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For this discussion, you will get financial information using www.morningstar.com website.

Please long at www.morningstar.com.

Type the stock symbol (BGS) in the search window. This is the window just below the title MORNINGSTAR on the top of the screen.

Once you have your company page, click on Key Ratios.

Click on Full Key Ratios Data.
https://financials.morningstar.com/ratios/r.html?t=0P00008WF2&culture=en&platform=sal

ROE and its components for DuPont formula can be found under Profitability. The debt/equity ratio can be found under Key Ratios – Financial Health.

To get the list of competitors now, you need to click on Analysis – and click on Competitors.
https://www.morningstar.com/stocks/xnys/bgs/quote

Your assignment:

Please also note that your answers should be written in your own words. Don't use quotes from the articles.

In your initial response to the topic, you have to answer all the questions.

Find ROE, Net profit margin (listed as net margin), asset turnover, financial leverage for the last three years for your company. You also may use the debt/equity ratio in your analysis.
Find ROE, Net profit margin (listed as net margin), asset turnover, financial leverage for the last year for its major peer competitor. You also may use the debt/equity ratio of peer competitors in your analysis.
Has the company's ROE changed over the last three years? What was the main factor that influenced this change?
Compare the ratios of your company to the peer competitor. If the management of the company would like to improve their return on equity, what should the management of the company do?
Reflection – the students also should include a paragraph in the initial response in their own words reflecting on precisely what they learned from the assignment and how they think they could app

Chapter 2 “Financial Statements, Taxes, and Cash Flow” from Finance by Boundless is used under the terms of the Creative Commons Attribution-ShareAlike 3.0 Unported license. © 2014, boundless.com. UMGC has modified this work and it is available under the original license.

Chapter 2

Financial Statements, Taxes, and Cash Flow

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What is a Financial Statement?

Uses of a Financial Statement

Limitations of Financial Statements

Section 1

Introducing Financial Statements

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What is a Financial Statement? Financial statements report on a company's income, cash flow and equity.

KEY POINTS

• Financial statements are formally prepared documents communicating an entity’s financial activities to  parties including investors, management and tax officials.

• An entity’s financial statement typically includes four basic components: a balance sheet, income statement, cash flow statement, and statement of changes in equity.

• The balance sheet reports a point-in-time snapshot of the assets, liabilities and equity of the entity.

• An income statement reports on a company's expenses and profits to show whether the company made or lost money.

• The cash flow statement reports the flow of cash in and out of the business, dividing cash into operating, investing and financing activities.

• A statement of changes in equity explains the changes of the company's equity throughout the reporting period, including profits or losses, dividends paid and issue or redemption of stock.

A financial statement is a formal report of the financial activities of a business, person, or other entity. Financial statements are a key component of accounting; the process of communicating information about a financial entity (Figure 2.1). Financial statements are presented in a structured manner with conventions accepted by accounting and regulatory personnel. An entity’s financial statement typically includes four basic components: a balance sheet, income statement, cash flow statement, and statement of changes in equity:

1. The company’s balance sheet reports on a company's assets, liabilities and ownership equity. A balance sheet is often described as a "snapshot of a company's financial condition" at a single point in time. Balance sheets are usually

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Financial Statements help keep money organized.

Figure 2.1 Keeping Money Organized

presented with assets in one section and liabilities and net worth in the other.

2. An income statement reports on a company's expenses and profits to show whether the company made or lost money. It also displays the revenues of a specific period, and the cost and expenses charged against these revenues. In contrast with the balance sheet, which represents a single moment in time, the income statement represents a period of time

3. A cash flow statement shows how changes in income affect cash and cash equivalents, breaking the analysis down to operating, investing and financing. Essentially, the cash flow statement is concerned with the flow of cash in and out of the business. As an analytical tool, a cash flow statement is useful in determining the short-term viability of a company.

4. A statement of changes in equity explains the company's equity throughout the reporting period. The statement breaks down changes in the owners' interest in the organization and in the application of retained profit or surplus from one accounting period to the next. Line items typically include profits or losses, dividends paid, redemption of stock, and any other items credited to retained earnings.

For complex entities, financial statements often include an extensive set of notes as an explanation of financial policies. The notes typically describe each item in detail. For example, the notes may explain financial figures or the accounting methods used to prepare the statement.

