Principles of Financial Accounting: Financial Statement Analysis - Purpose of Financial Statement, Analysis

What It Is

Financial statement analysis is the process of reviewing and interpreting a company's financial statements to make informed decisions. It involves analyzing the company's financial performance, position, and cash flows to identify trends, strengths, and weaknesses. For example, if a company buys $10,000 of inventory, financial statement analysis would help determine whether this investment is generating sufficient revenue to cover its costs.

Key Concepts & Formulas

• Gross Profit: Gross profit is the difference between sales revenue and cost of goods sold (COGS). Gross profit = Sales – COGS. For example, if a company has sales revenue of $100,000 and COGS of $60,000, its gross profit would be $40,000.
• Operating Expenses: Operating expenses are costs incurred to generate revenue. They include salaries, rent, utilities, and other expenses. For example, if a company has operating expenses of $20,000, it would be deducted from gross profit to calculate net income.
• Debt-to-Equity Ratio: The debt-to-equity ratio is a measure of a company's financial leverage. It is calculated by dividing total debt by total equity. For example, if a company has total debt of $50,000 and total equity of $100,000, its debt-to-equity ratio would be 0.5.
• Return on Equity (ROE): ROE is a measure of a company's profitability. It is calculated by dividing net income by total equity. For example, if a company has net income of $20,000 and total equity of $100,000, its ROE would be 0.2 or 20%.
• Current Ratio: The current ratio is a measure of a company's liquidity. It is calculated by dividing current assets by current liabilities. For example, if a company has current assets of $100,000 and current liabilities of $50,000, its current ratio would be 2.
• Asset Turnover Ratio: The asset turnover ratio is a measure of a company's efficiency in using its assets to generate revenue. It is calculated by dividing sales revenue by total assets. For example, if a company has sales revenue of $100,000 and total assets of $200,000, its asset turnover ratio would be 0.5.

Journal Entry Examples

Example 1: Purchasing Inventory

Dr. Inventory $10,000 Cr. Cash $10,000

Explanation: The company purchases inventory for $10,000, which is recorded as an increase in inventory and a decrease in cash.

Example 2: Selling Inventory

Dr. Cash $15,000 Cr. Sales Revenue $15,000 Cr. Cost of Goods Sold $10,000

Explanation: The company sells inventory for $15,000, which is recorded as an increase in cash and sales revenue, and a decrease in cost of goods sold.

Example 3: Accrued Salaries

Dr. Salaries Expense $5,000 Cr. Salaries Payable $5,000

Explanation: The company accrues salaries expense of $5,000, which is recorded as an increase in salaries expense and a decrease in salaries payable.

Common Mistakes

• Mistake: Confusing debits and credits for expense accounts.
• Correction: Expense accounts are debited, not credited. Remember the rule: "Debit what comes in, credit what goes out."
• Mistake: Not considering the normal balance of an account when making journal entries.
• Correction: Normal balances are assets (debit), liabilities and equity (credit), and revenues and expenses (credit). Use the mnemonic "ADE" (Assets, Drawings, Expenses) to remember.
• Mistake: Not using the correct formula for calculating ratios.
• Correction: Use the correct formula for each ratio, and make sure to use the correct numbers.

Exam Tips

• Tip: A debit increases assets AND expenses – remember "ADE" (Assets, Drawings, Expenses).
• Tip: Reversing normal balances can be a trap. Make sure to use the correct formula and numbers.
• Tip: Don't forget to consider the normal balance of an account when making journal entries.

Quick Practice

Problem 1

What is the adjusting entry for accrued salaries of $5,000?

Answer: Dr. Salaries Expense $5,000, Cr. Salaries Payable $5,000

Explanation: The company accrues salaries expense of $5,000, which is recorded as an increase in salaries expense and a decrease in salaries payable.

Problem 2

What is the journal entry for purchasing inventory for $10,000?

Answer: Dr. Inventory $10,000, Cr. Cash $10,000

Explanation: The company purchases inventory for $10,000, which is recorded as an increase in inventory and a decrease in cash.

Problem 3

What is the formula for calculating the debt-to-equity ratio?

Answer: Debt-to-Equity Ratio = Total Debt ÷ Total Equity

Explanation: The debt-to-equity ratio is a measure of a company's financial leverage. It is calculated by dividing total debt by total equity.

Last-Minute Cram Sheet

• Assets: Normal balance is debit.
• Liabilities and Equity: Normal balance is credit.
• Revenues and Expenses: Normal balance is credit.
• Gross Profit: Gross profit = Sales – COGS.
• Operating Expenses: Operating expenses are costs incurred to generate revenue.
• Debt-to-Equity Ratio: Debt-to-Equity Ratio = Total Debt ÷ Total Equity.
• Return on Equity (ROE): ROE = Net Income ÷ Total Equity.
• Current Ratio: Current Ratio = Current Assets ÷ Current Liabilities.
• Asset Turnover Ratio: Asset Turnover Ratio = Sales Revenue ÷ Total Assets.
• Dividends: Dividends are NOT an expense – they go directly to retained earnings.