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Financial Statements & Common Size Statements

Lecture -2

Introduction to Business Finance (BA 5401) Prepared by: Sunilla Faisal Spring 08
http://ba5401.googlepages.com
Contents

• What are Financial Statements?

• Importance of Finacial Statements

• Types of Statements (Income, Retained Earnings, Cash

Flow & Balance Sheet).

• Comparison of Income Statement & Balance Sheet

• Common Size Statements.

• Book Values in Finance


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What are Financial Statements?

Financial Statements are like fine perfume – to be sniffed but not

swallowed. (Abraham Brilloff)

• Financial Statements provide an overview of a business’

financial condition in both short and long term. (OR)

• Financial statements are the medium by which a company

discloses information concerning its financial performance.

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Importance of Financial Statements
• Internally
– Plan - Focus on assessing the current financial position and evaluating
potential firm opportunities.

– Control - Focus on return on investment for various assets and asset


efficiency.

– Understand - Focus on understanding how suppliers of funds analyze


the firm.

• Externally
– Trade Creditors - Focus on the liquidity of the firm.

– Bond Holders - Focus on the long-term cash flow of the firm

– Shareholders - Focus on the profitability and long-term health of the firm.


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Financial Statements – The System

•Financial statements paint a picture


of the transactions that flow through
a business. Each transaction or
exchange - for example, the sale of a
product or the use of a rented a
building block - contributes to the
whole picture.

Let's approach the financial


statements by following a flow of
cash-based transactions. In the
illustration (left), we have numbered
four major steps:

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Financial Statements – The System
1) Shareholders and lenders supply
capital (cash) to the company.
2) The capital suppliers have claims on
the company. The balance sheet is an
updated record of the capital invested
in the business. On the right-hand
side of the balance sheet, lenders
hold liabilities and shareholders hold
equity. The equity claim is "residual",
which means shareholders own
whatever assets remain after
deducting liabilities.

The capital is used to buy assets,


which are itemized on the left-hand
side of the balance sheet. The assets
are current, such as inventory, or
long-term, such as a manufacturing
plant.

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Financial Statements – The System
3) The assets are deployed to create cash
flow in the current year .Selling equity
and issuing debt start the process by
raising cash. The company then "puts
the cash to use" by purchasing assets
in order to create (build or buy)
inventory. The inventory helps the
company make sales (generate
revenue), and most of the revenue is
used to pay operating costs, which
include salaries.
4) After paying costs (and taxes), the
company can do three things with its
cash profits. One, it can (or probably
must) pay interest on its debt. Two, it
can pay dividends to shareholders at
its discretion. And three, it can retain
or re-invest the remaining profits. The
retained profits increase the
shareholders' equity account (retained
earnings).
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Types of Financial Statements

• Profit & Loss Account / Statement (Income


Statement)

• Balance Sheet

• Statement of Retained Earnings.

• Cash Flow Statement.

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Income Statement

• Also referred to as Profit & Loss Account.


• The Income Statement shows a firm's revenues and expenses,
and taxes associated with those expenses for some financial
period. Where the Balance Sheet may be thought of in terms of
the "left–right" orientation previously discussed, the income
statement would be thought of in "top–down" terms. (OR)
• An Income Statement, is a financial statement for companies
that indicates how Revenue (money received from the sale of
products and services before expenses are taken out, also
known as the "top line") is transformed into net income (the
result after all revenues and expenses have been accounted
for, also known as the "bottom line"). The purpose of the
income statement is to show managers and investors whether
the company made or lost money during the period being
reported.

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Income Statement

• Usefulness & Limitations


– Income statements should help investors and creditors determine
the past performance of the enterprise, predict future performance,
and assess the capability of generating future cash flows.
– However, information of an income statement has several limitations:
– The items that might be relevant but cannot be reliably measured are
not reported (e.g. brand recognition and loyalty)
– some numbers depend on different accounting methods used (e.g.
using FIFO or LIFO accounting to measure inventory level)
– some numbers depend on judgments and estimates (e.g. depreciation
expense depends on estimated useful life and salvage value).

