Engineering Economics

Chapter Two: Understanding

Financial Statements
 Objectives of the chapter
At the end of the chapter, you will be able to
 Know the role of accounting in Economic
Decisions
 Four types of financial statements
 How to read the balance sheet
 How to use the income statement
 The sources and use of cash in the Business
 How to conduct ratio analysis and what
numbers mean
 Accounting: The basis of Decision
Making
• All business and most individuals keep
accounting records to aid in making decisions

• Accounting is called “the language of

business”. The better you understand this
language, the better you can manage your
financial well-being and the better your
financial decisions will be.
 The uses of Accounting
• Individual people use accounting information in
their day-to-day affairs.
• Business managers use it to set goals and
evaluate progress towards those goals and take
corrective actions if necessary
• Investors and creditors provide money to a
business that need to begin and broaden
operations. To decide whether to help start a new
venture or invest on-going operations, investors
and creditors evaluate financial statement of the
business.
 Financial statements of the business
Balance Sheet: this statement explains the financial
position of the business at the end of the
reporting period (or fiscal year).
Income statement: this statement explains how well
did the business operate during the fiscal period.
It explains the profitability of the business.
Statement of Retained earning: this statement
explains on what did the business decide to use
its profits.
Statement of Cash flows: How much cash did the
business generate and spend during the fiscal
period/reporting period.
 The Balance Sheet
• Balance sheet statement explains the financial
position of the business on the reporting time.
• Balance sheet consist of three main category
of items
1. Assets
2. Liabilities
3. Stockholders equity/Owners Equity
 Balance Sheet
XYZ Company
31 Dec, 2017 31 Dec, 2016
Assets
Cash $ 113,500 $ 110,250
Account Receivable $ 33,000 $ 25,300
Inventories $ 21,000 $ 17,500
Total Current Assets $ 167,500 $ 153,050
Buildings $ 43,000 $ 43,000
Machinery and Equipment $ 19,500 $ 10,216
Land $ 31,300 $ 31,300
Total Fixed Assets $ 93,800 $ 84,516
Total Assets $ 261,300 $ 237,566

Liabilities
Notes Payable within one Year $ 43,500 $ 40,250
Account Payable within one year $ 11,250 $ 43,530
Total Current Liabilities $ 54,750 $ 83,780
Longterm Notes Payable $ 23,500 $ 25,600
Total Longterm Liabilities $ 23,500 $ 25,600
Total Liability $ 78,250 $ 109,380

Equity
Owners's Equity $ 137,693 $ 128,186
Retained Earnings $ 45,357
Total Owners Equity $ 183,050 $ 128,186
Total Liability and Owners Equity $ 261,300 $ 237,566
• The accounting equation shows the relationship
among assets, liabilities and owners equity.
Assets = Liabilities + Equity
• Every business transaction can be expressed in
terms of its affect on the accounting equation.
Whether the business grows or contracts,
equation between assets and claims against
assets are maintained. For example, a purchase
of equipment (asset) is paid with $50 cash (asset)
or funded with $50 bank loan (liability) or from
$50 retained earning (equity). This is called
double entry book keeping.
• On the other hand, the accounting equation of
non-profit organization is
Assets = Liability + Net Assets
• Equity here becomes Net Assets, since there are
no owners.
• Likewise, non-profit organizations every
transaction maintains the equation of assets
and claims against assets. For example, if a
donor contributes $500 to a public university,
that affects the accounting equation as
$500 cash (assets) = Liabilities + $500 (Net Assets)
• Assets are arranged in order of Liquidity. the
most liquid assets appear at the top of the assets
section of the balance sheet.
• Current Assets are separately totaled. They are
what will hold the business afloat for the next
year.
• Liabilities are arranged in order of payment and
the most pressings are at the top.
• Current liabilities are separately totaled. They are
what will be paid out during the next year.
• Stockholders/Owners Equity is the amount
invested in the business by the owners plus the
profits generated by the business in the previous
year.
 Assets
• The amount shown in the assets portion of the
balance sheet represents how much the
business owns at the time it issues the report.
• Assets in the balance sheet are listed in terms
of liquidity or length of time it takes to convert
them into cash.
Current Assets: assets that can be
converted into cash within or less than one year.
It consists of three accounts
a) Cash: actual money owned by the business,
also the cash equivalents such as the short
term investments.
b) Account receivable: Money owned by the
business but not yet received which is
expected to be received in one year or less.
c) Inventory: the amount that the business
invested in the raw materials work in process
and finished goods available for sale.
Fixed Assets: fixed assets are relatively permanent
and take a longer time to convert into cash.
• Most common fixed assets are Land, Buildings,
Machinery, Office Equipment and Automobiles.
• With the exception of land, most fixed assets
have limited useful life. For example, buildings
and equipment are used up over a period of time.
Each year a portion of the usefulness of their
total cost or value should be recognized as
depreciation expense.
• Other assets such as goodwill, copyright,
franchise and etc. appear on the balance sheet.
 Liabilities and Equity
• Claims against assets are of two types
a) Liabilities: money that the business owes
by other than the owners of the business. These
borrowed money is usually used for the
acquisition of the business assets.
b) Equity: it is liability of the business to its
owners. These money is invested to the
business.
• Liability in the Balance sheet is classified into
Current and Long-term liability.
Current Liability: it is debts which must be paid
in the near future (normally with in one year).
• Examples of current liabilities are
Account Payable: money the business owes to its
suppliers. These account payables must be paid
back in one year.
Notes Payable: Money the business owes to
financial institution like Banks which is normally
received in cash. These notes payables must be
paid back in one year.
• Other current liabilities can be rent which not
yet paid, salaries and wages not yet paid,
taxes and etc.
• long-term liabilities are Bonds, Mortgages
and long-term payables that are due in
payment for more than a year.

