Szabist Ibf Spring08 Lec2

Financial Statements & Common Size Statements Lecture -2

Introduction to Business Finance (BA 5401) Prepared by: Sunilla Faisal Spring 08 http://ba5401.googlepages.com

Contents • What are Financial Statements? • Importance of Finacial Statements • Types of Statements (Income, Retained Earnings, Cash Flow & Balance Sheet). • Comparison of Income Statement & Balance Sheet • Common Size Statements. • Book Values in Finance 2

What are Financial Statements? Financial Statements are like fine perfume – to be sniffed but not swallowed. (Abraham Brilloff)

• Financial Statements provide an overview of a business’ financial condition in both short and long term. (OR) • Financial statements are the medium by which a company discloses information concerning its financial performance.

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Importance of Financial Statements •

Internally – Plan - Focus on assessing the current financial position and evaluating potential firm opportunities. – Control - Focus on return on investment for various assets and asset efficiency. – Understand - Focus on understanding how suppliers of funds analyze the firm.

• Externally – Trade Creditors - Focus on the liquidity of the firm. – Bond Holders - Focus on the

long-term cash flow of the firm

– Shareholders - Focus on the profitability and long-term health of the firm. 4

Financial Statements – The System Financial statements paint a picture of the transactions that flow through a business. Each transaction or exchange - for example, the sale of a product or the use of a rented a building block - contributes to the whole picture. •

Let's approach the financial statements by following a flow of cash-based transactions. In the illustration (left), we have numbered four major steps:

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Financial Statements – The System 1) Shareholders and lenders supply capital (cash) to the company. 2) The capital suppliers have claims on the company. The balance sheet is an updated record of the capital invested in the business. On the right-hand side of the balance sheet, lenders hold liabilities and shareholders hold equity. The equity claim is "residual", which means shareholders own whatever assets remain after deducting liabilities. The capital is used to buy assets, which are itemized on the left-hand side of the balance sheet. The assets are current, such as inventory, or long-term, such as a manufacturing plant.

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Financial Statements – The System 3) The assets are deployed to create cash flow in the current year .Selling equity and issuing debt start the process by raising cash. The company then "puts the cash to use" by purchasing assets in order to create (build or buy) inventory. The inventory helps the company make sales (generate revenue), and most of the revenue is used to pay operating costs, which include salaries. 4) After paying costs (and taxes), the company can do three things with its cash profits. One, it can (or probably must) pay interest on its debt. Two, it can pay dividends to shareholders at its discretion. And three, it can retain or re-invest the remaining profits. The retained profits increase the shareholders' equity account (retained earnings). 7

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Types of Financial Statements • Profit & Loss Account / Statement (Income Statement) • Balance Sheet • Statement of Retained Earnings. • Cash Flow Statement.

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Income Statement • Also referred to as Profit & Loss Account. • The Income Statement shows a firm's revenues and expenses, and taxes associated with those expenses for some financial period. Where the Balance Sheet may be thought of in terms of the "left–right" orientation previously discussed, the income statement would be thought of in "top–down" terms. (OR) • An Income Statement, is a financial statement for companies that indicates how Revenue (money received from the sale of products and services before expenses are taken out, also known as the "top line") is transformed into net income (the result after all revenues and expenses have been accounted for, also known as the "bottom line"). The purpose of the income statement is to show managers and investors whether the company made or lost money during the period being reported. 10

Income Statement • Usefulness & Limitations – Income statements should help investors and creditors determine the past performance of the enterprise, predict future performance, and assess the capability of generating future cash flows. – However, information of an income statement has several limitations: – The items that might be relevant but cannot be reliably measured are not reported (e.g. brand recognition and loyalty) – some numbers depend on different accounting methods used (e.g. using FIFO or LIFO accounting to measure inventory level) – some numbers depend on judgments and estimates (e.g. depreciation expense depends on estimated useful life and salvage value).