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Income Statement (a)

Net Sales b
$ 2,211 • a. Measures profitability over a
Cost of Goods Sold 1,599 time period.
Gross Profit $ 612 • b. Amount received, or
SG&A Expenses c 402
receivable, from customers.
EBITd $ • c. Sales comm., adv., officers’
210 Interest Expensee salaries, etc.
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EBT f $ 151 • d. Operating income.
Income Taxes 60 • e. Cost of borrowed funds.
EATg $ 91
• f. Taxable income.
Cash Dividends 38
• g. Amount earned for
Increase in RE $ 53 shareholders.

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Income Statement – another example

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Retained Earnings

• Retained Earnings shows the amount of income allowed to


accumulate from the beginning of the corporation’s life to the
present.
• Retained Earnings represents a claim on assets, but it is not
cash.

Retained earnings, Dec 31, 20x4 (original) $390,000

Less: Prior-period adjustments – to correct


error in the 20x4 income tax 10,000
Retained earnings, Dec. 31, 20x4, adjusted $380,000
Net income for 20x5 114,000
Total $494,000
Deduct: Dividends declared in 20x5 41,000
Retained earnings, December 31, 20x5 $453,000

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Balance Sheet

• It is a statement detailing what a company owns (assets) and


claims against the company (liabilities and owners' equity) on a
particular date. Keeping in mind the assets and claims, it is
helpful to remember the "left–right" accounting equation
orientation—assets on the left side, claims on the right.
(OR)

• Balance sheet or statement of financial position is a


summary of a persons or organization's assets, liabilities and
Ownership equity on a specific date, such as the end of its
financial year. A balance sheet is often described as a
snapshot of a company's financial condition.

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Cash Flow Statement
• A cash flow statement or statement of cash flows is a financial
statement that shows a company's incoming and outgoing money
(sources and uses of cash) during a time period (often monthly or
quarterly). The statement shows how changes in balance sheet and
income accounts affected cash and cash equivalents, and breaks
the analysis down according to operating, investing, and financing
activities.
• As an analytical tool the statement of cash flows is useful in
determining the short-term viability of a company, particularly
its ability to pay bills.
• People and groups interested in cash flow statements include:
– accounting personnel, who need to know whether the organization will be able
to cover payroll and other immediate expenses
– potential lenders or creditors, who want a clear picture of a company's ability
to repay
– potential investors, who need to judge whether the company is financially
sound
– potential employees or contractors, who need to know whether the company
will be able to afford compensation
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Cash Flow Statement - Sample

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Balance Sheet
• A company balance sheet has three parts: assets, liabilities and
shareholders' equity. The main categories of assets are usually
listed first and are followed by the liabilities. The difference
between the assets and the liabilities is known as the net
assets or the net worth of the company. According to the
accounting equation, net worth must equal assets minus
liabilities.

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Balance Sheet (a) - contd

Cash and C.E. $ 90 • a. How the firm stands on a


Acct. Rec.c 394 specific date.
Inventories 696
Prepaid Exp d 5 • b. What BW owned.
Accum Tax Prepay 10
• c. Amounts owed by
Current Assets e
$1,195 customers.
Fixed Assets (@Cost) f
1030 • d. Future expense items
Less: Acc. Depr. g
(329) already paid.
Net Fix. Assets $701 • e. Cash and other liquid assets
Investment, LT 50 easily convertible to cash
Other Assets, LT 223 within 1 year.
Total Assets b $2,169 • f. Original amount paid.
• g. Acc. deductions for wear
and tear.

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Types of Balance Sheet
• Personal balance sheet - A personal balance sheet lists
current assets such as cash in checking accounts and savings
accounts, long-term assets such as common stock and real
estate, current liabilities such as loan debt and mortgage debt
due or overdue, and long-term liabilities such as mortgage and
other loan debt. Securities and real estate values are listed at
market value rather than at historical cost or cost basis.
Personal net worth is the difference between an individual's
total assets and total liabilities.
• Small business balance sheet - A small business balance
sheet lists current assets such as cash, accounts receivable,
and inventory, fixed assets such as land, buildings, and
equipment, intangible assets such as patents, and liabilities
such as accounts payable, accrued expenses, and long-term
debt. Contingent liabilities such as warranties are noted in the
footnotes to the balance sheet. The small business's equity is
the difference between total assets and total liabilities.

