Webinar on

Understanding

Balance Sheet and

Cash Flow Statement

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Session Agenda

• Part I- Understanding the Balance Sheet

– Balance Sheet Components and Presentation Formats

– Current and Non-Current Assets and Liabilities

– Measurement of Assets and Liabilities

– Treatments for marketable and non-marketable financial instruments

– Shareholders Equity

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• Trading Strategies

– Cash Flow Classifications

– Key differences in cash flow statements prepared under GAAP and IFRS

– Direct and Indirect Method for Cash Flows

– Cash flow link to income statement and balance sheet

– Cash Flow Analysis

– Free Cash Flow to Firm and Free Cash Flow to Equity

– Cash flow ratios

Part II- Understanding the Cash Flow Statement

Expect around 5-8 questions in the CFA level 1 exam from today’s webinar

Part-I: Understanding the

Balance Sheet

Balance Sheet Components

• Balance sheet: Also called “Statement of financial position” or “Statement of financial condition”

• Equation that governs this Financial statement:

• Assets: Provide economic benefits to the entity

– Current Assets

• Cash and cash equivalents

• Accounts receivable

• Inventory

• Prepaid expenses

– Property, plant and equipment

– Investments

– Intangible assets

– Deferred tax assets

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Equity sr'Shareholde sLiabilitie Assets

Balance Sheet – Liabilities & Equity Accounts

• Liabilities: Obligations for an entity; occurred from historical transactions and to be paid in future

– Current liabilities

• Accounts payable

• Accrued expenses

• Unearned revenues

– Bank Loan

– Bonds

– Pension obligation

– Deferred tax liabilities

• Owner’s Equity:

– Capital stock

– Additional paid-in-capital (capital in excess of par)

– Treasury stock

– Retained earnings

– Accumulated other comprehensive income

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Balance sheet presentation formats

• Generally two formats are common

– Account Format : layout in which assets are present on left –hand side & liabilities & equity are present

on right-hand side

– Report Format: assets, liabilities & equity are presented in one column

• Classified Balance Sheet:

– Current and non-current assets are reported separately, as are current and non-current liabilities

• Liquidity based format:

– Assets and Liabilities are presented in the order of their liquidity

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Assets / liabilities and accrual process

• Assets / liabilities are also created using accrual concept in addition to acquisition through cash

• For Example:

– If an income (rent / interest income) is earned but not received in cash, accrued income is created and is

shown in current assets

– If an expense is accrued but not paid, it creates a liability for the firm and is shown in accrued expenses

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Current and non current assets and liabilities

• Current Account is a balance sheet account that represents the value of all assets that

are reasonably expected to be converted into cash within one year in the normal course of business.

This include cash, accounts receivable, inventory, marketable securities, prepaid expenses and other

liquid assets.

• Non Current assets are held for long term purpose to operate business activity and does not meet

current assets definition

• Current liabilities are obligation which needs to be paid within a year. These are generally short term

debt, accounts payable, accounts payable, accrued liabilities and other debts.

• Working Capital

– Current assets minus current liabilities equals working capital

– Not enough working capital may indicate liquidity problems

– Too much working capital may be an indication of inefficient use of assets

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Measurement of assets and liablitlies

• Assets and liabilities are shown either at

– Historical value (cost – verifiable through historical records)

– Fair Value (Subjective)

• To value a firm, an analyst must adjust accordingly to understand firms investment potential

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Inventory and Tangible Assets

• Inventory contains items held for sale or to be used in manufacturing process

– Raw Material

– WIP

– Finished Goods

• Inventory is reported at the lower of

– Cost which includes direct labor, direct material and overheads but does not include abnormal wastage,

admin overheads and selling costs

– Net realizable value: selling price of inventory less the estimated cost of completion and disposal costs

• Costs can be assigned using standard costing (predetermined costs) or retail methods (sale price less

profit)

• Tangible Assets:

– Shown at Costs less accumulated depreciation

– Costs include all costs incurred till assets is ready for use – installation costs as well

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Imp

Intangible assets

• Identifiable: purchased with finite life like patents, trademark etc.

• Unidentifiable: not purchased separately with infinite life like goodwill

– Goodwill is excess value paid over the fair value of a business acquired

– Internally generated goodwill – expenses when incurred; can only be recognized on acquisition

• R&D Costs

– Under US GAAP

• Except for certain legal costs, intangible assets that are created internally including research and

development costs, are expensed as incurred

– Under IFRS, a firm must

• Expense costs during the research stage but

• Can capitalize Costs during the development stage

• Under GAAP, all of the following should be expensed as incurred:

– Start-up and training costs.

