BACKGROUND KNOWLEDGE for Teachers and Students

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1 Pathway: Business, Marketing, and Computer Education Lesson: BMM C6 4: Financial Statements and Reports Common Core State Standards for Mathematics: N.Q.2 Domain: Quantities Cluster: Reason quantitatively and use units to solve problems. Standard: 2. Define appropriate quantities for the purpose of descriptive modeling.* Student Objectives: 1. Analyze financial statements. 2. Calculate financial performance ratios. 3. Compare mathematical results with industry standards. Math Concepts: BACKGROUND KNOWLEDGE for Teachers and Students Arithmetic: Arithmetic is a branch of mathematics in which problems are solved by calculating with numbers, using any one or a combination of the following operations: addition, subtraction, multiplication, division. Two types of problems are solved with arithmetic. Counting, grouping, or regrouping objects solves one type. Measuring or comparing quantities solves the other type. Logic: Logic is the laws that govern valid thinking patterns and the structure of statements. Order of operations: Order of operations follows these rules: (1) If grouping symbols are used, perform the operations within the grouping symbols first. (2) Perform all multiplications and divisions in order from left to right. (3) Then, perform all additions and subtractions in order from left to right. COMMON CORE MATH INTEGRATION ACTIVITY: BMM C6 4: Financial Statements and Reports Page 1

2 Percent: Percent is per hundred. It is the ratio of a number to 100 with a percent sign. For example, 20% means 20 out of 100 or 20 / 100. Problem solving: Problem solving is understanding what a problem is asking and applying formulas to complete the calculation. Ratio: Ratio is a comparison of two quantities by division. Ratio analysis: Ratio analysis is an evaluation of relationships between elements of financial statement information used to identify trends over time. Ratio analysis focuses on liquidity (cash), profitability, and solvency (wealth). Business, Marketing, and Computer Education Concepts: Accountants and financial analysts review financial statements to assess a company s strength and performance. One component of this review involves conducting ratio analysis comparing various line items in a financial statement to a particular item and comparing the calculations from period to period. As a requirement of many loans, certain minimum/maximum levels must be maintained for a financial institution to continue to offer its lending services or to maintain a specific interest rate. Account: An account is a chronological record of changes to assets, liabilities, or stockholder s equity. The Cash account is an example; all transactions related to cash would be recorded in the Cash account. Accounts Payable: Accounts Payable is the amount owed by a company to its vendors/ creditors. It is sometimes referred to as a current liability on a Balance Sheet. Accounts Payable Turnover: Accounts Payable Turnover is a ratio that determines how long it takes a business, on average, to pay its bills. Turnover Rate = Cost of Goods Sold Average Accounts Payable. Accounts Payable Turnover = 365 Turnover Rate. Accounts Receivable: Accounts Receivable is the amount owed to a company by its creditors (customers). Accounts Receivable Turnover: Accounts Receivable Turnover is an accounting measure that shows how efficiently a business uses its assets to extend credit and to collect debt. Turnover Rate = Sales Average Accounts Receivable. Accounts Receivable Turnover = 365 Turnover Rate. This ratio indicates how long it takes a business, on average, to be paid by its customers. Asset: An asset is something valuable, such as a resource, owned or controlled by a business as a result of past events and from which future economic benefits are expected. Balance Sheet: A Balance Sheet is a financial statement that lists all a business s accounts, capital, assets, liabilities, and shareholders equity at a point in time. Balance Sheets detail the balance of income and expenditures over the prior period. The statement is called a Balance Sheet because the two sides balance out. COMMON CORE MATH INTEGRATION ACTIVITY: BMM C6 4: Financial Statements and Reports Page 2

