Financial Statements - Comments PDF

Slide N°2 Financial statements are written records that convey the business activities and the financial performance of a company. Financial statements are often audited by government agencies, accountants, firms, etc. to ensure accuracy and for tax, financing, or investing purposes. Following usu...

Slide N°2 Financial statements are written records that convey the business activities and the financial performance of a company. Financial statements are often audited by government agencies, accountants, firms, etc. to ensure accuracy and for tax, financing, or investing purposes. Following usual accounting standard there are four Financial statements that the firm must produce and broadcast regularly (yearly): 1. Balance Sheet 2. Income Statement 3. Statement of Cash Flows 4. Statement of Stockholders’ Equity These one will be detailed after. Slide N°3 The balance sheet gives details the contents of the main categories:  the assets of the firm: the resources it owns  the liabilities of the firm: the deb of the firm (right of the creditors)  Owner equity: the rights of the owner (also called net assets (asset – liabilities). It provides a basis for computing rates of return and evaluating its capital structure. It is a snapshot of what a company owns and owes, as well as the amount invested by shareholders. Slide N°4 An asset is any resource owned by a business or an economic entity. It is anything (tangible or intangible) that can be owned or controlled to produce value and that is held by an economic entity and that could produce positive economic value. In the balance sheet, assets are presented by decreasing order of liquidity. Thus, assets are ordered by decreasing amount of time it would usually take to convert them into cash. Thus, cash is always presented first, followed by marketable securities, then accounts receivable, then inventory, and then fixed assets. 1. current assets 2. investments 3. property, plant and equipment 4. intangible assets, such as patents, trademarks and goodwill 5. other assets, such as bond issue costs Formula Used for a Balance Sheet The balance sheet adheres to the following accounting equation, where assets on one side, and liabilities plus shareholders' equity on the other, balance out: Assets=Liabilities + Shareholders’ Equity This formula is intuitive: a company has to pay for all the things it owns (assets) by either borrowing money (taking on liabilities) or taking it from investors (issuing shareholders' equity). For example, if a company takes out a five-year, $4,000 loan from a bank, its assets (specifically, the cash account) will increase by $4,000. Its liabilities (specifically, the long-term debt account) will also increase by $4,000, balancing the two sides of the equation. If the company takes $8,000 from investors, its assets will increase by that amount, as will its shareholders' equity. All revenues the company generates in excess of its expenses will go into the shareholders' equity account. These revenues will be balanced on the assets side, appearing as cash, investments, inventory, or some other asset. Slide N°5 Liabilities gives the debts of the firm, they are ordered by maturity on a balance sheet. Thus, first current liabilities (< 1 year), long term liabilities (> 1 an) The most common liabilities are usually the largest like accounts payable and bonds payable. Most companies will have these two line items on their balance sheet, as they are part of ongoing current and long-term operations. Off-balance sheet (OBS) items is a term for assets or liabilities that do not appear on a company's balance sheet. Off-balance sheet items are typically those not owned by or are a direct obligation of the company. For example, when loans are securitized and sold off as investments, the secured debt is often kept off the bank's books. Prior to a change in accounting rules that brought obligations relating to most significant operating leases onto the balance sheet, an operating lease was one of the most common off-balance items. One must recast these OBS for proper Financial Analysis. Slide N°6 Stockholders’ equity represent the investor who own the firm. This equity can take different shapes:  Preferred stock: is quite similar to common stock. The preferred stock is a type of share that often has no voting rights, but is guaranteed a cumulative dividend. If the dividend is not paid in one year, then it will accumulate until paid off. Example: A preferred share of a company is entitled to $5 in cumulative dividends in a year. The company has declared a dividend this year but has not paid dividends for the past two years. The shareholder will receive $15 ($5/year x 3 years) in dividends this year.  Common stock: represents the owners’ or shareholder’s investment in the business as a capital contribution. This account represents the shares that entitle the shareowners to vote and their residual claim on the company’s assets. The value of common stock is equal to the par value of the shares times the number of shares outstanding. For example, 1 million shares with $1 of par value would result in $1 million of common share capital on the balance sheet.  