Equity represent the amount that is available

to the owners after all other debts have been
paid.
• Generally the typical equity portion in the balance
sheet for a corporation consist of
a. Preferred stock: a share which entitles the holder of a
fixed dividend. Preferred shares have a dividend that
must be paid before common stock.
b. Common stock: the ordinary shares of the business
c. Treasury stock: a portion of shares that a company
keeps in its own treasury. It is used for the incentives
or the stock repurchases.
d. Capital surplus (paid in capital): the amount of money
received from the sale of stock that is over the par
value of the stock.
e. Retained earnings: earning not paid out as dividends
but instead are reinvested in the business or used to
pay of debts.
 Income Statement
Income statement indicates whether the
company is making or losing money during a
stated period.
Basic Income statement Equation
Revenue
Expense
Net Income (Profit/Loss)
 Income Statement
XYZ Company
31 Dec, 2017 31 Dec, 2016

Total contract revenues Earned $ 253,600 $ 185,200

Cost of Contracts $ 157,470 $ 123,259

Gross Margin $ 96,130 $ 61,941

Salaries and Administrative $ 12,500 $ 10,257

Rent and Transportation $ 8,250 $ 6,240

Annual Interest Payment $ 2,100 $ 2,100

Others $ 15,254 $ 13,700

Total Operating Cost $ 38,104 $ 32,297

Operating Income $ 58,026 $ 29,644

Income Tax Provision $ 14,250 $ 7,263

Net Income $ 43,776 $ 22,381

Revenue/Sales: is the income from goods sold and services
rendered during an accounting period.
Cost of Revenue/cost of goods sold: expenses incurred in
making the products sold.
Gross Margin: Money the company generated over the cost
of producing its products or services.
Operating Expenses: expenses incurred in carrying out
business day-to-day activities but not directly related to the
production. For instance, salaries, transportation, employee
benefits, interest, rent, repairs and etc.
Operating Income: states whether the business made a
profit or loss during activity period.
Net Income: It is calculated deducing operating income
from tax on taxable income. It states the last income of the
business during the fiscal period.
 Statement of Retained Earnings
• Retained earnings are earnings/profits that is
reinvested to the business in order to finance
business expansion or support other business
activities.
RE = beginning RE + Net Income – Dividends
• If net loss is greater than the RE remained from
the previous year, the RE can become negative
and create further deficit.
Dividends: a sum of money paid regularly by a
business to its owners of its profits.
 The Cash flow Statement
• It is a financial statement that show the details
of how the business generated the cash it
received and how the business used that cash
during the reporting period.
• Many businesses identify the sources and uses
of cash according to the types of business
activities.
• There are three types of activities
 Conti….
1. Operating activities: it represents the cash
flows related to the production and sales of
goods and services.
2. Investing activities: it represents those cash
flows related to investments such as
purchase of new fixed asset or reselling old
equipment.
3. financial activities: it represents cash
transactions related to financial capital used
in the business. For example, borrowing
money, selling stock and paying off debts.
 Typical Cash Flow Statement
Cash Flows from operating activities
Additions to cash:
Cash from sales ………………………………………….… xx
Decrease in account receivables ………………..…. xx
Subtraction to cash:
Increase in inventory ……………………………………….xx
Net cash flow from operating activities …………………... xx
Cash flow from Investing Activities
Additions to cash:
Reselling old equipment ……………….......………… xx
Subtractions from cash:
Purchase of new equipment ……………….………… xx
Building a new office ………………………………….…. xx
Net Cash Flow from investing Activities ………………..... xx “addition of net cash flows”
Cash flow from financing activities
Additions to cash:
Increase in notes payables ……….………………..…. xx
Subtraction to cash:
Paying an outstanding debt ……….…………………. xx
Interest payment ………………………………….………. xx
Net cash flow from financing activities ……………….…... xx

