Let's take a moment to discuss some key observations and insights from the first two years of financial statements for the garden spot. It's important for managers to step back and see what they can learn from the financial information that has been compiled for their use. So, let's go through the financial statements together and see how we might do that. We won't do anything too sophisticated, but there are certainly a lot we can learn from looking at some of the basic relationships on these financial statement. Here are some examples of what we might glean. From the Income statement, we can get a sense of whether, and how much the company is growing. Determine how profitable it is. And get a sense of the relationship between the company's revenues and costs. From the statement of cash flows, we can see whether cash flow is positive or negative. Whether the company is generating cash from its day-to-day operations, what it is investing in. And how it is financing those investments? From the Balance sheet we can see what type of assets the company has. How it has chosen to finance the purchase of those assets, and how much in earnings the company has retained since its inception. Okay, let's dive into the income statement. We have the income statement for years one and two. Where might we start looking? Well first, let's look at revenues. Revenues grew, By 25% From Year 1 to Year 2. Is that a lot? It's important for us to have something to compare to when we look at some of these numbers. We don't really have a comparison for that 25% until we see the financial statements for year three. But my instinct is that for a startup company, that's probably pretty good. Second, let's look at how much income the company generated from it sales, this way show is called return on sales, ROS and its calculated by taking net income divided by sales. This is a ratio that's commonly used to assess profitability. Now return on sales for year one was 1.4%. We can take net income and divide by sales to get the 1.4%. And for Year 2, it increased to 5.9% of the $29,325 divided by the $500,000 in sales. Companies also often calculate what is called a gross margin. Gross margin is defined as revenues minus cost of goods sold. I can put that right in here. It tells us how much profit is remaining after subtracting out the cost of the product itself. To cover the company's other costs like selling, general and administrative expenses, and interest expenses. Here, the gross margin in Year 1 is 160 thousand. Or the sales minus the cost of goods sold and in Year 2 it's 200,000. The 500 in sales minus the 300 in cost of goods sold. We can also calculate a gross margin percent. Which, is another ratio that helps assess profitability. Here the gross margin percent. Which is the gross margin divided by sales, is 40% in both years. So that stayed constant. So let's go back to return on sales. Why did ROS, or return on sales, increase from Year 1 to Year 2? Can we tell from the income statement what might've led to that increase? Well, let's look at the relationship between revenues and some of the costs on the statement. Let's look at the cost of goods sold as a percent of revenues. If we divide cost of goods sold, divided by revenues, we say that that was 60%. And we do the same thing for Year 2, 60%. So that was a cost that maintained its relationship with sales from Year 1 to Year 2. Which explains, obviously, why the gross margin didn't change in Year 2. If I draw a graph here, with revenues on the horizontal axis, and costs on the vertical axis I see that in total cost of goods sold increases as revenues increase. We call that a variable. Cost that's a term that's used frequently in managerial accounting. I'm representing it here as a straight line on the graph since in this case it increases proportionately with revenues. Now look at operating expenses. These stayed relatively constant from Year 1 to Year 2. Not exactly, but close. We call that a fixed, Cost. Or a cost that stays the same regardless of revenues within a certain range. So what does this mean for Mary Jo? Well, I would infer that she has a certain group of costs, operating expenses that are probably relatively constant regardless of revenues up to a certain point. And so in year two when she was able to generate 25% more revenues with the same operating expenses, the return on sales was able to increase substantially.
