Understanding Financial Statements Handout Final
Transcript of Understanding Financial Statements Handout Final
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Understanding Financial Statements
Training Program Handbook
Corporate and Professional Services (CaPS)
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Reading Material for CaPS Participants
Introduction
Training participants are required to go through this module prior to the start of
training.The aim of the module is to:
Familiarize the reader with the format and basic terminologies of the three
financial statements
Using financial statements to understand business position of a company
Linkage between the three statements
Note: The accounting guideline followed in the handbook is US GAAP, unless stated
otherwise
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Reading Material for CaPS Participants
Contents
Introduction ...............................................................................................................21Income Statement ...................................................................................................5
Overview of Income Statement..........................................................................................5
Readings for Income Statement........................................................................................5
Learning Outcomes Income Statement..........................................................................5
1.1Introduction ...................................................................................................................6
1.2Basic Components, Format and Terminologies ............................................................6
1.3Chapter Summary .......................................................................................................10
2Balance Sheet .......................................................................................................12
Overview of Balance Sheet.............................................................................................12
Readings for Balance Sheet............................................................................................12Learning Outcomes Balance Sheet..............................................................................12
2.1Introduction .................................................................................................................13
2.2Basic Components, format, and Terminology .............................................................13
2.3Analysis of Balance Sheet..........................................................................................20
2.4Chapter Summary .......................................................................................................23
2.5Answers to the questions ............................................................................................23
3Cash Flow Statement ............................................................................................25
Overview of Cash Flow Statement..................................................................................25
Readings for Cash Flow Statement.................................................................................25
Learning Outcomes - Cash Flow Statement....................................................................25
3.1Introduction .................................................................................................................26
3.2Basic Components, Format, and Terminology ...........................................................26
3.3Cash Flow from Operations (CFO) and Free Cash Flow ............................................28
3.4Analysis of Cash flow Statement................................................................................ 32
3.5Important Cash Flow Ratios .......................................................................................32
3.6Chapter Summary .......................................................................................................34
3.7Answers to the Questions ...........................................................................................34
34
4Appendix ................................................................................................................35
5Evalueserve Disclaimer ........................................................................................36
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Understanding Income Statement
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Understanding Income Statement
1 Income Statement
Overview of Income Statement
Income statement can reveal a lot of insights on the company, such as how the company has grown in thepast, is it able to retain its clients, does it need to offer discounts to sell its products and is it doing better orworse than its peers? Income statement can also help us understand the efficiency of companys operations,its distribution systems, productivity of its employees, etc.
This module will help you use the income statement to get insights on a companys business and financialperformance.
Readings for Income Statement
Introduction to the Income Statement
Components of an Income Statement
Learning Outcomes Income Statement
At the end of this module, you will be able to
Understand the format/presentation of the income statement
Understand revenue recognition principals
Learn to identify revenue drivers
Understand operating/non-operating income
Learn to analyze a companys Gross and EBIT margins
Understand definition/significance of non-recurring items
Understand and analyze earnings per share (basic and diluted)
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Understanding Income Statement
1.1 Introduction
Income statement is one of the most important financial statements used by companies to report their earningsover a specific period of time, e.g., yearly, quarterly, etc. It is also known as Profit and Loss Statement or
Statement of Revenue and Expense.
1.2 Basic Components, Format and Terminologies
Income statement reports the effect of a companys current operations on its financial performance. Itsummarizes the revenues earned, the expenses incurred and the net profit generated for a given period oftime. Income statement can be presented in the following two formats:
Format A where items are clubbed in respective heads such as COGS, selling expenses, andadministrative expenses
Format B where items are presented separately such as raw material cost, employee cost, andtransportation expenses
FORMAT A | FORMAT B
PARTICULARS $ MN | PARTICULARS $ MN
Sales 8,000 Sales 9,000
Less: Cost of Goods Sold 3,000 Less: Raw Material Cost/Labor Cost 3,750
Gross Profit 5,000 Less: Marketing and Administrative Cost 1,500
Less:Selling, general, and AdministrationExpenses
1,500 Less: R&D Cost 133
Operating Income beforeDepreciation and Amortization(EBITDA)
3,500 Less: Other (Income) Expenses 256
Less: Depreciation, Amortization 300 Pretax Income 3,361
Operating Profit or Earnings beforeInterest & Taxes (EBIT)
3,200 Less: Interest Expenses 110
Less: Interest Expense 100 Less: Income Tax 390
Non-Operating Income 300 Net Income 2,861
Less: Non-Operating Expenses 200
Pretax Accounting Income/EarningsBefore Taxes (EBT)
3,200
Less: Income Taxes 700
Net Income 2,500
Following are the terminologies which are related to the Income statement:
LINE ITEMS DEFINITION
Revenue or Sales
The first line item on any Income Statement is Revenue or Sales. It pertains to the sales abusiness generates from selling goods or rendering services during the specified time period forwhich the income statement is prepared. For instance, a firm prepares customized researchreports for its clients by charging $25 per hour of effort spent. If the firm spends 160 hours a monthon making those reports, then the revenue for that month would be $4,000. It is also known as TopLine.
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Understanding Income Statement
LINE ITEMS DEFINITION
Cost of GoodsSold (COGS) orCost of Revenueor Cost of Sales
Cost of Goods Sold or Cost of Sales refers to the total of direct expenses incurred by a companyto produce/sell a product. This refers to costs that can be directly associated to the production of agood or service. It includes the purchase price of raw material and expenses incurred in turning theraw material into a finished product, e.g., expenses incurred for raw materials, labor, and other
manufacturing overheads used in the production of goods/services.
Gross Profit
Gross Profit reflects the total revenues less the cost incurred in generating that revenue (cost ofgoods sold). In other words, it refers to the amount that a company can generate as profits if itdoes not pay other expenses besides direct costs.
Gross Profit = (Total Revenue) (Cost of Goods Sold)
OperatingExpenses
Operating Expenses means costs incurred by the company during the course ofoperating/running the business. Apart from direct costs, it also includes the following:
Research and Development Costs (R&D costs)
Selling, General, and Administrative Expenses: includes expenses such as salaries,commissions, travel expenses, and advertising and promotion expenditure.
Operating IncomebeforeDepreciation/EBITDA
Earnings Before Interest, Tax, Depreciation, and Amortization (EBITDA) refers to the incomegenerated by the company from its operations. Note that it does not include line items such asincome from investment in other businesses. It is calculated after the deduction of Cost of GoodsSold and Operating Expenses from the Total Revenues figure.
EBITDA = (Gross Profit) (Operating Expenses)
Depreciation
Depreciation is an expense allocated to the asset costs, which is spread across the useful life ofthe asset.
It can be calculated using straight line (SLM) method or written down value method (WDV).SLM calculates depreciation by taking the purchase price of an asset less its salvage value dividedby the total productive years the asset can be reasonably expected to benefit the company (usefullife). For example if an asset worth $100 is expected to be used for 5 years, at the end of which it
will have zero value, its depreciation will be $ 20 per year.WDV method calculates depreciation by charging a fixed rate on the reducing balance of the asset.In the above example, lets say the fixed rate is 20% then the first years depreciation will be $20,the second years depreciation will be ($100 $20) * 20%, i.e., $16, and the third years ($100 $20 $16) * 20%, i.e., $12.8.Similarly, it can be calculated for the rest of the years.
