CHAPTER 2CHAPTER 2

FINANCIAL STATEMENTS FINANCIAL STATEMENTS

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A)Needs of financial statementsB) Financial statements

1.Income Statement 2.Balance Sheet3.Statement of retained

earnings4.Statement of Cash Flows

Objectives :Objectives :

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Needs of Financial Needs of Financial StatementsStatements

• Company Act 1965 required companies to expose their annual report to Company Registrar.

• Among the content of the report is financial statement, covers; income statement, balance sheet, cash flow statement, and explanation notes about those accounts.

• Financial statements can be classified into 2 types:

• External users• Internal users

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THE IMPORTANCE OF FINANCIAL THE IMPORTANCE OF FINANCIAL STATEMENTSTATEMENT

A firm’s financial statements can help managers to carry out three important duties: a) supervise the current performance b) establish that all works are accuratec) check ,monitor and supervise operationsd) list, plan, arrange and forecast future performance and make sure the things in a good position or order.

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1)Income Statement1)Income Statement Also known as profit and loss account. Shows

the performance / achievement for a firm in certain period (annually, semi annually, monthly etc)

Income statement supplied information on sales or revenue that firm earned over a specified period of time, usually a quarter of a year or a full year.

It contain expenses incurred such as cost of good sold , depreciation , other operating expenses ,taxes and interest paid to bondholders.

The answer for “how profitable is the business?”5

Income Income StatementStatement

SALES

- EXPENSES

= PROFIT

•Cost of Goods Sold•Operating Expenses• Financing Costs•Taxes

Revenue

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5 activities related to business:

1. Sales – Income from sales of products or services

2. Cost of good sold – Cost of produce the product / services

3. Operation expenses – expenses related to marketing and distributing the products or services, and also administration cost

4. Financing cost – Interest paid to debtors and dividend paid to preferred stock holders (excluding dividend paid to common stock holders)

5. Tax expenses – Amount of tax depends on company’s taxable income.

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SALES

- Cost of Goods Sold

GROSS PROFIT

- Operating Expenses

OPERATING INCOME (EBIT)

- Interest Expense

EARNINGS BEFORE TAXES (EBT)

- Income Taxes

EARNINGS AFTER TAXES (EAT)

- Preferred Stock Dividends

- NET INCOME AVAILABLE TO COMMON STOCKHOLDERS

Income Income StatementStatement

Financing Activities

Operating Activities

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Three additional important Three additional important issues:issues:

Operating income is NOT affected by how the firm is financed.

Interest expense is subtracted from income before computing the firm’s tax liability. i.e Interest is not taxable expenses

Firm that has a +ve net income does NOT necessarily mean it has any cash.

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2)Balance Sheet2)Balance Sheet Balance sheet is a statement that shows

the financial position for a company at certain time.

Give information about assets, liabilities and equities of a company.

Asset – Productive sources that give return to the company.

Liability – Creditor claim Equity – Owner claim.

Total Asset = Total Liability + Total Equity

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Balance SheetBalance SheetAssets Liabilities (Debt) &

EquityCurrent Assets Cash Marketable

Securities Accounts Receivable Inventories

Prepaid Expenses

Fixed Assets Machinery &

Equipment Buildings and Land

Other AssetsInvestments & patents

Current Liabilities Accounts Payable Accrued Expenses Short-term notesLong-Term Liabilities Long-term notes MortgagesEquity Preferred Stock Common Stock (Par value) Paid in Capital Retained Earnings11

Balance SheetBalance Sheet Types of assets :

Current asset Fixed asset Other asset

Types of financing : Liability (Debt) Long-term liability Owners’ equity

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Current AssetsCurrent AssetsIt includes the assets with high

liquidity (can be converted within 1 year.)

Among the current assets are:• Cash• Marketable securities• Account receivable• Inventory• prepaid expenses

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Cash – currency or coins owned by company either in bank account or hand.

Marketable security – investment on short term financial assets with high liquidity. Example: T-bill, bankers acceptance, etc.

Account receivable – the cash payment agreement by customers whose bough by credit.

Inventory – raw materials, working in process and final products that will be sold.

Prepaid expenses – it is reported in profit and loss account and deducted as expenses income statements after has been used. Example: rent expenses and insurance.

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Fixed AssetsFixed Assets Cannot be converted into cash in

short period.. Including plant and machinery,

building and land. Some businesses have more

fixed assets than the other. Example: factory

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Other AssetsOther Assets Besides current and fixed assets. Example

the assets that can’t be touched or saw physically such as pattern, right and goodwill.

Information exposed is different because it reported based on cost in the time transaction occur. The value appeared known as ‘accounting book value’ of the company.

