FINANCIAL STATEMENTS ANALYSIS

CONTENTS:
 The balance sheet
 The income statement
 The cash flow statement

After studying this material you should be able to

 Interpret the information contained in the balance sheet, income statement, and
statement of cash flows
 Distinguish between market and book value
 Explain why income differs from cash flow
 THE KEY FINANCIAL STATEMENTS
 There are three main financial statements:
 Tha balance sheet
 The income statement
 Cash flow statement

 They are useful for

 Managers use them to assess performance and identifies areas for action
 Shareholders look at them to check how well their capital is being managed
 Investors use them to identify opportunities
 Suppliers examine them to determine the ability to pay of the companies with which
they deal

 Significance of these statements

 The balance sheet shows what the company owns (its assets), what it owes (its liabilities),
and its book value or net worth (also called ownersʼ equity or shareholdersʼ equity)

 The income statement shows cumulative business results within a defined time frame
(such as a quarter, semester or a year). It indicates how much profit or loss was generated
over a period of time / profit or loss

 Cash flow statement shows how a company acquired and spent its cash during a given span
of time / the net total of inflows and outflows – it can be either positive or negative
 BALANCE SHEET
 BALANCE SHEET - financial statement that shows the value of the firm’s assets and
liabilities at a particular time. It states what the firm owns and how it is financed
BALANCE SHEET AS OF DECEMBER 31, 2014 [RON]
ASSETS LIABILITIES
Current Assets Current Liabilities
Cash 95.500 Accounts payable 16.000
Accounts receivable 5000 Taxes payable 950
Merchandise inventory 19.000 Short-term debt 70.000
Prepaid expenses 2.000 Total current liabilities 86.950
Total current assets 121.500 Non-current liabilities
Fixed Assets Mortgage payable 24.900
Land 30.000
Warehouse building, at cost 40.000 OWNER’ EQUITY
Less: accumulated depreciation (300) Common stock 110.000
Warehouse net value 39.700 Retaining earnings 1.500
Vehicle 10.000
Franchise fee 22.150 Total liabilities and Owners’ 223.350
Equity
Total Assets 223.350
 THE BALANCE SHEET
 ASSETS
 Current assets – are assets can be converted to cash within a year from the date of the
balance sheet / they have short lives (inventory) and are the most liquid
 Cash and financial instruments (such as stocks and bonds)
 Accounts receivable are amounts not yet collected from customers for good or
services sold to them
 Inventory is composed of raw materials to be used in production, work in process, and
finished goods

 Fixed assets – are those that will last a long time (more than one year) – Tangible fixed
assets include property, plant, and equipment and Intangible assets have no physical
existence but can by very valuable – the value of a trademark or the value of a patent

 DEPRECIATION – is the systematic allocation of the cost of a capital asset against revenue
over it estimated useful life. Depreciation is a non-cash expense. It is a source of funds because
the cash outflow occurs at the time of purchase and is then amortized over the life of the asset
by including it as an expense in product/service pricing

 The depreciation methods: (1) Straight – line depreciation and (2) Accelarated depreciation. Most
firms use straight-line depreciation method. For example: If the fully acquition cost of server is
10.000 RON, annual depreciation charges using straight-line depreciation would be 10.000 / 5, or
2.000 RON (the depreciable life of the asset is 5 years)
 THE BALANCE SHEET
 The liabilities and the stockholders’ equity are listed in the order in which they would typically
be paid over time. They are debts to suppliers and other creditors (for example, if a firm borrows
money from a bank)

 LIABILITIES - are obligations of the firm that require a payout of cash within a
stipulated period:

 Current liabilities – loans and other obligations that must be repaid within one year.
They include short-term loans, accrued salaries, accrued income taxes, accounts
payable, and the current yearʼs repayment obligation on a long-term loan. For example,
funds owed to suppliers are known as accounts payable

 Long-term debts – are usually bonds and mortgages / They are debts that the
company is contractually obliged to repay over a period of time longer than a year

 OWNERSʼ EQUITY – includes retained earnings (net profits that accumulate on a

companyʼs balance sheet after payment of dividends to shareholders) and contributed
capital (capital received in excenge for shares). For example, a company with $3 million in
total assets and $2 million in liabilities has $1 million in ownersʼequity (we subtract total
liabilities from total assets)

 CONCLUSION: The balance sheet shows how the company assets were paid for: (1)
from borrowed money (liabilities), (2) the capital of the owners, or (3) both
 THE BALANCE SHEET

