CHAPTER 2: Understand financial statements and cash flows

A Preview of Chapter 2

Accounting is the language of business.

➔ Financial statements are prepared in accordance with a set of accounting principles

that drives a wedge between reported statement figures, present values and cash
flows.

➔ A firm's financial statements contain information that can be important to the

formation of investor expectations concerning the firm’s future performance and
market prices.

➔ A firm’s financial statements provide a visual representation of the firm that is used to
describe the business to:
● investors
● others outside the firm
● firm’s employees

BASIC FINANCIAL STATEMENTS

The accounting and financial regulatory authorities mandate the following 4 types of financial
statements:

1. Income statement aka statement of comprehensive income or a profit and loss statement
provides the following information for a specific period of time (for example, a full year or a
quarter, or month):

● revenue earned
● expenses incurred
● Profit generated

2. Balance sheet aka statement of financial position

contains information as of the date of its preparation about the firm’s assets (resources from
which the firm expects to obtain future economic benefits), liabilities (the firm’s debts) and
shareholders' equity (the money invested by the company owners). As such, the balance
sheet is a snapshot of the firm’s assets, liabilities and owners’ equity for a particular date.

3. Cash flow statement aka statement of cash flows

reports cash received and cash spent by the firm over a specified period of time, usually a
quarter of a year or a full year.
4. Statement of changes in equity
provides a detailed account of the firm’s activities in the ordinary and preference share
accounts, the retained earnings account and changes to owners’ equity that do not appear in
the income statement.

Why study financial statements?

Analysing a firm’s financial statements can help managers carry out three important tasks:
(1) assess current performance
(2) monitor and control operations
(3) plan and forecast future performance

1. Financial statement analysis.

● The basic objective of financial statement analysis is to assess the financial condition
of the firm being analysed. In a sense, the analyst performs a financial analysis so he
or she can see the firm’s financial performance the same way an outside investor
would see it.

2. Financial control.
● Managers use financial statements to monitor and control the firm’s operations. The
performance of the firm is reported using accounting measures that compare the
prices of the firm’s products and services with the estimated cost of providing them to
buyers. Moreover, the board of directors uses these performance measures to
determine executives’ bonuses.
● The company’s creditors also use performance measures based on the firm’s
financial statements to determine whether or not to extend the company’s loans.

3. Financial forecasting and planning.

● Financial statements provide a universally understood format for describing a firm’s
operations. Consequently, financial planning models are typically built using the
financial statements as a prototype.

What are the accounting principles used to prepare financial statements?

1. The accrual basis assumption.

● revenues are recognised when earned, not necessarily when received in cash.
● expenses are recognised when incurred, not necessarily when paid in cash.

2. The historical cost principle.

● record assets and liabilities at the price paid to acquire them (Historical cost), which
is usually not the price the asset could be sold for today (Usually it does not).

The Income Statement

Revenue (or sales) - Expenses = Profit

 ● Cost of goods sold: The cost of producing or acquiring the products or services that
the firm sold during the period covered by an income statement.
● Operating expenses: this includes the salaries paid to the firm’s administrative
staff, the firm’s electricity bills, and so forth).One of the operating expense categories
is depreciation expense.
● Depreciation expense: is a non-cash expense used to allocate the cost of the
firm’s long-lived assets (such as its plant and equipment) over the useful lives of the
assets.
● The firm’s operating profit shows the firm’s ability to earn profits from its ongoing
operations—before it makes interest payments and pays its tax. For our purposes,
operating profit will be synonymous with earnings before interest and tax (EBIT).
● Interest expense: To this point, we have calculated the profit resulting only from
operating the business, without regard for any financing costs, such as the interest
paid on money the firm might have borrowed.

Balance Sheet

The balance sheet (or statement of financial position) contains information on a specific date
(for example, as at 31 December, 2015) in regard to the following:

● Assets (resources that will generate a future economic benefit)

● Liabilities (debts), and
● Owners or shareholders’ equity (investment by the owners).

The balance sheet provides a snapshot of the firm’s financial position on a specific date. It is
defined by the equation:

Total assets = Total liabilities + Total shareholders’ equity

This can also be written as:

Total assets - Total liabilities = Total shareholders’ equity

Assets and liabilities are generally shown on the Balance Sheet as “current” and “non-
current”.