Other paid-in capital is another term for contributed surplus. It represents any amount paid over the par value paid by investors for stocks purchases that have a par value. This account also holds different types of gains and losses resulting in the sale of shares or other complex financial instruments. Example: The company issues 100,000 $1 par value shares for $10 per share. $100,000 (100,000 shares x $1/share) goes to common stock, and the excess $900,000 (100,000 shares x ($10-$1)) goes to Contributed Surplus. One important resource for the firm is the part of the benefit that it keep:  Retained earnings: is the portion of net income that is not paid out as dividends to shareholders. It is instead retained for reinvesting in the business or to pay off future obligations.  Treasury stock: is a contra-equity account. It represents the amount of common stock that the company has purchased back from investors. This is reflected in the books as a deduction from total equity.  Other comprehensive income: Other comprehensive income is excluded from net income on the income statement because it consists of income that has not been realized yet. For example, unrealized gains or losses on securities that have not yet been sold are reflected in other comprehensive income. Once the securities are sold, then the realized gain/loss is moved into net income on the income statement.  Other equity items: For instance, available-for-sale security (AFS) is a debt or equity security purchased with the intent of selling before it reaches maturity or holding it for a long period should it not have a maturity date. Available-for-sale securities are reported at fair value; changes in value between accounting periods are included in accumulated other comprehensive income in the equity section of the balance sheet. Slide N°7 Also known as, the profit and loss statement or the statement of revenue and expense, the income statement primarily focuses on the company’s revenues and expenses during a particular period.  Operating Revenue Revenue realized through primary activities is often referred to as operating revenue. For a company manufacturing a product, or for a wholesaler, distributor or retailer involved in the business of selling that product, the revenue from primary activities refers to revenue achieved from the sale of the product. Similarly, for a company (or its franchisees) in the business of offering services, revenue from primary activities refers to the revenue or fees earned in exchange of offering those services.  Primary Activity Expenses All expenses incurred for earning the normal operating revenue linked to the primary activity of the business. They include the cost of goods sold (COGS), selling, general and administrative expenses (SG&A), depreciation or amortization, and research and development (R&D) expenses. Typical items that make up the list are employee wages, sales commissions, and expenses for utilities like electricity and transportation.  Secondary Activity Expenses All expenses linked to non-core business activities, like interest paid on loan money.  Gains Also called other income, gains indicate the net money made from other activities, like the sale of long-term assets. These include the net income realized from one-time non-business activities, like a company selling its old transportation van, unused land, or a subsidiary company.  Losses as Expenses All expenses that go towards a loss-making sale of long-term assets, one-time or any other unusual costs, or expenses towards lawsuits. While primary revenue and expenses offer insights into how well the company’s core business is performing, the secondary revenue and expenses account for the company’s involvement and its expertise in managing the ad-hoc, non-core activities. Net Income = (Revenue + Gains) – (Expenses + Losses) Comprehensive income is the sum of regular income and other comprehensive income. It provides a more complete view of a company's income. Other comprehensive income items occur rather infrequently for smaller businesses, so it is most important for valuing larger corporations. Unrealized gains and losses from assets are the primary representation of other comprehensive income. Other comprehensive income is not listed with net income, instead, it appears listed in its own section, separate from the regular income statement and often presented immediately below it.  Slide N°8 In accounting, revenue is the income that a business has from its normal business activities, usually from the sale of goods and services to customers. Revenue is also referred to as sales or turnover. List of Revenue Accounts 1. Service Revenue - revenue earned from rendering services. Other account titles may be used depending on the industry of the business, such as Professional Fees for professional practice and Tuition Fees for schools. 2. Sales - revenue from selling goods to customers. It is the principal revenue account of merchandising and manufacturing companies. o Sales Discounts - a contra-revenue account that represents reduction in the amount paid by customers for early payment. It is shown in the income statement as a deduction to Sales. o Sales Returns and Allowances – is also a contra-revenue account and therefore shown as a deduction to Sales. Sales return occurs when there is actual return of a defective item. Sales allowance happens when the customer is willing to keep the item with a reduction in its selling price. 