 The liabilities and stockholders’ equity reflects the types and proportions of financing –
which depend on management‘s choice of capital structure, or between debt and equity or
between current debt and long-term debt

 Fundamental accounting equation:

Assets - Liabilities = Owenrs/Stockholders’ equity
or
Assets = Liabilities + Owners/Stockholders’ equity

 The balance sheet shows assets on one side of the table, liabilities and ownersʼ equity on
the other side - THE TWO SIDES MUST ALWAYS BALANCE

 Example 1. A company acquires a server ($1 million worth), with payment due in 30 days.
Effects: (1) Inventory assets increses by $1 million and (2) its liabilities (accounts payable)
increses by an equal amount.The equation stays in balance
 Example 2. A company borrowes $100,000 from a bank.
Effects: The cash asset would increse by $100,000 and its liabilities by an equal amount
 THE BALANCE SHEET

 Stockholdersʼ equity = Assets – Liabilities / is residual difference between

assets and libilities / The accounting value of stockholdersʼ equity increases when
retained earnings are added

 Book value of the assets – the accounting value of a firmʼs assets

 Market value ot the assets - is the price at which willing buyers and sellers
would trade the assets

 Management ʼs job is to create value for the firm that exceeds its cost

 The balance sheet information:

 a banker may look at accounting liquidity and working capital
 a supplier may note the size of account payables (payment capacity)
 an investor want to know the value of the firm, not its cost
 BALANCE SHEET

 CORPORATE FINANCE
 The amount of cash you investment in assets (inventory, machinery, land, and labor)
must be matched by an equal amount of cash raised by financing (create value for
owner)
 The Balance Sheet Model of the Firm:

Current assets: Net Current liabilities:

Cash & securities Working Payable
Receivables capital  Short-term debt
Inventories
Prepaid expenses Long-term debt
Fixed assets:
1. Tangible fixed assets
2. Intangible fixed assets Shareholders’ equity

Total Value of Assets Total Value of the Firm to Investors

BALANCE SHEET (example)
 THE BALANCE SHEET of the Cristal company (example)

ASSETS 2014 2013 Liabilities (Debts)/ 2014 2013

Stockholders 'Equity
Current assets: Current liabilities:
Cash and equivalents 140 128 Accounts payable 260 198
Accounts receivable 294 256 Notes payable 60 40
Inventories 269 210 Accrued expenses 258 226
Other 40 38 Total current liabilities 578 464
Total current assets 743 632 Long-term liabilities 119 103
Fixed assets: Total long-term liabilities 119 103
Property, equipment 896 760 Stockholders’ equity:
Intangible assets 320 310 Common stock 1092 965
Others 180 150 Accumulated retained earnings 350 320
Total fixed assets 1396 1220 Total equity 1442 1285
TOTAL ASSETS 2139 1852 TOTAL LIABILITIES and 2139 1852
Stockholders’ equity
 THE INCOME STATEMENT
 Income statement shows cumulative business results within a defined time frame, such as
quarter, semester or a year. It tells us whether the company is making a profit or a loss
(that is, whether it has positive or negative net income). It also tells us the companyʼs
revenues and expenses during the time period it covers

 The income statement is referred to as the profit-and-loss statement, or P&L .

Equation: Revenue – Expenses = Net Income

 The companyʼs sales, or revenue (the value of the goods or services delivered to
customers). Revenues in most cases are not the same as cash. For example, if a company
delivers 100.000 RON goods in December 2013 and sends out an invoice at the end of
the month, this transaction counts as revenue for the tear 2014 even though the
customer hasnʼt yet paid the bill

 Various expenses – the costs of making and storing a companyʼs goods, administrative
costs, depreciation of plant and equipment, interest expense, and taxes – are deducted
from revenues

 The bottom line – is the net income (or net profit, or net earnings) for the period
covered by the statement
 The cost of goods sold (COGS) represents the direct costs of manufacturing (finished
goods)
 THE INCOME STATEMENT (example)
 The income statement measures performance over a specific period (say a year).
It shows how profitable the firm has been during the past year

