FIN 420

PPT 02
March 2015

CHAPTER 2

UNDERSTANDING FINANCIAL STATEMENT

SYLLABUS CONTENT 2

CODE CHAPTER WEEK

Ppt 01 Introduction to Financial Management 1
Ppt 02 Understanding Financial Statements 2
Ppt 03 Financial Ratios and Analysis 3
Ppt 04 Financial Forecasting and Planning 4
Ppt 05 Working Capital Management 5
Ppt 06 Cash and Marketable Securities Management 6
Ppt 07 Accounts Receivable & Inventory 7
Management
Ppt 08 Short Term Financing 8
Ppt 09 Long Term Financing 9
Ppt 10 Mathematics of Finance 10 & 11
Ppt 11 Capital Budgeting 12 & 13
CHAPTER OUTLINE 3

NO. CONTENT
1 Balance Sheet
2 Income Statement
3 Sources and Uses of Funds
4 Cash Flow Statement
Definitions and Roles of financial statement

What is Financial Statements?

 A structured report of a business financial activity.

 Primary source of financial data and the standing of operations.
 Is prepared of at least once a year (or monthly, quarterly, semi
annually)
 Provide an overall picture of the business health and wealth.

 Consists of:
 Balance sheet,
 Income Statement,
 Cash flows statement,
 Statement of retained earnings

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Definitions and Roles of financial statement

What is Financial Analysis?

 A process of collecting and refining financial data to provide necessary

information to aid decision making to determine future actions.
 A study of financial statement (i.e. historical performance).
 Financial analysis generally consists of two branches: securities analysis
and corporate financial analysis. Our focus? corporate financial analysis
that is financial ratio analysis.

 Enables:
 To asses operating result & financial status of a firm.
 To develop plans and strategies so as to keep the firm's performance
in line with the goal to maximize the owners wealth.

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 BALANCE SHEET
 Is a financial statement that summarizes firm’s financial position in three
segments; 1) company's assets, 2) liabilities and 3) shareholders' equity at
a specific period of time.
 The three balance sheet segments give investors an idea as to what the
company owns and owes, as well as the amount invested by the
shareholders.
 A balance sheet is prepared as soon as the income statement is completed.
 Consist of :
 Assets (i.e. current and fixed)
 Liabilities (i.e. short and long term)
 Owner’s equity (i.e. common equity)
 Balance Sheet Equation

ASSETS = LIABILITIES + OWNERS’ EQUITY

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 Format of Balance Sheet
1. Horizontal Balance Sheet

Balance Sheet as at December 2015

ASSETS LIABILITIES AND EQUITIES

Current Assets Current Liabilities
Marketable Securities Account Payable
Account Receivable Notes Payable
Inventories Accruals
Prepaid expenses Total Current Liabilities
Total Current Assets

Fixed Assets Long Term Debt

Plant and Machinery
Land and Buildings Common Equity
Total Fixed Assets Common Stock
Preferred Stock
Retained Earnings

TOTAL ASSETS TOTAL LIABILITIES AND EQUITY

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 Format of Balance Sheet
2. Vertical Balance Sheet
Balance Sheet as at December 2015

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Format of Balance Sheet

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 Definition and Types of Assets
Assets are resources or items of value that the business owns and are expected to
generate income in the future.

1. Current Assets:
 short term in nature (less than 12 months).
 relatively liquid, and are expected to be converted to cash within a year.
 easy to convert into cash and are the floating money of the company.
 E.g., cash (in hand and/or at bank), marketable securities, accounts
receivable, inventories, prepaid expenses, advance payment.
 A video on marketable securities.

2. Fixed Assets:
 Long term in nature (more than 1 year), subjected to depreciation.
 Is divided into 3; tangible asset, intangible asset and long term
investment.
 E.g., machinery and equipment, office buildings, copyright, pattern,
trademark, furniture and fittings and land.

3. Other Assets: any asset that is not a 10

current asset or fixed asset.
 Definition and Types of Liabilities

 Liabilities are amounts owed by a business to outside parties.

 Categorized into two; current liabilities and long term liabilities.

1. Current liability
 Short term in nature (less than 12 months).
 Debts or obligations of the business which are repayable within 1 year.
 Example: notes payable (short draft loan), account payable (creditors),
accrual expenses.

2. Long term liability

 Long term in nature (more than 1 year).
 Debts or obligations of the business which are repayable more than 1
year.
 Example: Mortgage, long term loans and debentures.

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Definition and Components of Owners’ Equity

 Represent the owner’s claim on or supplied funds for acquisition of

assets for the business.
 It shows how much of the total assets belong to the owner and
financial obligation of the business to the owner.
 Equity is made up of capital + profit – drawing (for sole trader) or
dividend (for partnership).
 Example: Capital stock (i.e. common or preferred stock) and retained
earnings or profit (i.e. reserved).

 Can be illustrated as follows:

Equity = Capital + accumulated profit –

drawing or dividends

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 INCOME STATEMENT

 Is also referred to as ‘statement of the financial performance’ or ‘statement of

profit and loss’.
 Is a summary of the firm’s operating and financing activities over a specific
period of time.
 Provides a view of how the business incurs its revenues (i.e. sales & other
income), costs (i.e. COGS) and expenses.
 Also shows the net profit or loss incurred over a specific accounting period.
 Offers information on whether a business earn a net profit or bear a net loss.

PROFIT= REVENUES - EXPENSES

 Split into 2 parts:

 Operating activities
 Financing activities

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 Revenues Versus Expenses

Revenues
 Revenues are income generated by the business from the course of ordinary
activities.
 Revenues represent inflows of assets, such as cash (from cash sales), receivable
(from credit sales) etc.
 Examples: Sales of goods (selling price – cost), other revenues (e.g., tuition fee,
royalties, dividend income) and net income (i.e., to distribute to shareholders).

Expenses
 Expenses or costs incurred in the normal course of business to generate revenues.
 Expenses is outflow of assets and will decrease the owner’s equity
 Examples: Cost of sales (COGS – cost to produce goods), marketing expenses,
operating or administration expenses (salaries, utility, rental), finance cost
(interest on loan), payment to government (taxes).

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 Format of Income Statement

Income Statement for the year ended December 2015

Revenue/Net Sales
less: COGS
Operating Gross Profit
Activities less: Operating Expenses
Depreciation
Operating Income/EBIT

plus: other income

less: Interest
Earnings Before Taxes
Financing less: Corporate Taxes
Net Income
Activities
Dividend: Preferred
Common
Retained Earnings

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 Variables of Income Statement

Variables:
 Sales/Revenue (i.e. cash & credit sales)
 COGS (i.e. cost to produce goods or services)
 Operating expenses (i.e. marketing, administration etc)
 Interest (i.e. financing cost)
 Tax expenses (i.e. payment to govt)
 Net Income (i.e. to distribute to shareholders)
 SOURCES AND USES OF FUNDS

 The changes of financial position represent the Sources and Uses of funds.
 The sources and uses of fund can be formatted into a statement, that is a
“Fund Flow Statement” or “Statement of Changes in Financial Position”.
 The statement concerns on:
 Where did firms get its funds from during the year? (Sources)
 What did the firm do with available funds? (Uses)
 How does operations affect firm’s assets and liabilities?

 In order to identify sources & uses of funds, we need to have at least two
latest year of balance sheets and the latest year of income statement.

 Combine changes in B/Sheet with other relevant financial figures (i.e.

income statement).
 Funds inflow – Sources
 Funds outflow – Uses

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 How to Identify Sources or Uses of Funds?
 Analyze the balance sheets.
i. Calculate the amount of changes in balance sheet (t=1 minus t=0).
ii. Classify the change (i.e., uses or sources) of funds for the firm within
one year period. Ignore the negative sign as it only indicates the
direction of change, only absolute value is relevant for the analysis
purposes.

 Analyze the income statement

i. Determine the net income for the year.
ii. Determine the disposition of net income: 1) dividend and 2) retained
earning.
iii. Determine the depreciation charges for the year. Note that if the
figures are not available; refer to the balance sheet accounts for the
change in the accumulated depreciation. The differences can be
considered as present depreciation charges for the purpose of our
analysis.
iv. Therefore, the items in income statement that important for fund flow
statement are dividend and depreciation.
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 Mekar Inc Bhd
Balance Sheet as at 31 December 20X1 and 20X2
(RM'000) 20X1 20X2
Current Assets
Cash 28 97
Marketable Securities 42 10
Account Receivable 93 128
Inventories 65 85
Total Current Assets 228 320

Fixed Assets
Gross Fixed Assets 887 1020
less: depreciation 226 285 To analyze the
Total Fixed Assets 661 735 Balance Sheet or to
TOTAL ASSETS 889 1,055
identify Sources and
Current Liabilities Uses of funds,
Account Payable 64 95 Two Balance Sheet is
Notes Payable 20 87
Accrued Expenses 95 75 Required.
Total Current Liabilites 179 257

Long Term Debt 297 318

Common Equity
Common Stock 140 160
Paid in capital 108 120
Retained Earnings 165 200
TOTAL LIABILITIES AND EQUITY 889 1,055
 Analyze Income Statement

Mekar Inc Bhd

Income statement for the year ended 31 December 20X2
Dividend is
(RM'000) 20X2
Transferred to the
Revenue/Net Sales 960
Fund Flow
less: COGS 624
Statement
Gross Profit 336
less: Operating Expenses 167
Depreciation 19
Operating Income/EBIT 150
less: Interest Expenses 30
Earnings Before Taxes 120
less: Corporate Taxes 48
Net Income 72
less: Dividend 37
Retained Earnings 35 BUT
If there is no IS
Div = EAT- (RE1-RE0)
How to Identify Sources or Uses of Funds? (cont.)

SOURCES OF FUNDS USES OF FUNDS

Decrease in assets Increase in assets
Increase in liabilities and equity Decrease in liabilities & equity
Earning After Tax / net profit Net loss from operations
Depreciation Dividends

Sources & Uses of Funds involve in Operations

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 STATEMENT OF RETAINED EARNINGS

 Is also referred to as a statement of owner's equity or statement of

shareholders' equity.

 It shows the amount of net earnings (income) re-invested (retained)

in the business.

 Retained earnings (inappropriate profit) are funds re-invested in the

business over a period of years and these funds are not usually held
in the form of cash but invested in other assets (eg: machinery,
equipment) of the company.

 The statement of retained earnings reconciles the beginning and

ending retained earnings for the period, using information such as
net income from the other financial
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statements.
 Format of Statement of Retained Earnings
Example A
Statement of Retained Earnings for The Year Ended Dec 31, 2015

Balance of Retained earnings on Dec 31,2014

(+) Earning After Taxes (EAT) / net profit after taxes 2015
(-) Dividend Payment 2015
Balance of Retained earnings on Dec 31,2015

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 CASH FLOW STATEMENT
 A financial statement that shows how changes on items in balance sheet
and net income will affect the amount of cash for the year.

 Also a statement that summarizes the cash inflows (cash received) and
cash outflow (cash paid) during a specified period.

 For the purpose to reconcile and recognize all the cash transactions.

 Cash might be changed due to changes in Balance Sheet items (i.e. assets,
liabilities and equity).

 Net ending cash in Cash Flow Statement is expected to be equaled to

cash in Balance Sheet for the year. Recall that! Cash is an item in
Balance Sheet.
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 CASH FLOW STATEMENT (cont.)

 Statement of cash flows is separated into 3 main categories:

1. Operating activities - includes net income, depreciation, changes in

current asset and current liabilities (except Cash, short-term
investment and Notes payable).
2. Investing activities – consists of changes in fixed assets.
3. Financing activities – summarizes changes in short-term
investment, notes payable, equity, long-term debt, dividends
payment.

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 Format of Cash Flow Statement
XXX Bhd
Statement of Cash Flows for 2015
Operating Activities
Net Income XXX
plus: Depreciation XXX
Due to changes in working capital:
Changes in CA or CL XXX The changes of items
EXCEPT CASH,NOTES PAYABLE
AND S/TERM INVESTMENT In Balance Sheet
Net cash provided by operating activities XXXX will be transferred
Long-term Investing Activities to the Statement of
Changes in Fixed Assets XXXX Cash flow
Financing Activities (i.e. the procedure is
Changes in Stocks, L/term Debt, Similar to determine
S/term Investment, Notes Payable XXX
Sources and Uses
Dividends XXX Of Funds)
Net cash provided by operating activities XXXX

Summary
Net change in cash XXXX
Cash at the beginning of year XXXX
Cash at the ending of year XXXX
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 Exercise: Construction of CFS and RES
Suria Bhd
Question: Consolidated Balance Sheet (RM'000)
Based on Suria Bhd 2004 2003
Cash 10,000 15,000
Balance Sheet and
Marketable securities 0 65,000
Income Statement for Account Receivable 375,000 315,000
the year 2003 and 2004, Inventories 615,000 415,000
you are required to Total Current Assets 1,000,000 810,000
prepare: Net Fixed Assets 1,000,000 870,000
TOTAL ASSETS 2,000,000 1,680,000

1. Statement of Account Payable 60,000 30,000

Retained Earnings Notes Payable 110,000 60,000
(RES) Accrued Expenses 140,000 130,000
2. Statement of Cash Total Current Liabilities 310,000 220,000
Flow (CFS) Long-term Debt 754,000 580,000
Common Stock 170,000 170,000
Retained Earnings 766,000 710,000
TOTAL LIABILITIES AND EQUITY 2,000,000 1,680,000

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Exercise: Construction of CFS and RES (cont.)

Suria Bhd
Income Statement for the year ended (RM'000)
2004 2003
Sales 3,000,000 2,850,000
less: Operating Expenses 2,616,200 2,497,000
Depreciation 100,000 90,000
Operating Income/EBIT 283,800 263,000
less: Interest Expenses 88,000 60,000
Earnings Before Taxes 195,800 203,000
less: Corporate Taxes (40%) 78,320 81,200
Net Income or EAT 117,480 121,800
Dividend to Shareholders 61,480 57,000
Retained Earnings 56,000 64,800

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Solution: Construction of CFS and RES

Suria Bhd
Statement of Retained Earnings for the year ended Dec 31, 2004
(RM'000)
Balanced of retained earnings, Dec 31, 2003 710,000
add: Earning after tax 2004 117,480
less: Dividend, 2004 61,480
Balanced of retained earnings, Dec 31, 2004 766,000

Balance of Retained Earnings 2004 is SIMILAR

With that Retained Earnings in 2004
Balance Sheet

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 Solution: Construction of CFS and RES (cont.)
Suria Bhd Items in
Consolidated Balance Sheet (RM'000) BS need to be
2004 2003 X1-X0 Action subtracted, X1-X0
Cash 10,000 15,000 and transferred
Marketable securities 0 65,000 -65,000 Add
to Cash Flow
Account Receivable 375,000 315,000 60,000 Minus
Inventories 615,000 415,000 200,000 Minus
Statement
Total Current Assets 1,000,000 810,000 Except for
Net Fixed Assets 1,000,000 870,000 130,000 Minus Cash & RE
TOTAL ASSETS 2,000,000 1,680,000

Account Payable 60,000 30,000 30,000 Add

The Procedure
Notes Payable 110,000 60,000 50,000 Add
Accrued Expenses 140,000 130,000 10,000 Add
Is similar
Total Current Liabilities 310,000 220,000 To determine
Long-term Debt 754,000 580,000 174,000 Add Sources (i.e. Add)
Common Stock 170,000 170,000 0 N/A and
Retained Earnings 766,000 710,000 Uses (i.e. Minus)
TOTAL LIABILITIES AND EQUITY 2,000,000 1,680,000 Of Funds
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Solution: Construction of CFS and RES (cont.)

Suria Bhd
Income Statement for the year ended (RM'000)
2004 2003
Sales 3,000,000 2,850,000
less: Operating Expenses 2,616,200 2,497,000
Depreciation 100,000 90,000 Dividend (i.e. Minus)
Operating Income/EBIT 283,800 263,000 and
less: Interest Expenses 88,000 60,000
Depreciation (i.e. Add)
Are transferred to
Earnings Before Taxes 195,800 203,000
Cash Flow
less: Corporate Taxes (40%) 78,320 81,200
Statement
Net Income 117,480 121,800
Dividend to Shareholders 61,480 57,000
Retained Earnings 56,000 64,800

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 Solution: Construction of CFS and RES (cont.)
Suria Bhd
Statement of Cash Flows for 2004 (RM'000)

Operating Activities Depreciation:

Net Income 117,480
plus: Depreciation 100,000 Extract from IS
Due to changes in working capital: or
Increase in account receivable (60,000)
Increase in inventories (200,000)
(Take the difference in BS)
Increase in account payable 30,000
Increase in accruals 10,000
Net cash provided by operating activities (2,520) Net Capex:
Long-term Investing Activities
Net FA1 – Net FA0+ Dep
Cash used to acquire fixed assets (230,000) or
Financing Activities
(Gross FA1 – Gross FA0 )
Sale of short-term investment 65,000
Increase in notes payable 50,000
Increase in long-term debt 174000 Ending Cash:
Dividends (61,480)
Net cash provided by operating activities 227,520
Same Amount with
Cash in the
Summary Balance Sheet
Net change in cash (5,000)
Cash at the beginning of year 15,000
Cash at the ending of year 10,000
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LOGO

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