows from Investments
(ex. Purchase of new equipment)
•
Cash flows from Financing
(ex. Borrowing funds, payment of
dividends)
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Three Sources of Cash Flows
(cont.)
• If we know the cash flows from operations,
investments, and financing, we can
understand the firm’s cash flow position
better, that is, how cash was generated and
how it was used.
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Income Statement Conversion:
From Accrual to Cash Basis
Cash Flow from Operations: Five Steps
1. Add back depreciation.
2. Subtract (add) any increase (decrease) in
accounts receivable.
3. Subtract (add) any increase (decrease) in
inventory.
4. Subtract (add) any increase (decrease) in other
current assets.
5. Add (subtract) any increase (decrease) in
accounts payable
6. Add (subtract) any increase (decrease) in other
accrued expenses.
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Coca-Cola(cash flow from
operations)
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Cash Flow from Investing
in Long-Term Assets
• Long-term assets include fixed assets and
other long-term assets. A firm may be
engaged in acquisition and sale of such
assets leading to cash flows.
• Coca-Cola example:
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Cash Flows from
Financing the Business
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Financing the Business
Illustrated: Coca-Cola
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Suggestions for Computing Cash
Flows
• Consider one section at a time.
• You need only 2 items from the income
statement: net income and depreciation
expense.
• Consider change for all items in the balance
sheet, except: ignore accumulated
depreciation and net fixed assets; ignore
change in retained earnings.
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GAAP AND IFRS
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GAAP and IFRS
• U.S. follows GAAP (Generally Accepted
Accounting Principles) – a set of standards,
conventions and rules established by FASB.
• Most other countries follow IFRS
(International Financial Reporting
Standards) – a set of broad and general
principles established by IASB.
• IFRS is simpler but allows more leeway for
accounting malpractice.
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INCOME TAXES AND
FINANCE
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Income Taxes and Finance
Computing Taxable Income for
Corporation
• Gross Income
– Dollar sales from a product or service less cost of
production or acquisition
• Taxable Income
– Gross income less tax deductible expenses, plus interest
income received and dividend income received
– Tax Deductible Expenses: Include operating expenses
(marketing, depreciation, administrative expenses) and
interest expense. Dividends paid are not deductible.
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THE LIMITATIONS
OF FINANCIAL STATEMENTS
AND ACCOUNTING MALPRACTICE
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Accounting Malpractice and
Limitations of Financial Statements
• Since accounting rules give managers
discretionary powers, it is possible that two
firms with similar financial performance may
report different results.
• There have been several cases of
accounting malpractice where rules have
been broken!
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Key Terms
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Accounts payable
Accounts receivable
Accrual basis accounting
Accounting book value
Accrued expenses
Accumulated depreciation
Additional paid-in-capital
Average tax rate
Balance sheet
Capital gains
Cash
Cash basis accounting
Common size financial statements
Common stock
Common stock holders
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Cost of goods sold
Current assets
Current debt
Debt
Debt ratio
Depreciation expense
Dividends per share
Earnings before taxes
Earnings per share
Equity
Financing cash flows
Fixed costs
Fixed assets
Free cash flows
GAAP
Gross fixed assets
Key Terms (cont.)
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Gross profit
Gross profit margin
IFRS
Income statement
Inventories
Liquidity
Long-term debt
Marginal tax rate
Mortgage
Net fixed assets
Net income
Net profit margin
Net working capital
Operating expenses
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Operating income
Paid-in capital
Par value
Preferred stockholders
Profit margins
Retained earnings
Semi-variable costs
Short-term notes (debt)
Statement of cash flows
Taxable income
Trade credit
Treasury stock
Variable costs

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