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Uses of a Financial Statement Financial statements are used to understand key facts about the performance and disposition of a business and may influence decisions.

KEY POINTS

• Owners and managers use financial statements to make important long-term business decisions. For example: whether or not to continue or discontinue part of its business, to make or purchase certain materials, or to acquire or rent/ lease certain equipment in the production of its goods.

• Prospective investors use financial statements to perform financial analysis, which is a key component in making investment decisions.

• A lending institution will examine the financial health of a person or organization and use the financial statement to decide whether or not to lend funds.

Uses of a Financial Statement

Financial Statements are used for a Multitude of Different Purposes

Readers of a financial statement are seeking to understand key facts about the performance and disposition of a business. They make

decisions about the business based on their reading of the statements. Because financial statements are widely relied upon, they must be straightforward to read and understand.

For large corporations, these statements are often complex and may include an extensive set of notes to the financial statements and explanation of financial policies and management discussion and analysis. The notes typically describe each item on the balance sheet, income statement, and cash flow statement in further detail. Notes to financial statements are considered an integral part of the financial statements.

Owners and managers frequently use financial statements to make important business decisions, for example:

• Whether or not to continue or discontinue part of the business.

• Whether to make or to purchase certain materials.

• Whether to acquire or to rent/lease certain equipment in the production of goods.

The documents are also helpful in making long-term decisions and as a source of historical records (Figure 2.2).

Other individuals and entities use financial statements too. For example:

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• Prospective investors use financial statements to perform financial analysis, which is a key component in making investment decisions.

• A lending institution will examine the financial health of a person or organization and use the financial statement to decide whether or not to lend funds.

• Philanthropies may use financial statements of a non-profit as a component in determining where to donate funds.

• Government entities (tax authorities) need financial statements to ascertain the propriety and accuracy of taxes and other duties declared and paid by a company.

• Vendors who extend credit may use financial statements to assess the creditworthiness of the business.

• Employees also may use reports in making collective bargaining agreements

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One of the uses of financial statements is as a budgeting tool, as in this example.

Figure 2.2 Budget

Limitations of Financial Statements Financial statements can be limited by intentional manipulation, differences in accounting methods, and a sole focus on economic measures.

KEY POINTS

• One limitation of financial statements is that they are open to human interpretation and error, in some cases even intentional manipulation of figures to inflate economic performance.

• Another set of limitations of financial statements arises from different ways of accounting for activities across time periods and across companies, which can make comparisons difficult.

• Another limit to financial statements as a window into the creditworthiness or investment attractiveness of an entity is that financial statements focus solely on financial measures. Some argue for a "triple bottom line” including social and environmental measures.

Limitations of Financial Statements

The limitations of financial statements include inaccuracies due to intentional manipulation of figures; cross-time or cross-company

comparison difficulties if statements are prepared with different accounting methods; and an incomplete record of a firm’s economic prospects, some argue, due to a sole focus on financial measures (Figure 2.3).

One limitation of financial statements is that they are open to human interpretation and error, in some cases even intentional manipulation of figures. In the United States, especially in the post-Enron era, there has been substantial concern about the accuracy of financial statements. High-profile

cases in which management manipulated figures in financial statements to indicate inflated economic performance highlighted the need to review the effectiveness of accounting standards, auditing regulations, and corporate governance principles.

As a result, there has been renewed focus on the objectivity and independence of auditing firms. An audit of the financial statements

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Financial statements can include a number of inaccuracies and limitations that affect the way a company can be viewed.

Figure 2.3 Consolidated financial statements

of a public company is usually required for investment, financing, and tax purposes, and these are usually performed by independent accountants or auditing firms and included in the annual report. Additionally, in terms of corporate governance, managing officials like the CEO and CFO are personally liable for attesting that financial statements are not untrue or misleading, and making or certifying misleading financial statements exposes the people involved to substantial civil and criminal liability.

Another set of limitations of financial statements arises from different ways of accounting for activities across time periods and across companies. This can make it difficult to compare a company’s finances across time or to compare finances across companies. Different countries have developed their own accounting principles, making international comparisons of companies difficult. However, the Generally Accepted Accounting Principles (GAAP), a set of guidelines and rules, are one means by which uniformity and comparability between financial statements is improved. Recently there has been a push toward standardizing accounting rules made by the International Accounting Standards Board (IASB).

