Financial Statements Explained PDF

\[00:00:00\] Budgeting revolves around three main statements. The income statement, the balance sheet, and the cash flow statement. Each one of them serves a different purpose and contains important information about how an enterprise is running. The full set of published financial statements of a c...

\[00:00:00\] Budgeting revolves around three main statements. The income statement, the balance sheet, and the cash flow statement. Each one of them serves a different purpose and contains important information about how an enterprise is running. The full set of published financial statements of a company can be found in its annual report for the given year. This is a good starting point for everyone who is involved in business planning. After all, you have to know the past before predicting the future, right? In this lesson, we will talk about the income statement, which basically answers the following questions. How did the company perform throughout the period Did it generate a profit or a loss? In short, it helps us understand whether the operations of the firm created economic value or not. By the same token, budgeting teams draft a projected income statement. Which illustrates the company\'s expected performance in terms \[00:01:00\] of profitability. We make the side note that profit, net income, and earnings are used interchangeably throughout the course. Okay, in reality, the income statement adopts various names, such as the statement of operations, statement of earnings, Profit and Loss Statement, or simply the P& L. Whatever the title, it all comes down to the very same thing. A company\'s profit, or net income, generated as a result of the normal business operations. Simple as that. Before we begin, you must bring to mind that the primary drivers of net income are revenue and expenses. It does ring a bell, doesn\'t it? Great. Logically, revenue minus expenses gives net income figure for the period. When preparing a budget, we have to start from the P& L\'s top line, the revenue figure. By definition, this is the inflow of economic benefits as a result of selling \[00:02:00\] goods and services in the normal business operations. In budgeting terms, total revenue is based on the sales that a company expects to generate in the upcoming periods. We all know that revenue is the main profit driver. Without sales, there would be no point in budgeting the rest of the P& L lines. Having a revenue estimate allows us to project the related production costs and other expenses and calculate profit an income statement summarizes all the company\'s expenses, too. Practically, this is the outflow of economic resources that results from normal business operations. To produce, deliver, and sell goods to clients, firms need to incur certain expenses, and so the most common ones are cost of goods sold. Selling, general and administrative costs, also known as SG& A, depreciation and amortization, as well as interest expenses, and \[00:03:00\] taxes. Let\'s see what these refer to. Costs of goods sold are expenses that are necessary to manufacture the goods that the firm sells. For example, a dairy company needs to buy raw milk from local producers, transport, process, and then package it, before it can sell it to supermarkets. For Thus, to produce cheese, the firm generates specific costs. Remember, expenses that directly derive from the production of finished products are recorded as cost of goods sold, or COGS. The difference between the total revenue and cost of goods sold is called gross profit. This is what a company makes after deducting its costs of production. If we scroll further down the income statement of a company, We come across operating expenses These are ongoing costs for running the business. For example, every organization generates some selling, general, and administrative expenses, often called SG& A. This is a large income \[00:04:00\] statement category that comprises the costs of making sales, such as marketing and promotional expenses. Besides, we also add office related operating expenses payroll costs for the management team or the accounting personnel. Office rent and utility bills are often common examples of S, G, and A expenses. So, Gross profit minus SG& A comes down to earnings before tax, amortization, and depreciation, or EBITDA amount. This is another level of profitability that we will need when preparing the projected financial statements then we come across the depreciation and amortization line. Broadly, it reflects the using up of tangible and intangible assets. Depreciation refers to assets of physical nature such as property, plants, or machinery. With time, the plants that a company owns become older, and their value goes down. To account for such reduction, its \[00:05:00\] accountants book an annual depreciation expense, which further decreases its profitability multiples. Amortization, on the other hand, is what we use to refer to the wear and tear of intangible assets, such as goodwill, licenses, copyrights, and so on. Okay, what\'s next? If we deduct the depreciation and amortization expense from the EBITDA figure, we obtain the operating profit of the company. It is sometimes referred to as earnings before interest and taxes, or simply