INCOME STATEMENT FOR STAR, INC., 2013

(Figures in millions of RON)
Net sales $22,348
Cost of goods sold (COGS) 9,330
Other expenses 291
Selling, general, and administrative expenses 8,912
Depreciation Subtracting operating expenses 1,234
and depreciation from gross profit
Earnings before interest and taxes (EBIT) 2,581
gives you a companyʼs operating
Net interest expense profit or Earnings Before Interest 321
Taxable income and Taxes - EBIT 2,260
Taxes (i=16%) 361.6
Net income 1898.4
Allocation of net income:
Addition to retained earnings 1343.4
Dividends 555
 THE INCOME STATEMENT (explanations)

 You can see that during 2013 STAR Inc. sold goods worth 22,348 million RON and
that the total expenses of producing and selling goods was (9,330 + 291 + 8,912) =
18,533 million RON. The largest expense item, amounting to 9,330 million RON,
consisted of the raw materials, labor, and so on, that were needed to produce the
goods. Almost all the remaining expenses were administrative expenses such as head
office costs, advertising, and distribution

 In addition to these out-of-pocket expenses, STAR Inc. also made a deduction for
the value of the plant and equipment used up in producing the goods. In 2013 this
charge for depreciation was 1,234 million RON. Thus STAR’s total earnings before
interest and taxes (EBIT) were EBIT = total revenues – costs – depreciation = 22,348
– 18,533 – 1,234 = 2,581 million RON / summarizes earnings before taxes and financing costs

 STAR, Inc. has partly financed its investment in plant and equipment by borrowing. In
2013 it paid 321 million RON of interest on this borrowing. A further slice of the
profit went to the government in the form of taxes. This amounted in 2013 to 361.6
million RON. The 1898.4 million RON that was left over after paying interest and
taxes belonged to the shareholders. Of this sum STAR paid out 555 million RON in
dividends and reinvested the remaining 1343.4 million RON in the business.
Presumably, these reinvested funds made the company more valuable / Interest
expenses – the nonoperating section of the income statement that includes all financing
costs
 WHY THE INCOME STATEMENT IS USEFUL TO MANAGERS

 If sales managers give too many discounts, they may reduce the companyʼs
gross profit

 If the marketers spend too much money in pursuit of new customers, they will
eat into operating profit

 If managers invest in any capital asset (e.g., server) – the depreciation expenses
will add to the depreciation line

 Staff departmentsʼ expenses usually show up in the operating expenses line

 If a manager oversee a unit in human resources, for example, he or she may

have little influence on revenue, but he or she will surely be expected to watch
the costs closely – and all those costs will affect the income statement

 Recommendation: a manger need to understand and track revenue, cost of goods

sold, and operating expenses
 INCOME STATEMENT (summary)

 An income statement reports on operating activities.

 It lists amounts for sales (and revenues) less all expenses (and costs) over a
period of time.
 Sales less expenses yield the “bottom-line” net income amount.
INCOME STATEMENT (example)
 STATEMENT OF CASH FLOWS
 The Cash Flow Statement shows in broad category how a company acquired and
spent its cash during a given span of time. It indicates the ability of company to pay
bills as they come due, and the extent to which it can transform its profit into cash

 CONVENTION: expenditures show up on the statement as negative figure, and

source of income figures are positive

 The bottom line in each category is simply the net total of inflows and outflows,
and it can be either positive or negative

 The cash flow statement has three major categories:

 Operating activities (or operations) – refers to cash generated by, and used in,
a companyʼs ordinary business operation
 Investing activities covers cash spent on capital equipment and other
investments (outgoing), and cash realized from the scale of such investments
(incoming)
 Financing activities refers to cash used to reduce debt, buy back stock, or pay
dividends (outgoing), and cash from loans or from stock sales (incoming)
 STATEMENT OF CASH FLOWS (example)

 The statement of cash flows reports on cash flows for

operating, investing, and financing activities over a period of time
 STATEMENT OF CASH FLOWS (example)
STAR Ltd. Cash flow statement for the year ending December 31, 2014 (RON)
Net income 347.500
Operating activties:
Accounts receivable (43.000)
Inventory (80.000)
Prepaid expenses (25.000)
Accounts payable 20.000
Accrued expenses 21.000
Income tax payable 8.000
Depreciation expense 42.500
Total changes in operating assets and liabilities (56.500)
Cash flow from operations 291.000
Investing activities
Sale of property, plant, and equipment 267.000
Capital expenditures (467.000)
Cash flow from investing activities (200.000)
Financing activities
Short-term debt decrease (65.000)
Long-term borrowing 140.000
Cash flow from financing activities 75.000
Increasing in cash during year 186.000