– Administrative overhead.

– Advertising and promotion.

– Relocation and reorganization costs.

– Termination costs.

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Imp

Treatments for marketable and non-marketable

financial instruments

• Reporting assets and liabilities at fair value is known as marking-to-market

• Marketable investment securities are classified as either held-to-maturity, trading, or available- for-

sale

– Dividend and interest income, and realized gains and losses on sales are recognized in income

statement for all three classifications of securities

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Imp

Marketable securities

• Held-to-maturity securities

– Debt securities acquired to hold till maturity

– Reported at amortized cost on the Balance Sheet

– Not adjusted for subsequent changes in market value

• Trading securities

– Debt and Equity securities acquired to profit over the near term

– Reported at Fair Value on the Balance Sheet

– Changes in the market value (Unrealized gains and losses) are reported in the income statement.

• Available-far-sale securities

– Debt and equity securities that are not expected to be held to maturity or traded in the near term.

– Reported at Fair Value on the Balance Sheet

– Any unrealized gains and losses are not recognized in the income statement but are rather reported in

other comprehensive income as a part of stockholders' equity

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Example: Classification of Securities

• Company ABC purchased a 5% annual coupon bond, 10 years maturity, with a face value of $100

and market value $100,000 on Dec 31 2011. Interest is paid on every 31st March. The market value

on purchase is $100. On March 31 2012, its YTM is 6% and it is to be reported on ABC’s balance

sheet.

• Describe the impact on financial statements if the bond were to be classified as:

I) Held to Maturity

II) Available for Sale

III) Held for Trading

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Solution: Classification of Securities

Held to Maturity

•The bond is reported at amortized price, which is $100 and has a market value of $100,000 which is

reported on the balance sheet.

•The coupon income, that is accrued till that date, 0.25*5%*100,000 = $1250 is reported in the income

statement.

Available for Sale

•The Bond Price on March 31st 2012 is $92.7486 and thus its market value is $92,749 which is reported

on the balance sheet.

•Coupon income $1250 is reported on the income statement.

•The unrealized loss of 100,000-92,749 = $7,251 is reported in under Other Comprehensive Income as

part of Shareholder’s Equity.

Held for Trading

•The Bond Price on March 31st 2012 is $92.7486 and thus its market value is $92,749 which is reported

on the balance sheet.

•The loss 100,000-92,749 = 7,251 and the coupon income $1250 are reported on the income statement

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Shareholders Equity

• Types of Common Shares

– Authorized shares

• Shares that a firm maximum can issue under the firm's articles of incorporation.

– Issued shares

• Shares that have actually been sold to shareholders

– Outstanding shares

• Issued shares less shares reacquired by the firm (i.e., treasury stock)

• Contributed Capital:

– Amount paid by common + preference shareholders

• Retained earnings: Cumulative earnings from operations till date

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Common-size Balance Sheets

• Common size statements normalize the balance sheet and allow the analyst to more easily compare

performances across firms and for a single firm over time.

• Vertical common side balance sheets express all balance sheet accounts as a percentage of total

assets.

• Vertical Common-size balance sheet ratios

• Horizontal Common-size balance sheet – the divisor is the first year values, so all first year values are

1.0 by contrsuction

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Assets Total

accountsheet Balance

Vertical Common Size Balance Sheet example

2009 2010 2011

Assets

Cash 9% 7% 7%

A/R 3% 2% 3%

Inventories 29% 33% 37%

Net Fixed Assets 59% 58% 53%

Total Assets 100% 100% 100%

Liabilities

A/P 6% 5% 5%

S.T. Debt 18% 18% 17%

L.T. Debt 35% 33% 30%

Equity

Preffered Stock 12% 18% 17%

Common Stock 29% 27% 31%

Liabilities + Equity 100% 100% 100%

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Horizontal Common/ Cross Sectional Size Balance Sheet