Amortization
It refers to the allocation of costs of intangible assets, such as patents and copyrights, over the lifeof such assets. For example, a pharma company buys a patent for the manufacture of a vaccinefor $30 million. The patent will last for 15 years. The amortization expense to be charged everyyear for the next 15 years will be 30/15= $2 million per year.
The intangible assets with a finite life are amortized and assets with infinite life are impaired. Forexample, goodwill is tested for impairment, whereas patents/copyrights, etc., are amortized.
Operating Profit(EBIT)
Profit earned from ordinary business activities before the deduction of interest expenses andincome tax expenses is called Operating Profit. It is also known as Earning Before Interest and
Taxes.
Interest Expense Expense incurred by the company on its borrowings (debt) is called Interest Expense.
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Understanding Income Statement
LINE ITEMS DEFINITION
Unusual or
Infrequent Items
As can be inferred from the name, these are either unusual or infrequent, but not both. Theexample includes asset impairment, gain/loss on sale of asset, and restructuring cost. Theseitems are reported before tax.
Impairment refers to the decline in the value of asset below its fair-market value. Impairment takes
place due to a change in product demand, technology, or a decline in the operational efficiency ofthe asset. For example, a bank provided a housing loan to an individual. The individual failed topayback the entire loan amount. The part of the loan amount not paid by the individual forms thepart of impairment losses for the bank.
Non-OperatingIncome
It refers to the income generated from activities other than the regular operations of the business,for instance, profit from the sale of a building/land.
PretaxAccountingIncome (EBT)
Deducting the Interest Expense from the Operating Income leads to the Pretax Income. It is alsoreferred to as Earnings Before Tax (EBT) or Profit Before Tax (PBT).
As the name suggests, these earnings are arrived at prior to the deduction of income taxes.
Income Taxes
It refers to the estimated tax liability for the year. This is usually different from the actual tax paid bya company, which is determined by a countrys tax rules. There are three important termspertaining to taxes as follows:
Income tax expenses Expenses based on current period pretax income (PBT in the financialstatements)
Current taxes Taxes actually paid/to be paid by the company
Deferred tax Difference between income tax expense and current taxes
Net Income or NetProfit (PAT)
Net Income refers to the amount that the company has actually earned or lost during theaccounting period, net of all costs, including depreciation, interest, and taxes. It is the moneyattributable to equity shareholders of the company after deducting for preferred dividends, if any.
Extraordinaryitems
Items that are both unusual and infrequent in nature are called extraordinary items. For examplelosses on early retirement of debt and losses due to natural disasters. Extraordinary items arepresented as net of taxes, after income from continuing operations.
Preferred StockDividends
A payment made to preference stock holders for investments made by them in the business iscalled Preferred Stock Dividends.
Preference stock: Preferred stock is regarded as a security, which has features similar to stocksand bonds. While it entitles owner a stake in the company, just like a common stock, it also pays afixed dividend like a bond. Preference shares can also be convertible preference shares and thesecan convert into a certain number of equity shares at a specific date.
Preference shareholders usually do not have voting rights but carry a preferential right overcommon stockholders to receive dividend. Preference shares are usually issued by companies thatdo not want to dilute their shareholding.
Minority interest
Minority interest is the part of PAT that belongs to minority share holders. Minority interestappears in the consolidated accounts and reflects the share of profit of subsidiaries that is notowned by the parent company. According to the US GAAP as well as IFRS guidelines, companiesneed to show the minority interest separately and show the profit after accounting for minorityinterest.
Professors note: Minority interest is only an accounting concept, for the calculation of acompanys net worth, we consider minority interest as a part of the net worth.
Dividend
Profit that is redistributed to shareholders is called dividends. While the companys profit after taxideally belongs to shareholders, companys management has discretion to decide how much theywant to distribute to shareholders. Part of profit that is distributed as dividend (Dividend/PAT) iscalled dividend pay out ratio.
Dividends are very powerful tools to understand the financial health of a company, becausedividends (except stock dividend) are paid in cash and can not be manipulated through accountinggimmicks.
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Understanding Income Statement
1.2.1 Operating and Non-operating Section of Income Statement
Income statement can be further sub-divided into two parts operating and non-operating. While theoperating section reveals information about revenues and expenses arising out of day-to-day regularbusiness operations, the non-operating section provides revenue gain and expense/loss due to activities notdirectly linked to the companys regular operations.
For example, a chemical manufacturing company may report income on the sale of land or a profit on the saleof investment; these items are not directly related to its operations. Similarly, the company could report non-operating expenses such as loss on sale of land and loss on an investment. Some of the non-operating items,such as sale of investment, are very regular and may appear every year.
Operating and Non-Operating section of Income Statement: Given below is the example ofAcer limited,which clearly mentions the operating and non-operating items in the income statement:
(Note: NT$ = Currency is New Taiwanese Dollar)
Source: Company Annual Report 2008
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Operating Section:This includes the line items
like revenue, COGS, GP,
SG&A, R&D etc. All these line
items are closely related to
day to day operations. So
these items are classified as
operating items
Non-Operating Section:
This includes an income/ gain
or losses/ expenses related to
items not closely related to
day to day operations. E.g.
interest expenses/ income,
gain/ losses on purchase or
disposal of assets, etc.
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Understanding Income Statement
1.3 Chapter Summary
Income statement reports the effect of a companys current operations on its financial position. It summarizesthe revenues earned; expenses incurred, and measure net profit for a given period of time. Income statement
can be presented in two formatsone where items are clubbed in respective heads such as COGS, Sellingexpenses, administrative expenses and other where items are presented separately such as raw material cost,employee cost, and transportation expenses.
Some of the key terms related to P&L include revenue, COGS, depreciation, interest, non-recurring items,EBIT, PAT, and EPS. Revenues refer to the sales generated by a company for a particular period, COGSrefers to the direct cost incurred for revenue generation, and selling expenses denote marketing costs incurredto make sales. Depreciation is an expense that is recorded in the P&L to allocate the cost of fixed assets overits useful life. Interest refers to the interest paid/to be paid on a companys debt obligations. EBIT, EBT arevarious terms used to denote the profitability of a company.
Revenues on the income statement are recognized when sales are made or services are performed and notwhen cash is received. Once the revenue has been recognized, expenses pertaining to the revenues that havebeen recognized are shown in the P&L, and if the company has incurred expenses for which revenue has notbeen recognized, they are shown as assets. Expenses are recognized regardless of whether any payment hasbeen made towards those goods or services. It does not reflect cash receipts or cash disbursements.
Components of COGS vary depending on what the direct costs of running the business are, forexample
For a manufacturing company COGS will include raw material costs and labor costs
For a service provider, such as consulting company, COGS will only include employee cost
For a company with significantly automated operations, COGS will only have raw material cost anddepreciation
Following are the measures of a companys profitability:
Gross margins (Sales COGS)/sales indicates the profitability after direct expenses have been met
PBIT profitability after all operating expenses have been met
PBT profitability after accounting for operating and non-operating expenses
PAT profit after accounting for all costs, including taxes
EPS earnings per share, this denotes the amount of profits attributable to equity shareholders
While analyzing profitability one should try to understand the following:
How absolute profits have changed over years?