3 Cash: Cash is the amount of ready money residing in a company s financial accounts, such as petty cash, bank account balances, customer checks, and marketable securities. Cost of Goods Sold (COGS): Cost of Goods Sold is an Income Statement figure that reflects the cost of obtaining raw materials and producing finished goods sold to consumers. Cost of Goods Sold = Beginning Merchandise Inventory + Net Purchases of Merchandise Ending Merchandise Inventory. For example: Beginning Merchandise Inventory = $180,000 Net Purchases of Merchandise = $650,000 Ending Merchandise Inventory = $205,000 COGS = 180, , ,000 = $625,000 Current assets: Current assets are those assets that will be consumed within one year or will be used to pay for the business s current liabilities. Current liabilities: Current liabilities are those obligations due to be paid within one year. Current ratio: Current ratio is a financial indicator of a company s ability to repay its shortterm debt (within 12 months). Current Ratio = Current Assets Current Liabilities. Debt-to-equity ratio: Debt-to-equity ratio is an indicator of how much of a business s financing is through debt (borrowing); it is a type of financial ratio found on Balance Sheets, Income Statements, and Statements of Cash Flows. Debt-to-Equity Ratio = Total Debt Total Stockholders Equity. Financial ratios: Financial ratios evaluate the overall financial condition of an organization. Examples include return on investment (ROI), return on assets (ROA), and debt-to-equity. Financial statements: Financial statements are records that summarize the monetary activities of a business. The four main financial statements are Balance Sheet, Income Statement, Statement of Cash Flows, and Statement of Retained Earnings. Gross Margin: Gross Margin is the amount of money generated from selling a product after the product costs are deducted. The formula is Gross Margin = Sales Cost of Goods Sold. Gross Margin ratio: Gross Margin ratio (gross profit margin) is a measure of a company s profitability, specifically the costs related to purchasing a product for resale. It is expressed as a percentage of gross profit. The formula is Gross Margin Ratio = Gross Profit Sales Revenue. Income Statement: An Income Statement is a financial document that reports revenue and expenses over a designated period (usually one month or one year). Inventory Turnover: Inventory Turnover is a measure of how long inventory sits, on average, in stock how many times inventory is sold and replaced during a given period. Turnover Rate = Cost of Goods Sold Average Inventory. Inventory Turnover = 365 Turnover Rate. COMMON CORE MATH INTEGRATION ACTIVITY: BMM C6 4: Financial Statements and Reports Page 3

4 Long-term assets: Long-term assets are the value of a business s property, facility, equipment, and other capital assets minus depreciation. Included, also, are long-term investments and other assets the business uses for more than 12 months. Long-term assets provide economic benefit for an extended period. Long-term liabilities: Long-term liabilities are a category of debt; they are obligations that become due after one year or more. Net Income/Loss: Net Income/Loss is the overall profit or loss after all expenses are deducted from the Gross Margin. Profit Margin: Profit Margin is the ratio of profits earned to total sales receipts over a specific period. It measures the financial health of a business. For example, a company that makes a profit of $10 on a $100 cell phone has a Profit Margin of 10%. The formula to calculate Profit Margin is Earnings Product Cost = Profit Margin. In this case, $10 $100 = COMMON CORE MATH INTEGRATION ACTIVITY: BMM C6 4: Financial Statements and Reports Page 4

5 1. a. $60,000 Guided Practice Exercises: ANSWER KEY b. $152,600 c. $39,250 d. $2,000 e. $215,000 f. $221,800 g. $55,000 h. $394,450 i. $572,300 j. $350, a. Current Assets Current Liabilities 152,600 51,500 = 2.96 ANALYSIS: A result >1 suggests the business s strong ability to repay its current obligations. A 2.96 current ratio means that there are $2.96 of current assets to cover each $1.00 of current liabilities. b. Gross Margin Sales 221, ,300 = 38.76% ANALYSIS: The result of this performance ratio calculation means that the company has 38.76% of its funds left over to cover other non-sales related expenses. c. Net Income Sales 18, ,300 = 3.15% ANALYSIS: A 3.15% Profit Margin is rather low. This means that only 3.15% of funds are available to reinvest in the business and that the company profited only $3.15 for every $ of sales. Although industry averages may vary, anything below 10% is considered critical. d. Cost of Goods Sold Average Inventory 350,500 [(32, ,800) 2] = = Turnover Rate = 31.77, or 32 days in inventory COMMON CORE MATH INTEGRATION ACTIVITY: BMM C6 4: Financial Statements and Reports Page 5

