Chapter 3

Financial statements and ratio analysis – Part A

What are Financial Statements?

Financial statements are a collection of summary-level reports about an organization's financial
results, financial position, and cash flows. They include the income statement, balance sheet,
and statement of cash flows.

The Income Statement

The income statements show the results of an entity's operations and financial activities for the
reporting period. It usually contains the results for either the past month or the past year, and
may include several periods for comparison purposes.

It can have two formats:

1. the income statements according to Accountants
2. the income statement according to financiers (Finance professionals)

An example of the income statement according to accountants:

1. Sales Revenue
2. Less: Cost of goods sold
3. = Gross profit (the profit generated before any expense is deducted)
4. Less: Operating expenses: (expenses a business incurs through its normal business
operations)
- It is generally divided into a. selling expenses b. general and administrative expenses.
5. = Income for operations / Operating profits (the profit realized from a business' own
operations, before Tax and interest are deducted)

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 6. Less: Interest expense
7. = income before Tax / net profit before taxes
8. Less: Tax (income before Tax * tax rate)
9. = Net income / Net profit after tax
10. Less: preferred stock dividends
11. Earnings available to common stock holders

The difference in the income statement according to financiers

Finance employees use different terms when describing the Income statement, and we will
focus on the following:

EBITDA: Earnings before interest, taxes, depreciation, and amortization (the amount of money
a company generated during a period, before deducting interest costs and taxes, and before
considering the depreciation and amortization of assets)

EBIT : Earnings before interest and tax (company's net income before income tax expense and
interest expenses are deducted) and is the same as Income from operations

EBT : Earnings before tax ( a measure of the company’s profitability before Taxes are deducted)
and is the same as Income before Tax

Question : Jordan International Ltd started its business on 1st January 2024. The company has
generated revenue of J.O.D 180,000 from sales. The cost of goods sold is J.O.D 100,000. It has
incurred selling expenses in the advertisement of J.O.D 6,000 and paid commission to sales
agents of J.O.D 3,500. The office supplies expense was J.O.D 2,500, and the office equipment
Depreciation expense was J.O.D 2,000. The interest paid on loan taken was J.O.D 1,100, and the
tax paid by the company was J.O.D 800. The CFO of Jordan International Ltd wants to know the
Net Income position of the company to analyze it in detail. Find :
1. EBITDA 2. EBIT 3. EBT 4. Net income

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The balance sheet (Also known as the statement of financial position)
The balance sheet displays the company’s total assets and how the assets are financed, either
through either debt or equity. It can also be referred to as a statement of net worth or a
statement of financial position. The balance sheet is based on the fundamental equation:
Assets = Liabilities + Equity.

A classified statement of financial position presents information about an entity's assets, liabilities, and
shareholders' equity that is aggregated (or "classified") into subcategories of accounts (and that means
accounts that are similar in nature are grouped together). It is extremely useful to include classifications,
since information is then organized into a format that is more readable than a simple listing of all the
accounts that comprise a financial position statement. When information is aggregated in this manner,
users may find that useful information can be extracted more readily than would be the case if an
overwhelming number of line items were presented.

In order to be able to compile a classified statement of financial position we must first understand the
grouping of accounts (What accounts are included in each group , and what that grouping is based on) :

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 Assets

“An asset is a resource with economic value that an individual, corporation, or country owns or controls
with the expectation that it will provide a future benefit.”

The following will be an explanation of assets , their types and why they are group with each other

Types of assets :

I. Current assets : Current assets are short-term economic resources that are expected to be
converted into cash or used within one year or operating cycle whichever is longer.

Examples of Current assets :

Cash and Cash equivalents : includes checking accounts, coins and paper money, undeposited receipts,
and money orders.

Marketable securities : are securities that are heavily traded on public exchanges (Stock markets , Such
as Amman Stock Exchange). Marketable securities are of two types – Equity (such as Stocks) and debt
(Such as Bonds) securities. The buyers for these securities are readily available (They can be sold at any
time). therefore, they are short term assets.

Trade and other receivables (Also known as Accounts receivables) : Are amounts the Company has lent
to others and expects for them to be repaid in a short amount of time (the process can be the company
lending the amount in cash OR preforming services and exchanging goods with the promise of later
payment )

Supplies : are Materials the company owns and uses within their operations (Such as : paper, toner
cartridges, and writing instruments , and are usually short-lived)

Inventory : are the items the company or organization sells within their operations (for example the
inventory for a clothing shop is the clothes itself , for a supermarket the items they sell such as
chocolate , and for an automobile dealer the cars they sell)

Prepaid Expenses : are expenses the company has paid for before they have been performed for them
(an example is prepaid rent , where a company may choose to pay the amount of rent before the
beginning of the month , and another example is when you may pay the drycleaner when dropping off
the clothes before he actually cleans them for you )

Note : please notice that these are assets that are supposed to be used within one year (Also please
note that they are ordered by their liquidity)

II. Long-Term investments : long term investments are assets that the organization (Company)
plans on holding (Keeping) for MORE than one year or accounting period (whichever is longer),
and also the organization will NOT use in their operations

Example (1) of long-Term investment : Jordan Co. owns a land that they do not plan to sell within the
current year , and Jordan Co. is NOT using it , and so this land can be categorized as a long-term
investment.

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Example (2) Of Long-term investments : Jordan Co. owns stock in Tesla Co. , and Jordan Co. is not
planning on selling or trading these stocks within the current year , and so these stocks can be
categorized as a long-term investment.

