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Understanding the Financial

Statements
Lecture No.2
Chapter 2
Contemporary Engineering Economics
Copyright 2006
Contemporary Engineering Economics, 4th
edition. 2007

Understanding Financial Statements

Accounting: The
Basis of DecisionMaking
Financial Statements:
Financial Status for
Businesses
Financial Ratios:
Using Ratios to Make
Business Decisions
Contemporary Engineering Economics, 4th
edition. 2007

Chapter Opening Story Dell Computer


Corporation

1983 Michael Dell starts business of preformatting IBM PC


HDs on weekends
1985 - $6 million sales, upgrading IBM compatibles for local
businesses
1986 - $70 million sales; focus on assembling own line of PCs
1990 - $500 million sales with an extensive line of products
1996 Dell goes online; $1 million per day in online sales; $5.3B
in annula sales
1997 Dell online sales at $3 million per day; 50% growth rate
for third consecutive year, 7.8B in total annual sales
2005 - $49.2 B in sales

How would you evaluate the financial performance of


Dell Corporation?
Contemporary Engineering Economics, 4th
edition. 2007

A. Why Engineers need to understand the financial


statements?

Contemporary Engineering Economics, 4th


edition. 2007

Accounting The Language of Business

Contemporary Engineering Economics, 4th


edition. 2007

Financial Status for Business

Contemporary Engineering Economics, 4th


edition. 2007

B. Understanding the Balance Sheet


1.

2.

3.

The basic accounting equation and the


definition of capital
How to instantly determine liquidity and too
much debt
How the firm gets equity: only two ways

Contemporary Engineering Economics, 4th


edition. 2007

The Basic Accounting Equation

For the Balance Sheet Presentation


Assets = Liabilities + Owners Equity

For the Financial Analysis


Assets - Liabilities = Owners Equity

Contemporary Engineering Economics, 4th


edition. 2007

How Items Are Arranged on the Balance


Sheet

Liabilities

Assets

Owners
Equity

Contemporary Engineering Economics, 4th


edition. 2007

Using the Four Quadrants of the Balance


Sheet and Why?
ASSETS

LIABILITIES

Current Liabilities

Current Assets

Long-Term Liabilities

Long-Term Assets

Equity
1.
2.

Owner Contributions
Retained Earnings

Contemporary Engineering Economics, 4th


edition. 2007

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The Balance Sheet Statement Dell Computer


Corporation
Current
Assets
Long-term
Assets
Current
Liabilities
Long-term Liabilities

Equity

Contemporary Engineering Economics, 4th


edition. 2007

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How to Instantly Determine Liquidity and


Too Much Debt?

Liquidity

Current Ratio (2:1)

Too Much Debt?

Debt To Equity Ratio


Contemporary Engineering Economics, 4th
edition. 2007

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Liquidity Current Ratio


ASSETS

LIABILITIES

Current Assets

Current Liabilities

Long-Term Liabilities

Long-Term Assets

Equity
1.
2.

Owner Contributions
Retained Earnings

Contemporary Engineering Economics, 4th


edition. 2007

13

Too Much Debt? Debt to Equity Ratio

LIABILITIES

Current Assets

Current Liabilities

Debt

ASSETS

Long-Term Liabilities

Long-Term Assets
1.
2.

Equity

Equity
Owner Contributions
Retained Earnings

Contemporary Engineering Economics, 4th


edition. 2007

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How the Firm Gets Equity: Only Two


Ways

Owners Contributions

By issuing stocks through financial markets

Retained Earnings

By retaining operating profits instead of paying

Contemporary Engineering Economics, 4th


edition. 2007

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C. Using the Income Statement to Manage


a Business
1.
2.

3.

How to Use profit check points


Why gross margin is the critical measure
for engineers?
How does inventory production impact
profit?

Contemporary Engineering Economics, 4th


edition. 2007

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Basic Income Statement Equation


Revenue

Expenses
Net Income (Loss)

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edition. 2007

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Why Gross Margin is the Critical Measure


for Engineers?

Sales
Cost of Goods Sold
Gross Margin
Contemporary Engineering Economics, 4th
edition. 2007

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How Inventory Production Impacts Profit

Calculating the Cost of Goods Sold


Beginning Inventory

+ Additions to Inventory
- Ending Inventory
Cost of Goods Sold
Contemporary Engineering Economics, 4th
edition. 2007

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How to Use Profit Check Points


ABC Company, Inc.
Statement of Operations (Year Ended December 31, 200x)

Sales

$5,000,000

100.0%

3,250,000

65.0%

1,750,000

35.0%

1,000,000

20.0%

Operating Profit

750,000

15.0%

Less: Interest

250,000

5.0%

500,000

10.0%

175,000

3.5%

$325,000

6.5%

Less: Cost of Goods Sold


Gross Profit
Less: Selling, G&A Expenses

Net Income Before Taxes (NIBT)


Less: Taxes
Net Income

Bottom line
Contemporary Engineering Economics, 4th
edition. 2007

20

The Income Statement Dell Computer


Corporation
FY 2005

100.00%
18.32%

8.65%

6.18%

Contemporary Engineering Economics, 4th


edition. 2007

1
8
.
3
2
%

Gross margin

Operating margin

Net margin

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D. Understanding the Statement of Cash


Flows
1.

2.

3.

The business operating cycle: How


a business earns its cash
Sources and Uses of Cash
The engineers focus on the
investing section: Capital Budgeting

Contemporary Engineering Economics, 4th


edition. 2007

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Cash Flow Transactions within Business


Shareholders
To pay dividend,
To purchase back
shares
To purchase

From sale
of shares

Government
To pay taxes

From sale

CASH

To pay interest
and principal

From cash sales

Customers

Fixed Assets

From credit
sales

From sale
of debt
To pay labor,
materials, and
overhead

Debt holders

Inventory
Contemporary Engineering Economics, 4th
edition. 2007

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The Cash Flow Business Cycle


Pay taxes

Changes in equity

Pay interest
Pay dividends

Changes in liabilities

Cash
Collection of
receivable

Production

Labor
Materials
Overhead

Investment

Accounts
receivable

Cash
Sales

Credit
Sales

Inventory
Depreciation

Fixed assets
Contemporary Engineering Economics, 4th
edition. 2007

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The Cash Flow Statement Dell Computer Corporation

Contemporary Engineering Economics, 4th


edition. 2007

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Sources and Uses of Cash


Financial
position
Balance Sheet
Jan. 31, 2005

Statement of
Changes in
Financial Position

Sources and
Uses of Funds

Sources

Financial
position
Balance Sheet

Feb. 02, 2004

Uses

Increase in equity
Decrease in assets
Increase in liabilities

Decrease in equity
Increase in assets
Decrease in liabilities

Contemporary Engineering Economics, 4th


edition. 2007

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The Engineers focus on the Investing Section: Capital


Budgeting
Section
Cash from Operations

Cash from
Investments

Cash from Financing

Information
Cash from operations
(profit)
Cash spent on
Property, Plant,
Equip.
Cash received from
bonds and stocks

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edition. 2007

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