Chapter 2.

Overview of F. Statement

2.1. Balance sheet

2.2. Income statement
2.3.Cash flow statement
 Chapter objective
After studying this chapter, you should be able to:

● Discuss the content, form and utility of financial

statements (BS,IS,CFS)
● Show the relationship among financial
statements
● Identify the uses and limitations of an financial
statements.
 Fruit
Businesses are like Fruit Trees…

Net Goods &

Earnings Services
Operating
Activities

Reinvested Investment
Investing in Producing Branches
Activities Assets Trunk &

Debt
Payment Debt
Financing Financing
Activities Roots
Dividends Equity
Financing
 The 3 basic activities involved in conducting a business
are:
• Financing activities (Roots):
- Owners contribute cash and receive equity shares in return.
- Creditors loan cash in return for the promise of interest and principal payments.

• Investing activities (Trunk and branches):

Once the capital is collected it is invested in producing assets, like buildings,
equipment, machinery and vehicles.

• Operating activities (Fruit):

The assets are operated to produce goods & services which are sold to customers.

The Net Income of these sales can be used in three ways:

1. Reinvested in the producing assets

2. Returned to the creditors in the form of debt payments

3. Returned to the owners in the form of dividends

 The Financial Statements are designed to measure
different
• The Balance Sheet aspects
of branches,
Is a picture of the tree (fruit, the business (the
trunk & fruit
roots)tree):
at a certain point in time.
It includes assets (inventory of goods and producing assets) and financing sources
(equity, debt and reinvestments from net income) of the business.

• The Income Statement

Accounts for all activities involved in the operation of the business (growing and
selling the fruit) over a period of time. It contains a list of all operating expenses and
revenues of the business.

• The Statement of Cash Flows

Details all the cash inflows and outflows that occurred over a period of time
associated with the operating (fruit), investing (trunk and branch) and financing (roots)
activities of the business.

• The Statement of Retained Earnings

Reports how much of the net income from the operating activities are retained by the
business and how much paid as dividends.
 2.1.The Balance Sheet
● The balance sheet
shows assets and
the financing of
those assets at a
point in time
● Assets are the things
that a firm owns
● Liabilities are the
debts of the firm
● Equity is the
difference between
assets and liabilities
 Major Balance Sheet Items

Assets Liabilities and Equity

● Current assets: ● Current liabilities:
● Cash & securities ● Payables
● Receivables ● Short-term debt
● Inventories
● Fixed assets: ● Long-term liabilities
● Tangible assets
● Intangible assets ● Shareholders' equity
Current and Fixed Assets
● Current assets: convert to cash over the next 12
months
● Fixed Assets are held for periods longer than the
accounting period.
● Tangible assets: land, building, machinery…
● Intangible assets: patent, copy rights, goodwill….
 Liquidity
●Liquidity refers to the firm’s ability to pay debt
as they mature.
● Current assets: liquid assets
● Fixed assets: illiquid assets
●Liquidity assets are generally less profitability
to hold.
 LIMITATION OF B.S
● Under GAAP, assets are showed at historical Cost
● It ignores : Time (how long assets are purchased)
Present value (how much they are worth to day)
● Many of most valuable assets that a firm may have
(good mgt, reputation, talented employees) don’t
appear on the balance sheets.
2.2.The Income Statement
The income
statement provides
a summary of the
revenues and
expenses of a
company during an
accounting period
(annual, quarter,
month, etc.)

Note: G& A = general and administrative

 The Income Statement

●Revenues – Expenses = Income

●Revenues : is recognized at the time of

sale ( # time collection)
●Expenses associated with the sale of that
product will be recognized at that time.
 The Income
measures operating Statement
performance over a particular period of time.

Operating Revenues
− Operating Expenses
= Operating Income
+ Other Revenues (non- operating
Revenues)
− Other Expenses (non- operating Expenses)
= Net Income before Taxes
− Income Taxes
= Net Income after Taxes
/ Number of Shares
= Income
Net income is the most important perdisclosed
number Share on the financial statements.
Nature of Revenues
●Revenues are amounts which the customers
pay to the firm for providing them goods &
services.
● Eg: - sale goods for $5,000 in cash
- a customer sent an advance of $5,000
●It can arise from:
+ Sales of goods/services
+ Sales of assets
+Interest, dividend, fees….
 Nature of expense
● Expense is the cost of economic resources
used to earn revenue during a period of
time
● Eg: paying wages to workers

● Cost is not the same as an expense.