3. Rent Income - earned from leasing out commercial spaces such as office space, stalls, booths, apartments, condominiums, etc. 4. Interest Income - revenue earned from lending money 5. Commission Income - earned by brokers and sales agents 6. Royalty Income - earned by the owner of a property, patent, or copyrighted work for allowing others to use such in generating revenue 7. Franchise Fee - earned by a franchisor in a franchise agreement On the income statement, net income is computed by deducting all expenses from all revenues. Revenues are presented at the top part of the income statement, followed by the expenses. Revenue is one of the most important measures used by investors in assessing a company’s performance and prospects. However, revenue recognition guidance differs in U.S. Generally, Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS)—and many believe both standards are in need of improvement.  Presently, U.S. GAAP has complex, detailed, and disparate revenue recognition requirements for specific transactions and industries including, for example, software, real estate, and construction contracts. As a result, different industries use different accounting for economically similar transactions.  Conversely, IFRS has two main revenue recognition standards with limited implementation guidance that many believe can be difficult to understand and apply. The objective of the new guidance is to establish the principles to report useful information to users of financial statements about the nature, timing, and uncertainty of revenue from contracts with customers. It will:   Provide a more robust framework for addressing revenue issues as they arise  Increase comparability across industries and capital markets  Require better disclosure so investors and other users of financial statements better understand the economics behind the numbers. The new guidance establishes the following core principle: Recognize revenue in a manner that depicts the transfer of goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. Slide N°9 An operating expense is an expense a business incurs through its normal business operations. Often abbreviated as OPEX, operating expenses include rent, equipment, inventory costs, marketing, payroll, insurance, step costs, and funds allocated for research and development. Income statements typically categorize expenses into six groups: 1) cost of goods sold (manufacturing sector); Cost of sales (services) 2) selling, general, and administrative costs; 3) depreciation and amortization; 4) other operating expenses; 5) interest expenses; 6) income taxes (provision) All these expenses can be considered operating expenses, but when determining operating income using an income statement, interest expenses and income taxes are excluded. Slide N°10 A non-recurring item is a gain or loss found on a company's income statement that is not expected to occur regularly. Examples of non-recurring items are litigation fees, write-offs of bad debt or worthless assets, employee-separation costs, and repair costs for damage caused by natural disasters. To get ahead as a financial analyst, you must become very skilled at using past information to make reasonably accurate predictions of the future. When it comes to analyzing a company, successful analysts spend considerable time trying to differentiate between accounting items that are likely to recur going forward from those that most likely will not. A key part of this analysis is to understand items that qualify as extraordinary items or nonrecurring items. A good analyst will separate these items from recurring ones and will stand a much better chance at predicting the future of a company than one who simply looks at the bottom-line earnings companies must report in their financial statements.  Extraordinary items are gains or losses in a company's financial statements that are unlikely to happen again.  A nonrecurring item refers to an entry that is infrequent or unusual that appears on a company's financial statements.  The difference between extraordinary items and nonrecurring items is often subjective, and therefore extraordinary items are often lumped under nonrecurring items.  The International Financial Reporting Standards (IFRS) does not recognize extraordinary items, only nonrecurring items.  Generally accepted accounting principles (GAAP) makes more of a distinction between the two but this has become less common as the tax advantages of extraordinary items have disappeared Most financial literature tends to lump one-time items together and focus on separating them from those that are likely to recur in the future. In many cases, this is fine because the most important exercise in analyzing a firm’s financial statements is separating recurring from nonrecurring items. However, there are differences to note. For instance, nonrecurring items are recorded under operating expenses in the net income statement. By contrast, extraordinary items are most commonly listed after the bottom line net income figure. They are also usually provided after taxes and must be explained in the notes to the financial statements. Slide N°11 Gross Profit = Total Revenue – Cost of Goods Sold (COGS) Gross profit is an effective measure to assess a company's efficiency in producing goods and services. It is a very good indicator of the cost of production. This may include things such as labor, raw materials, or consumable supplies. Operating income is an accounting figure that