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Income Statement Net Sales

b

$

Cost of Goods Sold Gross Profit

2,211

•

a. Measures profitability over a time period.

•

b. Amount received, or receivable, from customers.

•

c. Sales comm., adv., officers’ salaries, etc.

•

d. Operating income.

•

e. Cost of borrowed funds.

•

f.

•

g. Amount earned for shareholders.

1,599 $

SG&A Expenses c EBITd 210 Interest Expensee 59

612 402

EBT f Income Taxes

$

EATg

$

Cash Dividends Increase in RE

(a)

151 60 91 38

$

53

$

Taxable income.

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Income Statement – another example

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Retained Earnings • Retained Earnings shows the amount of income allowed to accumulate from the beginning of the corporation’s life to the present. • Retained Earnings represents a claim on assets, but it is not cash. Retained earnings, Dec 31, 20x4 (original)

$390,000

Less: Prior-period adjustments – to correct error in the 20x4 income tax Retained earnings, Dec. 31, 20x4, adjusted Net income for 20x5 Total Deduct: Dividends declared in 20x5 Retained earnings, December 31, 20x5

10,000 $380,000 114,000 $494,000 41,000 $453,000

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Balance Sheet • It is a statement detailing what a company owns (assets) and claims against the company (liabilities and owners' equity) on a particular date. Keeping in mind the assets and claims, it is helpful to remember the "left–right" accounting equation orientation—assets on the left side, claims on the right. (OR) • Balance sheet or statement of financial position is a summary of a persons or organization's assets, liabilities and Ownership equity on a specific date, such as the end of its financial year. A balance sheet is often described as a snapshot of a company's financial condition.

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Cash Flow Statement •

A cash flow statement or statement of cash flows is a financial statement that shows a company's incoming and outgoing money (sources and uses of cash) during a time period (often monthly or quarterly). The statement shows how changes in balance sheet and income accounts affected cash and cash equivalents, and breaks the analysis down according to operating, investing, and financing activities.

•

As an analytical tool the statement of cash flows is useful in determining the short-term viability of a company, particularly its ability to pay bills.

•

People and groups interested in cash flow statements include: – accounting personnel, who need to know whether the organization will be able to cover payroll and other immediate expenses – potential lenders or creditors, who want a clear picture of a company's ability to repay – potential investors, who need to judge whether the company is financially sound – potential employees or contractors, who need to know whether the company will be able to afford compensation 16

Cash Flow Statement - Sample

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Balance Sheet • A company balance sheet has three parts: assets, liabilities and shareholders' equity. The main categories of assets are usually listed first and are followed by the liabilities. The difference between the assets and the liabilities is known as the net assets or the net worth of the company. According to the accounting equation, net worth must equal assets minus liabilities.

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Balance Sheet (a) - contd Cash and C.E. Acct. Rec.c Inventories Prepaid Exp d Accum Tax Prepay Current Assets

Less: Acc. Depr. Net Fix. Assets Investment, LT Other Assets, LT

•

a. How the firm stands on a specific date.

•

b. What BW owned.

•

c. Amounts owed by customers.

•

d. Future expense items already paid.

•

e. Cash and other liquid assets easily convertible to cash within 1 year.

•

f. Original amount paid.

•

g. Acc. deductions for wear and tear.

$1,195

e

Fixed Assets (@Cost)

Total Assets b

$ 90 394 696 5 10

g

f

1030 (329) $701 50 223 $2,169

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Types of Balance Sheet • Personal balance sheet - A personal balance sheet lists current assets such as cash in checking accounts and savings accounts, long-term assets such as common stock and real estate, current liabilities such as loan debt and mortgage debt due or overdue, and long-term liabilities such as mortgage and other loan debt. Securities and real estate values are listed at market value rather than at historical cost or cost basis. Personal net worth is the difference between an individual's total assets and total liabilities. • Small business balance sheet - A small business balance sheet lists current assets such as cash, accounts receivable, and inventory, fixed assets such as land, buildings, and equipment, intangible assets such as patents, and liabilities such as accounts payable, accrued expenses, and long-term debt. Contingent liabilities such as warranties are noted in the footnotes to the balance sheet. The small business's equity is the difference between total assets and total liabilities. 20

Balance Sheet Structure

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Income Statement Vs Balance Sheet •

Communicates inflows and outflows of assets – inflows being the revenues generated and outflows are the expenses.

