INSTRUCTOR MANUAL
Instructor’s Manual for Principles of Finance
03/21/22 1
, Instructor’s Manual for Principles of Finance
Chapter 5
Financial Statements
Chapter Summary
This chapter discusses the nature of financial statement reporting, its key elements, and the
significance of the major financial statements. Additional topics include the measurement of
operating cash flow and free cash flow and the use of common-size financial statements in
analyzing a firm’s operations.
Lecture Outline
5.1 The Income Statement
The purpose of an income statement is to determine a firm’s profitability for a specified period
of time. It summarizes the result of revenues and expenses recognized and incurred for a
period of time.
Profitability is defined as: Revenues less Expenses
In instances when revenues are greater than expenses, a firm has net income and is profitable,
and when expenses are greater than revenues, the firm has a net loss and is unprofitable.
There are, of course, entities that are characterized as nonprofits who measure their success in
meeting their objectives in ways other than via profit.
A classified income statement subtracts expenses in this order:
Cost of goods sold is deducted first (from sales), and the result is gross profit.
Operating expenses are deducted from gross profit, and the result is operating profit.
Interest expenses are deducted from operating profit, and the result is pretax profit.
Lastly, income tax expenses are deducted from pretax profit, and the final result is net
income.
There are intermediate steps between revenues and net income, in other words.
5.2 The Balance Sheet
A balance sheet reflects a company’s financial health as of a point in time. It is composed of:
Assets=Liabilities+Owner ’ s Equity
Assets on the left side are resources available to the firm to generate revenues, profits, and
cash flow. The right side consists of two elements: a) liabilities and b) owner’s equity, and it
shows how the resources on the left side were funded.
Liabilities are funds owed to suppliers, banks, employees, and other creditors.
Owner’s equity represents funding via contributed capital (i.e., obtained from its owners
or stockholders) or earned capital (i.e., earnings retained and not distributed by the
company).
03/21/22 2
Instructor’s Manual for Principles of Finance
03/21/22 1
, Instructor’s Manual for Principles of Finance
Chapter 5
Financial Statements
Chapter Summary
This chapter discusses the nature of financial statement reporting, its key elements, and the
significance of the major financial statements. Additional topics include the measurement of
operating cash flow and free cash flow and the use of common-size financial statements in
analyzing a firm’s operations.
Lecture Outline
5.1 The Income Statement
The purpose of an income statement is to determine a firm’s profitability for a specified period
of time. It summarizes the result of revenues and expenses recognized and incurred for a
period of time.
Profitability is defined as: Revenues less Expenses
In instances when revenues are greater than expenses, a firm has net income and is profitable,
and when expenses are greater than revenues, the firm has a net loss and is unprofitable.
There are, of course, entities that are characterized as nonprofits who measure their success in
meeting their objectives in ways other than via profit.
A classified income statement subtracts expenses in this order:
Cost of goods sold is deducted first (from sales), and the result is gross profit.
Operating expenses are deducted from gross profit, and the result is operating profit.
Interest expenses are deducted from operating profit, and the result is pretax profit.
Lastly, income tax expenses are deducted from pretax profit, and the final result is net
income.
There are intermediate steps between revenues and net income, in other words.
5.2 The Balance Sheet
A balance sheet reflects a company’s financial health as of a point in time. It is composed of:
Assets=Liabilities+Owner ’ s Equity
Assets on the left side are resources available to the firm to generate revenues, profits, and
cash flow. The right side consists of two elements: a) liabilities and b) owner’s equity, and it
shows how the resources on the left side were funded.
Liabilities are funds owed to suppliers, banks, employees, and other creditors.
Owner’s equity represents funding via contributed capital (i.e., obtained from its owners
or stockholders) or earned capital (i.e., earnings retained and not distributed by the
company).
03/21/22 2
