Financial Accounting Chapter 3 Key Concepts
Acid-test/quick ratio (measures liquidity)
The acid-test ratio provides a more stringent indication of a company's ability to pay its current obligations. The numerator includes cash, accounts receivables, and short-term investments. This ratio excludes inventories, prepaid items, restricted cash, and deferred taxes from current assets before dividing by current liabilities.
Debt to equity ratio (measures solvency)
The debt to equity ratio indicates the extent of reliance on creditors, rather than owners, in providing resources.
What are the elements of the balance sheet?
Assets are probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events. Simply, these are the economic resources of a company. Liabilities are probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events. Simply, these are the obligations of a company. Equity (or net assets), called shareholders' equity or stockholders' equity for a corporation, is the residual interest in the assets of an entity that remains after deducting liabilities. Stated another way, equity equals total assets minus total liabilities.
Current ratio (measures liquidity)
Working capital, the difference between current assets and current liabilities, is a popular measure of a company's ability to satisfy its short-term obligations.
What is the purpose of the balance sheet?
The purpose of the balance sheet, sometimes referred to as the statement of financial position, is to report a company's financial position on a particular date. The balance sheet presents an organized array of assets, liabilities, and shareholders' equity at a point in time. It is a freeze frame or snapshot of financial position at the end of a particular day marking the end of an accounting period. USEFULNESS The balance sheet provides information useful for assessing future cash flows, liquidity, and long-term solvency. The balance sheet provides a list of assets and liabilities that are classified (grouped) according to common characteristics. These classifications, which we explore in the next section, along with related disclosure notes, help the balance sheet to provide useful information about liquidity and long-term solvency. Liquidity most often refers to the ability of a company to convert its assets to cash to pay its current obligations. Long-term solvency refers to an assessment of whether a company will be able to pay its long-term debt
Long term vs short term
There are both long term and short term assets and liabilities.
Times interest earned ratio (measures solvency)
Times interest earned (TIE) or interest coverage ratio is a measure of a company's ability to honor its debt payments.
Long-Term Assets
1. Investments: are assets not used directly in operations. 2. Property, plant, and equipment: Tangible, long-lived assets used in the operations of the business 3. Intangible assets: generally represent exclusive rights that a company can use to generate future revenues. 4. Other long-term assets: This category of long-term assets (reported by most companies) represents a catch-all classification of long-term assets that were not reported separately in one of the other long-term classifications. This amount most often includes long-term prepaid expenses, called deferred charges.
What additional information is presented alongside the balance sheet?
DISCLOSURE NOTES - Financial disclosures make up a significant portion of the information reported to shareholders. - The full-disclosure principle requires that financial statements provide all material relevant information concerning the reporting entity. Examples: - Pension plans - Leases - Long-term debt - Investments - Income taxes - Property, plant, and equipment - Employee benefit plans Disclosure notes must include certain specific notes such as a summary of significant accounting policies, descriptions of subsequent events, and related third-party transactions, but many notes are fashioned to suit the disclosure needs of the particular reporting enterprise. Actually, any explanation that contributes to investors' and creditors' understanding of the results of operations, financial position, and cash flows of the company should be included. Let's take a look at just a few disclosure notes. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES conveys valuable information about the company's choices from among various alternative accounting methods. SUBSEQUENT EVENTS is a significant development that occurs after a company's fiscal year-end but before the financial statements are issued or available to be issued. NOTEWORTHY EVENTS AND TRANSACTIONS The economic substance of related-party transactions should be disclosed, including dollar amounts involved.
How are financial statements analyzed? (Horizontal Analysis, Vertical Analysis and Ratio Analysis)
- A horizontal analysis, or trend analysis, is a procedure in fundamental analysis in which an analyst compares ratios or line items in a company's financial statements over a certain period of time. - Vertical analysis is a method of financial statement analysis in which each entry for each of the three major categories of accounts, or assets, liabilities and equities, in a balance sheet is represented as a proportion of the total account. - A ratio analysis is a quantitative analysis of information contained in a company's financial statements. Ratio analysis is used to evaluate various aspects of a company's operating and financial performance such as its efficiency, liquidity, profitability and solvency.
