Dr. John A. Dominick

Introduction to Financial Statements In this session we will review the different forms of business organizations and business financial statements: balance sheet, income statement, and the traditional (EBITDA) cash flow statement. I. Forms of Business Organization A. Proprietorship (Sole Proprietorship) A person who goes into business by himself and takes no steps to create any other type of business organization has formed a proprietorship. The individual has no partners, board of directors, or committee to report to or share earnings with. The owner assumes all tax and legal liability of the business. If the business is sued, the owner’s business and personal assets are at risk. That is, the owner has unlimited liability for the obligations of the business. The IRS requires sole proprietors to report business income and expenses on Schedule C of the proprietor's personal income tax return, disregarding the business activity as a separate entity that would need to file its own business tax return. The IRS does not give sole proprietors the option of filing a separate tax return for the business. B. Partnership (General Partnership) A general partnership is created where two or more individuals (or businesses) go into business together and take no steps to create any other form of business. Partners have unlimited liability for the obligations of the business. A partnership is a pass-through entity, rather than an independent entity for tax purposes. The IRS requires partnerships to pass business profits and losses through to the partners in proportion to their ownership interest, so the partnership does not pay taxes on those amounts at the business level. Instead, each partner pays taxes on his share of business profits and losses at his individual tax rate. The partnership files an informational tax return with the IRS on Form 1065 but does not have the option of filing a tax return to pay taxes on income at the entity level. In addition to the general partnership, there are two other classifications of partnerships: limited partnership (LPs)--in additional to at least one general partner, there are one or more limited partners who have limited liability to the

Introduction to Financial Statements 2 extent of their investment—the limited partners are “passive” and play no active role in the business; and limited liability partnership (LLPs)--all of the partners have limited liability of the business debts; it has no general partners. LLPs are particularly well-suited to professional groups, such as lawyers and accountants. Professionals often prefer LLPs to general partnerships, corporations, or LLCs (limited liability companies) because they don't want to be personally liable for another partner's problems -- particularly those involving malpractice claims. An LLP protects each partner from debts against the partnership arising from professional malpractice lawsuits against another partner. (A partner who loses a malpractice suit for his own mistakes, doesn't escape liability.) LPs and LLPs are pass-through entities for tax purposes. LPs, LLPs, LLC’s, and corporations are statutory forms of business, which means that they formed under applicable state statute. C. Limited Liability Company The owner or owners of an LLC are called members, rather than shareholders. Members have limited liability. Pass-through taxation unless the LLC elects to be taxed as a C corporation. A member of an LLC is generally shielded from personal liability for the debts or obligations of the business. This is not an absolute right, however, and LLC members should take steps to preserve the "veil" of limited liability that distinguishes themselves from the business. These steps should include keeping personal and business funds separate, and keeping records of the company's finances similar to those required of a corporation; avoid intentionally underfunding the business so as to prevent it from paying its creditors. D. Corporation The owner or owners are called shareholders; they have limited liability for the obligations of the corporation. C corporations pay income taxes; S corporations are pass-through tax entities. II. Balance Sheet A balance sheet shows the assets, liabilities and equity capital (shareholders’ equity or net worth) of an entity as of a specific date (e.g., December 31, March 31, June 30, etc.). The balance sheet equation is:

Introduction to Financial Statements 3

Assets (Things Owned)

=

Liabilities (Amounts Owed)

+

Equity (Owners’ Claim)

$1,000

=

$300

+

$700

Assets

-

Liabilities

=

Equity

$1,000

-

$300

=

$700

Assets

=

+

Equity

Also

And

How Funds Are Employed

Liabilities

Sources of Funds: Creditors and Owners

A. Assets 1. Current Assets Current assets are cash plus those assets that are expected to be turned to cash or a cash equivalent within one year or one operating cycle. a. Cash and cash equivalents b. Accounts receivable c. Inventory Inventory of a manufacturing company: Raw materials Work-in-process Finished goods d. Prepaid or deferred expenses – Costs that have been paid in advance of use and will be expensed as used within one year: prepaid rent, prepaid insurance. e. Other current assets – Other current assets not listed elsewhere, such as supplies, short-term advances to officers and employees.