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2009 2010 2011

Assets

Cash 1.0 1.1 1.5

A/R 1.0 1.0 2.2

Inventories 1.0 1.7 2.3

Net Fixed Assets 1.0 1.5 1.7

Total Assets 1.0 1.5 1.9

Liabilities

A/P 1.0 1.2 1.5

S.T. Debt 1.0 1.5 1.8

L.T. Debt 1.0 1.4 1.6

Equity

Preffered Stock 1.0 2.3 2.8

Common Stock 1.0 1.4 2.0

L + E 1.0 1.5 1.9

Questions for practice

1. Which of the following R&D expenses need to be expensed as per IFRS

A. All expenses incurred during research stage

B. All expenses incurred during development stage

C. All expenses must be incurred except certain legal costs

2. Which of the following securities needs to be reported at amortized cost in BS

A. Held for trading

B. Held to maturity

C. Available for sale

3. Contributed capital equals to

A. Amount paid by common shareholders plus retained earnings

B. Amount paid by common shareholders plus preference shareholders

C. Amount paid by common shareholders only

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Solutions

1. A.

– Under IFRS, a firm must expense costs during the research stage but can capitalize costs during the development stage

2. B.

– Held-to-maturity securities are debt securities acquired to hold till maturity and reported at amortized cost in BS

3. B.

– Contributed capital is amount paid by common shareholders plus preference shareholders.

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Part-II: Understanding the

Cash Flow Statement

Cash flow

• Cash flow can be used to know whether

– Regular operations generate enough cash to sustain the business

– Enough cash is generated to payoff existing debts as they mature

– The firm can acquire new business opportunities in future

– The firm is likely to need additional financing

– Unexpected obligations can be met

• All receipts / payments of cash flows are classified in 3 following activities:

– Cash flow from operating activities

– Cash flow from investing activities

– Cash flow from financing activities

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U.S. GAAP Cash Flow Classifications

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• Cash flows related to firms day to day normal business activities

Operating Activities Cash flow

Cash Inflow

Cash Sales / cash revenues

Cash collected from customers

Interest and dividends received

Cash collected on sales of trading securities

Cash Outflow

Cash purchases

cash paid to suppliers

cash paid to employees

Cash paid on buying trading securities

cash paid for other expenses

cash paid as interest

cash paid for taxes

U.S. GAAP Cash Flow Classifications

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• Cash flows related to purchasing and selling non current assets – Income generated from

investments are operating activities (dividends / interest received)

Investing Activities Cash flow

Cash Inflow

Cash collected on sales of debt and equity investments

Cash collected on sales of long lived assets

Received principals on loans

Cash Outflow

Cash paid on buying debt and equity investments

Cash paid on buying long lived assets

Loans made to others

U.S. GAAP Cash Flow Classifications

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• Cash flows related to capital structure of the company

Financing Activities Cash flow

Cash Inflow

Cash received on issuance of equity and related cash flows

Cash received on issuance of debt and related cash flows

Cash received on issuance of preferred shareholders

Cash Outflow

Cash paid on buying back equity

Principal paid on debt

Cash paid on redemption of preferred shareholders

Dividend paid to shareholders

Non cash activities

• Noncash investing and financing activities are not reported in the cash flow statement as non cash

does involve inflows and outflows of cash

– Exchange of debt for equity

– Stock dividend

• Must be disclosed in either a footnote or supplemental schedule to Cash Flow statement

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Key differences in cash flow statements

prepared under GAAP and IFRS

The difference is in the treatment of dividends, interest paid & taxes:

• U.S. GAAP:

– Dividends paid to the firm's shareholders are reported as financing activities while interest paid is

reported in operating activities

– Interest received and dividends received from investments as operating activities

• IFRS:

– Dividends or interest received may be classified as either operating or investing activities

– Dividends or interest paid may be classified as either operating or financing activities

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Imp

Key differences in cash flow statements

prepared under GAAP and IFRS

Taxes:

• U.S. GAAP

– All taxes paid are reported as operating activities

• IFRS

– Firm can report a investing inflow net of taxes under investing activity

• For example, Paramount industries sells one of its buildings with a book value of $3 Million, for a price

of $4 Million. The taxes on the profit of the sale is $350,000.

• Under US GAAP, the company shows a CFI inflow of $4 Million and a CFO outflow of $350,000 for

the income tax.

• Under IFRS, the company, these two cash flows are netted and a CFI inflow of $3,650,000 is

reported.