EBIT. As easy as that. Hang on a minute. Since we have earnings before interest and taxes, Shouldn\'t we have earnings after interest and taxes too? That\'s true. Most companies incur finance costs, which they don\'t consider when calculating their operating profits. For instance, interest expense is the cost that an organization incurs for borrowing funds externally. Quite often, firms would receive bank \[00:06:00\] loans and pay interest expenses for the amounts they owe. So, the next accounting equation we need to remember is, EBIT minus interest expense results in earnings before tax. the EBT figure. And finally, we have taxes. As Albert Einstein once said, the hardest thing in the world to understand is income tax. He might have been right. The rules for measuring the amount of income tax generated by a firm vary widely among countries. every organization pays corporate taxes that are proportional to the amount of their pre tax profits. https: TheBusinessProfessor. com Once all expenses are recorded, we arrive at net income. This is the excess of revenues over total expenses. It is also known as the bottom line of the income statement. The net income figure is very important, as it represents profitability after accounting for all its costs. Browsing through the income statement of ABC Corporation, you can see all the \[00:07:00\] individual lines we have just discussed. You can quickly tell that this is a profitable business. Net income is positive and growing, and elaborate on the different types of expenses if needed. For financial professionals, it is important to understand in detail the published reports of a company before trying to make any forecasts of the future. Excellent. To sum up, when companies prepare a budget, they pay special attention to the sales projection, As soon as the revenue estimate is ready, the expense lines in the income statement are thoroughly budgeted, often taking into consideration the planned level of sales. The next step of the planning process has to do with budgeting the company\'s balance sheet. The balance sheet is a statement that shows what the company owns and owes. It is a snapshot of a firm\'s financials at a certain date. Officially, we call it a statement of financial position. how do we prepare the balance sheet budget? To do that, we will divide the process into three \[00:08:00\] simple steps. First, you need to find the major line items to be projected. After that, you must decide on the end period dates. And the third and final step is to work out the estimates. Let\'s now take a closer look at each of them separately. All right, when it comes to building a projected balance sheet, You should make sure that you include three major elements. The first one is the company\'s assets. These are resources controlled by the entity as a result of past events that are expected to bring future economic benefits. The second section is liabilities, which illustrates the current obligations of a company arising from past events expected to result in a future outflow of economic benefits finally, the equity section. It merely displays the owner\'s residual interest in the company. As such, the equity amount equals the difference between total assets and total liabilities. Here comes the tricky part. The total assets figure in the balance sheet \[00:09:00\] should always equal the sum of total liabilities and owner\'s equity. This is the basic accounting equation. It is valid for every single set of financial statements out there. The relationship could also be summarized in a slightly different way. If we say that the left hand side reflects the resources that will be controlled by a company, or its assets, then the right hand side shows how it will finance these resources. firms can raise funds by incurring liabilities to external and internal stakeholders, Or by increasing owner\'s share in the business. This is an important relationship to remember when planning your budget. Altogether, these three components are the backbone of your projections. You should put much thought into each of the sections and have them reflect the company\'s goals accurately. Having specified the budget elements, you can now decide on the period of time you wish to project for. In that regard, you should be mindful that, the balance sheet always pertains to a specific point in \[00:10:00\] time. remember ABC Corporation? Its Statement of Financial Position is prepared as at 31st of December each year. So, we say that the balance sheet date is December 31st. In practice, the end period date of your projected statement does not necessarily have to be the same as the firm\'s financial year end. It can vary depending on your budget, horizon, and goals. Okay, let\'s look at the three major classes we\'ve included in the report again. More specifically, we will delve into the subtotals in each section. we divide items into current and non current assets, as well as current and non current liabilities. There must be a reason for such a distinction. Yes, there is. It is fundamental for you to understand this classification The simplest way to differentiate is to set a threshold of one year after the balance sheet date. This is how it works in practice. If assets are primarily held for trading, or are \[00:11:00\] expected to be sold, used, or otherwise realized in cash within one year, They are current assets. Inventory, trade receivables, cash and cash equivalents are among the most common current assets lines in every statement of financial position. For instance, if receivables from clients are expected to be collected on 30th of June next year, then we report them as trade receivables in the current assets section. To make proper assumptions about the expected amount of current assets, We should dig deeper into the firm\'s customer agreements, financial stats, and inventory policies. So far, so good. Did you notice that we may also need to include a trade receivables line in the non current assets section? Why is that? That\'s right. Some receivables may be overdue or may be scheduled for receipt later than 31st of December next year. And that\'s longer than the one year threshold. In short, assets that are \[00:12:00\] expected to be used for a longer period are defined as non current, long term, or long lived assets. Common examples are property, plant, equipment owned by the company, intangible assets, or deferred tax assets. As such, it is your job to find out what are the expected non current assets and how much they will account for in the given period. Okay. Similarly, liabilities to be settled within a year after the reporting date are classified as current liabilities. Can you think of some examples? Trade payables, of course. Companies usually pay their suppliers in 30 to 90 days, depending on agreements. That\'s why trade payables will be included in the current liabilities section of the budgeted balance sheet. Of course, the total amount outstanding largely depends on the firm\'s volume of purchases from suppliers and the respective credits it might get. Nice. What \[00:13:00\] else does this subcategory cover? Current income tax payable is normally due three months after the balance sheet date, and you will find it in this section too. So are the borrowings due within the next 12 months. Looking at the respective loan contracts and payment schedules, You will be able to estimate these items. Okay, further down the line, there are non current liabilities. These are obligations settled after one year of the balance sheet date. Some of the common items you will find in this section are long term borrowings, deferred tax liabilities, and non current liabilities. and provisions for retirement benefit obligations. Finally, we need to balance up the balance sheet by estimating the expected owner\'s equity. It is affected by all the transactions with shareholders, such as the issuance of share capital, distribution of dividends, or profit accumulation in the retained earnings account. More on that later in the course. \[00:14:00\] Excellent! Don\'t forget that the sum of total equity and liabilities should always reconcile to total assets. This stands not only for a firm\'s historical balance sheet, but also for its predicted statement of financial position. Good job, everyone. After we prepare a budget and the balance sheet, we can move on to cashflow planning. You already know about the balance sheet and the income statement. What connects these two? Yes, the net income figure It is calculated as revenue minus expenses in the income statement, and then accumulated as retained earnings in the balance sheet. However, the profit figure is not the only key indicator of business performance. An integral part of a firm\'s financial well being happens to be its cash flow position. How so? Think about it. From an analytical standpoint, the income statement might show that a company is quite profitable. But then you notice it\'s \[00:15:00\] running low on cash, and you can\'t help but envision major shortages. Unfortunately, many firms fail to recognize the difference between profitability and liquidity. And in doing so, expose themselves to huge risks. For an entrepreneur, one thing that is worse than a cash flow squeeze is a cash flow squeeze that happens when the business is growing. Imagine you browse through a firm\'s income statement, and you see it earns a profit. For the last year, its net income amounts to 1 million. That\'s great. However, in the next 30 days, the company needs to repay a portion of its debt equal to 500, 000. At first glance, the business is doing fine, Most of its revenues and expenses have been collected and paid on time. Nevertheless, it\'s yet to collect 750, 000 from two of its big clients. Hence, a big portion of total receivables is now overdue. \[00:16:00\] As a result, the firm has 250, 000 left in its insufficient to cover the debt obligation. At the same time, two clients continue to delay their payments. So, is this a profitable business? Yes, it is. Does it have liquidity issues? It certainly does. If the company can\'t collect cash from these two clients, it runs the risk of being unable to repay its load on time, which, by definition, makes it insolvent. Therefore, the survival of an entity depends on its ability to pay its obligations when they fall due. Rather than striving for profits at the expense of cash shortages. This is just one of the myriad examples out there, proving the significance of having cash and cash equivalents at the ready. Companies performance