measures the amount of profit realized from a business's operations, after deducting operating expenses such as wages, depreciation and cost of goods sold (COGS). Operating income—also called income from operations—takes a company's gross income, which is equivalent to total revenue minus COGS, and subtracts all operating expenses. A business's operating expenses are costs incurred from normal operating activities and include items such as office supplies and utilities. Income before taxes can be a particularly useful metric, especially if you examine it over multiple years by comparing it to other metrics. Pretax income is calculated by subtracting a company's operating expenses from its revenue. For example, if a company has $10 million in revenue and its operating expenses are $8 million, it has $2 million in income before taxes. Looking at income before taxes is informative because income tax laws change from time to time depending on economic, social, and political factors. This causes after-tax income to fluctuate in a way that does not always indicate the economic engine a business has running under the hood. Income before taxes should be more consistent than after-tax income. Look at a firm's long- term income before taxes figure and compare it to total sales, tangible assets, or shareholders' equity. Put it side by side with other companies in the same sector or industry to fully understand its performance. Certain industries tend to outperform other industries by this metric, so making an apples-to-apple comparison is of particular importance for this type of analysis. Looking at income before taxes also helps with comparing companies because while everyone has the same federal tax rate, state taxes vary significantly. Continuing operations refer to all business operations, excluding the segments that are discontinued. These operations generate revenue for the business through the sale of goods and services. The income from the continuing operations is reported in a multi-step income statement of the business that accounts for the regular business activities, including the tasks required for making a product or providing a service. It is defined as the earnings of the business after expenses have been deducted. [Close to operating income when there is none discontinued segment.] Net income, also called net earnings, is sales minus cost of goods sold, general expenses, taxes, and interest. Comprehensive income is the variation in a company's net assets from non-owner sources during a specific period. Comprehensive income includes net income and unrealized income, such as unrealized gains or losses on hedge/derivative financial instruments and foreign currency transaction gains or losses. Slide N°12 The Statement of Cash Flows (also referred to as the cash flow statement) is one of the key financial statements. It reports the cash generated and spent during a specific period of time (e.g., a month, quarter, or year). The statement of cash flows acts as a bridge between the income statement and balance sheet by showing how money moved in and out of the business. Three Sections of the Statement of Cash Flows: 1. Operating Activities: The principal revenue-generating activities of an organization and other activities that are not investing or financing; any cash flows from current assets and current liabilities 2. Investing Activities: Any cash flows from the acquisition and disposal of long-term assets and other investments not included in cash equivalents 3. Financing Activities: Any cash flows that result in changes in the size and composition of the contributed equity capital or borrowings of the entity (i.e., bonds, stock, dividends) Plus The statement of stockholders’ equity combines the required statement of retained earnings and information about changes in other equity accounts into a single. Slide N°13 Cash flow from operations is the section of a company’s cash flow statement that represents the amount of cash a company generates (or consumes) from carrying out its operating activities over a period of time. Operating activities include generating revenue, paying expenses, and funding working capital. It is calculated by taking a company’s (1) net income, (2) adjusting for non-cash items, and (3) accounting for changes in working capital. While the exact formula will be different for every company (depending on the items they have on their income statement and balance sheet), there is a generic cash flow from operations formula that can be used: Cash Flow from Operations = Net Income + Non-Cash Items + Changes in Working Capital While operating cash flow tells us how much cash a business generates from its operations, it does not take into account any capital investments that are required to sustain or grow the business. To get a complete picture of a company’s financial position, it is important to take into account capital expenditures (CapEx), which can be found under Cash Flow from Investing Activities. Deducting capital expenditures from cash flow from operations gives us Free Cash Flow, which is often used to value a business in a discounted cash flow (DCF) model. Slide N°14 Cash flow from investing activities is one of the sections on the cash flow statement that reports how much cash has been generated or spent from various investment-related activities in a specific period. Investing activities