Objective of Financial Statements

<< Analyzing a Companyâ€™s Profitability

RESEARCH PHILOSPHY >>

Investment Analysis & Portfolio Management (FIN630)

Lesson # 18

COMPANY ANALYSIS Contd...

Financial statements (or financial reports) are formal records of business financial activities.

These statements provide an overview of a business profitability and financial condition in

both short and long term. There are four basic financial statements:

1. Balance sheet is also referred to as statement of financial position or condition,

reports on a company's assets, liabilities and net equity as of a given point in time.

2. Income statement is also referred to as Profit or loss statement, reports on a

company's results of operations over a period of time.

3. Statement of retained earnings explains the changes in a company's retained

earnings over the reporting period.

4. Statement of cash flows are reports on a company's cash flow activities,

particularly it's operating, investing and financing activities.

For large corporations, these statements are often complex and may include an extensive set

of notes to the financial statements and management discussion and analysis. The notes

typically describe each item on the balance sheet, income statement and cash flow statement

in further detail. Notes to financial statements are considered an integral part of the financial

statements.

Objective of Financial Statements:

The objective of financial statements is to provide information about the financial strength,

performance and changes in financial position of an enterprise that is useful to a wide range

of users in making economic decisions. Financial statements should be understandable,

relevant, reliable and comparable. Reported assets, liabilities and equity are directly related

to an organization's financial position. Reported income and expenses are directly related to

an organization's financial performance.

Financial statements are intended to be understandable by readers who have a reasonable

knowledge of business and economic activities and accounting and who are willing to study

the information diligently.

1. Balance sheet:

In financial accounting, a balance sheet or statement of financial position is a summary of

the value of all assets, liabilities and owners' equity for an organization or individual 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 on a given date. Of the four basic financial

statements, the balance sheet is the only statement which applies to a single point in time,

instead of a period of time.

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.

113

Investment Analysis & Portfolio Management (FIN630)

Assets:

Current assets:

In accounting, a current asset is an asset on the balance sheet which is expected to be sold or

otherwise used up in the near future, usually within one year, or one business cycle

whichever is longer. Typical current assets include cash, cash equivalents, accounts

receivable, inventory, the portion of prepaid accounts which will be used within a year, and

short-term investments.

On the balance sheet, assets will typically be classified into current assets and long-term

assets. The current ratio is calculated by dividing total current assets by total current

liabilities. It is frequently used as an indicator of a company's liquidity, its ability to meet

short-term obligations.

o Inventories:

Inventory is a list for goods and materials, or those goods and materials themselves, held

available in stock by a business. Inventory are held in order to manage and hide from the

customer the fact that manufacture/supply delay is longer than delivery delay, and also to

ease the effect of imperfections in the manufacturing process that lower production

efficiencies if production capacity stands idle for lack of materials.

o Accounts receivable:

Accounts receivable is one of a series of accounting transactions dealing with the billing of

customers who owe money to a person, company or organization for goods and services that

have been provided to the customer. In most business entities this is typically done by

generating an invoice and mailing or electronically delivering it to the customer which is to

be paid within an established timeframe called credit or payment terms.

On a company's balance sheet, accounts receivable is the amount that customers owe to that

company. Sometimes called trade receivables, they are classified as current assets. To

record a journal entry for a sale on account, one must debit a receivable and credit a revenue

account. When the customer pays off their accounts, one debits cash and credits the

receivable in the journal entry. The ending balance on the trial balance sheet for accounts

receivable is always debit.

o Cash and cash equivalents:

Cash and cash equivalents are the most liquid assets found within the asset portion of a

company's balance sheet. Cash equivalents are assets that are readily convertible into cash,

such as money market holdings, short-term government bonds or Treasury bills, marketable

securities and commercial paper. Cash equivalents are distinguished from other investments

through their short-term existence; they mature within 3 months whereas short-term

investments are 12 months or less, and long-term investments are any investments that

mature in excess of 12 months.

Long-term assets:

Long-term assets or non-current assets are those assets usually in service over one year such

as lands and buildings, plants and equipment, and long-term investments. These often

114

Investment Analysis & Portfolio Management (FIN630)

receive favorable tax treatment over current assets. Tangible long-term assets are usually

referred to as fixed assets.

o Property, plant and equipment:

Non-current asset, also known as property, plant, and equipment (P, P&E), is a term used in

accountancy for assets and property which cannot easily be converted into cash. This can be

compared with current assets such as cash or bank accounts, which are described as liquid

assets. In most cases, only tangible assets are referred to as fixed.

Fixed assets normally include items such as land and buildings, motor vehicles, furniture,

office equipment, computers, fixtures and fittings, and plant and machinery. These often

receive favorable tax treatment (depreciation allowance) over short-term assets.

o Intangible assets:

Intangible assets are defined as those non-monetary assets that cannot be seen, touched or

physically measured and which are created through time and /or effort. There are two

primary forms of intangibles - legal intangibles (such as trade secrets (e.g., customer lists),

s, patents, trademarks, and goodwill) and competitive intangibles (such as

knowledge activities (know-how, knowledge), collaboration activities, leverage activities,

and structural activities).

Liabilities:

o Accounts payable:

Accounts payable is a file or account that contains money that a person or company owes to

suppliers, but hasn't paid yet. When you receive an invoice you add it to the file, and then

you remove it when you pay. Thus, the A/P is a form of credit that suppliers offer to their

purchasers by allowing them to pay for a product or service after it has already been

received.

Commonly, a supplier will ship a product, issue an invoice, and collect payment later,

which creates a cash conversion cycle, a period of time during which the supplier has

already paid for raw materials but hasn't been paid in return by the final customer.

