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MCREY BANDERLIPE II, M.Sc. (CPA)
PRE-READ:
Understanding Financial Statements and
Cash Flows
UNDERSTANDING FINANCIAL STATEMENTS, ETC.
Objectives
• Review the fundamental concepts surrounding the
financial statements and cash flows.
• Compute a company’s profits as reflected by an
income statement.
• Determine a firm’s accounting book value, as
presented in a balance sheet.
• Measure a company’s free cash flows.
UNDERSTANDING FINANCIAL STATEMENTS, ETC.
Important Principles:
Cash-Not Profits-Is King
Managers Won’t Work for the Owners Unless It’s in
Their Best Interest
UNDERSTANDING FINANCIAL STATEMENTS, ETC.
Basic Financial Statements
• Balance Sheet (Statement of Financial Position)
• Income Statement
• Statement of Changes in Equity
• Cash Flow Statement
• Notes to the Financial Statements
UNDERSTANDING FINANCIAL STATEMENTS, ETC.
Income Statement
• Profit/Loss Statement
• Indicates the amount of profits generated
by a firm over a given period of time
• Sales – Expenses = Profit
UNDERSTANDING FINANCIAL STATEMENTS, ETC.
Income Statement Terminology
• Revenue (Sales)
– Money derived from selling the company’s product or service
• Cost of Goods Sold (COGS) or Cost of Sales (COS)
– The cost of producing or acquiring the goods or services to be sold
• Operating Expenses
– Expenses related to marketing and distributing the product or service and
administering the business
• Financing Costs
– The interest paid to creditors and the dividends paid to preferred
stockholders
• Tax Expenses
– Amount of taxes owed, based upon taxable income
UNDERSTANDING FINANCIAL STATEMENTS, ETC.
Income Statement
Sales
Less cost of goods sold
= Gross profit
Less operating expenses
= Operating income
Less interest expense
= Earnings before taxes
Less corporate taxes
= Net income
UNDERSTANDING FINANCIAL STATEMENTS, ETC.
ABC Corporation Sample Income
Statement ($M)
Sales $4,076
Cost of Goods Sold 3,207
Gross Profit $ 869
Operating Expenses
Marketing expenses and general and
Administrative expenses $227
Depreciation Expense 206
Total Operating Expenses $ 433
Operating Profits $ 436
Interest Expense 3
Earnings before taxes $ 433
Income taxes 165
Net income $ 268
UNDERSTANDING FINANCIAL STATEMENTS, ETC.
Balance Sheet (Statement of
Financial Position)
• Provides a firm’s financial position at a specific point
in time
• Assets are resources owned by the firm
• Liabilities and owner’s equity indicate how those
resources are financed
Total Assets = Liabilities (debt) + Shareholder’s Equity
(Accounting Equation)
UNDERSTANDING FINANCIAL STATEMENTS, ETC.
• Current assets comprise assets that are relatively liquid, or
expected to be converted into cash within 12 months.
• Current assets typically include:
– Cash
– Marketable Securities
– Accounts Receivable
payments due from customers who buy on credit
– Inventory
raw materials, work in process, and finished goods held for eventual
sale; or merchandise inventory
– Prepayments
Prepaid expenses are those items paid for in advance such as rent,
insurance, supplies
Balance Sheet Terminology
UNDERSTANDING FINANCIAL STATEMENTS, ETC.
• Property, Plant, and Equipment (Fixed Assets)–
Noncurrent assets held for more than one year. Typically
Include:
– Machinery and equipment
– Buildings
– Land
– Investment property accounted for under cost model
• Other Noncurrent Assets – Assets that are not current
assets or fixed assets
– Patents, copyright, goodwill, and other intangible assets
– Long-term investments
– Deferred assets
Balance Sheet Terminology
UNDERSTANDING FINANCIAL STATEMENTS, ETC.
• Liabilities (Debt)
– Money that has been borrowed and must be
repaid at some predetermined date
– Debt Capital
• financing provided by a creditor
• Current/short-term debt and long-term debt
• Current/short-term liabilities must be repaid within
the next 12 months
Balance Sheet Terminology
UNDERSTANDING FINANCIAL STATEMENTS, ETC.