Expired and unexpired cost
•Expired costs are the
ones that helped to •Unexpired costs are
those costs that will
produce revenues.
helped to produce
• Expired costs revenues in the future
recognized as
•Unexpired costs
expenses in income
recognized as assets
statement.
in balance sheet.
•Expired costs are also
•Unexpired costs are
known as revenue
also known as capital
expenditure
expenditure
 Profit
●Gross profit = Sales – Cost of goods sold
●Profit before interest and taxes (EBIT)
= Gross Profit – selling, G&A expenses
●Profit before taxes (PBT):
= EBIT – interest
●Profit after taxes (PAT) or net profit (NP):
● =PBT – taxes
● Accounting versus Economic Profit??
Depreciation: a non-cash item
●Accountants define depreciation as, “a
systematic method of allocating the cost of
an asset over its useful life.”
For tax purposes, we aren’t allowed to
deduct the full cost of an asset in the year
of purchase. Instead, we must deduct the
cost over the life of the asset through
depreciation
●In finance, we tend to think of depreciation
as a way of reducing taxes
 Straight-line Depreciation

● Straight-line depreciation assumes that the value

of an asset declines equally in each year of its
life:

Where:
Cost of the asset is the purchase price of the asset
Salvage value is the value of the asset at the end of its useful life
Useful life of asset represents the number of periods/years in
which the asset is expected to be used by the company
Straight Line Example
Company A purchases a machine for $100,000 with
an estimated salvage value of $20,000 and a useful
life of 5 years.
The straight line depreciation for the machine would be calculated as
follows:
●Cost of the asset: $100,000
●Cost of the asset – Estimated salvage value: $100,000 – $20,000 =
$80,000 total depreciable cost
●Useful life of the asset: 5 years
●Divide step (2) by step (3): $80,000 / 5 years = $16,000 annual
depreciation amount
●Therefore, Company A would depreciate the machine at the amount
of $16,000 annually for 5 years.
MACRS Depreciation
● Generally speaking, we prefer to receive cash
flows sooner rather than later
● Ideally, we would like to be able to deduct the
full cost of an asset at the time of purchase
● However, except for small assets, this is not
allowed
● The IRS does allow accelerated depreciation
which is an improvement over straight-line
because it allows quicker tax savings
 MACRS Depreciation method
D = m(1/n)NBV
Where:
D is Depreciation cost per year
n is Useful life of the asset
NBV is Net book value of the asset
m is Depreciation coefficient
If:
n = 3; 5; 7 or 10 years => m = 2 (double-declining-balance
depreciation or 200%-declining-balance depreciation)
n = 15 or 20 years => m = 1.5
 MACRS example
An asset valued at $10,000 with a life of 5 years purchased in
February using the declining balance method of depreciation has a
depreciation coefficient of 200% and the half depreciation law applies to
the year of acquisition of the asset and the final year for depreciation, in
addition, from the fourth year onwards, the straight line is converted to
depreciation
The depreciation over the years is determined as follows:
N Formula D NBV
0 - - $10,000
1 [2(1/5)10000]0.5 = 2000 2000 10000 – 2000 = 8000
2 2(1/5)8000 = 3200 3200 8000 – 3200 = 4800
3 2(1/5)4800 = 1920 1920 4800 – 1920 = 2880
4 2880/2.5 = 1152 1152 2880 – 1152 =1728
5 2880/2.5 = 1152 1152 1728 – 1152 =576
6 0.5(2880/2.5) = 576 576 576 – 576 = 0
Usefulness of Income
Statement
1. Evaluate the past performance of the
enterprise.
2. Provide a basis for predicting future
performance.
3. Help assess the risk or uncertainty of
achieving future cash flows.
2.3.The Statement of Cash Flows