Cash flow for the year {x} …………………………………………………………….. XX

 Using ratios to make business
Decisions
• Most users of financial statements are concerned
about what will happen in the future. For
example
Stockholders: concern future earnings and
dividends
Creditors: Concern company’s ability t repay debts
Managers: Concern company’s ability finance
future expansion
Engineers: Concern planning actions that result
efficient utilization of fixed assets
• An important part of financial analysis is the
calculation of various financial ratios to
predict the future course of events in the
business.
• These ratios can be grouped into five
categories
1. Debt management ratios
2. Liquidity ratios
3. Asset management ratios
4. Profitability ratios
5. Market trend ratios
 Debt Management
• To acquire assets, business raise capital and these
capital come in two forms
a. Debts: Capital borrowed from financial
institution or individuals e.g. notes payable,
Bonds and etc.
b. Equity: Capital obtained from owners of he
company
• Debt management ratios show how the business
uses its debts and the business ability to meet
debt repayment obligations. These ratios are
1. debt ratio
2. Times interest earned ratio
 Debt ratio
• It shows the proportion of company’s assets that
are financed by debt. It is expressed in terms of
percentage.

𝑇𝑜𝑡𝑎𝑙 𝐷𝑒𝑏𝑡
𝐷𝑒𝑏𝑡 𝑟𝑎𝑡𝑖𝑜 = × 100
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠

For example: The total liabilities of a business are

$78,200 and total assets of the business are
$261,300. Then, the business financed 30% it assets
through or by debt.
 Times interest earned ratio
• The most common measure of the ability of
business’s operations to provide protection to
the long-term creditors is the times interest
earned ratio.
• TIE is a metric used to measure a business’s
ability to meet long term liability obligations.
• It indicates how many times the business can
cover its interest charges on pretax earning
basis. It is expressed in decimal terms.
 𝐸𝐵𝐼𝑇
𝑇𝐼𝐸 =
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐸𝑥𝑝𝑒𝑛𝑠𝑒

EBIT: income/earnings before interest and tax

Interest expense: annual interest paid which is
calculated by multiplying the interest rate and the
long term liability/debt.

For example: income before tax and interest of a

business is $60,126 and annual interest payment of
the business is $2,100. Then, TIE is 28.6.
• It means that the business can cover its long-term
debt 29 times a year.
 Liquidity Ratios
• Short time creditors want to be paid on time. So,
they focus on company’s working capital which is
the excess of current assets over current liability.
The larger the working capital the better the
business is able to pay its debts.
• Liquidity analysis ratios are those that show the
relationship of firms current assets to its current
liability. There are two liquidity ratios used
1. Current ratio
2. Quick ratio
 Current ratio
• It measures the business ability to pay its short term
obligation.

• For example: the current assets of a business is

$16,000 and current liability of the business is $14,000.
then the ratio is 1.19.
• It means that the business can cover its short term
debt obligation 1 time a year.
 Quick (acid-test) ratio
• This ratio measures whether the business could pay all of
its current liability if they come due immediately. It
measures how well the business can pay the short term
debts with out liquidating its standing inventories.

• In the previous example if the business inventories are

valued $400, then that business can still cover its current
debt with in one year.
 Asset management ratios
• It is the ability to sell inventory and collect
account receivables of the business. These
ratios are related to firms asset management
and they are
1. inventory turn over ratio
2. the day’s sales outstanding
3. total asset turnover ratio
 Inventory turnover ratio
• This ratio measures how many times the company sold
or replaced its inventory over a specific period.