How profit margins have changed over years?
How are profit margins compared to peers?
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Understanding Balance Sheet
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Understanding Balance Sheet
2 Balance Sheet
Overview of Balance Sheet
While the Income Statement provides an overview of companys profitability over a period of time, BalanceSheet provides a snapshot of the financial strength/financial position/financial condition of a company at agiven point of time (usually at the end date of an accounting period, year or a quarter).
In this module, you will learn about the important components of a balance sheet and their accountingtreatment.
You will also learn about the ratios that are helpful in analyzing the balance sheet.
Readings for Balance Sheet
Components of the balance sheet
Accounting of balance sheet items
Analyzing liquidity & working capital
Analyzing capital structure
Learning Outcomes Balance Sheet
At the end of this module, you will be able to
Understand the format/components of the balance sheet
Understand important balance sheet concepts and classifications
Understand components of shareholders equity
Learn to analyze liquidity, working capital using turnover ratios
Learn to analyze capital structure using leverage ratios
Understand definition/significance of Invested Capital
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Understanding Balance Sheet
2.1 Introduction
Balance sheet is one of the important financial statements used by a company to report its financial position orfinancial condition on a particular date, which is called a Balance Sheet date. Balance sheet date is usually the
end of an accounting period, which could be a year, or a quarter, e.g., Balance Sheet as on December 31,2009. However, some companies adopt a fiscal year ending, i.e., a date other than December 31, 2010, e.g.,Balance Sheet as on March 31, 2010.
2.2 Basic Components, format, and Terminology
Balance Sheet has three major components what the company owns (assets), what it owes to outsiders(liabilties) and to internal owners (stockholders equity). These are explained as follows:
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Assets Liabilities Equity
It refers to the resources that arecontrolled and owned by an entity,these resources have futureeconomic value that can bemeasured and expressed in amonetary value for financial reportingpurposes. Asset can be of two types
non-current assets or current
assets.
Current Assets An asset whichcan be converted into cash within aperiod of one year, e.g., receivables,inventory, cash & cash equivalent.
Non-Current Assets Asset whichcan not be classified as current assetand which can not be easilyconverted into cash in a period ofone year is a non-current asset. Non-current assets can be of two types tangible assets (land, machine, etc.)and Intangible assets (goodwill).
Balance Sheet
It refers to the present obligationsof an entity. Its settlement results inthe outflow of the cash/funds.Liabilities can be of two types non-current liabilities and current
liabilities.Current Liabilities Liabilitieswhich are to be paid off with in aperiod of one year, e.g., accountpayables, current portion of long-term debt, etc.
Non-Current Liabilities Liabilities which a company owesfor a period of more than one year,e.g., long-term debt, deferred taxliabilities, etc.
It is the residual interest of theowners in the assets of the entityafter deducting all the liabilties.It isalso known as Net Worth or NetAssets. It comprises the following:
Share Capital Funds raised bythe company by issuing shares to
the public.Retained Earnings It is thecumulative net income which isretained by the company afterdistributing dividends.
Reserves These are created outof retained earnings to meet futurefund requirements, such ascontingencies, etc.
Comprehensive Income Changesin the value of balance sheet itemsthat do not flow through the P&Lare reflected here.
= +
Authors Note
The fact that the balance sheet is prepared on a particular date is significant. For example, cash & cashequivalents (which are usually the first line item on the Balance Sheet) represent the amount of cash & cashequivalents on December 31; the amount could be materially different on December 30 or January 1.
By definition, the account balances on a Balance Sheet must tally, i.e., the total of all assets must beequal to the sum of liabilities and stockholders equity. This is because, from an economic
perspective, each dollar of assets must be funded by a dollar of liabilities or equity. Therefore, theBalance Sheet equation is expressed as follows:
Asset = Liabilities + Stockholders Equity
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Understanding Balance Sheet
Account format: The assets are presented on the left hand side and liabilities and equity are presented on theright hand side.
ACCOUNT FORMAT - SAMPLE BALANCE SHEET OF ABC LIMITED AS ON 31ST DECEMBER 20XX
ASSETS $ MN LIABILITIES & STOCKHOLDERS EQUITY $ MN
Current Assets 5,000 Current Liabilities 4,000
Fixed Assets 8,000 Other Liabilities
Intangible Assets 1,200 Long-Term Debt 7,000
Financial Investment 1,000 Deferred Taxes 200
Total Liabilities 11,200
Owners Equity 4,000
Total Assets 15,200 Total Liabilities and Stockholders Equity 15,200
Report format: The assets, liabilities, and equity are presented in one single column, starting with assets and
then moving to assets and liabilities.REPORT FORMAT SAMPLE BALANCE SHEET OF ABC LIMITED AS ON 31ST DECEMBER 20XX
ASSETS $ MN
Current Assets 5,000
Fixed Assets (tangible) 8,000
Intangible Assets 1,200
Financial Investments 1,000
Total Assets 15,200
LIABILITIES & STOCKHOLDERS EQUITY $ MN
Current Liabilities 4,000
Other Liabilities
Long-term Debt 7,000
Deferred Taxes 200
Total Liabilities 11,200
Stockholders Equity 4,000
Total Liabilities and Stockholders Equity 15,200
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Understanding Balance Sheet
Accountants usually prepare classified balance sheets. Classified means that the balance sheet accounts arepresented in distinct groupings, categories, or classifications. Given below are the definitions of some importantclassifications/categories:
LINE ITEMS DEFINITION
CURRENTASSETS
AssetAssets are the economic resources which are controlled by the company. They can betangible or intangible in nature.
Current Assets
These are the items which can be converted into cash or be used up completely within 12months (one year) or within the firms operating cycle1(which is generally one year). Currentassets are presented in the order of liquidity (ease of convertibility to cash), i.e., cash,marketable securities, short-term investments, accounts receivable, inventory, prepaidinsurance.
Cash & Cashequivalents
Cash and cash equivalents include cash in any form (cash awaiting deposit or in a bankaccount) and cash substitutes (e.g., marketable securities or short-term investments), whichreflect cash that is not needed immediately in the business and is temporarily invested toearn a return. These investments are in instruments with short-term maturities (less than oneyear) such as treasury bills, certificates, notes, bonds and commercial paper (unsecuredpromissory notes of large business firms), and shares and mutual funds
Restricted cash
The cash is available with the company but it is not allowed to use it. This could be in theform of minimum cash balance that a company is required to keep at all times as a part of itsagreement with its lenders. It could also be a fixed deposit that has been pledged to raisemoney.
AccountsReceivables
Accounts receivables are the amounts due from customers on account of credit sales and arereported on the balance sheet as their net realizable value, that is, the actual amount of theaccount less an allowance for doubtful accounts. The allowance for doubtful accounts can beimportant in assessing earnings quality. Therefore, management must estimate based onfactors such as past experience, knowledge of customer quality, the state of economy, thefirms collection policies, etc. The estimation of this account will affect both the valuation ofaccounts receivables on the balance sheet and the recognition of bad debt expense on theincome statement.
The analyst must pay attention to changes in the allowance account both relative to level ofsales and the amount of accounts receivables outstanding and to the justification for anyvariations in the past.