Equity:

The net assets shown by the balance sheet equals the third part of the balance sheet, which

is known as the shareholders' equity. Formally, shareholders' equity is part of the company's

liabilities: they are funds "owing" to shareholders (after payment of all other liabilities);

usually, however, "liabilities" is used in the more restrictive sense of liabilities excluding

shareholders' equity. The balance of assets and liabilities (including shareholders' equity) is

not a coincidence. Records of the values of each account in the balance sheet are maintained

using a system of accounting known as double-entry bookkeeping. In this sense,

shareholders' equity by construction must equal assets minus liabilities, and are a residual.

Numbers of shares authorized, issued and fully paid, and issued but not fully paid

Par value of shares

Reconciliation of shares outstanding at the beginning and the end of the period

Description of rights, preferences, and restrictions of shares

Treasury shares, including shares held by subsidiaries and associates

115

Investment Analysis & Portfolio Management (FIN630)

Shares reserved for issuance under options and contracts

A description of the nature and purpose of each reserve within owners' equity

2. Income statement:

An Income Statement, also called a Profit and Loss Statement (P&L), 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.

Charitable organizations that are required to publish financial statements do not produce an

income statement. Instead, they produce a similar statement that reflects the fact that the

charity is not operating to make a profit.

Cost of goods sold:

Cost of goods sold, COGS, or "cost of sales", includes the direct costs attributable to the

production of the goods sold by a company. This amount includes the materials cost used in

creating the good along with the direct labor costs used to produce the good. It excludes

indirect expenses such as distribution costs and sales force costs. COGS appear on the

income statement and can be deducted from revenue to calculate a company's gross margin.

COGS is the cost that go into creating the products that a company sells; therefore, the only

costs included in the measure are those that are directly tied to the production of the

products. For example, the COGS for an automaker would include the material costs for the

parts that go into making the car along with the labor costs used to put the car together. The

cost of sending the cars to dealerships and the cost of the labor used to sell the car would be

excluded.

Gross profit:

Gross profit or sales profit or gross operating profit is the difference between revenue and

the cost of making a product or providing a service, before deducting overheads, payroll,

taxation, and interest payments.

In general, it is the profit shown on a transaction if one disregards the indirect costs. It is the

revenue that remains once one deducts the costs that arise only from the generation of that

revenue.

For a retailer, gross profit is the shop takings less the cost of the goods sold. For a

manufacturer, the direct costs are the costs of the materials and other consumables used to

make the product. For example, the cost of electricity to operate a machine is often a direct

cost while the cost of lighting the machine room is an overhead. Payroll costs may also be

direct if the workforce is paid a unit cost per manufactured item. For this reason, service

industries that sell their services by time units often treat the fee-earners' time cost as a

direct cost.

Gross profit is an important guide to profitability but many small businesses fail because

they overlook the regular demand to meet the fixed costs of the business. The indirect costs

are considered when calculating net income, another important guide to profitability.

116

Investment Analysis & Portfolio Management (FIN630)

Operating section:

o Revenue:

Cash inflows or other enhancements of assets of an entity during a period from delivering or

producing goods, rendering services, or other activities that constitute the entities on going

major operations. Usually presented as sales minus sales discounts, returns, and allowances.

o Expenses:

Cash outflows or other using-up of assets or incurrence of liabilities during a period from

delivering or producing goods, rendering services, or carrying out other activities that

constitute the entity's ongoing major operations.

o General and administrative expenses (G & A):

It represent expenses to manage the business (officer salaries, legal and professional fees,

utilities, insurance, depreciation of office building and equipment, stationery, supplies).

o Selling expenses:

It represents expenses needed to sell products (e.g., sales salaries and commissions,

advertising, freight, shipping, depreciation of sales equipment).

o R & D expenses:

It represents expenses included in research and development.

o Depreciation:

It is the charge for the year with respect to fixed assets that have been capitalized on the

Balance Sheet.

Non-operating section:

o Other revenues or gains:

Revenues and gains from other than primary business activities (e.g. rent, patents). It also

includes unusual gains and losses that are either unusual or infrequent, but not both (e.g.

sale of securities or fixed assets).

o Other expenses or losses:

Expenses or losses not related to primary business operations.

Earnings before Interest & Tax (EBIT):

An indicator of a company's profitability, calculated as revenue minus expenses, excluding

tax and interest. EBIT is also referred to as "operating earnings", "operating profit" and

"operating income", as you can re-arrange the formula to be calculated as follows:

EBIT = Revenue - Operating Expenses

117

Investment Analysis & Portfolio Management (FIN630)

Net earnings:

Gross sales minus taxes, interest, depreciation, and other expenses. Net earnings are one of

the most important measures of a company's performance, since the pursuit of earnings is

the primary reason companies exist. Sometimes net earnings include one-time and

extraordinary items, and sometimes it does not also called net earnings or net income or

bottom line.

Retained earnings:

In accounting, retained earnings refer to the portion of net income which is retained by the

corporation rather than distributed to its owners. Similarly, if the corporation makes a loss,

then that loss is retained. Retained earnings are cumulative from year to year.

Retained earnings are reported in the Shareholders' equity section of the balance sheet. A

complete report of the retained earnings or retained losses is presented in the Statement of

retained earnings or Statement of retained losses.

When assets are greater than liabilities, you have a positive equity (positive book value).

When liabilities are greater than assets, you have a negative stockholders' equity also

sometimes called stockholders' deficit. Stockholders' deficit does not mean that stockholders

owe money that they may safely go away from such a company. It just means that the value

of the assets of the company will have to rise above its liabilities before the stockholders

will reap any value (above zero) from owning the company's stock.

118

Table of Contents: