CHAPTER 2CHAPTER 2

ELEMENTS OF FINANCIAL ELEMENTS OF FINANCIAL STATEMENTS AND OTHER FINANCIAL STATEMENTS AND OTHER FINANCIAL

REPORTSREPORTS

OBJECTIVESOBJECTIVES

• Explain and analyze the main items in the financial statements.

• Identify off-balance-sheet financing• Discuss the component under the cash flow

statement and free cash flow.• Describe the link under financial statement and

types of footnote.

INTRODUCTIONINTRODUCTION

• Important things when looking at the financial statements:– Dates– Comparing results among companies.– Economic conditions are certainly different,

comparison doesn’t give you an accurate view of how well the companies competed in similar economic conditions.

TYPES OF FINANCIAL STATEMENT:TYPES OF FINANCIAL STATEMENT:

(1) Balance Sheet(1) Balance Sheet

(2) Income Statement(2) Income Statement

(3) Statement of Cash Flows(3) Statement of Cash Flows

(4) Statement of Retained Earnings(4) Statement of Retained Earnings

(1) BALANCE SHEET

Assets = Liabilities + Shareholders' Equity

• Assets represent the resources that the business owns or controls at a given point in time. This includes items such as cash, inventory, machinery and buildings.

• Liabilities represent obligations, which must be paid back.

• Equity represents the value of money that the owners have contributed to the business - including retained earnings, which is the profit made in previous years.

• The balance sheet tells investors a lot about a company's fundamentals:

– How much debt the company has, – How much it needs to collect from customers (and how

fast it does so), – How much cash and its equivalents it possesses and

what kinds of funds the company has generated over time.

Main Items in the Balance Sheet

• Assets– Current Assets are resources likely to be used up or

converted into cash within one business cycle - usually treated as twelve months. Three important current asset items found on the balance sheet are:

• Cash - Any item of economic value owned by an individual or corporation, especially that which could be converted to cash. Examples are cash, securities, accounts receivable, inventory, office equipment, real estate, a car, and other property.

• Inventories - The raw materials, work-in-process goods and completely finished goods that are considered to be the portion of a business's assets those are ready or will be ready for sale

• Accounts receivables - Money owed by customers (individuals or corporations) to another entity in exchange for goods or services that have been delivered or used, but not yet paid for

– Long-term or Non-Current Assets are defined as resources that not classified as current asset. This includes items that are fixed assets, such as property, plant and equipment (PP&E).

Beginning Inventory 75,000

Purchases 250,000

Plus: Freight-in 10,000

Less: purchase discounts (5,000)

Returns and allowances (15,000)

Net delivered cost of purchases 240,000

Total goods available for sale 315,000

Less: Cost of goods sold (255,000)

Ending inventory 60,000

• Liabilities – Current Liabilities are obligations the firm must pay

within a year, such as payments to suppliers. Current liabilities appear on the company's balance sheet and include short-term debts, accounts payable, accrued liabilities and other debts.

– Non-current Liabilities are those obligations of the business that are not expected to be paid for at least one year from the date on the balance sheet. Typically, non-current liabilities represent bank and bondholder debts.

• Equity

– Equity represents what shareholders own, so it is often called shareholder's equity. The two important equity items are:

• Paid-in capital is the amount of money shareholders paid for their shares when the stock was first offered to the public. It basically represents how much money the firm received when it sold its shares

• Retained earnings are the money the company has chosen to reinvest in the business rather than pay to shareholders (in terms of dividend). Investors should look closely at how a company puts retained capital to use and how a company generates a return on it.

Equity = Total Assets – Total Liabilities

• Off-Balance-Sheet Financing

– Companies will often use off-balance-sheet financing to keep their debt to equity (D/E) and leverage ratios low,

– Examples of off-balance-sheet financing include joint ventures, research and development partnerships, and operating leases (rather than purchases of capital equipment).

– Operating leases are one of the most common forms of off-balance-sheet financing. In these cases, the asset itself is kept on the lessor's balance sheet, and the lessee reports only the required rental expense for use of the asset.

Generally Accepted Accounting Principles and IRB have set numerous rules for companies to follow in determining whether a lease should be capitalized (included on the balance sheet) or expensed.