Inventory
Inventory refers to raw materials, work in progress or finished goods that are there with thecompany at a point in time. While a manufacturing firms inventory is in the form of rawmaterials, a retailers inventory is largely the finished items that are stocked in theshowrooms.
Prepaid ExpensesThese include expenses which are paid in advance such as insurance premium, advance tax,etc. For example, companies are required to pay part of the tax in the beginning (usually first
quarter).
NON
CURRENT
ASSETS
Non-Current Assets
Assets which produce economic benefits for more than one year are non-current assets.They are of the following two types:
Tangible Non-Current Assets Those non-current assets which have physical substanceare known as tangible non-current assets, e.g., property, plant and equipment, investmentproperties building given on rent, etc. Tangible assets are depreciated each year.
Intangible Non-Current Assets These include non-current assets which are not physicalin nature. These assets do not have any physical value but are very valuable, e.g.,copyrights, patents, trademarks, and goodwill.
Investments
These represent the funds invested by the company into various financial instruments suchas bonds and notes.
Financial Instruments can be simple (equity or bonds, etc.) or complex (derivatives, foreigncurrency instruments, etc.). This could also represent companys investment in anothercompany where it holds less than 51% ownership.
1 The Operating Cycle is the time required to purchase or manufacture inventory, sell the product, and collect cash. For most companies,
the operating cycle is less than one year, but in some industries such as tobacco and wine it is longer.
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Understanding Balance Sheet
LINE ITEMS DEFINITION
Deferred TaxAssets
It measures the assets that the firm expects to get in future periods for overpaying taxes incurrent and past periods. Deferred tax asset on a company's balance sheet may benefit thecompany by lowering future income taxes.
Liability
It refers to the obligation of a company, settlement of which results in cash outflow. It is of two
typesCurrent and Non Current.
CURR
ENTLIABILITY
Current LiabilitiesCurrent liabilities are the claims against assets, which are expected to be settled within 12months or one operating cycle. It includes accounts payable, short-term debt, current portionof LT debt, accrued liabilities, etc.
Accounts PayablesAccounts payable is an amount that must be paid off within the credit period provided by theseller against the goods or services.
Financial Liabilities(Current Portion)
The long-term debt that is to be paid off within the current year qualifies under Current Portionof Long-Term Debt.
Accrued Liabilities
These are result of recognition of the expenses in financial statements prior to its payments.For example, salaries of the employees recognized as expenses at the end of the financialyear. For instance, let us assume that a company pays salary on January 1, however onDecember 31 the salaries will be accrued and will reflect in the balance sheet under accrued
liabilities.
Deferred Revenue
Sometimes a company collects the cash in advance for the goods or services which itpromises to render to its customers in the future. Such collected money is known as DeferredRevenue or Unearned Revenue. Examples of such transactions can be advance paymentsby the customers for the magazine subscription, etc.
Deferred TaxLiability (DTL)
It measures the liability that the firm sees in the future as a consequence of underpayingtaxes in the current or past periods. The liability will take the form of higher taxes in futureperiods (and a higher effective tax rate)
Financial Liabilities(Long Term)
This represents the money which a company has borrowed for more than one year andqualifies under long-term debt (financial liability) or non-current liabilities.
EQUITY
Share Capital &Paid-in Capital
Share capital is the fund raised by the companies by issuing common2orpreferential3 sharesto individuals or institutional investors. Paid-in Capital is the difference between the issue
price and the face value of a share. It is also called Contributed Capital or Capital Surplus.For Example, if a share has a face value of $15 and is issued at $20 and 100 such shares areissued
Share capital = $15 * 100= $1500
Paid in capital/share premium = $5 * 100 = $500
Treasury StockThese are the shares which are bought back by the issuing company; it reduces the numberof outstanding stocks in the market. The company may buy back the stock because it hascash, and it believes that its own shares are good investment.
EQUITY
Retained Earnings(RE)
These are the undistributed earnings of the company after meeting out the requirements suchas paying dividend. Retained earnings are calculated as follows:
RE (Current Year) = RE (Beginning of the Year) + Net Income Dividends Paid
Retained earnings should not be confused with unused cash, since these are the funds whicha company elects to reinvest in the operations of the business.
ReservesThese are created from retained earnings for meeting future requirements, such as bad debt,warranty, and restructuring requirements.
Accumulated otherComprehensiveIncome
Unrealized gains/losses in the market value of investments in available-for-sale securities,changes in the value of certain derivative instruments, and adjustment related to foreigncurrency translations are reported as part of comprehensive income.
ContingentLiabilities
Liabilities that could result in cash outflow for the company, subject to occurrence of certainevents. For example, a pending court case, a guarantee given on behalf of a subsidiary etc.These are not recorded in the financial statements but are detailed in the notes to thefinancial statements.
2Common Shares is an equity instrument through which companies raise capital from the Stock Market. By issuing common stock, owners
sell a part of their ownership in the company to others.3 Preferential Shares is as a security which has features similar to stocks and bonds. While it entitles owner a stake in the company,
just like a common stock, it also pays a fixed dividend like a bond.
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Understanding Balance Sheet
2.2.1 Exercise
1. Balance sheet summarizes:
Operating results for a period
Financing position at a point in time
Financing and investing activities for a period Profit at a point in time
2. What is common between Current assets and Current Liabilities?
Current assets are claims against current liabilities
If current assets increase, then there will be a corresponding increase incurrent liabilities
Current assets and current liabilities can be converted into cash
Current assets and current liabilities are those items that will be satisfiedand converted into cash, respectively, in one year or one operating cycle, whichever is longer
3. Which of the following items could cause the recognition of accrued liabilities?
Sale, interest income, rent
Sale, interest income, taxes
Salaries, rent, insurance
Salaries, interest income, interest expense
4. Which of the following can be classified as long-term debt?
Mortgages, current maturities of long-term debt, bonds
Mortgages, long-term notes payables, bonds due in 10 years
Account payables, bonds, obligations under leases
Accounts payables, long-term notes payables, long-term warranties
5. What does the additional paid-in capital indicates? The difference between par and stated value of the common stock
The price changes that result for stock trading subsequent to its originalvalue
The market price of all common stocks issued
The amount by which the original sales price of the stock exceeds the par value
6. What do the retained earnings account measure?
Cash held by the company since inception
Payments made to the shareholders in the form of cash or stock dividends
All undistributed earnings
Financial resources currently available to satisfy financial obligations
7. What accounts are most likely to be found in shareholders equity section?
Common stock, long-term debt, preferred stock
Common stock, additional paid-in capital, liabilities
Common stock, retained earnings, dividends payable
Common stock, additional paid-in capital, retained earnings
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Understanding Balance Sheet
2.2.2 Non-Current Assets
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Tangible Assets
Non-current Assets
Intangible Assets
Assets which produce economic benefits for more than one year
Assets having physical existence,e.g., plants, properties, equipment, machines,etc.
Assets which do not have any physicalexistence,e.g., goodwill, copyright, etc.
Assets are
Impairment if the book value becomes lower than the fair value
How they are recorded in Balance Sheet?