and prospects practically stem from the ability to balance their profitability and liquidity indicators. The latter go hand in \[00:17:00\] hand with the firm\'s cash position And what better way to keep an eye on all this than to set up a separate financial statement? As such, the cash flow statement identifies the cash that flows in and out of an entity and points out where it is generated and spent. It shows whether day to day operations bring enough cash to sustain the business, pay obligations, and interest expenses. It also tells us how much has been invested so far. Along with a company\'s liquidity and resourcefulness to take advantage of new business opportunities as they arise. That\'s why it plays an important role in budgeting and forecasting as well. Needless to say, the use of the cash flow statement is very much in sync with the rest of the financial reports. users can gain further appreciation of the change in assets and liabilities, or scratch the surface of an entity\'s liquidity and solvency positions. By the same \[00:18:00\] token, we can see an organization\'s ability to adapt to changing circumstances by adjusting the amount and timing of cash flows. In other words, projecting the cash flow will enable a firm to predict and possibly prevent unfavorable scenarios in the future. Essentially, understanding how the cash flow statement functions is your bread and butter in budgeting. You should understand that profitability and growth potential are worthless without cash generating abilities. Therefore, it\'s critical for you to learn how to draft projected cash reports properly. In this lesson, we\'ll look at the three components, or sections, of a typical cash flow statement. In short, cash flows appear as a result of an entity\'s operating, investing, and financing activities. Why do we need to cluster business activities, you may wonder? Because this gives us a better idea of how a company makes and spends its \[00:19:00\] money. Digging deeper, users may see the impact of business transactions on each component and their relationships with each other. It makes sense, doesn\'t it? You can see the same three sections in ABC Corporation\'s cash flow statement. Let\'s examine them separately. Starting with cash flows from operating activities, often abbreviated as CFO. In short, they result from transactions that affect a firm\'s net income. This is perhaps the key part of each cash flow statement. It shows whether, and to what extent, companies generate cash from core operations. At the end of the day, the net operating cash flows must be enough to cover all cash outflows deriving from the other two sections. Think about this. Where can we find the results from normal business operations of a company? In the income statement, of course. That\'s why most of the components of the Operating \[00:20:00\] Activities section overlap with these determining the net profit or loss for the year. For example, cash receipts from the sale of goods and the rendering of services, cash payments to suppliers for goods and payments to employees. These transactions impact the income statement and are simultaneously classified as cash flows from Operating Activities. In that regard, please note that there are quite a few exceptions to this. For instance, if ABC Corporation sells one of its production machines at a profit, it will increase net income for the year. However, this is not a core business activity for the company. Therefore, the proceeds of the sale are not reported as operating cash inflows. Rather, they fall into the cash flows from investing activities The cash flows classified under this heading tell us the extent to which new investment in assets would generate future cash \[00:21:00\] flows. We observe that investments or proceeds from the sale of tangible and intangible assets are included in this section. In addition, it records cash receipts from sales or cash payments to acquire financial instruments issued by other enterprises. Alright, what else is there? ABC Corporation also has cash in and outflows resulting from financing activities, or CFF. These refer to the share of cash transactions that affect a company\'s capital structure. Cash proceeds from the issuance of new shares, cash payments to stockholders to redeem shares, or cash dividends paid are normally included in this section. You will also see cash proceeds from the issuance of bonds, loans, notes, and other short and long term borrowings, as well as repayments of the amounts borrowed. Great. Logically, the sum of cash flows from \[00:22:00\] operating, investing, and financing activities gives us the company\'s net increase or decrease in cash. This is the total cash generated, given with a plus sign, Or used when it is negative during the year. Looking at ABC Corporation, we see that it has generated 3, 123 million from operating activities whilst using 137 million. and 2, 531 million in investing and financing activities, respectively. This results in a net increase in cash flows of 455 million during the currently reported year. How can we cross check whether this number Do you see the reference to footnote number 9 here? Okay, now head for ABC Corporation\'s Balance Sheet. Then, you go to the Current Assets section. There is