ABC CorpComparative Balance Sheet December 31

(RM in millions)

2007 2006

AssetsCurrent assets Cash Receivables Inventories Other current assets

95.8227.2103.773.6

80.0192.4107.545.2

Total current Assets 500.3 425.1

Noncurrent AssetsGross Property, plant, & equipment Accumulated depreciation & depletionNet Property, plant, & equipmentOther noncurrent assets

771.2(372.5)

398.742.2

646.6(379.9)

316.719.7

Total Noncurrent assets 440.9 336.4

Total AssetsLiabilities and Stockholders’ EquityCurrent liabilitiesAccount payableShort-term debtOther current liabilities

941.2114.2174.385.5

761.582.479.389.6

Total Current liabilities 374.0 251.3

Noncurrent liabilitiesLong-term debtOther noncurrent liabilities

177.894.9

190.9110.2

Total noncurrent liabilities 272.7 301.1

Total liabilitiesStockholders equityCommon sharesRetained earnings

646.792.6

201.9

552.4137.671.5

Total equity 294.5 209.1

Total Liabilities and Stockholders’ equity 941.2

761.5

EXAMPLE :

(2) INCOME STATEMENT(2) INCOME STATEMENT

• Income statement measures a company's performance over a specific time frame

• The income statement presents information about– Revenues – Expenses – Profit

• It also shows:– how much money the company generated (revenue)– how much it spent (expenses) – the difference between the company’s return (profit) over a

certain time period

• It also contains the numbers most often discussed when a company announces its results - numbers such as and

– earnings per share, – dividend per share

REVENUE

• Revenue as a signal Known as sales - represents all the money a company brought in during a specific time period, although big companies sometimes break down revenue by business segment or geography.

The best way for a company to improve profitability is by increasing sales. Consistent sales growth has been a strong driver of company’s profitability.

The best revenues are those that continue year in and year out. Temporary increases, such as those that might result from a short-term promotion, are less valuable and should garner a lower price-to-earnings multiple for a company.

What is Expenses?

• Two most common are:– Cost of goods sold (COGS) - the expense most directly

involved in creating revenue. It represents the costs of producing or purchasing the goods or services sold by the company

– Selling, general and administrative expenses (SG&A) - marketing, salaries, utility bills, technology expenses, other general costs associated with running a business, depreciation and amortization( a cost of replacing worn out assets), costs of taxes and interest payments.

For example, if Mydin pays a supplier RM4 for a box of soap, which it sells to customers for RM5. When it is sold, Mydin’s cost of goods sold for the box of soap would be RM4.

What is Profit?

• Several commonly used profit subcategories that tell investors how the company is performing.

– Gross profit is calculated as revenue minus cost of sales.

– Operating profit - the profit a company made from its actual operations, and excludes certain expenses and revenues that may not be related to its central operations.

Profits = Revenue - Expenses

Operating Profits = Gross Profit – Operating Expenses

Gross Profit = Revenue - COGS

What is net income?

• The company's profit after all expenses, including financial expenses, have been paid.

• • Often called the "bottom line" and is generally the figure people refer

to when they use the word "profit" or "earnings".

• When a company has a high profit margin, means that it has more advantages over its competitors. Companies with high net profit margins have a bigger cushion to protect themselves during the hard times.

• Companies with low profit margins can get wiped out in a downturn.

• Companies with profit margins reflecting a competitive advantage is able to improve their market share during the hard times - leaving them even better positioned when things improve again.

ABC CorpIncome statements

Fiscal year ended December 31(RM in millions)

2007 2006

Net salesCost of goods sold

1,938.01,128.5

1,766.21,034.5

Gross operating profit 809.5 731.7

Selling, administrative, and other operating expensesDepreciation & authorizationOther income, net

497.777.1

0.5

445.362.112.9

Earnings before interest & taxes 234.2 237.2

Interest expense 13.4 7.3

Earning before taxes 221.8 229.9

Income taxes 82.1 88.1

Net profit after taxDividends paid per shareEarnings per share (EPS)Number of common shares outstanding ( in millions)

138.7

0.152.2661.8

116.0 0.13

2.1765.3

(3) STATEMENT OF CASH FLOW(3) STATEMENT OF CASH FLOW

• Three core activities: – Cash is raised from the capital suppliers - cash flow

from financing, (CFF)

– Cash is used to buy assets - cash flow from investing (CFI)

– Cash is used to create a profit - cash flow from operations (CFO)

Sell Equity Issue Debt

< Buy Assets > < Buy Inventory >

Sell Equity Issue Debt

< Pay Dividend >

< Buy Assets >

Make Sales! < Pay Costs > < Pay Taxes >

Make Sales!< Buy Inventory >< Pay Costs >< Pay Taxes >< Pay Interest >

< Pay Dividend > < Pay Interest >

= NET CASH FLOW

“Natural” Cash Flow

Cash Flow StatementClassifications

Financing(CFF)

Investing(CFI)

Operating(CFO)

• Statement of cash flows is broken into three sections:

– Cash flow from financing (CFF) includes cash received (inflow) for the issuance of debt and equity. As expected, CFF is reduced by dividends paid (outflow).