Accounting book value – Value of assets as shown in balance sheet of a firm. It represents historical cost compare to present value of the asset.

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Debt CapitalDebt Capital Liability is money borrowed and must

be pay back at fixed date. It includes credit give by suppliers and bank loans.

Current debt/short-term liabilities-liability that must be paid within 12 months.

Sources of short term liability: Account payable Other payable Accrued expenses Short-term notes 17

Long-term DebtLong-term Debt Covers loan from bank or other

sources that provide capital for liability term more than 1 year.

Example; loan from bank where the period of payment is 5 years or loan of buying machinery, building, equipment or land for period 25 to 30 years.

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EquityEquity Equity investment by shareholders in the company and the profit

which is not distributed to them will be pooled in company. Equity shows the company’s financing structure , it means how

many percent of the assets finance by debt and how many contribute by owners.

Relationship between debt and equity is important to the debtors and investors in certain situation. We will discuss about it in others topic later.

Preferred stockholders Received dividend in fixed amount. Priority after creditor pay the liability.

Common stockholders Receive whatever left over-good or bad. The firm common stock value as reported in balance sheet

includes sales value of the stocks and the firm’s retain earning. Retain earning-earning assembled and retained and will be

reinvest in the firm. 19

Debt vs Equity :

- DEBT: If the firm borrows money, its usually give first claim to

the firm’s cash flow to creditors. The bondholders are the first

creditor who can claims for their income.

- EQUITY: refers to stockholder’s investment in the firm and the

cumulative profits of retained earnings.

Market vs Book Value

- Market Value? is the current price at which the assets,

liabilities or equity can actually be bought or sold.

- Book Value ? which is stated in the balance sheet. Refer to

the assets, liabilities and equity.

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Liquidity & Net working Liquidity & Net working capitalcapital

Liquidity refers to how fast the assets can be converted to cash. Illiquid assets are refer to assets that are not easily convertible to cash.

Net working capital: Differentiate between current assets and current liabilities.

Working Capital = Current assets – Current liabilities It is important for lenders because it give a picture of

company’s liability to determine the ability to pay back. Liquidity means how fast & how easy an asset can be

converted into cash without losing its value. More current assets than current liabilities in a company means

higher liquidity. Positive when the cash that will be received over the next 12

months exceeds the cash that will be paid out. If your net working capital is positive, it shows that that company is in a good condition and seem to be a healthy firm. 22

3)Statement of retained earnings

A statement or retained earnings express how much of the firm’s earning were retained in the business rather than paid out in dividends.

The amount or value for retained earnings that available here is the sum of the annual retained earnings for each year of the firm’s history.

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Example: Falah Junior Statement of Retained Example: Falah Junior Statement of Retained Earning for year ending Dec. 31,2011 (RM)Earning for year ending Dec. 31,2011 (RM)

Balance of retained earnings Dec. 31, 2010 709Add: Net income 2011 113.5Dividend to common stockholders

(57.5)Balance retained earnings 2011

765.0

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4)Statement of cash flows

Statement of cash flows is a firm’s financial statement that states all sources and uses of cash over a specified period.

Cash Flow Identity: 1) Cash Flow From Assets = Cash Flow to Creditors + cash Flow to Owners (shareholders)

Sources of cash or supply cash: Sources ( a firm’s activities that produce cash). Cash inflow- occurs when we offer or sell something.

Uses or spent of cash: Uses ( a firm ‘s activities in which cash is spent).Cash Outflow – occurs when we buy something.

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Three categories of sources and uses of fund

– Operating activities – includes net income and changes in most current account

– Investment activities– includes changes in fixed assets

– Financing activities– includes changes in notes payable, long term debt and equity accounts as well as dividends.

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Cash flow identity

• Cash Flow From Assets (CFFA) = Cash Flow to Creditors + Cash Flow to Stockholders

• Cash Flow from Assets = Operating Cash Flow – Net Capital Spending – Changes in Net Working Capital (NWC)

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Operating Cash Flow

• OCF = EBIT + DEP – TAXES• Net Capital spending = Ending net –

beginning net fixed asset + Depreciation

• Change in net working capital = Ending net working – beginning net working

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Cash Flows to creditors and stockholders

• Cash flows to creditors = Interest paid – Net new borrowing

• Cash Flows to stockholders = Dividend paid – Net new equity raised

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TAXATION AND DEPRECIATION FROM TAXATION AND DEPRECIATION FROM FINANCIAL PERSPECTIVEFINANCIAL PERSPECTIVE

Taxation - % of tax is set by the government Tax expenses – Amount of tax depends on

company’s taxable income.

Depreciation Depreciation expenses : a non-cash

expense to allocate the cost of depreciable assets, such as plant & equipment, over the life of the assets.

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