Finman - FINANCIAL STATEMENTS

Basic Financial Statements
Following four types of financial statements are mandated by the accounting and financial regulatory authorities:
1. 2. 3. 4. Income statement Balance sheet Cash flow statement Statement of shareholders equity
Copyright 2011 Pearson Prentice Hall. All rights reserved.
3-1
Basic Financial Statements (cont.)

1. Income Statement:
An income statement provides the following information for a specific period of time (for example, a year or 6 months or 3 months):
Revenue, Expenses, and Profit.
3-2

2. Balance sheet:
Balance sheet provides a snap shot of the following on a specific date (for example, as of December 31, 2010)
Assets (value of what the firm owns), Liabilities (value of firms debts), and Shareholders equity (the money invested by the company owners).
3-3

3. Cash flow statement:
It reports cash received and cash spent by the firm over a period of time (for example, over the last 6 months).
3-4

4. Statement of shareholders equity:
It provides a detailed account of the firms activities in the following accounts over a period of time (for example, last six months):
Common stock account, Preferred stock account, Retained earnings account, and Changes to owners equity.
3-5
Why Study Financial Statements?

Analyzing a firms financial statement can help managers carry out three important tasks: 1. Assess current performance through financial statement analysis, 2. Monitor and control operations, and 3. Forecast future performance.
3-6
What are the Accounting Principles Used to Prepare Financial Statements?

The following three fundamental principles are adhered to by accountants when preparing financial statements: 1. The revenue recognition principle, 2. The matching principle, and 3. The historical cost principle. An understanding of these basic principles allows us to be a more informed user of financial statements.
3-7
What are the Accounting Principles Used to Prepare Financial Statements? (cont.) 1. The revenue recognition principle:
It states that the revenue should be included in the firms income statement for the period in which: Its goods and services were exchanged for cash or accounts receivable; or The firm has completed what it must do to be entitled to the cash.
3-8
What are the Accounting Principles Used to Prepare Financial Statements? (cont.) 2. The matching principle:
This principle determines whether specific costs or expenses can be attributed to this periods revenues. The expenses are matched with the revenues they helped produce.
For example, employees salaries are recognized when the product produced as a result of that work is sold, and not when the wages were paid.
3-9
What are the Accounting Principles Used to Prepare Financial Statements? (cont.) 3. The historical cost principle:
This principle provides the basis for determining the dollar values the firm reports in its balance sheet. Most assets and liabilities are reported in the firms financial statements at historical cost i.e. the price the firm paid to acquire them. The historical cost generally does not equal the current market value of the assets or liabilities.
3-10
An Income Statement
An income statement is also called a profit and loss statement. An income statement measures the amount of profits generated by a firm over a given time period (usually a year or a quarter).
3-11
An Income Statement (cont.)

Income statement can be expressed as follows:
Revenues (or Sales) Expenses = Profits
3-12

An income statement will contain the following basic elements:
1. Revenues 2. Expenses
Cost of goods sold, Interest expenses, SGA (selling, general and administrative) expense, depreciation expense, Income tax expense
3. Profits
Gross profit, net operating income (also known as EBIT), earnings before taxes (EBT), and net income
3-13

Sales
= Gross Profit Minus Operating Expenses
Minus Cost of Goods Sold
= Operating income (EBIT) Minus Interest Expense = Earnings before taxes (EBT) Minus Income taxes
Selling expenses General and Administrative expenses Depreciation and Amortization Expense
= Net income (EAT)

EBIT = Earnings before interest and taxes; EBT = Earnings before taxes; EAT = Earnings after taxes
3-14
Sample Income Statement
3-15
Evaluating a Firms EPS and Dividends

We can use the income statement to determine the earnings per share (EPS) and dividends. EPS = Net income Number of shares outstanding
3-16
Evaluating a Firms EPS and Dividends (cont.)