– Cash flow from investing (CFI) is usually negative because the biggest portion is the expenditure (outflow) for the purchase of long-term assets such as plants or machinery.

– Cash flow from operations (CFO) naturally includes cash collected for sales and cash spent to generate sales. This includes operating expenses such as salaries, rent and taxes. But notice two additional items that reduce CFO: cash paid for inventory and interest paid on debt.

CFF + CFI + CFO = net cash flow.

• A statement of cash flows focuses on the following cash-related activities:

– Operating Cash Flow (CFO): Cash generated from day-to-day business operations

– Cash from investing (CFI): Cash used for investing in assets, as well as the proceeds from the sale of other businesses, equipment or long-term assets

– Cash from financing (CFF): Cash paid or received from the issuing and borrowing of funds

IMPORTANT!IMPORTANT!

• Accrual accounting requires companies to record revenues and expenses when transactions occur, not when cash is exchanged. At the same time, the income statement often includes non-cash revenues or expenses, which the statement of cash flows does not include.

.

Cash Flow StatementCompany XYZ

FY Ended 31 Dec 2007 All figures in RM

Cash Flow From Operations

Net earnings 2,000,000

Additional Cash

Depreciation 10,000

Decrease in Accounts Receivable 15,000

Increase in Accounts Payable 15,000

Increase in Taxes Payable 2,000

Subtractions From Cash

Increase in Inventory (30,000)

Net Cash From Operations 2,012,000

Cash Flow From Investing

Equipment (500,000)

Cash Flow From Financing

Notes Payable 10,000

Cash Flow for FY Ended 31 Dec 2007 1,522,000

FINANCIAL STATEMENT LINKSFINANCIAL STATEMENT LINKS

• The notes to the financial statements (sometimes called footnotes) tie up any loose ends and complete the overall picture of financial statement.

• If the income statement, balance sheet and statement of cash flows are the heart of the financial statements, then the footnotes are the arteries that keep everything connected. Therefore, if you aren't reading the footnotes, you're missing out on a lot of information.

• The footnotes list important information that could not be included in the actual ledgers.

• Two types of footnotes:

– Accounting Methods - This type of footnote identifies and explains the major accounting policies of the business that the company feels that you should be aware of.

– Disclosure - provides additional disclosure that simply could not be put in the financial statements.

• The Auditor's Report -the auditors' job is to express an opinion on whether the financial statements give a “true and fair” of the state of affairs of the firm. This is the purpose behind the auditor's report, which is sometimes called the "report of independent accountants".

• By law, every company that is registered with the Company Commission of Malaysia (CCM) must have its financial statements being audited by an audit firm.

• An auditor's report is meant to scrutinize the company and identify anything that might undermine the integrity of the financial statements.

• Auditor's report is almost always broken into three paragraphs and written in the following fashion:

Independent Auditor's ReportParagraph 1 Recounts the responsibilities of the auditor and directors in general and lists the areas of the financial statements that were audited.

Paragraph 3 Provides the auditor's opinion on the financial statements of the company being audited. This is simply an opinion, not a guarantee of accuracy.

Paragraph 2 Stresses on the use of the generally accepted auditing standards (GAAS), assesses the generally accepted accounting principles (GAAP) applied and the overall financial statement presentation.

How truthful are the accounting numbers?

• Financial statements are prepared using the approved accounting standards, in Malaysia, known as Financial Reporting Standards (FRSs).

• Compliance with FRSs is mandatory as stipulated in the Companies Act (1965). However, it is not a guarantee that the financial statements are truthful.

• Because corporate managers who prepare the financial statements possess inside information which is either “too private” to be shared with the general public or the information, if disclosed, would end up in the managers looking bad.

• Thus, managers have the tendency to “manipulate” the financial statements either to hide the information or to make them look good.

• The term that is often used is “earnings management” because the objective of the manipulation is to make earnings (or the bottom line) appear to be strong than it should be without manipulation.

END OF CHAPTER 2 !!!!!

LETS DO EXERCISE…………..