Tangible Assets are recorded asBook Value of the Asset AccumulatedDepreciationWhere, Book Value of the assets includesPurchase priceCosts related to bringing the assets to its
locationInstallation costsBorrowing costs
How they are recorded?Intangible Assets are recorded asSeparately Acquired Intangible Assets (for
example, patents)Recognized at purchase price +
attributable costsAcquired in Business Acquisition (e.g.,. license
acquired as a part of running business)Recognized at fair value at
acquisition date
Depreciated over their useful life Amortized over their useful life
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Understanding Balance Sheet
2.2.3 Understanding Debt Short-term (current) and long-term (non-current)
2.2.4 Shareholders Equity
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Share & Paid-inCapital
Capital raised via
equity market has two
components one
share capital, which
is the face value of
the stock and the
other is paid-in
capital, which is - the
premium paid by the
investors for the
stock.
Retained Earnings
Cumulative Net
Income left after
paying the dividends
to the investors.
Sometimes part of
retained earnings is
set aside as
contingency reserves
such as bad debt.
Treasury Stock
These are shares that
a company purchases
back from the open
market. The
companies retire it or
keep it for future
issuance. If the
company keeps the
share for future
reissuance, it creates
contra equity account
generally a negative
number which reflects
the stocks purchased
(account with negative
numbers) and hence
are not retired.
AccumulatedComprehensive
Income
Unrealizedgains/losses in the
market value of
investments, foreign
currency translationgains losses are
reflected here
Shareholders Equity and its Components
LoanIt is a type of debt which is an agreement betweentwo parties a borrower and a lender in which asum of money is borrowed fom the lender with thecondition that it be returned or repaid at a later date,along with the interest charges
Debt
Debt (Bond) SecuritiesThe securities are sold to more than one party. The
borrower is the seller of the security and lenders are
the buyers
Debt is amount which is borrowed by the company for a specified period of time. If the period is less than one year then it
is classified as current debt else non-current debt.
Both the types can be current ornon-current innature depending on the term of liability.
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Understanding Balance Sheet
Please refer to the following snippet of the Shareholders Equity Section of the Balance Sheet:
2.3 Analysis of Balance Sheet
2.3.1 Balance Sheet Analysis
Balance sheet should be analyzed to seek the following information:
1. Asset quality
2. Liquidity condition (adequacy of the cash)
3. Funding mix
4. Operational efficiency
5. Returns
Note: We will learn to analyze the balance sheet in the classroom session, but we need to familiarize ourselveswith the following ratios before we discuss analyzing balance sheet.
For the analysis of Balance Sheet, one needs to have an idea of certain important ratios. These ratios are animportant part of the balance sheet analysis; given below is the explanation of some of the important ratios:
RATIOS DEFINITION/INTERPRETATION
Days Sales ofInventory
(DSI)
This number indicates the number of days a company takes to covert its inventory (inventoryincludes the work in progress inventory) into sales. Its formula is
DSI = 360/Inventory Turnover
where, Inventory Turnover = Cost of Goods Sold/Average Inventory
Interpretation:
A Lower DSI vis--vis peer is, generally, good for the company; it means inventory gets replacedwith newer one in less time than the industry. It indicates that inventory is quickly getting convertedinto finished good and getting sold. If a company has DSI of 15 days, it indicates on an average ittakes the company 15 days to convert its inventory into sales.
High DSI vis--vis peers means company is not able to replace its inventory quickly; it could bebecause sales are decreasing due to which inventory is kept for a long time.
Days SalesOutstanding
(DSO)
This number indicates the number of days a company takes to collect the revenue after the sale of
product or service. Its formula isDSO = 360/Account Receivables Turnover
where, Account Receivables Turnover = Net Revenue/Average Accounts Receivables
Interpretation:
Lower DSO vis--vis industry indicates that a company takes less time to collect its revenues
High DSO vis--vis industry indicates that a company gives more credit period to its customers;this has to be investigated further.
Days PayableOutstanding
(DPO)
This number indicates the number of days a company takes to pay outstanding to the suppliers,from which the inventory or finished goods has been purchased. Its formula is
DPO = 360/Account Payables Turnover
where, Account Payables Turnover = Cost of Goods Sold/Average Accounts Payables
Interpretation:
Less DPO indicates that a company pays the cash to its suppliers quickly or a company has shortpayment cycle.
High DPO indicates that a company has longer credit period. If DPO is very high vis--vis industryaverage, one needs to investigate the reasons. Sometimes, if a company is facing financialdifficulties, it may not be able to pay its suppliers on time.
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Understanding Balance Sheet
RATIOS DEFINITION/INTERPRETATION
Cash ConversionCycle (CCC)
This is measured in days indicating the number of days a company takes to convert its resourcesinto cash. Its formula is
CCC = DSI + DSO DPO
Interpretation:CCC measures the time between cash outflow and inflow. It is an extremely important measure ofthe efficiency of the retailers and similar businesses. It basically measures How fast a companycan convert its products into cash through sales. The shorter the cycle, the less time capital is tiedup in the business process, and thus the company has more cash available to spend on its growth.
Current Ratio
It is a liquidity measure of the companys ability to pay short-term obligations. It is calculated as
Current Ratio = Current Assets/Current Liabilities
Interpretation:
Current ratio greater than one is an indication that a company has enough liquidity to meet short-term liabilities. However, sometimes companys current ratio could look higher because it hasobsolete inventory and old debtors. Since some of the inventory and debtors could be non current(old and not liquid), current ratio is not a very helpful measure of liquidity.
Quick (Acid Test)Ratio
It is another liquidity measure which takes into account only those current assets which are most
liquid in nature to the short-term obligations. It is calculated asQuick Ratio = (Cash & Cash Equivalent + Marketable Securities + Account Receivables)/Current
Liabilities
Interpretation:
Higher the quick ratio better will be the companys ability to meet its short-term liquidity needs,which is good for the creditor.
Cash Ratio
It is another liquidity measure which takes into account only cash and cash equivalent as currentassets to the short-term obligations. It is calculated as
Quick Ratio = Cash & Cash Equivalent/Current Liabilities
Interpretation:
It further refines the Current and Quick Ratio. This is seen by the most conservative investors.
Return on Asset(ROA)
It measures the amount of profit the company is able to make by using its assets. It is calculated as
ROA = Net Income/fixed assetsInterpretation:
ROA gives an idea of how effectively a company can convert its invested money into net income. Ifthe return on assets is showing an improving trend, it indicates that the company is able to utilizeits assets more efficiently.
Return on Equity
(ROE)
It is another profitability measure which talks about the returns a company is generating for itsshare holders.
ROE = Net Income/Average Shareholders Equity
Interpretation:
It measures how much profit a company generates with the money shareholders have invested.
It is calculated by PAT/Average equity
ROE can be further broken down into three components, and such analysis is known as DU-PontAnalysis
ROE = (Net income/sales)* (sales/assets)* (assets/equity)
= Net profit margin * Asset Turnover * Leverage
ROE is a function of its profitability, efficiency of using assets, and use of leverage. Higherleverage results in the deployment of lower equity and therefore improves return on equity.However, leverage is optimal only up to a point, because excessive leverage would mean thatcreditors would not provide further capital and also interest expenses would increase andprofitability would decrease.
Return onInvested Capital(ROIC)
It measures operating profits generated out of total invested capital. It is more comprehensive thanROE because unlike ROE it considers both debt and equity in the denominator.
ROIC = EBIT/(Average Total Assets Average Current Liabilities)
WorkingCapital/Total
Sales Ratio
This ratio is known as working capital productivity ratio. It is an indicator of the working capitalintensity of companys operations.