6 ANALYSIS: The result of this calculation means that the company s inventory is turned over, or sold, every 32 days. This number varies based on the type of business (i.e., fast-food restaurant versus furniture store). e. Cost of Goods Sold Average Accounts Payable 350,500 [(42, ,000) 2] = 8.93 = Turnover Rate = 40.87, or 41 days ANALYSIS: The result means that, on average, this company pays its bills in 41 days. f. Sales Average Accounts Receivable 572,300 [(20, ,000) 2] = = Turnover Rate = 15.3, or 16 days ANALYSIS: The result means that, on average, customers pay the company in 16 days. This number 16 days should be compared with the company s payment terms (i.e., invoices due in 10 days? 30 days?). Independent Practice Exercises: ANSWER KEY 1. a. Current Assets Current Liabilities 140,500 27,500 = 5.11 ANALYSIS: A result >1 suggests a strong ability of a business to repay its current obligations. A 5.11 current ratio means that there are $5.11 of current assets to cover each $1.00 of current liabilities. b. Gross Margin Sales 152, ,000 = 38% ANALYSIS: The result of this performance ratio calculation means that the company has 38% of its funds left over to cover other non-sales related expenses. c. Net Income Sales 27, ,000 = 6.88% ANALYSIS: A 6.88% Profit Margin is rather low. This means that only 6.88% of funds are available to reinvest in the business and that the company profited only $6.88 for every $ of sales. Although industry averages may vary, anything below 10% is considered critical. d. Cost of Goods Sold Average Inventory 248,000 [(72, ,000) 2] = 3.65 = Turnover Rate = 100 days in inventory COMMON CORE MATH INTEGRATION ACTIVITY: BMM C6 4: Financial Statements and Reports Page 6

7 ANALYSIS: The result of this calculation means that the company s inventory is turned over, or sold, every 100 days. This number varies based on the type of business (i.e., fast-food restaurant versus furniture store). This number 100 days is considered high. e. Cost of Goods Sold Average Accounts Payable 248,000 [(24, ,000) 2] = 8.13 = Turnover Rate = 44.90, or 45 days ANALYSIS: The result means that, on average, this company pays its bills in 45 days. f. Sales Average Accounts Receivable 400,000 [(41, ,000) 2] = 9.94 = Turnover Rate = 36.72, or 37 days ANALYSIS: The result means that, on average, customers pay the company in 37 days. This number 37 days should be compared with the company s payment terms (i.e., invoices due in 10 days? 30 days?). COMMON CORE MATH INTEGRATION ACTIVITY: BMM C6 4: Financial Statements and Reports Page 7

8 Guided Practice Exercises: Name: 1. Use the information on the West Company, Inc., Balance Sheet and Income Statement dated December 31, (Current Year), to locate and/or calculate the following account balances. a. Land b. Total Current Assets c. Advertising Expense d. Interest Payable e. Total Stockholders Equity f. Gross Margin g. Retained Earnings h. Average Total Assets [HINT: Compare last year and this year.] i. Sales j. Cost of Goods Sold COMMON CORE MATH INTEGRATION ACTIVITY: BMM C6 4: Financial Statements and Reports Page 8

9 West Company, Inc. Comparative Balance Sheet December 31, (Current Year) Current Year Last Year Assets Cash 98, , Accounts Receivable 20, , Inventory 32, , Supplies 2, , Total Current Assets 152, , Buildings 155, , Vehicles 35, , Land 60, , Total Assets 402, , Liabilities Accounts Payable 42, , Interest Payable 2, , Salaries Payable 7, , Total Current Liabilities 51, , Long-Term Debt 130, , Interest on Long-Term Debt 6, , Total Liabilities 187, , Stockholders Equity Common Stock 100, , Preferred Stock 60, , Retained Earnings 55, , Total Stockholders Equity 215, , Total Liabilities and Stockholders Equity $402, $386, COMMON CORE MATH INTEGRATION ACTIVITY: BMM C6 4: Financial Statements and Reports Page 9

10 West Company, Inc. Income Statement For the year ended December 31, (Current Year) Current Year Revenue Sales 572, Cost of Goods Sold 350, Gross Margin 221, Expenses Advertising Expense 39, Communications Expense 6, Interest Expense 2, Miscellaneous Expense 1, Salaries Expense 135, Utilities Expense 19, Total Expenses 203, Net Income 18, Use the information on the West Company, Inc., Balance Sheet and Income Statement dated December 31, (Current Year), presented in Exercise 1, to calculate the following performance ratios. Then, analyze the results. a. Current Ratio (Find these line items on the Balance Sheet. Round your answer to two decimal places.) ANALYSIS: What does a result >1 suggest about a business s ability to repay its current obligations? What does the West Company, Inc. s current ratio mean in relation to current assets with which it can cover current liabilities? COMMON CORE MATH INTEGRATION ACTIVITY: BMM C6 4: Financial Statements and Reports Page 10