• Current Liabilities:
– Accounts payable
• Credit extended by suppliers to a firm when it purchases inventories
– Accrued expenses
• Short term liabilities incurred in the firm’s operations but not yet
paid for
– Short-term borrowings
• Borrowings from a bank or lending institution due and payable
within 12 months
• Long-Term Liabilities
– Loans from banks or other institutions for longer than 12 months
– Long-term lease liabilities, employee benefits, deferred tax liabilities, etc.
Balance Sheet Terminology
UNDERSTANDING FINANCIAL STATEMENTS, ETC.
• Shareholder’s Equity
• Includes the shareholder’s investment
– Preferred stock
– Common stock
• Treasury Stock
– stock that was once outstanding and has been re-
purchased by the company
• Retained Earnings
– cumulative total of all the net income over the life of
the firm, less common stock dividends that have been
paid out over the years.
Balance Sheet Terminology
UNDERSTANDING FINANCIAL STATEMENTS, ETC.
Balance Sheet
• ASSETS
– Current Assets
– Fixed Assets
• Total Assets
• LIABILITIES
– Current Liabilities
– Long-Term Liabilities
• Total Liabilities
• SHAREHOLDER’S EQUITY
– Preferred Stock
– Common Stock
– Retained earnings
• Total Owner’s Equity
• Total Liabilities and Equity
UNDERSTANDING FINANCIAL STATEMENTS, ETC.
Some Important Terms
• Net Working Capital
Current assets – current liabilities
• Debt Ratio
Percentage of debt a firm uses to finance its assets
• Accrual Basis of Accounting
Recording revenues when earned and expenses when
incurred, rather than when cash is exchanged
• Free Cash Flows
Cash flow that is free and available to be distributed to
the firm’s investors.
UNDERSTANDING FINANCIAL STATEMENTS, ETC.
The Statement of Cash Flows
• Measures the amount of inflow and outflow of
cash and cash equivalents
• How a company manages its cash position (cash
generation to pay its liabilities and operating
expenses)
• Where money comes from? How money is spent?
• Creditors look at it for liquidity purposes
Liquidity (availability of cash)
UNDERSTANDING FINANCIAL STATEMENTS, ETC.
Traditional Statement of Cash Flows
• Three sections:
– Cash flows from Operating Activities
– Cash flows from Investing Activities
– Cash flows from Financing Activities
UNDERSTANDING FINANCIAL STATEMENTS, ETC.
Cash Flows from Operating Activities
• Operating activities include any source and use of
cash from business activities
• Generally, changes made in cash, accounts
receivable, depreciation, inventory, and accounts
payable are reflected in cash from operations.
• Methods in determining cash flows from operating
activities:
Direct Method – Add all receipts and deduct all payments
Indirect Method - Net income adjusted for non-operating
activities and changes in non-cash current assets and
some current liabilities
UNDERSTANDING FINANCIAL STATEMENTS, ETC.
Cash Flows from Operating Activities
• Some examples of operating activities
Receipts from sales of goods and services
Interest expense payments
Income tax payments
Payments made to suppliers of goods and services used in
production
Salary and wages
Rent payments
Prepaid expenses
Any other type of operating expenses
UNDERSTANDING FINANCIAL STATEMENTS, ETC.
Cash Flows from Investing Activities
• Investing activities include any sources and uses of
cash from a company's investment and fixed
assets portfolio, and loans extended
• Usually “cash out” items for purchase of
equipment, fixed assets, and marketable
securities; “cash in” when divested
UNDERSTANDING FINANCIAL STATEMENTS, ETC.
Cash Flows from Financing Activities
• Financing activities include includes the sources of
cash from investors or banks, as well as the uses of
cash paid to shareholders
• “Cash out” for dividend payments and repayment
of principal loan amounts; “Cash in” when equity
is raised and bonds are issued
UNDERSTANDING FINANCIAL STATEMENTS, ETC.
Caveat: Negative Cash Flows
• Not necessarily a red flag
• May indicate cash flows for business expansion
• Requires further analysis through notes to
financial statements and other research
UNDERSTANDING FINANCIAL STATEMENTS, ETC.
