Chapter 3

UNDERSTANDING FINANCIAL STATEMENTS & CASH FLOWS

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Slide Contents
1. The Income Statement 2. The Balance Sheet

3. Measuring Cash Flows

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1. The Income Statement

It is also known as Profit/Loss Statement It measures the results of firms operation over a specific period.

The bottom line of the income statement shows the firms profit or loss for a period.
Sales Expenses = Profits

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Income Statement Terms

Revenue (Sales)
Money derived from selling the companys product or service

Cost of Goods Sold (COGS)

The cost of producing or acquiring the goods or services to be sold

Operating Expenses
Expenses related to marketing and distributing the product or service and administering the business

Financing Costs
The interest paid to creditors

Tax Expenses
Amount of taxes owed, based upon taxable income

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Figure 3-1 (cont.)

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Common-size Income Statement

Common-size income statement restates the income statement items as a percentage of sales. Common-size income statement makes it easier to compare trends over time and across firms in the industry.

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Table 3-2

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Profit-to-Sales analysis from Common-size income statement

See Table 3-2
Gross profit margin (or percentage of sales going towards gross profit) is 23.3% Operating profit margin (or percentage of sales going towards operating profit) is 12.5% Net profit margin (or percentage of sales going towards net profit) is 7%
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2. The Balance Sheet

The balance sheet provides a snapshot of a firms financial position at a particular date. It includes three main items: assets, liabilities and equity.
Assets (A) are resources owned by the firm Liabilities (L) and owners equity (E) indicate how those resources are financed

A=L+E
The transactions in balance sheet are recorded historically at cost price, BV current market value.

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Figure 3-3

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Balance Sheet Terms: Assets

Current assets comprise assets that are relatively liquid, or expected to be converted into cash within 12 months. Current assets typically include:
Cash Accounts Receivable (payments due from customers who buy on credit) Inventory (raw materials, work in process, and finished goods held for eventual sale) Other assets (ex.: Prepaid expenses are items paid for in advance)

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Balance Sheet Terms: Assets

Fixed Assets assets that will be used for
Machinery and equipment Buildings Land

1 year.

Other Assets long-term investments intangible assets (patents, copyrights, and goodwill)

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Balance Sheet Terms: Liabilities

Debt (Liabilities)
Money that has been borrowed from a creditor and must be repaid at some predetermined date. Debt could be current (must be repaid within twelve months) or long-term (repayment time exceeds one year).

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Balance Sheet Terms: Liabilities

Current Debt:
Accounts payable (Credit extended by suppliers to a firm when it purchases inventories) Accrued expenses (Short term liabilities incurred in the firms operations but not yet paid for) Short-term notes (Borrowings from a bank or lending institution due and payable within 12 months)

Long-Term Debt
Borrowings from banks and other sources for more than 1 year

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Balance Sheet Terms: Equity

Equity: Shareholders investment in the firm in the form of preferred stock and common stock. Preferred stockholders enjoy preference with regard to payment of dividend and seniority at settlement of bankruptcy claims. Treasury Stock: Stock that have been re-purchased by the company. Retained Earnings: Cumulative total of all the net income over the life of the firm, less common stock dividends that have been paid out over the years. Note retained earnings are not equal to hard cash!

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Balance Sheet: A = L + E
ASSETS (A)
Current Assets Fixed Assets

LIABILITIES (L)
Current Liabilities Long-Term Liabilities

Total Assets

Total Liabilities OWNERS EQUITY (E)

Preferred Stock Common Stock Retained earnings

Total Owners Equity Total liabilities + Equity

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Net Working Capital

NWC = Current assets current liabilities

Larger the net working capital, better the firms ability to repay its debt
Net working capital can be or 0 or

An increase in net working capital may not always be good news. For example, if the level of inventory goes up, current assets will increase and thus net working capital will also increase. However, increasing inventory level may well be a sign of inability to sell.
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Debt Ratio
Debt ratio is the percentage of assets that are financed by debt.

Debt ratio is an indication of financial risk. Generally, higher the ratio, the more risky the firm is, as firms have to pay interest on debt regardless of the earnings or cash flow situation.

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3. Measuring Cash Flows

Profits in the financial statements are calculated on accrual basis rather than cash basis What is accrual basis?

Thus profits are not equal to cash.

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Accrual Basis Accounting

Accrual basis is the principle of recording 1) revenues when earned (include credit sales) 2) expenses when incurred (include credit purchases) rather than when cash is received or paid.
Thus sales revenue recorded in the income statement includes both cash and credit sales.

Treatment of long-term assets: written off every year as depreciation expense.

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Figure 3-6

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Three sources of cash flows

Cash flows from Operations (ex. Sales revenue, labor expenses)

Cash flows from Investments (ex. Purchase of new equipment) Cash flows from Financing (ex. Borrowing funds, payment of dividends)

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Three sources of cash flows (cont.)

If we know the cash flows from operations, investments and financing =>we can understand the firms cash flow position better, that is, how cash was generated and how it was used.

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Income Statement Conversion: From Accrual to Cash Basis

Two steps:
Add back depreciation (as it is a noncash expense) to net income Subtract any uncollected sales (i.e. increase in accounts receivable) and cash payment for inventories (i.e. increase in inventories less increase in accounts payables)
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Figure 3-7

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Table 3-5

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Table 3-6

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Table 3-7

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Figure 3-2 (cont.)

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Figure 3-4

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Table 3-4

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TUTORIAL

Please prepare answers for the following STUDY PROBLEMS before attending tutorial next week: CHAPTER 2 2.1, 2.4 & 2.5 CHAPTER 3 3.3 & 3.5
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