include purchases of physical assets, investments in securities, or the sale of securities or assets. Cash flows from investing activities provides an account of cash used in the purchase of non- current assets–or long-term assets– that will deliver value in the future. Investing activity is an important aspect of growth and capital. A change to property, plant, and equipment (PPE), a large line item on the balance sheet, is considered an investing activity. When investors and analysts want to know how much a company spends on PPE, they can look for the sources and uses of funds in the investing section of the cash flow statement. Capital expenditures (CapEx), also found in this section, is a popular measure of capital investment used in the valuation of stocks. An increase in capital expenditures means the company is investing in future operations. However, capital expenditures are a reduction in cash flow. Typically, companies with a significant amount of capital expenditures are in a state of growth. Cash flow from financing activities (CFF) is a section of a company’s cash flow statement, which shows the net flows of cash that are used to fund the company. Financing activities include transactions involving debt, equity, and dividends. Cash flow from financing activities provides investors with insight into a company’s financial strength and how well a company's capital structure is managed. Formula and Calculation for CFF Investors and analyst will use the following formula and calculation to determine if a business is on sound financial footing. CFF = CED − (CD + RP) Where: CED = Cash inflows from issuing equity or debt CD = Cash paid as dividends RP = Repurchase of debt and equity Add cash inflows from the issuing of debt or equity. 1. Add all cash outflows from stock repurchases, dividend payments, and repayment of debt.  2. Subtract the cash outflows from the inflows to arrive at the cash flow from financing activities for the period. As an example, let us say a company has the following information in the financing activities section of its cash flow statement:  Repurchase stock: $1,000,000 (cash outflow)  Proceeds from long-term debt: $3,000,000 (cash inflow)  Payments to long-term debt: $500,000 (cash outflow)  Payments of dividends: $400,000 (cash outflow) Thus, CFF would be as follows:  $3,000,000 - ($1,000,000 + $500,000 + $400,000), or $1,100,000 Slide N°15 The Statement of Stockholders’ Equity highlights the changes in value to stockholders' or shareholders' equity, or ownership interest in a company, from the beginning of a given accounting period to the end (Typically, from the beginning of the year through the end). In its simplest form, shareholders' equity is determined by calculating the difference between a company's total assets and total liabilities. The statement of shareholders' equity highlights the business activities that contribute to whether the value of shareholders' equity goes up or down. The statement of shareholders' equity typically includes the following components:  Preferred stock. This is a special type of stock, or ownership stake in a company, that offers holders a higher claim on a company's earnings and assets than those who own the company's common stock. Preferred stockholders will typically be entitled to dividends before holders of common stock can receive theirs. Preferred stock is usually listed on the statement of shareholders' equity at par value, or face value, which is the amount at which it is issued or redeemable. Holders of preferred stock do not have voting rights in the issuing company.  Common stock. This is a type of stock, or ownership stake in a company, that comes with voting rights on corporate decisions. Common stockholders are lower down on the list of priorities when it comes to paying equity holders. If a company needs to liquidate, holders of common stock will be paid after preferred stockholders and bondholders. Like preferred stock, common stock is typically listed on the statement of shareholders' equity at par value.  Treasury stock. Treasury stock is stock that the issuing company repurchases. A company might repurchase its own stock in an attempt to avoid a hostile takeover or boost its stock price. Shareholders' equity is reduced by the amount of money spent to repurchase the shares in question.  Additional paid-up capital. Also known as, contributed capital, additional paid-up capital is the excess amount investors pay over the par value of a company's stock.  Retained earnings. Retained earnings are the total earnings a company has brought in that have not yet been distributed to shareholders. This figure is calculated by subtracting the amount paid out in shareholder dividends from the company's total earnings since inception. A company that has been profitable for quite some time will probably show a large amount of retained earnings.  Unrealized gains and losses. Unrealized gains and losses reflect the changes in pricing for investments. An unrealized gain occurs when an investment gains in value but has not been cashed in. Similarly, an unrealized loss occurs when an investment loses value but has not yet to be sold off. The statement of shareholders' equity enables shareholders to see how their investments are faring. It is also a useful tool for companies in helping them make decisions about future issuances of stock shares.