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Imp

Direct and Indirect method for cashflow

• Direct method - Remove impact of accruals and shows only cash receipts and payments

Operating Activities Cash flow - Direct Method Amount

Cash Inflow

Cash Sales / cash revenues 5100

Cash collected from customers 10000

Interest and dividends received 500

Cash collected on sales of trading securities 100

Cash Outflow

Cash purchases (4000)

cash paid to suppliers (6000)

cash paid to employees (3000)

Cash paid on buying trading securities (100)

cash paid for taxes (500)

cash paid for interest (500)

Operating Activity Cash flow 1600

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Direct Method

• Cash Collections = Sales + Opening balance (OB) of a/c receivable – Closing Balance (CB) of a/c

receivable

• Cash paid to supplier: COGS + (CB of inventory – OB of inventory) + (OB of a/c payable – CB of a/c

payable)

• Cash paid for expenses: Expenses incurred + OB of outstanding Exp – CB of o/s expenses

• Cash taxes: tax expense + OB of tax payable – CB of tax payable + OB of deferred tax liability – CB

of DTL

• Value of PP&E Sold = Book Value + Gain ( or - loss) on sales

– Book Value of assets sold = Historical cost of assets sold – accumulated depreciation for the assets

– Historical cost of assets sold = OB of Gross PP&E – CB of Gross PP&E + Capital expenditures

– Accumulated Depreciation (AD) of assets sold = OB of AD – CB of AD + Depreciation charged in

P&L

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Imp

Cashflow – Indirect method

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• Indirect method: Without requiring specific cash transactions, adjusts net income to calculate

operating cash flow . Adjustments are done for:

־ Financing or investing activity cash flow

־ Non cash items

־ Changes in working capital

Operating Activities Cash flow - Indirect Method Amount

Net Income 4900

Depreciation 2000

Loss on sale of assets 100

Deferred income taxes 500

Increase in accounts receivable (3000)

Decrease in inventory 1000

Decrease in accounts payable (2000)

Increase in prepaid expenses (2000)

Increase in Taxes Payable 100

Operating Activity Cash flow 1600

Direct and Indirect method

• Direct method presents the firm's operating cash receipts and payments

• Indirect method only presents the net results of these receipts & payments

• Thus, direct method provides more information

• Indirect method focuses on net income & operating cash flow providing a link to income statement

when forecasting future operating cash flow

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Cash flow link to income statement and balance sheet

• Income statement: Net Income

• Balance Sheet

– Linkage with each assets and liabilities

– Changes in current assets and liabilities to calculate cash flow from operations

– Changes in non current assets to investing activities

– An increase in the assets is cash outflow while cash inflow for decrease in assets

Cash paid for assets = Ending balance – beginning balance + depreciation + costs of assets sold

– An increase in the liability is cash inflow while outflow in case it increases

– Changes in common shares and bonds to financing activities

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Cash Flow analysis

• Negative operating cash flow – question mark on sustainability of business

• Comparison of earnings with operating cash flows: stable the better

• Low cash flow compared to earnings: aggressive revenue recognition policies

• Selling assets to generate cash flow from investing activity

– Size, trends – if huge can be a question mark on future

• Investing / financing activity can show uses of debt:

– Debt should be used in productive activities

– Not in paying dividends or acquiring stocks

• Common size Cash flow

– Shows as a percentage of revenue

– Cash inflow as a percentage of total inflows

– Cash outflow as a percentage of total outflows

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Imp

Common Size Cash Flow

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Net Revenue 1,032,000

Cash Flow from Operating Activities

Net Income 258,000 25%

Depreciation 102,000 10%

Gain on Sale of Equipment 35,000 3%

Increase in Accounts Receivable (20,040) -2%

Increase in Inventory (75,740) -7%

Increase in Accounts Payable 5,400 1%

Net Cash provided by Operating Activitites 304,620 30%

Cash Flow from Investing Activities 0%

Cash from Sale of Equipment 10,700 1%

Cash paid for Equipment (54,000) -5%

Net Cash provided by Investing Activitites (43,300) -4%

Cash Flow from Financing Activities 0%

Cash paid to retire long term debt (56,000) -5%

Cash paid for dividends (38,000) -4%

Net Cash provided by Financing Activitites (94,000) -9%

Net Increase/Decrease in Cash 167,320 16%

Free Cash Flow

• Free Cash Flow to the Firm:

• Free cash flow to the firm (FCFF) is the cash available to all investors, both equity owners and debt

holders

• FCFF can be calculated by starting with either net income or operating cash flow.

