Analyzing Financial Information
Learning Resources
Topic Review
Organizations maintain financial records to keep track of performance. Select information is also published so that decision makers such as investors, creditors, customers and the government can have ready access to relevant and reliable data.
Common records maintained by an organization include:
1.Cash Receipts Journal (records any transactions in which cash was paid out)
2.Cash Disbursements Journal (records any transactions in which cash was received)
3.Cash Budget (a prediction about the amount of cash to come and go from the organization in the future)
4.Lists of creditors and customers
5.Accident reports/claims
6.Employment records
7.Bank statements & Reconciliations
8.Cancelled checks
9.Insurance records
10.Bills
11.Property records
12.Tax records
13.Lists and amounts of ASSETS = things of value owned by an organization that will provide future benefits.
14.Lists and amounts of LIABILITIES = amounts that the organization owes to another party.
15.Lists and amounts of EQUITY = net worth of the company to the owners…the amount of the company’s assets that are claimed by its owners.
Common financial reports include:
1.Income Statement (follows the formula: Revenues – Expenses = Net Income)
2.Balance Sheet (follows the formula: Assets = Liabilities + Equity)
3.Statement of Changes in Owner’s Equity (follows the formula: Beginning Equity + Net income (or –Net loss) + Owner Investments – Owner Withdrawals = Ending Equity)
There are two basic methods of accounting: the cash basis and the accrual basis. The difference between the two is based on when revenues and expenses are recorded. Since financial reports must be published at a set point in time even though business transactions occur continuously, a standard system must be set up to account for partially completed transactions. For example, a particular job may have been paid for but not yet completed at the time the financial statements must be published.
Under the cash basis, all revenue and expenses are recorded when cash is received or paid, not necessarily when they have been received or committed to.
Under the accrual basis, all revenue and expenses are recorded when they are earned or committed to, not necessarily when the cash is received or paid.
Financial records can be examined to determine an organization’s liquidity (available cash or equivalent) and profitability. Three common ratios are:
Current Ratio = Current Assets/Current Liabilities
This ratio measures liquidity. Specifically, it tells how able an organization is to pay current debts with currently available resources. Generally, a higher current ratio is better so long as the number does not become too high for this would mean that the organization has a lot of extra cash lying around unused.
Debt to Net (Debt to Equity) = Total Liabilities/Total Equity X 100
This ratio measures liquidity. Specifically, it compares the amount of the organization’s resources financed by debt as opposed to by owner’s investment. That is, it tells us the percentage of the company’s worth that comes from borrowing and what percentage comes from owner supplied resources. Generally, a lower number is better because it means there is less debt although a certain amount of debt is often healthy for a company to maintain.
Return on Investment (ROI) = Net Profit/Total Assets X 100
This ratio measures profitability. Specifically, it tells us how efficiently the assets are being used to produce profit. If the ROI is 25, for example, this means that for every dollar of assets an organization has, $.25 in profit is being made during an accounting period. Generally, the higher the number the better.
Checks are used frequently to ensure that there is a record of where cash is spent. Important related terms include:
Common records maintained by an organization include:
1.Cash Receipts Journal (records any transactions in which cash was paid out)
2.Cash Disbursements Journal (records any transactions in which cash was received)
3.Cash Budget (a prediction about the amount of cash to come and go from the organization in the future)
4.Lists of creditors and customers
5.Accident reports/claims
6.Employment records
7.Bank statements & Reconciliations
8.Cancelled checks
9.Insurance records
10.Bills
11.Property records
12.Tax records
13.Lists and amounts of ASSETS = things of value owned by an organization that will provide future benefits.
14.Lists and amounts of LIABILITIES = amounts that the organization owes to another party.
15.Lists and amounts of EQUITY = net worth of the company to the owners…the amount of the company’s assets that are claimed by its owners.
Common financial reports include:
1.Income Statement (follows the formula: Revenues – Expenses = Net Income)
2.Balance Sheet (follows the formula: Assets = Liabilities + Equity)
3.Statement of Changes in Owner’s Equity (follows the formula: Beginning Equity + Net income (or –Net loss) + Owner Investments – Owner Withdrawals = Ending Equity)
There are two basic methods of accounting: the cash basis and the accrual basis. The difference between the two is based on when revenues and expenses are recorded. Since financial reports must be published at a set point in time even though business transactions occur continuously, a standard system must be set up to account for partially completed transactions. For example, a particular job may have been paid for but not yet completed at the time the financial statements must be published.
Under the cash basis, all revenue and expenses are recorded when cash is received or paid, not necessarily when they have been received or committed to.
Under the accrual basis, all revenue and expenses are recorded when they are earned or committed to, not necessarily when the cash is received or paid.
Financial records can be examined to determine an organization’s liquidity (available cash or equivalent) and profitability. Three common ratios are:
Current Ratio = Current Assets/Current Liabilities
This ratio measures liquidity. Specifically, it tells how able an organization is to pay current debts with currently available resources. Generally, a higher current ratio is better so long as the number does not become too high for this would mean that the organization has a lot of extra cash lying around unused.
Debt to Net (Debt to Equity) = Total Liabilities/Total Equity X 100
This ratio measures liquidity. Specifically, it compares the amount of the organization’s resources financed by debt as opposed to by owner’s investment. That is, it tells us the percentage of the company’s worth that comes from borrowing and what percentage comes from owner supplied resources. Generally, a lower number is better because it means there is less debt although a certain amount of debt is often healthy for a company to maintain.
Return on Investment (ROI) = Net Profit/Total Assets X 100
This ratio measures profitability. Specifically, it tells us how efficiently the assets are being used to produce profit. If the ROI is 25, for example, this means that for every dollar of assets an organization has, $.25 in profit is being made during an accounting period. Generally, the higher the number the better.
Checks are used frequently to ensure that there is a record of where cash is spent. Important related terms include:
- Payee = the party to whom the check is written.
- Payer = the party that wrote the check and who is paying the amount shown.
- Blank endorsement = payee signs the back of the check authorizing payment to anyone holding the check from that point forward.
- Restrictive endorsement = payee writes “for deposit only” on the back of the check and then signs below it to ensure that whenever the check is deposited it will only go into the payee’s bank account.
- Special (or full) endorsement = payee writes “pay to the order of” and the name of a party to whom the payee would like the check transferred to. Payee then signs the back of the check.
- Bank Reconciliations involve comparing the organization’s records of cash on hand to what the bank statement shows. This process involves:
- Adding to the bank balance any as yet unrecorded deposits to the account
- Subtracting any outstanding checks (not yet cashed by the payee) from the bank balance
- Adding any as yet unrecorded interest earned to the checkbook account
- Subtracting any bank fees from the checkbook account
- Adding or subtracting any corrections for errors by either party