Example 1: A firm reports a net income $90 million and has 35 million shares outstanding, what will be the earnings per share (EPS)? EPS = Net income Number of shares = $90 million $35 million = $2.57
3-17

We can determine the dividends paid by the firm to each shareholder by dividing the total amount of dividend (reported on the income statement) by the total number of shares outstanding. Dividends per share = Net income Number of shares
3-18

Example 2: A firm reports dividend payment of $20 million on its income statement and has 35 million shares outstanding. What will be the dividends per share? Dividends per share = Net income Number of shares = $20 million $35 million = $0.57
3-19
Connecting the Income Statement and the Balance Sheet

What can the firm do with the net income?:
1. Pay dividends to shareholders, and/or 2. Reinvest in the firm
3-20
Connecting the Income Statement and the Balance Sheet (cont.)

Example 3: Review examples 1 & 2. How much was retained or reinvested by the firm? Amount retained = Net Income Dividends = $90m - $20m = $70m The firms balance on retained earnings will increase by $70 million on the balance sheet.
3-21
Interpreting Firm Profitability using the Income Statement

What can we learn from H.J. Boswell Inc.s income statement (Table 3-1)?
1. The firm has been profitable as its revenues exceeded its expenses.
3-22
Interpreting Firm Profitability using the Income Statement (cont.)

2. The gross profit margin (GPM) = gross profits sales = $675 million $2,700 million = 25%
GPM indicates the firms mark-up on its cost of goods sold per dollar of sales.
3-23

3. The operating profit margin = net operating income sales = $382.5 million $2,700 million = 14.17%
The operating profit margin is equal to the ratio of net operating income or EBIT divided by firms sales.
3-24

Net profit margin: = net profits sales = $204.75 million $2,700 million = 7.58%
Net profit margin indicates the percentage of revenues left after all expenses (including interest and taxes) have been considered.
3-25

These profit margins (gross profit margin, operating profit margin, and net profit margin) should be closely monitored and compared to previous years and those of competing firms.
3-26
GAAP and Earnings Management

While the firms must adhere to set of accounting principles, GAAP (Generally Accepted Accounting Principles), there is considerable room for managers to influence the firms reported earnings. Managers have an incentive to tamper with reported earnings as their pay depends upon it and investors care about it.
3-27
Corporate Taxes
A firms income tax liability is calculated using its taxable income and the tax rates on corporate income.
3-28
The Balance Sheet

The balance sheet provides a snapshot of the firms financial position on a specific date.
The balance sheet is defined by the following equation:

Total Assets = Total Liabilities + Total Shareholders Equity
3-29
The Balance Sheet (cont.)

Total assets represents the resources owned by the firm. Total liabilities represent the total amount of money the firm owes its creditors Total shareholders equity refers to the difference in the value of the firms total assets and the firms total liabilities.
3-30

In general, GAAP requires that the firm report assets on its balance sheet using the historical costs. Cash and assets held for sale (such as marketable securities) are an exception to the rule. These assets are reported using the lower of their cost or current market value.
3-31

Assets whose value is expected to decline over time (such as equipment) is reported as net equipment which is equal to the historical cost minus accumulated depreciation. Note, the net value reported on balance sheet could be significantly different from the market value of the asset.
3-32
3-33

The balance sheet includes the following main components: 1.Assets Found on the left-hand side of the balance sheet. It includes current assets and fixed assets. 2.Sources of financing Found on the right-hand side of the balance sheet. It includes current liabilities, long-term liabilities, and owners equity.
3-34

Current assets consists of firms cash plus other assets the firm expects to convert to cash within 12 months or less, such as receivables and inventory. Fixed assets are assets that the firm does not expect to sell within one year. For example, plant and equipment, land.
3-35

Current liabilities represent the amount that the firm owes to creditors that must be repaid within a period of 12 months or less such as accounts payable, notes payable. Long-term liabilities refer to debt with maturities longer than a year such as bank loans, bonds.
3-36

The stockholders equity is broken down into two components:
(1) The amount the company received from selling stock to investors. It may be shown as common stock in the balance sheet or it may be divided into two components: par value and additional paid in capital above par. Par value is the stated or
face value a firm puts on each share of stock. Paid in capital is the additional amount the firm raised when it sold the shares.
3-37

