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ANALYSIS OF FINANCIAL

STATEMENTS AND CASH FLOWS


TOPIC 2
Learning Objectives
1. Understand the needs of financial statements.
2. Distinguish between income statement, balance sheet
and statement of cash flows and identify the items in
those statements.
3. Explain the usage of financial ratio analysis in financial
statements analysis.
4. Calculate liquidity ratio, asset management ratio,
profitability ratio, leverage ratio and market value ratio
to evaluate a companys performance.
5. Describe the limitations of financial ratio analysis.

WRMAS 2
Needs of Financial Statements
In Malaysia, 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 users can be classified into 2 types:


Internal users- persons employed by the firm
External users- potential investors, the Government,
lenders, the public etc...

WRMAS 3
INCOME STATEMENT
Also known as Profit and Loss Statement.
It measures the results of a firms operation over a specific
period.
The bottom line of the income statement shows the firms profit
or loss for a period.
Usefulness of income statement:
-Evaluate the past performance of the firm.
-Provide a basis for predicting future performance.

WRMAS 4
Income Statement Terms
Revenue (Sales)-Money/Income derived from selling the
companys product or service
Cost of Goods Sold (COGS)-Cost of producing the
goods/services to be sold
Operating Expenses-Expenses related to marketing and
distributing the product or service and administration cost
(Example: marketing & selling, general & administrative,
depreciation expenses)
Financing Costs-The interest paid to creditors/bondholders
Tax Expenses-Amount of taxes owed, based upon taxable
income

WRMAS 5
Income Statement Form
SALES
- Cost of Goods Sold (COGS)
GROSS PROFIT
Operating Activities
- Operating Expenses
OPERATING INCOME (EBIT)
- Interest Expense
EARNINGS BEFORE TAXES (EBT)
- Income Taxes
Financing
EARNINGS AFTER TAXES (EAT) Activities
- Preferred Stock Dividends (if any)
NET INCOME (EARNING AVAILABLE FOR STOCKHOLDERS)
WRMAS 6
Example of Income Statement

WRMAS 7
Three additional important issues:

Operating income is NOT affected by how the firm is


financed.

Interest expense (financing cost) is subtracted from


income before computing the firms tax liability. i.e
Interest is not taxable expenses.

Firm that has a positive net income does NOT necessarily


mean it has any cash

WRMAS 8
BALANCE SHEET
Provides a snapshot of firms financial position at a
particular date.
It includes three main parts: assets, liabilities and equity.
Assets (A) -Productive resources owned by the firm
Liabilities (L) - Creditors claim
how those resources
Equity (E) - Owner claim are financed
A=L+E
The items are recorded at historical cost, so the book value
of a firm may be very different from its market value.

WRMAS 9
Balance Sheet A = L + E
Assets Liabilities (Debt) & Equity
Current Assets Current Liabilities
Cash Accounts Payable
Accounts Receivable Accrued Expenses
Short-term notes
Inventories Long-Term Liabilities
Prepaid Expenses Long-term notes
Fixed Assets Mortgages
Machinery & Equipment Equity
Buildings and Land Preferred Stock
Other Assets Common Stock (Par value)
Paid in Capital
Copyrights, Goodwill &
Retained Earnings
patents
Treasury Stock

TOTAL ASSETS TOTAL LIABILITIES + EQUITY


WRMAS 10
Balance Sheet Terms: Assets
CURRENT ASSETS
The assets will not stay in the business for long (relatively
liquid), or expected to be converted into cash within 12
months.
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.
Accounts receivable payments due from customers who
buy on credit.
Inventory raw materials, working in process and final
products that will be sold.
Prepaid expenses Items paid for in advance
WRMAS 11
Balance Sheet Terms: Assets
FIXED ASSETS
The assets are held for more than one year. Fixed assets
typically include: plant and machinery, building and land.
OTHER ASSETS
Assets that are neither current assets nor fixed assets. They
may include intangible assets that cant be touched or saw
physically such as patents, copyrights, and goodwill.

Balance Sheet Terms: Liabilities (Debt)


LIABILITIES are money borrowed from a creditor and must be
repaid at some predetermined date.
current liabilities (must be repaid within twelve months)
long-term liabilities (repayment time exceeds one year)

WRMAS 12
Balance Sheet Terms: Liabilities (Debt)
CURRENT LIABILITIES (Short-term Liabilities/Debts)
Liability that must be paid within 12 months.
Accounts payable (Credit extended by suppliers to a firm
when it purchases inventories)
Accrued expenses (Short term liabilities incurred in the
firms operations but not yet paid for)
Short-term notes (Borrowings from a bank or lending
institution due and payable within 12 months)

LONG-TERM LIABILITIES/DEBTS
Covers loan from banks or other sources that provide capital for
liability term more than 1 year.
(Example: buying machinery and building for period of 25 to 30
years using bank loan)

WRMAS 13
Balance Sheet Terms: Equity
EQUITY
Shareholders investment in the firm in the form of preferred
stock and common stock.
Preferred Stock (received dividend in fixed amount)
Common Stock
Treasury Stock (stock that has been re-purchased by the firm)
Retained Earnings (earnings retained and will be reinvest in
the firm)
Paid in Capital (money that a firm gets from potential
investors in addition to the stated value of the stock)

WRMAS 14
Example of Balance Sheet

WRMAS 15
STATEMENT OF CASH FLOWS
Definition: Shows the changes of cash for the company in
certain period of time.
Profits in the income statement are calculated on accrual
basis rather than cash basis.
Thus profits are not equal to cash.
Accrual basis is the principle of recording revenues when
earned and expenses when incurred, rather than when cash is
received or paid.
Thus sales revenue recorded in the income statement
includes both cash and credit sales.
Treatment of long-term assets: Asset acquisitions (that will last
more than one year, such as equipment) are not recorded as an
expense but are written off every year as depreciation expense.

WRMAS 16
Statement Of Cash Flows
Divided sources and uses of cash into THREE components:
Cash flow from operations (ex. Sales revenue, labor expenses)
Cash flow from investment (ex. Purchase of new equipment)
Cash flow from financing (ex. Borrowing funds, payment of div)

WRMAS 17
Income Statement Conversion:
From Accrual to Cash Basis
Two steps:
Add back depreciation (as it is a non-cash expense) to net income
Subtract any uncollected sales (i.e. increase in accounts receivable)
and cash payment for inventories (i.e. increase in inventories less
increase in accounts payables)

WRMAS 18
Example: Statement Of Cash Flows

WRMAS 19
The Concept of Cash Flow (CF Identity)
Cash flow is one of the most important pieces of information
that a financial manager can derive from financial statements
The statement of cash flows does not provide us with the same
information that we are looking at here
We will look at how cash is generated from utilizing assets and
how it is paid to those that finance the purchase of the assets

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 NWC

WRMAS 20
Cash Flow Summary

WRMAS 21
Statement of Retained Earnings
Statement of retained earnings reports how net
income and dividends affect a companys financial
position during the period.

Example for 2011:


Beginning balance, retained earnings 2010 + Net
income - Dividends = Ending balance, retained
earnings 2011

WRMAS 22