WC / TS = [ (Debtor + Inventory + Prepaid Assets) - (All current liabilities except short term debt) ] /Total Sales
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RATIOS DEFINITION/INTERPRETATION
Debt to EquityRatio (D/E)
It quantifies the relationship between the capital invested by owners & investors and the fundsprovided by creditors.
D/E = Debt/Equity
Interpretation:The higher the ratio, the greater the risk to a current or future creditor. A lower ratio means acompany is more financially stable and is probably in a better position to borrow now and in thefuture. However, one needs to remember that usage of debt (in optimal amount) enhances returns(so long as cost of debt is lower than the returns generated by the business), hence some amountof debt is desirable.
Debt to Totalcapital ratio
It indicates the percentage of the debt in the capital structure of the company or proportion ofassets financed by debt. Capital structure.
D/E = Debt/ Debt + Equity)
Interest Coverage
Ratio (ICR)
It determines the ability of the company to pay interest on the outstanding debt out of its operatingincome. It can be calculated as
ICR = EBITDA(normalized)/ Interest Expense
Normalized EBITDA: It is calculated by adding back non-recurring expenses
Interpretation:
If the ratio exhibits a declining trend and falls below one, it indicates that a companys operatingearnings are not sufficient to meet the interest charges.
2.3.2 Exercise
1. If the DSI have been rising for a company, it indicates
It has been managing its inventory efficiently
Sales may be slowing down
It may be giving higher credit period to its customers
2. The cash conversion cycle is
DSI + DSO DPO
DSI DSO + DPO
DSI + DSO + DPO
3. The flaw of the current ratio is
That it may not depict liquidity position accurately
It may not depict solvency position adequately
Both of these
None of these
4. ROIC the denominator is
Shareholders equity
Debt + equity
Debt +equity + current liabilities
5. Higher debt equity vis--vis industry average ratio indicates
Increasing creditworthiness
Increasing credit risk
None of these
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Understanding Balance Sheet
2.4 Chapter Summary
Balance sheet is the statement of financial position (SOFP)of the company till date. It represents the assetsowned by the company and the liabilities that a company owes. Liabilities are divided into two parts debt and
equity. Following are the important terms related to Balance Sheet:Shareholders Equity: The capital provided by the owners and the profit generated by the company
Current Liability: The obligations which are due within a year
Long-term Liability: Obligations that are for a period longer than a year
Current Assets: Items which can be converted into cash within 12 months period
Fixed Assets: Assets which consist of physical substance e.g., property, plant, equipment, etc.
While analyzing the balance sheet following ratios are helpful:
Working capital ratios: Days Inventory, Debtor Days, Payable Days, Working capital/Sales
Liquidity: Current ratio, Quick ratio
Leverage: Debt/Equity, Debt to Total Capital
Return ratios: Return on Asset, Return on Invested Capital, and Return on Equity
2.5 Answers to the questions
Section 2.2.1
Answer 1: Option 2
Answer 2: Option 4
Answer 3: Option 3
Answer 4: Option 2
Answer 5: Option 4
Answer 6: Option 3
Answer 7: Option 4
Section 2.3.2
Answer 1: Option 2
Answer 2: Option 1
Answer 3: Option 1
Answer 4: Option 2
Answer 5: Option 2
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Understanding Cash Flow Statement
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Understanding Cash Flow Statement
3 Cash Flow Statement
Overview of Cash Flow Statement
Cash flow statement helps understanding the cash generating capabilities of a company over a period of time.The cash generated can be different (more or less) than the profit made by a company.
This module will help you understand important terms related to cash flow statement; it will also acquaint youwith the different formats of cash flow statement and will help you in interpreting cash flow statement to getmore insights on the operational efficiency and financial soundness of a firm.
Readings for Cash Flow Statement
Analyzing Operating cash
Analyzing Free Cash Flow
Learning Outcomes - Cash Flow Statement
At the end of this module, you would be able to
Understand the format/presentation of the cash flow statement
Understand how to analyze the three basic sections of cash flow statement
Find the line items which are contributing and consuming the cash
Understand the characteristics of cash generation for different industries, e.g., capital intensive, laborintensive.
Understand the free cash flow and its different types with respect to firm and equity
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Understanding Cash Flow Statement
3.1 Introduction
Cash flow statement conveys the information on cash generated/spent in one operating cycle from variousactivities, these activities are divided under three basic headsoperating activities, investing activities, and
financing activities.Cash flow statement can also be used to extract information on how much cash has been generated fromoperations and how has it been utilized.
Cash flow statement captures the income statement and various line items of the balance sheet. While makinga financial model, cash flow statement serves as an important link between P&L and balance sheet.
3.2 Basic Components, Format, and Terminology
LINE ITEMS DEFINITION
Cash Flow from
Operations
Cash generated from operating activities, which includes all the activities which are related to thebusinesss operations
For example, if a company that sells food items generates $100 of cash from sale of land, $100 willnot be included in cash flow from operating activities.
Cash Flow FromInvesting
Cash generated of investing activities where investing activities are related to purchase/sale of fixedassets, investments in financial market products or other companies
Cash Flow FromFinancing
Cash generated of financing activities where financing activities are related to issuing capital (bondor common shares/any other instrument, repayments of the debt, repurchase of the companysstock (treasury stocks), dividend payment, etc.
Non Cash ChargesThese are expenses which do not require actual cash outlay. Example of such charges isdepreciation and amortization.
Free Cash Flow
from Firm
Cash which is available to the companys debt and equity holders after meeting all the operationsrelated expenses. It can be calculated as
FCFF = Net income + Non-cash charges + Interest * (1 Tax) CAPEX Working Capital
Or
FCFF = Cash flow from operations + Interest * (1 Tax) CAPEX
Free Cash Flowfrom Equity
Cash which is available to the companys equity holders after meeting all the operations relatedexpenses and expenses related to creditors. It can be calculated as
FCFE = CFO CAPEX + New Debt Issued Debt Repaid
3.2.1 Preparation of the Cash Flow Statement
There are two methods for preparing the cash-flow statement:
Direct method
Indirect method
Direct method for creating a cash flow includes major gross cash receipts and payments. While preparing thecash flow statement, it is important to identify the cash inflow and outflow items and separate them underrespective activities heads.
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Authors Note
Q: Why do we need the cash flow, we already have P&L statement which gives information on the
profitability of a company?
The net profits generated by the company can be different from the cash generated by it. This is on account
of accrual method for accounting where the revenues are recognized even though the cash has not been
received and expenses are recognized even when cash has not been spent. So, net income represents the
periodic earnings of the company where as cash flow statement represents the actual cash generated by
the company in the said period.
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Understanding Cash Flow Statement
The direct method for preparing the cash flow actually removes the effect of accruals.
Indirect method Starts with the Net Income (which is taken from Income statement) and is adjusted with allthe transactions related to non-cash items and further this number is adjusted with the changes in the workingcapital to arrive at Cash from Operations.
An increase in an asset account is deducted from net income, and an increase in a liability account is addedback to net income. This method converts accrual-basis net income (or loss) into cash flow by using aseries of additions and deductions.