Financing Cash Flows
A firm can either receive money from or
distribute money to its investors. The firm
can:
1. Pay interest to lenders
2. Pay dividends to stockholders
3. Increase or decrease in long-term debt
4. Issue stock to new shareholders or
repurchase stock from current shareholders

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Pre-Read - Understanding Financial Statements and Cash Flows.pdf

  • 1. MCREY BANDERLIPE II, M.Sc. (CPA) PRE-READ: Understanding Financial Statements and Cash Flows
  • 2. UNDERSTANDING FINANCIAL STATEMENTS, ETC. Objectives • Review the fundamental concepts surrounding the financial statements and cash flows. • Compute a company’s profits as reflected by an income statement. • Determine a firm’s accounting book value, as presented in a balance sheet. • Measure a company’s free cash flows.
  • 3. UNDERSTANDING FINANCIAL STATEMENTS, ETC. Important Principles: Cash-Not Profits-Is King Managers Won’t Work for the Owners Unless It’s in Their Best Interest
  • 4. UNDERSTANDING FINANCIAL STATEMENTS, ETC. Basic Financial Statements • Balance Sheet (Statement of Financial Position) • Income Statement • Statement of Changes in Equity • Cash Flow Statement • Notes to the Financial Statements
  • 5. UNDERSTANDING FINANCIAL STATEMENTS, ETC. Income Statement • Profit/Loss Statement • Indicates the amount of profits generated by a firm over a given period of time • Sales – Expenses = Profit
  • 6. UNDERSTANDING FINANCIAL STATEMENTS, ETC. Income Statement Terminology • Revenue (Sales) – Money derived from selling the company’s product or service • Cost of Goods Sold (COGS) or Cost of Sales (COS) – The cost of producing or acquiring the goods or services to be sold • Operating Expenses – Expenses related to marketing and distributing the product or service and administering the business • Financing Costs – The interest paid to creditors and the dividends paid to preferred stockholders • Tax Expenses – Amount of taxes owed, based upon taxable income
  • 7. UNDERSTANDING FINANCIAL STATEMENTS, ETC. Income Statement Sales Less cost of goods sold = Gross profit Less operating expenses = Operating income Less interest expense = Earnings before taxes Less corporate taxes = Net income
  • 8. UNDERSTANDING FINANCIAL STATEMENTS, ETC. ABC Corporation Sample Income Statement ($M) Sales $4,076 Cost of Goods Sold 3,207 Gross Profit $ 869 Operating Expenses Marketing expenses and general and Administrative expenses $227 Depreciation Expense 206 Total Operating Expenses $ 433 Operating Profits $ 436 Interest Expense 3 Earnings before taxes $ 433 Income taxes 165 Net income $ 268
  • 9. UNDERSTANDING FINANCIAL STATEMENTS, ETC. Balance Sheet (Statement of Financial Position) • Provides a firm’s financial position at a specific point in time • Assets are resources owned by the firm • Liabilities and owner’s equity indicate how those resources are financed Total Assets = Liabilities (debt) + Shareholder’s Equity (Accounting Equation)
  • 10. UNDERSTANDING FINANCIAL STATEMENTS, ETC. • Current assets comprise assets that are relatively liquid, or expected to be converted into cash within 12 months. • Current assets typically include: – Cash – Marketable Securities – Accounts Receivable payments due from customers who buy on credit – Inventory raw materials, work in process, and finished goods held for eventual sale; or merchandise inventory – Prepayments Prepaid expenses are those items paid for in advance such as rent, insurance, supplies Balance Sheet Terminology
  • 11. UNDERSTANDING FINANCIAL STATEMENTS, ETC. • Property, Plant, and Equipment (Fixed Assets)– Noncurrent assets held for more than one year. Typically Include: – Machinery and equipment – Buildings – Land – Investment property accounted for under cost model • Other Noncurrent Assets – Assets that are not current assets or fixed assets – Patents, copyright, goodwill, and other intangible assets – Long-term investments – Deferred assets Balance Sheet Terminology
  • 12. UNDERSTANDING FINANCIAL STATEMENTS, ETC. • Liabilities (Debt) – Money that has been borrowed and must be repaid at some predetermined date – Debt Capital • financing provided by a creditor • Current/short-term debt and long-term debt • Current/short-term liabilities must be repaid within the next 12 months Balance Sheet Terminology