Example (3) of long-term investments : Jordan Co. owns a building in downtown Amman , and they plan
on keeping this building for at least the current year , and they are NOT using it , and so this building can
be categorized as long-term investment.

Note : In example (3) if Jordan Co. was using the building in their operations (working out of it) then it
would NOT be a long-term investment.

III. Property , plant and equipment (also known as Fixed assets): Property, plant, and equipment
are physical (tangible) assets that are long-term assets that typically have a life of more than one
year. And are used within the operations of the company.

Examples of property, plant and equipment assets :

Equipment : long-lived (usually mechanical or digital) items that the company owns and uses within their
operations (for example the computers on campus , the university bus , a tractor on a farm )

Land : as the name implies if the company owns land then that land is an asset that the company
expects future economic benefit from

Buildings : are simple to understand as they have to be above the ground (or under in the case of
basements and bunkers) that the company owns and uses (for example: houses , office buildings ,
factories or compounds )

Note : in the classified statement of financial position , the Accumulated depreciation (which is a Contra-
asset account) appears beneath the Property , plant and equipment , and reduces them.

IV. Intangible assets : An intangible asset is an asset that is not physical in nature, Businesses can
create or acquire intangible assets. And intangible asset can be considered indefinite (as they
have an infinite life – as they do not expire with the passage of time such as a brand name) or
definite (as they will end after a certain period of time has passed, like a legal agreement)

Examples of intangible assets :

Goodwill : When one company acquires another company by paying extra amount as premium for
customer loyalty, brand value, and other non-quantifiable reasons, that premium amount is called
Goodwill.

Patents : Protection of new technologies from using or developing by others. For example, apples
operating system that is found in Iphones .

Copyrights : Protection of authorship from using and publishing by others; For example, Most of the
books published in the world cover copyrights, prevent others not to publish without consent of the
author.

Trademark : Protection of brand logo, or unique designs of the company. For example, the Nike swoosh

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Tradename : protection of brand names of the company . for example, the name Nike

Equity

“Equity, typically referred to as shareholders' equity ,represents the amount of money that would be
returned to a company's shareholders if all of the assets were liquidated (sold) and all of the company's
debt was paid off.”

the following will be a summary of equity accounts :

Capital : (Sometimes called investments by Shareholders) : and these amounts are what the owners
have put into the company , it can be Cash , or they may invest other assets (Such as buildings and
equipment).

But in the case of a corporation it is as follows :

Capital stock: (authorized, issued & outstanding)

Authorized stock : the maximum number of shares that a corporation is legally permitted to issue

Outstanding stock : the total number of shares issued and actively held by stockholders

Issued stock : the number of stocks that the corporation has issued (it includes both outstanding shares
and treasury shares)

Preferred stocks are calculated by multiplying the number of preferred stocks by their par value

Common stocks are calculated by multiplying the number of common stocks by their par value

Additional paid-in capital (APIC) in excess pf PV- preferred is calculated by multiplying the number of
preferred stocks by the difference between the market value and the par value = Number of preferred
stocks * (Market value – Par value) , and represents the additional funds generated by the firm due to its
valuation and reputation in the market

Additional paid-in capital (APIC) in excess pf PV- common is calculated by multiplying the number of
common stocks by the difference between the market value and the par value = Number of common
stocks * (Market value – Par value) , and represents the additional funds generated by the firm due to its
valuation and reputation in the market

Par value Vs. market value

Par value : also known as nominal value, is the face value of stock the value stated in the corporate
charter.

Market value : is the value at which the share is bought and sold in the active market.

Treasury stock (contra equity account) : refers to previously outstanding stock that has been bought
back from stockholders by the issuing company. The result is that the total number of outstanding
shares on the open market decreases. Treasury stock remains issued but is not included in the
distribution of dividends or the calculation of earnings per share (EPS).

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Retained earnings : are the amounts that the company has accumulated through operation through out
the years that the business has been established.

Liabilities

“Liabilities are Financial obligations that the company incurs , and from those obligations the company
expects the outflow (Decrease) of future economic benefits.”

Types of liabilities :

I. Current liabilities : are liabilities the company expects to pay or fulfill within one year or
operating cycle (whichever is longer) – sometimes called Short-Term liabilities.

Examples of current liabilities :

Accounts payable : are obligations the company incurs within their operations that may result from the
purchase of assets or the receipt of services on Account (the promise to pay later) , usually they are
short-Term and oral (not backed by a written note) and hold no interest (the company pays the same
amount they borrowed) (and thus are for smaller amounts)

Wages (salaries) Payable: The total amount of accrued income employees have earned but not yet
received.

Interest Payable: The total amount of accrued interest expense that the company has incurred but not
yet paid.

Unearned Revenues: This is a company's liability to deliver goods and/or services at a future date after
being paid in advance.

II. Non-Current liabilities : are liabilities the company expects to pay or fulfill within MORE than
one year or operating cycle (whichever is longer) – sometimes called Long-Term liabilities.

Examples of Non-current liabilities :

Notes payable : are obligations the company incurs within their operations , and usually they are long-
Term , backed by a written note , and hold interest (the company pays back more than they borrowed)
(and thus are for larger amounts).

Mortgages : a loan used to purchase or maintain a home, land, or other types of real estate.

Bonds : a loan made by an investor to a borrower (the Company), and holds interest (much like a Note
payable but is usually more secure and sold directly to investors)

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