For example, DLK corporations par value per share is $2.00 and the firm has 30 million shares outstanding such that the par value of the firms common equity is $60 million. If the stocks were issued to investors for $240 million, $180 million represents paid in capital.
3-38

(2) The amount of the firms retained earnings. Retained earnings are the portion of net income that has been retained (i.e. not paid in dividends) from prior years operations. Thus stockholders equity = Par value of common stock + Paid in Capital + Retained Earnings
3-39

We can also express stockholders equity as follows:
Shareholders' equity = Total Assets Total Liabilities
3-40
Firm Liquidity and Net Working Capital

Liquidity refers to the speed with which an the asset can be converted to cash without loss of value.
For example, a firms bank account is perfectly liquid. Other types of assets are less liquid as they more difficult to sell and convert to cash such as PPE (property, plant and equipment).
3-41
Firm Liquidity and Net Working Capital

For the overall firm, liquidity generally refers to the firms ability to covert its current assts (accounts receivable and inventories) into cash so that it can pay its bills (current liabilities) on time. We can thus measure a firms liquidity by computing the net working capital = current assets current liabilities
3-42
Firm Liquidity and Net Working Capital (cont.)

If a firms net working capital is significantly positive, it is in a good position to pay its debts on time and is consequently very liquid. Lenders consider the net working capital as an important indicator of firms ability to repay its loans.
3-43
The Balance Sheet
3-44
Debt and Equity Financing

The right-hand side of the balance sheet reveals the sources of money used to finance the purchase of the firms assets listed on the left-hand side of the balance sheet. It shows how much was borrowed (debt financing) and how much was provided by firms owners (equity financing, through the sale of equity or retention of prior years earnings).
3-45
Debt versus Equity

Payment: Payment for debt holders is generally fixed (in the form of interest); Payment for equity holders (dividends) is not fixed nor guaranteed. Seniority: Debt holders are paid before equity holders in the event of bankruptcy. Maturity: Debt matures after a fixed period while equity securities do not mature.
3-46
Book Values, Historical Costs, and Market Values

Book values (based on historical cost) reported in the balance sheet can differ from market values. The gap between book value and market value is likely to be higher for fixed assets relative to current assets for two reasons:
Inflation affects the market price of asset; and Depreciation adjustments in the balance sheet do not reflect actual changes in market values.
3-47
The Cash Flow Statement

The Cash Flow Statement is used by firms to explain changes in their cash balances over a period of time by identifying all of the sources and uses of cash.
3-48
Sources and Uses of Cash

Source of cash is any activity that brings cash into the firm. For example, sale of equipment.
Use of cash is any activity that causes cash to leave the firm. For example, payment of taxes.
3-49
Balance Sheet for H.J. Boswell, Inc.
3-50
Cash Flow Analysis

Why did the cash balance decline by $4.5 million from 2009 to 2010? 1.Accounts receivable increased by $22.5 million representing an increase in uncollected cash from credit sales. Thus it represents $22.5m of use of cash to invest in accounts receivable.
3-51
Cash Flow Analysis (cont.)

2. Inventory increased by $148.50 million indicating use of cash to procure inventory. 3. Equipment increased by $175.50 million indicating use of cash to invest in equipment. In general,
an increase in an asset account = use of cash a decrease in an asset account = source of cash
3-52

4. Accounts Payable, credit extended to the firm, increased by $4.5million. Thus source of cash increased by $4.5million due to accounts payable. 5. Long-term debt increased by $51.75 million indicating a source of cash. 6. Short-term debt decreased by $9 million indicating use of cash to pay off the debt.
3-53

7. Retained earnings increased by $159.75 million representing a source of cash to the firm from the firms operations.
In general,
An increase in a liability account = source of cash A decrease in a liability account = use of cash
3-54