•

Excess of Inflows over Outflows  Net Income.

•

Excess of Outflow over Inflows  Net Loss.

•

Revenue – Expenses = Net Income (Loss)

•

Always prepared for a period of time and the term “for the period ended” is included in the title.

•

Communicates what the entity owns in terms of assets, liabilities and the difference between the two, representing what the owners are entitled to.

•

Owners portion is called Equity.

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Assets = Liabilities + Equity

•

Snapshot of an organizations’ assets, liabilities and equity at one point in time.

•

Always prepared for a point in time and the term “as at” included in the title.

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Income Statement Vs Balance Sheet

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Common-Size Statements • An analysis of percentage financial statements where all balance sheet items are divided by total assets and all income statement items are divided by net sales or revenues. • On a common-size income statement, each item is expressed as a percentage of net sales. • In the balance sheet, the common size is total assets. • A common-size statement eases the comparison of different companies. • There are also used to compare the company to a specific company. • Enables valid comparisons over time or against competition.

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Common-Size Balance Sheet Regular (thousands of $) Assets

2005

2006

2007

Common-Size (%) 2005

2006

2007

Cash AR Inv Other CA

148 283 322 10

100 410 616 14

90 394 696 15

12.10 23.14 26.33 0.82

4.89 20.06 30.14 0.68

4.15 18.17 32.09 0.69

Tot CA Net FA LT Inv Other LT

763 349 0 111

1,140 631 50 223

1,195 701 50 223

62.39 28.54 0.00 9.08

55.77 30.87 2.45 10.91

55.09 32.32 2.31 10.28

1,223

2,044

2,169

100.0

100.0

100.0

Tot Assets

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Common-Size Balance Sheet

Regular (thousands of $) Liab+Equity

2005

2006

2007

Common-Size (%) 2005

2006

2007

Note Pay Acct Pay Accr Tax Other Accr

290 81 13 15

295 94 16 100

290 94 16 100

23.71 6.62 1.06 1.23

14.43 4.60 0.78 4.89

13.37 4.33 0.74 4.61

Tot CL LT Debt Equity

399 150 674

505 453 1,086

500 530 1,139

32.62 12.26 55.11

24.71 22.16 53.13

23.05 24.44 52.51

Tot L+E

1,223

2,044

2,169

100.0

100.0

100.0

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Common-Size Income Statement

Regular (thousands of $) 2005 Net Sales COGS

2006

2007

Common-Size (%) 2005

2006

2007

1,235 849

2,106 1,501

2,211 1,599

100.0 68.7

100.0 71.3

100.0 72.3

Gross Profit Adm.

386 180

605 383

612 402

31.3 14.6

28.7 18.2

27.7 18.2

EBIT Int Exp

206 20

222 51

210 59

16.7 1.6

10.5 2.4

9.5 2.7

EBT

186

171

151

15.1

8.1

6.8

EAT

112

103

91

9.1

4.9

4.1

Cash Div

50

50

50

4.0

2.4

2.3 27

Book Values in Finance • Book Value represents the value of an asset as recorded on the financial statements (books) of a company. • These are results of accounting procedures and reflect how the accountant is keeping track of a particular asset. • Book values exist for all assets and liabilities that a firm owns (plant, equipment, equity, bonds, short-term obligations, etc.) • Book Value (physical asset) = Purchase price – Accumltd Dep • Book Value (Financial Asset) = Total S.H.E / # of shares

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Thank you

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Backup Slides

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Financial Statements Tutorial

Microsoft PowerPoint Presentation

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