• Average inventory balance is calculated by adding the

inventory of the previous year and current year and
then dividing by two.
• If the sales of the business is $49,000 and the average
inventory balance of the business is $390. Then, the
inventory of that business turned over 126 times to
produce the revenue earned in that fiscal year
 day’s sales outstanding ratio
• It is also called account receivable turnover
ratio. It is a rough measure of how many times
a company’s account receivable have been
turned into cash during the year. It also
measures average collection period of account
receivables.
• Average sales per day is calculated by dividing
the total sales total days of the year
(sales/365).
• In the previous examples, total sales of a
business is $49,000 and suppose account
receivable of the business is $4,400. Then,
account receivable turnover in the year is
34.77 or 35.
• This means that it takes the business 35 days
on average to collect the account receivables.
 Total asset turnover ratio
• This ratio measures how effectively the
business uses its total assets in generating its
revenue.

• For example, if the total assets of you business

is $23,000 and total sales of your business is
$50,000. then your asset turned over 2.17
times to generate the revenue received in the
year.
 Profitability Analysis Ratios
• The most important goal for any business is to
earn a profit.
• Ratios that measure the profitability play a
large role in decision making.
• These ratios are three
1. Profit margin on sales
2. return on total assets
3. return on equity
 Profit margin on sales
• This ratio indicates the profit per Dollar of
sales.
𝑰𝒏𝒄𝒐𝒎𝒆 𝒂𝒇𝒕𝒆𝒓 𝒕𝒂𝒙 𝒂𝒏𝒅 𝒊𝒏𝒕𝒆𝒓𝒆𝒔𝒕 (𝑵𝒆𝒕 𝑰𝒏𝒄𝒐𝒎𝒆)
𝑷𝑴𝑶𝑺 =
𝑺𝒂𝒍𝒆𝒔

For example: if the net income of a business is

$9,000 and the total sales of the business is
$49,000. then PMOS becomes $0.18.
• It means that each Dollar of sales, there is
$0.18 profit.
 Return on total assets
• Return on total assets ratio measures the business
success in using its assets to earn profit.

𝑵𝒆𝒕 𝑰𝒏𝒄𝒐𝒎𝒆 + 𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕(𝟏 − 𝒕𝒂𝒙 𝒓𝒂𝒕𝒆)

𝑹𝑶𝑻𝑨 = × 𝟏𝟎𝟎
𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝒕𝒐𝒕𝒂𝒍 𝒂𝒔𝒔𝒆𝒕𝒔

For Example: given to that net income of a business is

$3,000, interest expense is $90, tax is $900 for the
year and average total assets is $21,000. Then ROTA is
14%.
• This means that the business assets contributes
14.5% to the profit earned in that year.
 Return on Equity
• This ratio shows the relationship between net
income (profit) and equity.
• It indicates how much profit earned per Dollar
invested in the business by the owners

𝑵𝒆𝒕 𝑰𝒏𝒄𝒐𝒎𝒆
𝑹𝑶𝑬 =
𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝒕𝒐𝒕𝒂𝒍 𝑬𝒒𝒖𝒊𝒕𝒚

For Example: Suppose that net income of a business

is $3,000 and the average total equity is $6,500.
Then ROE is $0.46.
• It means that each Dollar invested in the business
by the owners, there is $0.46 profit.
 Market Value Analysis Ratios
• The market value ratios indicate how investors of
the business see the future prospects of the
business referring past performance.
• The most common market value ratio used is Book
value per share.
• The Book value per share measures the amount
that would be distributed to stockholders of each
share if all assets were sold at their balance sheet
carrying amount and all debts are paid off.
• In other words, this ratio measure the well being
of stockholders/owners if the business dissolve.
 𝑻𝒐𝒕𝒂𝒍 𝑬𝒒𝒖𝒊𝒕𝒚
𝑩𝒐𝒐𝒌 𝑽𝒂𝒍𝒖𝒆 =
𝑻𝒐𝒕𝒂𝒍 𝑺𝒉𝒂𝒓𝒆𝒔 𝑶𝒖𝒕𝒔𝒕𝒂𝒏𝒅𝒊𝒏𝒈

For example: If the total equity of a business is

$6,500 and the total shares outstanding is
$2,000. Then Book value is $3.25.
• This means that owners will count on $3.25
per share if the business dissolve or get into
bankrupt.
THE END