Module 2 Introducing Financial Statements

In Module 1 we discussed the need to raise capital to start a company. In

addition, we learned that management prepares Financial Statements to report
back to the investors.

In Module 2, we will discuss Financial Statements in more detail, as well as their

limitations.

BALANCE SHEET – shows the company’s financial position at a point in time

 Reports assets (resources available to management) and liabilities (claims
against the resources by non-owners) and stockholders’ equity (claims against
the resources by owners) at a point in time.
 These are permanent accounts – ending balance from one period becomes the
beginning balance for the next.

CLASSIFICATION of ASSETS – provide FUTURE benefits

Current assets – will be converted into cash or used in the operations within the
coming year. (cash, short-term investments, accounts receivable, inventory, prepaid
expenses).
 Cash – dollar bills in bank.
NONCASH ASSETS NEED TO BE IDENTIFIED:
 Short-term investments – marketable securities or other investments the company
expects to sell in the short run.
 Accounts receivable – amount owed to the company from customers who bought the
product or service but haven’t paid for it yet (they bought on credit).
 Inventory – amount paid for items that are purchased or produced by the company to
be sold to customers.
 Prepaid expenses – costs paid in advance that are not USED UP but will provide future
benefits, like rent or insurance paid in advance.

Long-term assets – expected to be around for a long time. (property, plant and
equipment, long-term investments, intangible).
 Buildings, land, furniture, factory equipment – amount paid for these structures used by
the company.
 Long-term investments – investments the company expects to hold for more than one
year.
 Any PURCHASED intangible asset – if a company BOUGHT a trademark or patent.

When the asset is used up and there is NO more future benefits, there is NO asset
left, and it is removed from the Balance Sheet and reported in the Income
Statement as an expense.
CLASSIFICATION of LIABILITIES-sources of capital from borrowed funds

Current liabilities must be paid back within one year. (accounts payable, accrued
liabilities, unearned revenues, short-term notes payable).
 Accounts payable – unpaid bills such as for the phone or supplies or inventory.
 Accrued liabilities – unpaid amount usually owed to employees or other expenses.
 Unearned revenue – amount of money received from a customer who paid in advance
so you still owe them the product or service.
 Short-term notes payable – money owed to banks or other creditors maturing in less
than one year.

Non-current liabilities are obligations due after one year (long-term debt,).

 Long-term debt – money owed to banks or other creditors that is scheduled to be repaid
more than one year in the future.

CLASSIFICATION OF ITEMS THAT ARE CURRENT BECOME IMPORTANT TO

MEASURE LIQUIDITY – The ability to have enough cash, or assets that will be
converted into cash quickly to pay back the debts that will become due next year:
1. NET WORKING CAPITAL = CURRENT ASSETS – CURRENT LIABILITIES
2. “Cash conversion cycle” number of days the company has its cash tied up in
receivables and inventories, less the number of days of trade credit provided by
the company suppliers.

CLASSIFICATION of EQUITY – financing provided from company owners

 Contributed capital – net funding that a company received from issuing and
reacquiring its equity shares. (Common stock, Preferred stock, Additional paid-in
capital, Treasury stock).
 Earned capital – cumulative net income (loss) that has been retained by the
company (not paid out in dividends to shareholders) (Retained earnings,
Accumulated other comprehensive income or loss).
Limitations of the Balance Sheet –
 Assets are listed at their purchase price (historical cost) not current market value.
 Many assets are missing from the balance sheet because they are hard to value
objectively.
 Lots of items represent estimates.
 GAAP does not report expected future performance.

Therefore, many assets are not reported on the balance sheet as they cannot be
measured with relative certainty (brand name image, knowledge-based assets, superior
technology).

Currently, book value on the Financial Statement (Balance Sheet) is, on average
smaller than the market value of the company.

EXAMPLE OF A MICROSOFT WITH Book Value of equity < Market Value of equity

July 1, 2019: #shares outstanding=7,643,000,000, Price/share=$134.40

Market Value of Equity=Price/sh x # shares = $134.40/sh x 7,643,000,000 sh=$1,027,219,200,000,
BV of Equity= $102,330,000,000
Price-to-Book Ratio = Market Value of Equity / BV of Equity = $1,027,219,200,000 / $102,330,000,000
=10.04 times

July 2, 2018: #sh outstanding=7,677,000,000, Price/share=$97.49

Market Value of Equity=Price/sh x # shares =$97.49/sh x 7,677,000,000 sh= $748,430,730,000.
BV of Equity=$82,718,000,000
Price-to-Book Ratio = Market Value of Equity / BV of Equity = $748,430,730,000 / $82,718,000,000 =
9.05 times
INCOME STATEMENT – shows revenues less expenses for the accounting period