  • 13. UNDERSTANDING FINANCIAL STATEMENTS, ETC. • Current Liabilities: – Accounts payable • Credit extended by suppliers to a firm when it purchases inventories – Accrued expenses • Short term liabilities incurred in the firm’s operations but not yet paid for – Short-term borrowings • Borrowings from a bank or lending institution due and payable within 12 months • Long-Term Liabilities – Loans from banks or other institutions for longer than 12 months – Long-term lease liabilities, employee benefits, deferred tax liabilities, etc. Balance Sheet Terminology
  • 14. UNDERSTANDING FINANCIAL STATEMENTS, ETC. • Shareholder’s Equity • Includes the shareholder’s investment – Preferred stock – Common stock • Treasury Stock – stock that was once outstanding and has been re- purchased by the company • Retained Earnings – cumulative total of all the net income over the life of the firm, less common stock dividends that have been paid out over the years. Balance Sheet Terminology
  • 15. UNDERSTANDING FINANCIAL STATEMENTS, ETC. Balance Sheet • ASSETS – Current Assets – Fixed Assets • Total Assets • LIABILITIES – Current Liabilities – Long-Term Liabilities • Total Liabilities • SHAREHOLDER’S EQUITY – Preferred Stock – Common Stock – Retained earnings • Total Owner’s Equity • Total Liabilities and Equity
  • 16. UNDERSTANDING FINANCIAL STATEMENTS, ETC. Some Important Terms • Net Working Capital Current assets – current liabilities • Debt Ratio Percentage of debt a firm uses to finance its assets • Accrual Basis of Accounting Recording revenues when earned and expenses when incurred, rather than when cash is exchanged • Free Cash Flows Cash flow that is free and available to be distributed to the firm’s investors.
  • 17. UNDERSTANDING FINANCIAL STATEMENTS, ETC. The Statement of Cash Flows • Measures the amount of inflow and outflow of cash and cash equivalents • How a company manages its cash position (cash generation to pay its liabilities and operating expenses) • Where money comes from? How money is spent? • Creditors look at it for liquidity purposes Liquidity (availability of cash)
  • 18. UNDERSTANDING FINANCIAL STATEMENTS, ETC. Traditional Statement of Cash Flows • Three sections: – Cash flows from Operating Activities – Cash flows from Investing Activities – Cash flows from Financing Activities
  • 19. UNDERSTANDING FINANCIAL STATEMENTS, ETC. Cash Flows from Operating Activities • Operating activities include any source and use of cash from business activities • Generally, changes made in cash, accounts receivable, depreciation, inventory, and accounts payable are reflected in cash from operations. • Methods in determining cash flows from operating activities: Direct Method – Add all receipts and deduct all payments Indirect Method - Net income adjusted for non-operating activities and changes in non-cash current assets and some current liabilities
  • 20. UNDERSTANDING FINANCIAL STATEMENTS, ETC. Cash Flows from Operating Activities • Some examples of operating activities Receipts from sales of goods and services Interest expense payments Income tax payments Payments made to suppliers of goods and services used in production Salary and wages Rent payments Prepaid expenses Any other type of operating expenses
  • 21. UNDERSTANDING FINANCIAL STATEMENTS, ETC. Cash Flows from Investing Activities • Investing activities include any sources and uses of cash from a company's investment and fixed assets portfolio, and loans extended • Usually “cash out” items for purchase of equipment, fixed assets, and marketable securities; “cash in” when divested
  • 22. UNDERSTANDING FINANCIAL STATEMENTS, ETC. Cash Flows from Financing Activities • Financing activities include includes the sources of cash from investors or banks, as well as the uses of cash paid to shareholders • “Cash out” for dividend payments and repayment of principal loan amounts; “Cash in” when equity is raised and bonds are issued
  • 23. UNDERSTANDING FINANCIAL STATEMENTS, ETC. Caveat: Negative Cash Flows • Not necessarily a red flag • May indicate cash flows for business expansion • Requires further analysis through notes to financial statements and other research
  • 24. UNDERSTANDING FINANCIAL STATEMENTS, ETC. Financing Cash Flows A firm can either receive money from or distribute money to its investors. The firm can: 1. Pay interest to lenders 2. Pay dividends to stockholders 3. Increase or decrease in long-term debt 4. Issue stock to new shareholders or repurchase stock from current shareholders