• FCFF = net income + noncash charges (depreciation and amortization) + [Interest expense x (1 - tax

rate)] - fixed capital investment (net capital expenditures) – working capital investment

• FCFF = cash flow from operations + [Interest expense x (1 - tax rate)] - fixed capital investment (net

capital expenditures)

• Free Cash Flow to Equity:

• Free cash flow to equity (FCFE) is the cash available to equity owners

• FCFE = cash flow from operations - fixed capital investment (net capital expenditures) + debt issued -

debt repaid

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Questions for practice

1. Calculate cash paid to suppliers given following information (in $mn)

– Cost of Good Sold = $100

– Inventory => At the beginning of year = $10; At the closing of year = $12;

– Suppliers => At the beginning of year = $8; At the closing of year = $6;

A. $100 B.$104 C.$96

2. Given following information (in $mn), cash flow from operations is

– Dividend Paid to common shareholders = $10

– Retained Earnings => Opening Balance = $100; Closing Balance = $120

– Accounts Receivable =>Opening Balance = $50; Closing Balance = $60

– Account Payable => Opening Balance = $40; Closing Balance = $50

– Net Plant and Equipment =>Opening Balance = $100; Closing Balance = $80

A. $20 B.$30 C.$50

3. Under US GAAP, cash outflow on buying trading securities will be classified as

A. Operating activity

B. Investing activity

C. Financing activity

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Questions

4. Given following information (in $mn), calculate amount of plant and equipment a company sold

– Gross Plant and Equipment =>Opening Balance = $100; Closing Balance = $90

– Accumulated depreciation => Opening Balance = $20; Closing Balance = $25

– Capex incurred => $10

– Depreciation charged => $7

– Gain on sale of equipment => $2

A. $20 B.$22 C.$25

5. Under IFRS dividends received and interest paid will be classified in

Dividend Received Interest Paid

A. Operating Operating

B. Operating Financing

C. Either operating or investing Either operating or financing

6. Given following information, free cash flow to firm will be closest to

– Net Income: $8000; Depreciation = $2000; Interest Expenses = $1000

– Capital Expenditures= $3000; Increase in a/c receivables = $2000; Decrease in a/c payables = $1000

Tax Rate = 30%

A. 6,700

B. 4,700

C. 11,700

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Solutions

1. B.

– Cash paid to supplier: COGS + (CB of inventory – OB of inventory) + (OB of a/c payable – CB of

a/c payable) = $100 + (12-10) + (8-6) = $104

2. C.

– Net Income = Change in retained earnings + dividend paid = $20+$10 = $30;

– CFO = Net Income + Depreciation + Increase in payables – increase in receivables => $30 + (100-80) +

(50-40) – (60-50) = $50

3. A.

– US GAAP treats cash outflow on trading securities as operating activities as these are related to day to

day business activities

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Solutions

4. A.

– Amount received on sale = Book Value + Gain (loss) on sales

– Book Value of assets sold = Historical cost of assets sold – accumulated depreciation for assets

– Historical cost of assets sold = OB of Gross PP&E – CB of Gross PP&E + Capital expenditures

– Accumulated Depreciation (AD) of assets sold = OB of AD – CB of AD + Depreciation charged in P&L

– Hence => Historical cost of assets sold = 100 – 90 +10 = 20

– AD on assets sold = 20 – 25 + 7 = 2

– Book Value = 20 – 2 = 18

– Sale Receipt = 18 + 2 = 20

5. C.

– IFRS provide freedom to firms to report dividends or interest received as either operating or investing

activities and dividends or interest paid as operating or financing activities

6. B.

– FCFF = net income + noncash charges (depreciation and amortization) + [Interest expense x (1 - tax

rate)] - fixed capital investment (net capital expenditures) – decrease in A/c payable – increase in A/c

receivable

– FCFF = 8000 + 2000 + 1000 *(1-30%) – 3000 – 1000 - 2000= 4,700

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Other Webinars

Here are the links for the blogs of the other recent webinars on our website to

help you with CFA/FRM preparation

Linear regression analysis (11/04/2013)

Blog: http://www.edupristine.com/blog/demystifying-linear-regression-analysis-

for-frm-level-1-exam/

Understanding Income statement (12/04/2013)

Blog: http://www.edupristine.com/blog/cfa-tutorial-understanding-income-

statement-from-cfa-perspective/

Hedging strategies using futures (13/04/2013)

Blog: http://www.edupristine.com/blog/frm-tutorial-hedging-strategies-using-

futures-for-frm-level-1-exam/

You can find many more blogs on our website: www.edupristine.com/blog

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drop a mail to us to suggest a topic! You can check for updates on our site:

http://www.edupristine.com/webinars

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THANK YOU FOR YOUR PATIENCE!!

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