the same footnote reference against the cash and cash equivalents line. \[00:23:00\] So, let\'s take a closer look. At the end of the previous year, the company had an outstanding cash balance of 793 million, and at the end of this reporting period, it has 1, 248 million. by how much has the cash balance increased 1, 248 minus 793 makes 455 million dollars, the same as the net change in cash in the cash flow statement. And this is how we reconcile these two statements. Excellent job, everyone. To wrap up, we have three types of cash flows. Cash flow from operating activities, consisting of cash transactions affecting net income. Cash flow from investment activities, resulting from investments in fixed assets and other long term investments. cash flow from financing activities, made of transactions that influence capital structure, both debt and equity.\[00:24:00\] The sum of the three gives a company\'s net cash flow. This figure should reconcile the difference between the cash balance at the end of the current period and the amount of cash outstanding at the end of the previous period. This is an important rule we\'ll use in the videos to come. why do businesses prepare a budgeted cash flow statement after all? cash flow projections tell us about the prospects of a firm. Such a statement can practically help you find out how comfortable an entity will be to do business with more clients buying on credit. Moreover, it shows the impact of future investment schedules on the company\'s liquidity. It could even reveal seasonality trends, as well as other cash related issues. All this is valuable for business owners and potential investors. That\'s why projected cash flow reports play a vital role in financial planning. Financial reporting works with numbers. Using a firm\'s data to produce various statements inevitably creates \[00:25:00\] interrelation between these accounts. In the end, all reports utilize the same source of information, the company\'s operational performance. This is, by all means, true for the cash flow statement as well. Its fundamentals derive from changes in a company\'s income statement and balance sheet. In that regard, there are some general dependencies you should bear in mind when analyzing or budgeting the financial statements of an entity. First the cash flow from operations, CFO, relates to the operating activities of a company. to calculate it, you\'ll mostly need to refer to the firm\'s balance sheet and income statement. Take ABC Corporation\'s cash flow statement and assume the indirect method for the cash flows from operations. Where do we find net income? In the income statement, of course. This is our starting point. How about changes in accounts receivable, accounts payable, and \[00:26:00\] inventory? these are current assets and liabilities, go to ABC\'s Statement of Financial Position. An important point to remember is that changes in current assets and liabilities result in cash inflows or outflows generated in the same reporting period. we prepare a cash flow projection by looking at the budgeted balance sheet and expected changes in working capital. Good job! The next section is Cash Flows from Investing Activities. Or CFI. Looking at the items listed here, can you guess where they stem from? Yes, that\'s right. They all refer to changes in a firm\'s non current assets. If ABC purchases some fixed assets, these events affect the property, plant, and equipment line item in the balance sheet. What does this mean in cash flow terms? It tells us that the firm\'s management spends some cash on investments. So, you would see an outflow in the cash flow statement. \[00:27:00\] By the same token, projecting the cash flows from investing activities requires you to consider expected future changes in non current assets. Excellent. The third and final component is cash flows from financing activities, CFF. Proceeds from the issuance of share capital, dividends paid, long term borrowings repaid. What do these have in common? Well, they all relate to a company\'s potential sources of financing. Therefore, they have to do with the equity or non current liability sections in the balance sheet. to predict cash flows from financing activities of an organization, you should carefully examine the current state of its capital structure, along with any future growth plans. What are the terms of the firm\'s existing loan agreements? Is the company planning to fund a new project? How would it raise the capital needed? Also, are there any expected changes in \[00:28:00\] the dividend payout policy? These are just some of the questions you may need to answer when preparing the cash flow budget for this section. Fair enough. On a final note, the sum of these segments represents the total net cash increase or decrease for the respective period. Don\'t forget that we should always cross check this number to the change in cash and cash equivalence balance in the balance sheet. The bottom line is that the cash flow statement can hardly function on its own. To prepare it, you have to base your calculations on the balance sheet and income statement data. In the same way, the cash flow budget is closely linked to the projections and assumptions we\'ve made in the other two statements. Thank you for watching.