Current Liabilities
Accounts payable are obligations to suppliers of merchandise or of services purchased on open account, with payment usually due in 30 to 60 days. Notes payable are written promises to pay cash at some future date (I.O.U.s). Unlike accounts payable, notes usually require the payment of explicit interest in addition to the original obligation amount. Notes maturing in the next year or operating cycle, whichever is longer, will be classified as current liabilities. Deferred revenues, sometimes called unearned revenues, represent cash received from a customer for goods or services to be provided in a future period. For example, a company records deferred revenue when it sells gift cards and then waits to record the (actual) revenue until the cards are redeemed or expire. Accrued liabilities represent obligations created when expenses have been incurred but amounts owed will not be paid until a subsequent reporting period. For example, a company might owe salaries at the end of the fiscal year to be paid some time in the following year. In this case, the company would report salaries payable as an accrued liability in the current year's balance sheet (as well as the related salaries expense in the income statement). Other common examples of accrued liabilities include interest payable, taxes payable, utilities payable, and legal fees payable. In most financial statements these items are reported in the balance sheet as accrued liabilities and the categories may be found listed in the disclosure notes. Current maturities of long-term debt refer to the portion of long-term notes, loans, mortgages, and bonds payable that is payable within the next year (or operating cycle if that's longer).3 For example, a $1,000,000 note payable requiring $100,000 in principal payments to be made in each of the next 10 years is classified as a $100,000 current liability and a $900,000 long-term liability. Nike classifies the current portion of its long-term debt as a current liability.
Current Assets
Current assets include cash and other assets that are reasonably expected to be converted to cash or consumed within the coming year, or within the normal operating cycle of the business if that's longer than one year. The operating cycle for a typical merchandising or manufacturing company refers to the period of time from the initial outlay of cash for the purchase of inventory until the time the company collects cash from a customer from the sale of inventory. For a merchandising company, the initial purchase of inventory often is for a finished good, although some preparation may be necessary to get the inventory ready for sale (such as packaging or distribution). For a manufacturing company, the initial outlay of cash often involves the purchase of raw materials, which are then converted into a finished product through the manufacturing process. In keeping with common practice, the individual current assets are listed in the order of their liquidity (the ability to convert the asset to cash). CASH & CASH EQUVALENTS The most liquid asset, cash, is listed first. Cash includes cash on hand and in banks that is available for use in the operations of the business and such items as bank drafts, cashier's checks, and money orders. Cash equivalents frequently include certain negotiable items such as commercial paper, money market funds, and U.S. treasury bills. These are highly liquid investments that can be quickly converted into cash. Most companies draw a distinction between investments classified as cash equivalents and the next category of current assets, short-term investments, according to the scheduled maturity of the investment. It is common practice to classify investments that have a maturity date of three months or less from the date of purchase as cash equivalents. Nike's policy follows this practice and is disclosed in the summary of significant accounting policies disclosure note. Cash that is restricted for a special purpose and not available for current operations should not be included in the primary balance of cash and cash equivalents. These restrictions could include future plans to repay debt, purchase equipment, or make investments. Restricted cash is classified as a current asset if it is expected to be used within one year. Otherwise, restricted cash is classified as a long-term asset. SHORT-TERM INVESTMENTS. Liquid investments not classified as cash equivalents are reported as short-term investments, sometimes called temporary investments or short-term marketable securities. Investments in stock and debt securities of other corporations are included as short-term investments if the company has the ability and intent to sell those securities within the next 12 months or operating cycle, whichever is longer. ACCOUNTS RECEIVABLE Accounts receivable result from the sale of goods or services on credit (discussed in Chapter 7). Accounts receivable often are referred to as trade receivables because they arise