Change in cash balance = Sources of cash Use of Cash = $216 - $220.50 = -$4.50
Sources of Cash
Increase in Accounts Payable = $4.50 Increase in long-term debt =$51.75 Increase in retained earnings = $159.75
Uses of Cash
Increase in Accounts Receivable $22.50 Increase in inventory = $148.50 Increase in net plant and equipment = $40.50 Decrease in short-term notes = $9
Total Sources of cash = $216.00

Total Uses of cash = $220.50

3-55

An analysis of H.J. Boswells operations reveals the following for 2010: The firm used more cash than it generated, resulting in a deficit of $4.5 million The primary source of cash flow was retained earnings ($159.75 million) followed by longterm debt ($51.75 million) The largest use of cash was for acquiring inventory at $148.5 million.
3-56
Cash Flow Analysis Summary

Sources of Cash Uses of Cash
Decrease in an asset account Increase in a liability account Increase in an owners equity account
Increase in an asset account Decrease in a liability account Decrease in an owners equity account
3-57
Cash Flow Statement

The format for a traditional cash flow statement is as follows: Beginning Cash Balance Plus: Cash Flow from Operating Activities Plus: Cash Flow from Investing Activities Plus: Cash Flow from Financing Activities Equals: Ending Cash Balance
3-58
Cash Flow Statement (cont.)

Operating activities represent the companys core business including sales and expenses. Basically any activity that affects net income for the period. Investing activities include the cash flows that arise out of the purchase and sale of long-term assets such as plant and equipment.
3-59
Cash Flow Statement (cont.)

Financing activities represent changes in the firms use of debt and equity such as issue of new shares, payment of dividends.
3-60
H.J. Boswell, Inc. Statement of Cash Flows
3-61

Finman - FINANCIAL STATEMENTS

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Finman - FINANCIAL STATEMENTS

Uploaded by

Copyright:

Available Formats

Basic Financial Statements

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Basic Financial Statements (cont.)

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Basic Financial Statements (cont.)

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Basic Financial Statements (cont.)

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Basic Financial Statements (cont.)

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Why Study Financial Statements?

Copyright 2011 Pearson Prentice Hall. All rights reserved.

What are the Accounting Principles Used to Prepare Financial Statements?

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Copyright 2011 Pearson Prentice Hall. All rights reserved.

An Income Statement (cont.)

Copyright 2011 Pearson Prentice Hall. All rights reserved.

An Income Statement (cont.)

Copyright 2011 Pearson Prentice Hall. All rights reserved.

An Income Statement (cont.)

= Gross Profit Minus Operating Expenses

Minus Cost of Goods Sold

= Net income (EAT)

Sample Income Statement

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Evaluating a Firms EPS and Dividends

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Evaluating a Firms EPS and Dividends (cont.)

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Evaluating a Firms EPS and Dividends (cont.)

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Evaluating a Firms EPS and Dividends (cont.)

Connecting the Income Statement and the Balance Sheet

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Connecting the Income Statement and the Balance Sheet (cont.)

Interpreting Firm Profitability using the Income Statement

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Interpreting Firm Profitability using the Income Statement (cont.)

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Interpreting Firm Profitability using the Income Statement (cont.)

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Interpreting Firm Profitability using the Income Statement (cont.)

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Interpreting Firm Profitability using the Income Statement (cont.)

Copyright 2011 Pearson Prentice Hall. All rights reserved.

GAAP and Earnings Management

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Copyright 2011 Pearson Prentice Hall. All rights reserved.

The Balance Sheet

The balance sheet is defined by the following equation:

Copyright 2011 Pearson Prentice Hall. All rights reserved.

The Balance Sheet (cont.)

Copyright 2011 Pearson Prentice Hall. All rights reserved.

The Balance Sheet (cont.)

Copyright 2011 Pearson Prentice Hall. All rights reserved.

The Balance Sheet (cont.)

Copyright 2011 Pearson Prentice Hall. All rights reserved.

The Balance Sheet (cont.)

Copyright 2011 Pearson Prentice Hall. All rights reserved.