● This statement
shows where a
firm’s funds came
from and how they
were used
● Three parts:
Funds from Operations
● Funds from Investing
● Funds from Financing
 STATEMENT OF CASH FLOWS
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income after taxes
+ Depreciation and amortization
+ or - changes in current and noncurrent accounts that are associated
with the sale of goods and services
Net Cash Flows from Operating Activities (1)

CASH FLOWS FROM INVESTING ACTIVITIES:

+ Sales of plant, property, and equipment
- Purchases of plant, property, and equipment
Net Cash Flows from Investing Activities (2)

CASH FLOWS FROM FINANCING ACTIVITIES:

+ Increases in debt, preferred stock, common stock, and paid-in-capital
- Decreases in debt, preferred stock, common stock, and paid-in-capital
- Dividend payments
Net Cash Flows from Financing Activities (3)
Sources vs. Uses of Funds
● Sources of funds: Decrease ( ) in C. Assets
Increase ( ) in C.Liabilities

●Uses of funds: Increase ( ) in C. Assets

Decrease ( ) in C.Liabilities
Sourc Us
e e
(+) (-
Asse
)
t
Liabilit
y
 Cash outflow Cash inflows

Operating costs Operating revenues

Operating
activities

Purchase of assets Investing Sale of assets

activities

Dividends,debt payment Financing Equity, debt

activities
Depreciation and cash flows
DOLE COCA Income statement (2005)
Net sale: $600
Cost of goods sold: 300
● Depreciation is Depreciation : 150
not a new
EBIT: 150
source of
Interest: 30
funds.
Taxable income: 120
● Depreciation
Taxes: 41
should be add
Net income: 79
back to
determine the
amount of EBIT: $150
actual funds on +Depreciation: 150
hand. -Taxes: 41
=Operating Cash Flow (2005) 259
 The Relationships between the Financial
Statements
Statement of Cash Flows–1/1/N–12/31/N
Net cash flow from operating activities
Balance Sheet–12/31/N - Net cash used by investing activities Balance Sheet–12/31/N
1 Net cash provided by financing
Assets activities Assets
Cash Change in cash balance Cash
Other current assets Beginning cash balance (12/31/N-1) Other current assets
Long-term investments Ending cash balance (12/31/N) Long-term investments
Long-lived assets Long-lived assets
Income Statement–1/1/N–12/31/N Intangible assets
Intangible assets
Revenues
Liabilities and − Expenses Liabilities and
Stockholders’ Equity = Net income Stockholders’ Equity
Current liabilities Current liabilities
Long-term liabilities Statement of Retained Earnings Long-term liabilities
Contributed capital 1/1/N–12/31/N Contributed capital
Retained earnings Beginning retained earnings Retained earnings
balance
+ Net income
− Dividends
Ending retained earnings balance
Usefulness of F. Statement
1. Evaluate the past performance of the
enterprise.
2. Provide a basis for predicting future
performance.
3. Help assess the risk or uncertainty of
achieving future cash flows.
Limitations of F. Statement
●Use historical data
●Ignore inflationary trend and does not reflect
the true current worth of the enterprise,
● Ignore important qualitative elements :
quality and reputation of the management
team, employee and other,
ISSUES OR CHALLENGES
● When to and how much to recognize revenue in the
Income statement, ·
● The constant challenge of when to expense or to
capitalize the expenses.
● Method of depreciations
● Adequacy of provisions and method of providing for
doubtful debts. Are the trade debtors recoverable and to
what extent the accounting method for provision for
doubtful debts shows the realistic picture, ·
● Basis of valuation of assets- when can costs change to
reflect current values? Using replacement or current
costs? ·
Questions:
●Why is accounting income not the same as
cash flow? Give two reasons.
●Who need financial statement analysis?
(users of F.S)
Summary
● Balance Sheet
--> Reports the financial position at the end of the period.

● Income Statement
--> Reports the results of operations for the period.

● Statement of Cash Flows

--> Reports cash inflows and outflows during the period.

● Statement of Stockholders' Equity

--> Reports the changes in stockholders' equity during the
period.