in the course of a company's normal trade. Nontrade receivables result from loans or advances by the company to individuals and other entities. When receivables are supported by a formal agreement or note that specifies payment terms they are called notes receivable. Accounts receivable usually are due in 30 to 60 days, depending on the terms offered to customers and are, therefore, classified as current assets. Any receivable, regardless of the source, not expected to be collected within one year or the operating cycle, whichever is longer, is classified as a long-term asset, investments. INVENTORIES consist of assets that a retail or wholesale company acquires for resale or goods that manufacturers produce for sale. Inventories for a wholesale or retail company consist of finished goods for sale to customers. PREPAID EXPENSES Recall from Chapter 2 that a prepaid expense represents an asset recorded when an expense is paid in advance, creating benefits beyond the current period. Examples are prepaid rent and prepaid insurance. Even though these assets are not converted to cash, they would involve an outlay of cash if not prepaid. Whether a prepaid expense is current or noncurrent depends on when its benefits will be realized. For example, if rent on an office building were prepaid for one year, then the prepayment is classified as a current asset. However, if rent were prepaid for a period extending beyond the coming year, a portion of the prepayment is classified as an other asset, a long-term asset.
Long-term Liabilities
Long-term liabilities are obligations that will not be satisfied in the next year or operating cycle, whichever is longer. They do not require the use of current assets or the creation of current liabilities for payment. Examples are long-term notes, bonds, pension obligations, and lease obligations.
Additional financial information
MANAGEMENT'S DISCUSSION AND ANALYSIS - Management's discussion and analysis provides a biased but informed perspective of a company's (a) operations, (b) liquidity, and (c) capital resources. - Management acknowledges responsibility and certifies accuracy of financial statements. - The proxy statement contains disclosures on compensation to directors and executives. AUDITORS' REPORT Auditors examine financial statements and the internal control procedures designed to support the content of those statements. Their role is to attest to the fairness of the financial statements based on that examination. The auditors' attest function for public business entities results in an opinion stated in the auditors' report. There are four basic types of auditors' reports: 1. Unqualified 2. Unqualified with an explanatory paragraph 3. Qualified 4. Adverse or disclaimer An auditor issues an unqualified (or "clean") opinion when the auditor has undertaken professional care to ensure that the financial statements are presented in conformity with generally accepted accounting principles (GAAP). Professional care would include sufficient planning of the audit, understanding the company's internal control procedures, and gather evidence to attest to the accuracy of the amounts reported in the financial statements. Sometimes circumstances cause the auditor to issue an opinion that is unqualified with an explanatory paragraph. In these circumstances, the auditor believes the financial statements are in conformity with GAAP (unqualified), but the auditor feels that other important information needs to be emphasized to financial statement users. Most notably, these situations include: - Lack of consistency due to a change in accounting principle such that comparability is affected even though the auditor concurs with the desirability of the change. - Going concern when the auditor determines there is significant doubt as to whether the company will be able to pay its debts as they come due. Indicators of a going concern include significant operating losses, loss of a major customer, or legal proceedings that might jeopardize the company's ability to continue operations. - Emphasis of a matter concerning the financial statements that does not affect the existence of an unqualified opinion but relates to a significant event such as a related-party transaction.
Shareholders' Equity
Recall from our discussions in Chapters 1 and 2 that owners' equity is simply a residual amount derived by subtracting liabilities from assets. For that reason, it's sometimes referred to as net assets or book value. Also recall that owners of a corporation are its shareholders, so owners' equity for a corporation is referred to as shareholders' equity or stockholders' equity. Here's a simple way to think of equity. If someone buys a house for $200,000 by making an initial $50,000 payment and borrowing the remaining $150,000, then the house's owner has an asset of $200,000, a liability of $150,000, and equity of $50,000. Shareholders' equity for a corporation arises primarily from: 1. Paid-in capital 2. Retained earnings