11 b. Gross Margin Ratio (Find these line items on the Income Statement. Round your answer to two decimal places.) ANALYSIS: What does the calculated Gross Margin ratio mean? c. Profit Margin (Find these line items on the Income Statement. Round your answer to two decimal places.) ANALYSIS: What does the calculated Profit Margin mean? d. Inventory Turnover (Find these line items on the Income Statement and Balance Sheet. [HINT: For an Inventory Turnover ratio, the Income Statement account is always in the numerator position.] Round the turnover rate to two decimal places and your final answer up to the nearest full day.) ANALYSIS: What does the calculated Inventory Turnover ratio mean? COMMON CORE MATH INTEGRATION ACTIVITY: BMM C6 4: Financial Statements and Reports Page 11

12 e. Accounts Payable Turnover (Find these line items on the Income Statement and Balance Sheet. Round the turnover rate to two decimal places and your final answer up to the nearest full day.) ANALYSIS: What does the calculated Accounts Payable Turnover rate mean? f. Accounts Receivable Turnover (Find these line items on the Income Statement and Balance Sheet. Round the turnover rate to two decimal places and your final answer up to the nearest full day.) ANALYSIS: What does the calculated Accounts Receivable Turnover rate mean? COMMON CORE MATH INTEGRATION ACTIVITY: BMM C6 4: Financial Statements and Reports Page 12

13 Name: Independent Practice Exercises: 1. Use the information on the East Company, Inc., Balance Sheet and Income Statement dated December 31, (Current Year) to calculate the following performance ratios. Then, analyze the results. East Company, Inc. Comparative Balance Sheet December 31, (Current Year) Current Year Last Year Assets Cash 22, , Accounts Receivable 41, , Inventory 72, , Supplies 5, , Total Current Assets 140, , Buildings 160, , Vehicles 43, , Total Assets 343, , Liabilities Accounts Payable 24, , Salaries Payable 3, , Total Current Liabilities 27, , Long-Term Debt 100, , Interest on Long-Term Debt 6, , Total Liabilities 134, , Stockholders Equity: Common Stock 60, , Preferred Stock 20, , Retained Earnings 129, , Total Stockholders Equity 209, , Total Liabilities and Stockholders Equity 343, , COMMON CORE MATH INTEGRATION ACTIVITY: BMM C6 4: Financial Statements and Reports Page 13

14 East Company, Inc. Income Statement For the year ended December 31, (Current Year) Current Year Revenue Sales 400, Cost of Goods Sold 248, Gross Margin 152, Expenses Advertising Expense 39, Communications Expense 2, Interest Expense 15, Miscellaneous Expense 1, Salaries Expense 40, Rent Expense 15, Utilities Expense 11, Total Expenses 124, Net Income 27, a. Current Ratio (Find these line items on the Balance Sheet. Round your answer to two decimal places.) ANALYSIS: What does a result >1 suggest about a business s ability to repay its current obligations? What does the East Company, Inc. s current ratio mean in relation to current assets with which it can cover current liabilities? COMMON CORE MATH INTEGRATION ACTIVITY: BMM C6 4: Financial Statements and Reports Page 14

15 b. Gross Margin Ratio (Find these line items on the Income Statement.) ANALYSIS: What does the calculated Gross Margin ratio mean? c. Profit Margin (Find these line items on the Income Statement. Round your answer to two decimal places.) ANALYSIS: What does the calculated Profit Margin mean? d. Inventory Turnover (Find these line items on the Income Statement and Balance Sheet. [HINT: For an Inventory Turnover ratio, the Income Statement account is always in the numerator position.] Round the turnover rate to two decimal places.) ANALYSIS: What does the calculated Inventory Turnover ratio mean? COMMON CORE MATH INTEGRATION ACTIVITY: BMM C6 4: Financial Statements and Reports Page 15

16 e. Accounts Payable Turnover (Find these line items on the Income Statement and Balance Sheet. Round the turnover rate to two decimal places and your final answer up to the nearest full day.) ANALYSIS: What does the calculated Account Payable Turnover rate mean? f. Accounts Receivable Turnover (Find these line items on the Income Statement and Balance Sheet. Round the turnover rate to two decimal places and your final answer up to the nearest full day.) ANALYSIS: What does the calculated Accounts Receivable Turnover rate mean? COMMON CORE MATH INTEGRATION ACTIVITY: BMM C6 4: Financial Statements and Reports Page 16