● a “current” asset is one that is expected to be used up within 12 months, while a

“non-current” asset has a useful life longer than 12 months.
● a “current” liability is one that is expected to be settled within 12 months, while a
“non-current” liability will be due in greater than 12 months.

Some non-current (long-term) assets with long useful lives and the firm is not expected to
sell within 12 months (like equipment) are reported on the Balance Sheet as “net”, for
example “net equipment”.

● This is the cost of the asset less accumulated depreciation, where accumulated
depreciation represents the value of the asset which has already been “used up”.
● Net value (also known as carrying amount or book value) represents the future
benefit expected from the asset, but could be significantly different from the market
value of the asset.
Shareholders’ equity

To understand the shareholders’ equity account, we need to know how accountants

construct this account. Specifically, it is broken down into the following components:
1. The amount the company received from selling shares to investors. This amount will be
shown as ordinary shares or preference shares in the balance, depending on the type of
shares that have been issued (and there may be multiple types of preference shares and
other hybrid securities).

2. The amount of the firm’s retained earnings. Retained earnings are the portion of net profit
that has been retained (i.e. not paid in dividends) from prior years’ operations. Boswell has
retained a total of $542.25 million over the course of its existence.

3. Reserves. Sometimes (although not shown in Table 2.4), there may be reserves of
various kinds, such as general reserve or asset revaluation reserve. The ordinary
shareholders are the residual owners of everything listed under ‘Shareholders’ equity’ except
the preference shares.

In effect, shareholders’ equity is equal to the sum of the amount received for ordinary shares
and preference shares plus retained earnings plus reserves.
Alternatively, shareholders’ equity can be thought of as the difference between total assets
and total liabilities. For example, if some of your company’s assets (such as land) increased
in value over time, and were revalued, then the value of the company’s assets would
increase accordingly. Thus, in order for the balance sheet to balance, shareholders’ equity
must increase, and that is done through an increase in shareholders’ equity (specifically, by
an increase in the revaluation reserve). In effect,

Firm liquidity and net working capital

Liquidity generally refers to the firm’s ability to convert its current assets into cash so that it
can pay its current liabilities on time.

One measure of a firm’s liquidity is:

Net working capital = Current assets - Current liabilities

Higher levels of working capital indicate higher levels of liquidity, as a firm is in a good
position to pay its short term debts on time.

Lenders consider the net working capital as an important indicator of firm’s ability to repay its
loans.
However, working capital levels which are extremely high may indicate a poor use of
resources (for example, holding too much cash instead of investing excess cash in more
profitable ways).

Cash Flow Statement

The cash flow statement is a report, like the income statement and balance sheet, that
firms use to explain changes in their cash balances over a period of time by identifying all of
the sources and uses of cash for the period spanned by the statement.

The focus of the cash flow statement is the change in the firm’s cash balance for the period
of time covered by the statement (i.e. one year or one quarter):

Change in cash = Ending cash – Beginning cash balance balance balance

Cash Flow Statement

The cash flow statement reports cash inflows and cash outflows over a specific period of
time, and summarises these according to:

● Cash flows from operating activities

➔ represent the company’s core business, including cash received from sales
and cash paid for expenses.
● Cash flows from investing activities
➔ represent the cash flows that arise out of the purchase and sale of long-term
assets such as plants and equipment.
● Cash flows from financing activities
➔ represent changes in the firm’s use of debt and equity such as issue of new
shares, the repurchase of outstanding shares and the payment of dividends.
Cash Flow Statement analysis

The statement can be used to answer a number of important questions such as:

● How much cash did the firm generate from its operations?
● How much did the firm invest in non-current assets?
● Did the firm raise additional funds, and if so, how
much and from what sources (i.e. debt or equity)?
● Is the firm able to generate positive cash flows?

Statement of Changes in Equity

The statement of changes in equity provides a detailed account of the firm’s activities in
relation to movements in equity for a specific period of time.

This includes movements in accounts such as:

● Ordinary shares
● Preference shares
● Retained earnings
● Reserves