Introduction to Financial Statements 4 2. Non-current Assets Non-current assets are those assets that are not expected to be converted into cash within one year. a. Fixed assets Examples: land, buildings, equipment, automobiles, trucks, airplanes, machinery, tractors and other farm equipment, leasehold improvements. b. Other non-current assets Examples: deferred charges (long-term prepaid expenses), intangibles (goodwill, patents, copyrights), due from affiliates (depending upon maturity), investment in affiliates. B. Liabilities 1. Current Liabilities Current liabilities are amounts owed that are expected to be paid within one year or operating cycle. a. Overdrafts b. Accounts payable c. Accruals - Expenses and other items that have been accrued but not paid, such as accrued wages payable, accrued interest payable, accrued taxes payable. d. Deferred revenue – Revenue that is considered a liability until it has been earned, such as a payment received for work that has not been performed. Opposite of deferred charge (prepaid or deferred expense). e. Note(s) payable f. Current maturity of long-term debt (CMLTD) - That portion of long-term debt that becomes payable within one year. g. Other current liabilities 2. Non-current Liabilities Liabilities not due to be paid within one year, such as term debt (debt with a maturity greater than one year), bonds and other long-term liabilities.

Introduction to Financial Statements 5 C. Stockholders’ Equity or Net Worth (Corporation) 1. Common stock, par or stated value 2. Paid-in capital (known as “surplus” in a bank’s balance sheet) 3. Retained earnings 4. Treasury stock - A corporation purchases a portion of its stock but doesn’t retire it. Treasury stock is shown as a deduction from equity capital. II. Income Statement (Accrual Accounting) Shows the revenues earned during a specific accounting period minus the expenses incurred in earning the revenues. The income statement covers a time period: “Year ended December 31,” “Three months ended March 31,” “Six months ended June 30.” Total sales (sales revenue) Minus: sales returns and allowances Net sales Cost of goods sold Gross operating profit Operating expenses Selling Administrative Depreciation Total operating expense Gross operating income Interest expense Non-operating income/expense Pre-tax income Income taxes Net income

Introduction to Financial Statements 6

Arkansas Sports Sales, Ltd. Balance Sheet $000 December 31 200A Assets Current Assets Cash Accounts receivable Inventory Other current assets Total current assets Non-current assets Building, equipment and vehicles, net Total assets Liabilities and Equity Capital Current Liabilities Note payable, bank Current maturity of term debt Accounts payable Accrued salaries, wages and other expenses Other current liabilities Total current liabilities Non-Current Liabilities Term debt, bank Total liabilities Equity Capital Common stock Paid-in capital Retained earnings Total equity capital Total liabilities and equity capital

200B

200C

240 2,240 3,790 50 6,320

200 3,060 4,960 40 8,260

150 3,210 5,752 48 9,160

2,000 8,320

1,800 10,060

1,550 10,710

680 240 2,500 200 40 3,660

1,380 240 3,340 250 30 5,240

1,430 240 4,060 280 20 6,030

760 4,420

520 5,760

280 6,310

100 1,900 1,900 3,900 8,320

100 1,900 2,300 4,300 10,060

100 1,900 2,400 4,400 10,710

Introduction to Financial Statements 7

Arkansas Sports Sales, Ltd. Income Statement $000 For the Year Ended

Net sales Cost of goods sold Gross operating profit Salaries, wages, general adminstrative and selling expense Depreciation expense Total operating expense Interest expense Total expense Income before income taxes Income Taxes Net income

200A

200B

200C

23,000 18,860 4,140

27,600 22,900 4,700

28,980 24,340 4,640

2,450 300 2,750 100 2,850 1,290 360 930

2,680 250 2,930 120 3,050 1,650 460 1,190

3,190 250 3,440 140 3,580 1,060 260 800

Introduction to Financial Statements 8 III.

Traditional Cash Flow or EBITDA Why lenders are interested in cash flow? Because interest and principal payments are paid in cash, not in accrual profits or earnings! Many banks use non-GAAP (Generally Accepted Accounting Principles) cash flow in analyzing business credits. This often is called “traditional cash flow,” or EBITDA: Earnings Before Interest, Taxes, Depreciation and Amortization. Traditional cash flow is based solely on the income statement, and is calculated as follows (Arkansas Sports Sales, Ltd., Year 200B):

+ + + +

Net income $1,190 Interest expense 120 Income taxes 460 Depreciation 250 Amortization 0 EBITDA cash flow $2,020

(Note: Some banks eliminate “T” and use EBIDA – Earnings Before Interest, Depreciation and Amortization.) ………………………………………………. The GAAP cash flow statement reports the cash receipts and cash expenditures for a firm during an accounting period. EBITDA doesn’t. As noted, EBITDA is based solely on the income statement. GAAP cash flow is based on the income statement and balance sheet of the subject period and the balance sheet of the prior period. This enables the GAAP cash flow to report flows that aren’t reflected in EBITDA.