Revenues = based on net SALES price of products or services sold

- Cost of Goods Sold expense = based on COST of products or services sold.
GROSS PROFIT
- Operating expenses (Selling, general and admin. Expenses) =salaries, marketing
INCOME FROM OPERATIONS
+/- Nonoperating items = income/expenses not related to product or service sold.
- Income tax expense (income before income taxes * statutory tax rate)
INCOME FROM CONTINUING OPERATIONS

+/- INCOME/LOSS FROM DISCONTINUED OPERATIONS (NET OF TAXES)

NET INCOME

IMPORTANT SUBTOTALS on the INCOME STATEMENT:

1) GROSS PROFIT – profit from the sales price being greater than the cost.
2) INCOME FROM OPERATIONS - Operating income deducts only operating
expenses from sales revenue. Operating expenses are usual costs incurred to
support its operating activities (cost of goods sold and S,G &A expenses)
3) INCOME FROM CONTINUING OPERATIONS - (persistent) income is the
income that is likely to persist in the future (which consists of sales less operating
expenses less non-operating expenses less tax expense). Non-operating
revenue/expenses are costs related to financing and investment activities
(interest and dividend revenue, interest expense, gain and losses from sale of
investments).
4) INCOME/LOSS FROM DISCONTINUED OPERATIONS – Revenue less
expenses for the part of the company that is discontinued. This is reported at
bottom of income statement. Transitory income is the income that is not likely to
continue in the future and will not be helpful in predicting future earnings

Revenues = Recorded (recognized) in the period in which the goods and services
are sold (or performance obligation is satisfied), not necessarily the period in
which cash is received.

 If a sale has occurred and cash is received (cash is increased on the asset
side of the Balance Sheet and the Sales Revenue is recorded on the
Income Statement).
 If a sale has occurred and the customer has not paid yet (accounts
receivable is increased on the asset side of the Balance Sheet and the
Sales Revenue is recorded on the Income Statement).
Expenses = Recorded (recognized) in the period in which the expense are
incurred not necessarily the period in which cash is paid. The period in which an
expense is reported on the income statement is the period in which goods and services
are used to earn revenues, not necessarily the period in which cash is paid. An asset
remains on the company’s Balance Sheet until it is used up. The asset’s cost is
transferred from the Balance Sheet to the Income Statement where it becomes an
expense - when it is used up (or incurred to generate the revenue in that period).
 If an expense has occurred and cash is paid (cash is decreased on the
asset side of the Balance Sheet and the expense is recorded on the Income
Statement).
 If an expense has occurred and cash is not paid yet (accounts payable is
increased on the liability side of the Balance Sheet and the expense is
recorded on the Income Statement).

SUMMARY:
All cash payments result in a reduction in cash and an increase in “something”. If the
cash payment results in an immediate benefit, it is reported as an expense on the
Income Statement. If the cash payment creates a future benefit, it is reported as an
asset on the Balance Sheet first. When the benefit expires (or as it expires or is USED
UP) the asset is reduced and an expense is recorded on the Income Statement.
STATEMENT OF CASH FLOWS - reports a summary of where cash went
(payments) as well as where cash came from (receipts).

Allows us to assess a company’s cash management to help ensure they don’t end up
with cash shortages. It tells us how the company generated its cash and what it used
the cash generated for.

CLASSIFICATION

1. Cash flow from operating activities – related to its operations

2. Cash flow from investing activities – acquisition and divestitures of investments
and long-term assets.
3. Cash flow from financing activities – issuances of and payments toward
borrowings and equity.

CASH FLOW STATEMENT EQUATION

CFO + CFI + CFF = change in cash

 
Analyzing the cash flow statement:
Useful to both creditors and investors in predicting future cash flows that may be
available for payment of debt to creditors and dividends to investors.  The
operating activities section indicates the company’s ability to generate cash from
sales to meet its current cash needs.  Any amount left over can be used to pay
back the bank debt or expand the company.  Investment section shows
investments in new manufacturing equipment indicating growth of company.
The top line (net income) of the operating section represents the accrual-based
net income reported on the Income Statement. The bottom line of the operating
section represents the cash-based net income number (if the company has used
the cash based method to report revenue and expenses).

FINANCIAL STATEMENT LINKAGES:

1. Retained earnings – links Balance Sheet and Income Statement. Net income
from the Income statement is shown as an increase to retained earnings on the
Statement of Changes in Retained Earnings.
2. Cash – links Statement of Changes in Cash Flow and Balance Sheet. The
Statement of cash flows shows the change in cash from last year’s ending cash
on the Balance sheet to this year’s ending cash balance under assets on the
Balance sheet.
3. Changes in stockholder’s equity section – links Statement of Changes in
Retained Earnings and Balance Sheet. Ending retained earnings on the
Statement of Changes in Retained Earnings is shown as retained earnings under
stockholders’ equity on the Balance sheet.
The notes attached to the financial statements explain
 The accounting rules applied
 Details about line items in the statements
 Disclosures about items not listed in the statements.