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Balance Sheet Structure

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Income Statement Vs Balance Sheet

• Communicates inflows and outflows • Communicates what the entity owns


of assets – inflows being the in terms of assets, liabilities and the
revenues generated and outflows are difference between the two,
the expenses. representing what the owners are
entitled to.
• Excess of Inflows over Outflows 
Net Income. • Owners portion is called Equity.
• Excess of Outflow over Inflows  Net • Assets = Liabilities + Equity
Loss. • Snapshot of an organizations’ assets,
• Revenue – Expenses = Net Income liabilities and equity at one point in
(Loss) time.

• Always prepared for a period of time • Always prepared for a point in time
and the term “for the period ended” and the term “as at” included in the
is included in the title. title.

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Income Statement Vs Balance Sheet

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Common-Size Statements

• An analysis of percentage financial statements where all


balance sheet items are divided by total assets and all income
statement items are divided by net sales or revenues.
• On a common-size income statement, each item is expressed
as a percentage of net sales.
• In the balance sheet, the common size is total assets.
• A common-size statement eases the comparison of different
companies.
• There are also used to compare the company to a specific
company.
• Enables valid comparisons over time or against competition.

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Common-Size Balance Sheet

Regular (thousands of $) Common-Size (%)


Assets 2005 2006 2007 2005 2006 2007
Cash 148 100 90 12.10 4.89 4.15
AR 283 410 394 23.14 20.06 18.17
Inv 322 616 696 26.33 30.14 32.09
Other CA 10 14 15 0.82 0.68 0.69
Tot CA 763 1,140 1,195 62.39 55.77 55.09
Net FA 349 631 701 28.54 30.87 32.32
LT Inv 0 50 50 0.00 2.45 2.31
Other LT 111 223 223 9.08 10.91 10.28
Tot Assets 1,223 2,044 2,169 100.0 100.0 100.0

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Common-Size Balance Sheet

Regular (thousands of $) Common-Size (%)


Liab+Equity 2005 2006 2007 2005 2006 2007
Note Pay 290 295 290 23.71 14.43 13.37
Acct Pay 81 94 94 6.62 4.60 4.33
Accr Tax 13 16 16 1.06 0.78 0.74
Other Accr 15 100 100 1.23 4.89 4.61
Tot CL 399 505 500 32.62 24.71 23.05
LT Debt 150 453 530 12.26 22.16 24.44
Equity 674 1,086 1,139 55.11 53.13 52.51
Tot L+E 1,223 2,044 2,169 100.0 100.0 100.0

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Common-Size Income Statement

Regular (thousands of $) Common-Size (%)


2005 2006 2007 2005 2006 2007
Net Sales 1,235 2,106 2,211 100.0 100.0 100.0
COGS 849 1,501 1,599 68.7 71.3 72.3
Gross Profit 386 605 612 31.3 28.7 27.7
Adm. 180 383 402 14.6 18.2 18.2
EBIT 206 222 210 16.7 10.5 9.5
Int Exp 20 51 59 1.6 2.4 2.7
EBT 186 171 151 15.1 8.1 6.8
EAT 112 103 91 9.1 4.9 4.1
Cash Div 50 50 50 4.0 2.4 2.3

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Book Values in Finance

• Book Value represents the value of an asset as recorded


on the financial statements (books) of a company.
• These are results of accounting procedures and reflect
how the accountant is keeping track of a particular asset.
• Book values exist for all assets and liabilities that a firm
owns (plant, equipment, equity, bonds, short-term
obligations, etc.)

• Book Value (physical asset) = Purchase price – Accumltd Dep

• Book Value (Financial Asset) = Total S.H.E / # of shares

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Thank you

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Backup Slides

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Financial Statements Tutorial

Microsoft
PowerPoint Presentation

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