3.2.1.1 Format of Cash Flow Statement Direct Method and Indirect methodDIRECT METHOD FORMAT INDIRECT METHOD FORMAT
CASH FLOW STATEMENT(IN $ MILLION)
2008 2009CASH FLOW STATEMENT
(IN $ MILLION)2008 2009
Cash flows from operatingactivities:
Cash flows from operatingactivities:
Cash received from customers 149,661140,25
2Net Income 5,910 5,896
Interest received 838 738 Adjustments to reconcile net income to cash
Cash paid to suppliers for inventory -99,936 -83,035 Depreciation and amortization 2,984 2,501
Cash Paid to employees -26,382 -25,498 Deferred income taxes 136 118
Cash paid for other OPEX -21,350 -20,848 Cash provided (used) by CA & CL
Interest paid -2,277 -1,274 Accounts receivable -3,339 -448
Taxes Paid -4,321 -4,706 Inventories -7,006 -2,331
- - - Prepaid Expenses 295 -82
- - - Accounts payable -1,051 902
- - - Account Liabilities -1,696 -927
Change in cash from operatingactivities
-3,767 5,629 Change in cash from operatingactivities
-3,767 5,629
Cash flows from investingactivities:
Cash flows from investingactivities:
Additions to PP&E -4,773 -3,982 Additions to PP&E -4,773 -3,982
Other investing activities 0 0 Other investing activities 0 0
Change in cash from investingactivities
-4,773 -3,982Change in cash from investingactivities
-4,773 -3,982
Cash flows from financingactivities:
Cash flows from financingactivities:
Sale of common stock 183 124 Sale of common stock 183 124Increase (decrease) in STborrowings
1,854 1,326 Increase (decrease) in ST borrowings 1,854 1,326
Additions to long term borrowings 7,882 629 Additions to long term borrowings 7,882 629
Reductions of long term borrowings -1,593 -127 Reductions of long term borrowings -1,593 -127
Dividend paid -1,862 -1,841 Dividend Paid -1,862 -1,841
Change in cash from financingactivities
6,464 111Change in cash from financingactivities
6,464 111
Change in cash and cashequivalents
-2,076 1,758 Change in cash and cash equivalents -2,076 1,758
Cash &cash equivalents atbeginning of year
12,462 10,704 Cash &cash equivalents at beginningof year
12,462 10,704
Cash & cash equivalents at end ofthe year
10,386 12,462Cash & cash equivalents at end of theyear
10,386 12,462
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Understanding Cash Flow Statement
Note: Indirect method of cash flow statement is much more prevalent than direct method primarily because inmost of the reporting formats indirect method of reporting is preferred. So, in our further discussions, we
will consider indirect method.
3.2.2 Treatment of some items in US GAAP while preparing cash flow statement:
TREATMENT U.S. GAAP
Dividend Paid Financing Activity
Dividend Received Operating Activity
Interest Paid Operating Activity
Interest Received Operating Activity
Income tax Paid All taxes paid as classified as Operating Activity
3.3 Cash Flow from Operations (CFO) and Free Cash Flow
3.3.1 Cash Flow from Operating Activities (CFO)It reports the cash generated from sales and the cash used in the production process and sale process. Theitems for this segment are derived from Income Statement and working capital accounts (current assets andcurrent liabilities in balance sheet).
Examples of Balance Sheet items classified as operating cash flows include changes in the following:
Receivables Reported as current assets in Balance Sheet
Inventories Reported as current assets in Balance Sheet
Prepaid expenses Reported as current assets in Balance Sheet
Taxes, interest and miscellaneous payables Reported as current liabilities in Balance Sheet
Deferred taxes Reported as current assets or current liabilities depending on the nature of deferred taxes
Examples of Income Statement items classified as operating cash flows include the following:
Cash sales
Cash cost of sales
Cash general and administrative expenses
Cash taxes
Interest paid and received
Dividends received
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Understanding Cash Flow Statement
Let us understand with an example How to prepare cash flow statement from income statement andbalance sheet statement?
INCOME STATEMENT (IN$) 2007 (CY) BALANCE SHEET (IN $) 2006 (PY) 2007 (CY)
Sales 200,000 AssetsExpenses Current assets
COGS 90,000 Cash 10,000 79,550
Wages 5,000 Accounts receivable 9,000 12,000
Depreciation 5,000 Inventory 10,000 15,000
Interest 500 Non current assets
Total expenses 100,500 Land 50,000 40,000
EBIT 99,500 Gross PP&E 70,000 100,000
Gain from sale of land 7,000 Accumulated Depreciation 9,000 14,000
Pretax income 106,500 Net PP&E 61,000 86,000
Provision of taxes 31,950 Goodwill 10,000 10,000
Net income 74,550 Total assets 150,000 242,550
Dividends Paid 6,500
Liabilities
Current liabilities
Accounts Payable 5,000 10,000
Wages Payable 8,000 5,000
Interest Payable 3,000 3,500
Taxes Payable 4,000 5,000
Dividends Payable 1,000 4,000
Non current liabilities
Bonds 10,000 20,000
Deferred Taxes 15,000 25,000
Stock holders equity(SHE)
Common Stock 50,000 48,000
Retained Earnings 54,000 122,050
Total Liabilities & SHE 150,000 242,550
Solution
CASH FLOW STATEMENT (IN $) 2007 COMMENTSPAT 74,550 From Income Statement Net Income
Gain from sale of land (7,000) From Income Statement Gain from sale of land (one time gain)
Depreciation 5,000 Adding Back Non-Cash Charges taken from Income Statement
Working capital NOTE:
for Assets - the change is calculated as from (Previous year, PY Current Year, CY)
for Liabilities the change is calculated as from (CY PY)
Increase in receivable (3,000) From Balance Sheet - for Assets : (PY CY)
Increase in inventories (5,000) From Balance Sheet - for Assets : (PY CY)
Increase in payable 5,000 From Balance Sheet - for Liabilities : (CY PY)
Decrease in wages payable (3,000) From Balance Sheet - for Liabilities : (CY PY)
Increase in interest payable 500 From Balance Sheet - for Liabilities : (CY PY)
increase in taxes payable 1,000 From Balance Sheet - for Liabilities : (CY PY)
Increase in deferred taxes 10,000 All taxes are considered operational activity
Change in working capital 5,500
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Understanding Cash Flow Statement
CASH FLOW STATEMENT (IN $) 2007 COMMENTS
Cash flow from operations 78,050 (A)
Cash flow from investing
Cash from sale of land 17,000From Balance Sheet difference between the value of Land and
adding to it the gains from sale of landCapital expenditure (30,000) From Balance sheet difference in the Gross PP&E
Cash flow from Investing (13,000) (B)
Cash flow from financing
Increase in borrowing 10,000 From Balance sheet difference in the value of the Bond
Change in common stock (2,000) From Balance sheet difference in the value of Common Stock value
Cash dividends (3,500)
From Income Statement Dividends = 6500, From balance Sheetthere are some dividend payables which have increased by 3000that means from current declared dividends company had only paid6500 (4000-1000) = 3500, so a (3500) will come as dividends paid
Cash flow from Financing 4,500 (C)
Change in Cash 69,550 (D) = (A) + (B) + (C)
Cash at the beginning of the year 10,000 PY cash taken from Balance Sheet - Cash of 2006
Cash at the end of the year 79,550Adding (D) to Beginning Cash to get ending Cash balance forthe year
3.3.2 Understanding Free Cash Flow (FCF)
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Free Cash Flow to Firm (FCFF)
Free Cash Flow
Free Cash Flow to Equity (FCFE)
It is a measure of the cash that is available after mandatory/compulsory cash requirements of a firm havebeen met. FCF is the cash that is left after deploying all the money required to run a business (buying rawmaterial, paying salaries, spending for maintenance expenditure for running a business, etc)
Cash flow available to the companys suppliersof capital (both equity and debt holders) aftermeeting all the expenses and necessaryinvestments
Cash flow available to the companys equityholders after meeting all the expenses
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3.3.2.1 How to interpret FCFF?
3.3.2.2 Example of computing free cash flow:The following are selected numbers from the financial statements of XYZ Inc. for 2009 and 2010 (in USDmillions)
(IN USD MILLIONS)
2009
(IN USD MILLIONS)
2010
Revenues 544.0 620.0
(Less) Operating Expenses (465.1) (528.5)
(Less) Depreciation (12.5) (14.0)
= Earnings before Interest andTaxes
66.4 77.5
(Less) Interest Expenses (16.4) (17.5)
= Pre Tax Income 60.0 70.0
(Less) Taxes (@ 30%) (18.0) (21.0)
= Net Income 48.0 49.0
Working Capital 175.0 240.0
The working capital in 2008 was USD 180 million
During Fiscal 2009, the company has raised debt of USD 10 million, while it raised USD 15 million debt infiscal 2010. The company has also paid debt of USD 5 million and USD 7 million in 2009 and 2010,respectively.
The firm had capital expenditure of USD 15 million in 2009 and USD 18 million in 2010.
Determine the value of FCFF & FCFE in 2009 and 2010 based on the above given information?
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Positive and growing
Free Cash Flow to Firm
Negative
Firm is able to meet itsinterest/dividend paymentobligations.
It can then be allocated forgrowing and expanding the
business.Management has a lot of
flexibility in its decisionmaking. It can internallyfinance new projects.
If a company is experiencingnegative flow, it will have tolook elsewhere for funds tothink about growing the
business.It could be there for a firmwhich is in the rapid growthphase.
Stable
It indicates that the company
is mature.
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Solution:
FCFF in 2009 = Net income + Non-cash charges + Interest * (1 Tax) CAPEX Working Capital
= USD (48.0 + 12.5 + 16.4 (1 - 0.3) 15 (175 180))
= USD 61.98
FCFE in 2009 = FCFF + New Debt Issuance Debt Repayments= USD (61.98 + 10 5)
= USD 66.98
FCFF in 2010 = USD (49.0 + 14 + 17.5 (1 0.3) 18 (240 175))
= USD 7.75
FCFE in 2010 = FCFF + New Debt Issuance Debt Repayments
= USD (-7.75 + 15 7)
= USD 0.25
Note:FCFF & FCFE are different from each other mainly because of differences in the capital structure. FCFEis calculated when the companys capital structure is not volatile. On the contrary, if a company has negative
FCFE and significant debt outstanding, FCFF should be used to compute the free cash flow and for the same
reason it is preferred over FCFE.
3.4 Analysis of Cash flow Statement
Questions that are answered from the Cash flow Statement:
Is company generating cash from operations?
Trends in CFO, PAT versus CFO
How much cash is generated and consumed for working capital needs?
How has company funded its growth
Internal generation / funded, Refinance, Borrowings, Equity
Analyze the following ratio:
CFO/Capex
Net borrowings versus Capex,
Debt repayment versus fresh debt
What is the cash left for shareholders after the company has met its growth needs?
FCFE/FCFF
Note:We will learn to analyze the cash flow statement in the classroom session, but we need to be familiar
with the interpretation of cash flow before we discuss analysis of cash flow statement.
3.5 Important Cash Flow Ratios
3.5.1 Performance Ratios
There are certain ratios which are helpful in analyzing the cash flow better, lets understand the important ones:
1. Cash flow to revenue: CFO/RevenuesIt measures the amount of operating cash flow generated for each dollar of revenue.
2. Cash to income : CFO/Operating Income also CFO to PATIt indicates the capability of the company to generate cash from the operations. It also determines howmuch earnings are cash earnings and is an important indicator of earnings quality of a company.
3. Cash Flow Adequacy Ratio: CFO/(CAPEX + Debt Repayment + Dividend Payment)It measures how well a company can cover annual payments of items such as debt, CAPEX and dividend.It is an important indicator to judge liquidity position of a company.
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3.5.2 Coverage Ratios
1. Debt Coverage: CFO/Total DebtIt measures the financial risk and leverage
2. Interest Coverage: (CFO + Interest Paid + Tax Paid)/Interest Paid
It measures the companys ability to meet interest obligations3. Dividend payment: CFO/Dividend paid
It measures the companys ability to pay the dividend
3.5.3 Questions
Q1. How it is possible for a firm to be profitable and still go bankrupt?
If earnings have increased more rapidly than sales
If the firm has positive net income but has failed to generate cash from operations
If net income has been adjusted for inflationIf sales have not improved even though credit policies have been eased
Q2. Which of the following statement is false?
A negative cash flow can occur in a year in which net income is positive
An increase in account receivable represents accounts not yet collected in cash
An increase in account payable represents accounts not yet collected in cash
To obtain cash flow from operations, the reported net income must be adjusted
Q3. Which of the following would lead to cash flow problems?
Obsolete inventory, account receivables of inferior quality, easing of credit by suppliers
Slow moving inventory, account receivable of inferior quality, tightening of credit by suppliers
Obsolete inventory, increasing notes payable, easing of credit by suppliers
Obsolete inventory, improved quality of account receivables, easing of credit by suppliers
Q4. Which of the following is false?
FCFF is a more popular measure than FCFE for valuing a company.
FCFF can never be smaller than FCFE.
If there are no debt holder, FCFF will be equal to FCFE.
Interest costs are not deducted in calculation of FCFF.
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3.6 Chapter Summary
Cash Flow statement provides the information on the actual cash inflows and outflows during a period. Itsegregates the information on cash flow movement under three activitiesoperating activities, investing
activities and financing activities.There are two methods of the representation known as Direct Method and Indirect Method. In general, most ofthe companies report the cash flow statement using indirect method.
The users of cash flow statement are interested in knowing the trends in free cash flow (FCF); Free Cash flowrefers to the cash that is left for equity and debt holders after meeting necessary expenses to run a business.
While analyzing the cash flow statement one need to take care the following:
Trend in the Cash generated from operations (CFO)
Compare CFO with Net Income
How company is funding its growth plans by CFO or by external sources of capital
Analyze the Free cash flow
3.7 Answers to the Questions
Section 3.5.3
Answer 1: Option 2
Answer 2: Option 3
Answer 3: Option 2
Answer 4: Option 2
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4 Appendix
Earnings_per_Share
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5 Evalueserve Disclaimer
The information contained herein has been obtained from sources believed to be reliable. Evalueservedisclaims all warranties as to the accuracy, completeness or adequacy of such information. Evalueserve shallhave no liability for errors, omissions or inadequacies in the information contained herein or for interpretationsthereof.
Financial Modeling