Another limit to financial statements as a window into the creditworthiness or investment attractiveness of an entity is that financial statements focus solely on financial measures of health.

Even traditional investment analysis incorporates information outside of the financial statements to make organizational assessments. However, other methods such as full cost accounting (FCA) or true cost accounting (TCA) argue that an organization’s health cannot just be determined by its economic characteristics. Therefore, one needs to collect and present information about environmental, social, and economic costs and benefits (collectively known as the "triple bottom line") to make an accurate evaluation.

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Elements of the Income Statement

Limitations of the Income Statement

GAAP Implications on the Income Statement

Noncash Items

Section 2

The Income Statement

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Elements of the Income Statement The income statement, or profit and loss statement (P&L), reports a company's revenue, expenses, and net income over a period of time.

KEY POINTS

• The income statement consists of revenues and expenses along with the resulting net income or loss over a period of time due to earning activities. The income statement shows investors and management if the firm made money during the period reported.

• The operating section of an income statement includes revenue and expenses. Revenue consists of cash inflows or other enhancements of assets of an entity, and expenses consist of cash outflows or other using-up of assets or incurring of liabilities.

• The non-operating section includes revenues and gains from non-primary business activities, items that are either unusual or infrequent, finance costs like interest expense, and income tax expense.

• The "bottom line" of an income statement is the net income that is calculated after subtracting the expenses from

KEY POINTS (cont.)

• revenue. It is important to investors – also on a per share basis (as earnings per share, EPS) – as it represents the profit for the accounting period attributable to the shareholders.

Elements of the Income Statement

The income statement is a financial statement that is used to help determine the past financial performance of the enterprise, predict future performance, and assess the capability of generating future cash flows (Figure 2.4). It is also known as the profit and loss statement (P&L), statement of operations, or statement of earnings.

The income statement consists of revenues (money received from the

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Here are the key components of an income statement.

Figure 2.4 A Sample Income Statement

sale of products and services, before expenses are taken out, also known as the "top line") and expenses, along with the resulting net income or loss over a period of time due to earning activities. Net income (the "bottom line") is the result after all revenues and expenses have been accounted for. The income statement reflects a company's performance over a period of time. This is in contrast to the balance sheet, which represents a single moment in time.

Methods for Constructing the Income Statement

The income statement can be prepared in one of two methods: single or multi-step.

The Single Step income statement totals revenues, then subtracts all expenses to find the bottom line.

The more complex Multi-Step income statement (as the name implies) takes several steps to find the bottom line. First, operating expenses are subtracted from gross profit. This yields income from operations. Then other revenues are added and other expenses are subtracted. This yields income before taxes. The final step is to deduct taxes, which finally produces the net income for the period measured.

Operating Revenues and Expenses

The operating section includes revenue and expenses. Revenue consists of cash inflows or other enhancements of the assets of an entity. It is often referred to as gross revenue or sales revenue. Expenses consist of cash outflows or other using-up of assets or incurrence of liabilities.

Elements of expenses include:

• Cost of Goods Sold (COGS): the direct costs attributable to goods produced and sold by a business. It includes items such as material costs and direct labor.

• Selling, General and Administrative Expenses (SG&A): combined payroll costs, except for what has been included as direct labor.

• Depreciation and amortization: charges with respect to fixed assets (depreciation) and intangible assets (amortization) that have been capitalized on the balance sheet for a specific accounting period.

• Research & Development (R&D): expenses included in research and development of products.

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Non-operating Revenues and Expenses

The non-operating section includes revenues and gains from non- primary business activities (such as rent or patent income); expenses or losses not related to primary business operations (such as foreign exchange losses); gains that are either unusual or infrequent, but not both; finance costs (costs of borrowing, such as interest expense); and income tax expense.

In essence, if an activity is not a part of making or selling the products or services, but still affects the income of the business, it is a non-operating revenue or expense.

Reading the Income Statement

Certain items must be disclosed separately in the notes if it is material (significant). This could include items such as restructurings, discontinued operations, and disposals of investments or of property, plant and equipment. Irregular items are reported separately so that users can better predict future cash flows.

The "bottom line" of an income statement—often, literally the last line of the statement—is the net income that is calculated after subtracting the expenses from revenue. It is important to investors

as it represents the profit for the year attributable to the shareholders. For companies with shareholders, earnings per share (EPS) are also an important metric and are required to be disclosed on the income statement.

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Limitations of the Income Statement Income statements have several limitations stemming from estimation difficulties, reporting error, and fraud.

KEY POINTS

• Income statements include judgments and estimates, which mean that items that might be relevant but cannot be reliably measured are not reported and that some reported figures have a subjective component.

• With respect to accounting methods, one of the limitations of the income statement is that income is reported based on accounting rules and often does not reflect cash changing hands.

• Income statements can also be limited by fraud, such as earnings management, which occurs when managers use judgment in financial reporting to intentionally alter financial reports to show an artificial increase (or decrease) of revenues, profits, or earnings per share figures.

Income statements are a key component to valuation but have several limitations: items that might be relevant but cannot be reliably measured are not reported (such as brand loyalty); some figures depend on accounting methods used (for example, use of

FIFO or LIFO accounting); and some numbers depend on judgments and estimates. In addition to these limitations, there are limitations stemming from the intentional manipulation of finances.

One of the limitations of the income statement is that income is reported based on accounting rules and often does not reflect cash changing hands. This could be due to the matching principle, which is the accounting principle that requires expenses to be matched to revenues and reported at the same time. Expenses incurred to produce a product are not reported in the income statement until that product is sold. Another common difference across income

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Accounting for inventory can be done in different ways, leading to differences in statements.

Figure 2.5 Income statement

statements is the method used to calculate inventory, either FIFO or LIFO (Figure 2.5).

In addition to good faith differences in interpretations and reporting of financial data in income statements, these financial statements can be limited by intentional misrepresentation. One example of this is earnings management, which occurs when managers use judgment in financial reporting and in structuring transactions to alter financial reports in a way that usually involves the artificial increase (or decrease) of revenues, profits, or earnings per share figures.

The goal with earnings management is to influence views about the finances of the firm. Aggressive earnings management is a form of fraud and differs from reporting error. Managers could seek to manage earnings for a number of reasons. For example, if a manager earns his or her bonus based on revenue levels at the end of December, there is an incentive to try to represent more revenues in December so as to increase the size of the bonus.

While it is relatively easy for an auditor to detect error, part of the difficulty in determining whether an error was intentional or accidental lies in the accepted recognition that calculations are estimates. It is therefore possible for legitimate business practices to develop into unacceptable financial reporting.

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GAAP Implications on the Income Statement GAAP’s assumptions, principles, and constraints can affect income statements through temporary (timing) and permanent differences.

KEY POINTS

• Items that create temporary differences due to the recording requirements of GAAP include rent or other revenue collected in advance, estimated expenses, and deferred tax liabilities and assets.

• Also there are events, usually one-time events, which create "permanent differences," such as GAAP recognizing as an expense an item that the IRS will not allow to be deducted.

• The four basic principles of GAAP can affect items on the income statement. These principles include the historical cost principle, revenue recognition principle, matching principle, and full disclosure principle.

Although most of the information on a company’s income tax return comes from the income statement, there often is a difference between pretax income and taxable income. These differences are due to the recording requirements of GAAP for financial accounting (usually following the matching principle and allowing for accruals

of revenue and expenses) and the requirements of the IRS’s tax regulations for tax accounting (which are more oriented to cash) (Figure 2.6).

Such timing differences between financial accounting and tax accounting create temporary differences. For example, rent or other revenue collected in advance, estimated expenses, and deferred tax liabilities and assets may create timing differences. Also, there are events, usually one time, which create "permanent differences," such as GAAP, which recognizes as an

expense an item that the IRS will not allow to be deducted.

To achieve basic objectives and implement fundamental qualities, GAAP has four basic principles:

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GAAP and IRS accounting can differ.

Figure 2.6 Income statement

• The historical cost principle: It requires companies to account and report based on acquisition costs rather than fair market value for most assets and liabilities.

• The revenue recognition principle. It requires companies to record when revenue is (1) realized or realizable and (2) earned, not when cash is received.

• The matching principle. This governs the matching of expenses and revenues, where expenses are recognized, not when the work is performed or when a product is produced, but when the work or the product actually makes its contribution to revenue.

• The full disclosure principle. This suggests that the amount and kinds of information disclosed should be decided based on a trade-off analysis, since a larger amount of information costs more to prepare and use. GAAP reporting also suggests that income statements should present financial figures that are objective, material, consistent, and conservative.

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Noncash Items Noncash items, such as depreciation and amortization, will affect differences between the income statement and cash flow statement.

KEY POINTS

• Noncash items should be added back in when analyzing income statements to determine cash flow because they do not contribute to the inflow or outflow of cash like other gains and expenses eventually do.

• Depreciation refers to the decrease in value of assets and the allocation of the cost of assets to periods in which the assets are used—for tangible assets, such as machinery.

• Amortization is a similar process to deprecation when applied to intangible assets, such as patents and trademarks.

Noncash Items

Noncash items that are reported on an income statement will cause differences between the income statement and cash flow statement. Common noncash items are related to the investing and financing of assets and liabilities, and depreciation and amortization. When analyzing income statements to determine the true cash flow of a business, these items should be added back in because they do

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not contribute to inflow or outflow of cash like other gains and expenses.

Fixed assets, also known as a non-current asset or as property, plant, and equipment (PP&E), is an accounting term for assets and property. Unlike current assets such as cash accounts receivable, PP&E are not very liquid. PP&E are often considered fixed assets: they are expected to have relatively long life, and are not easily changed into another asset (Figure 2.7). These often receive a more favorable tax treatment than short-term assets in the form of depreciation allowances.

Broadly speaking, depreciation is a way of accounting for the decreasing value of long-term assets over time. A machine bought in 2012, for example, will not be worth the same amount in 2022 because of things like wear-and-tear and obsolescence.

On a more detailed level, depreciation refers to two very different but related concepts: the decrease in the value of tangible assets (fair value depreciation) and the allocation of the cost of tangible assets to periods in which they are used (depreciation with the matching principle). The former affects values of businesses and entities. The latter affects net income.

In each period, long-term noncash assets accrue a depreciation expense that appears on the income statement. Depreciation

expense does not require a current outlay of cash, but the cost of acquiring assets does. For example, an asset worth $100,000 in year 1 may have a depreciation expense of $10,000, so it appears as an asset worth $90,000 in year 2.

Amortization is a similar process to deprecation but is the term used when applied to intangible assets. Examples of intangible assets include copyrights, patents, and trademarks.

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Machinery is an example of a noncash asset.

Figure 2.7 Machinery

Assets

Liabilities and Equity

Working Capital

Liquidity

Debt to Equity

Market vs. Book Value

Limitations of the Balance Sheet

Section 3

The Balance Sheet

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Assets Assets on a balance sheet are classified into current assets and non-current assets. Assets are on the left side of a balance sheet.

KEY POINTS

• The main categories of assets are usually listed first, and normally, in order of liquidity. On a balance sheet, assets will typically be classified into current assets and non-current (long-term) assets.

• Current assets are those assets which can either be converted to cash or used to pay current liabilities within 12 months. Current assets include cash and cash equivalents, short-term investments, accounts receivable, inventories and the portion of prepaid liabilities paid within a year.

• A non-current asset cannot easily be converted into cash. Non-current assets include property, plant and equipment (PPE), investment property, intangible assets, long-term financial assets, investments accounted for using the equity method, and biological assets.

The Balance Sheet

A standard company balance sheet has three parts: assets, liabilities and ownership equity. The main categories of assets are usually

listed first, and normally, in order of liquidity. On the left side of a balance sheet, assets will typically be classified into current assets and non-current (long-term) assets (Figure 2.8).

Current Assets

A current asset on the balance sheet is an asset which can either be converted to cash or used to pay current liabilities within 12 months. Typical current assets include cash and cash equivalents, short-term investments, accounts receivable, inventories and the portion of prepaid liabilities which will be paid within a year.

Cash and cash equivalents are the most liquid assets found within the asset portion of a company's balance sheet. …