Introduction to Financial Statements

Learning Objectives

Different types of statements Purpose of each How they work together Why they are all important What we can learn from them

Financial Statements

The financial statements are windows into a company's performance and health.
Balance

Sheet Income Statement ~ Statement of Operations ~ Profit & Loss Statement (P&L) Statement of Cash Flows

All three of these statements are found in a firm's annual report.

The Balance Sheet ~ What is it?

The balance sheet represents a record of a company's assets, liabilities and equity at a particular point in time. The balance sheet is named by the fact that a businesss financial structure balances in the following manner:

Assets = Liabilities + Shareholders' Equity

Assets represent the resources that the business owns or controls at a given point in time. This includes items such as cash, inventory, machinery and buildings.
The other side of the equation represents the total value of the financing the company has used to acquire those assets. Liabilities represent debt, while equity represents the total value of money that the owners have contributed to the business - including retained earnings, which is the profit made in previous years.

The Balance Sheet

ASSETS LIABILITIES EQUITY

Cash
Inventory Land/Bldgs Equipment Accts Rcvbl Securities

Accts Payable
Wages Payable

Pref Stock
Common Stk

Taxes Payable Notes Payable Short term Long Term

APIC Retained Earnings

The Balance Sheet

Balance Sheet December 31, 2007 ASSETS Current Assets Cash Petty Cash Temporary Investments Accounts Receivable - net Inventory Supplies Prepaid Insurance Total Current Assets Investments Property, Plant & Equipment Land Land Improvements Buildings Equipment Less: Accum Depreciation Prop, Plant & Equip - net Intangible Assets Goodwill Trade Names Total Intangible Assets $ 2,100 100 10,000 40,500 31,000 3,800 1,500 89,000 LIABILITIES Current Liabilities Notes Payable Accounts Payable Wages Payable Interest Payable Taxes Payable Warranty Liability Unearned Revenues Total Current Liabilities $ 5,000 35,900 8,500 2,900 6,100 1,100 1,500 61,000 20,000 400,000 420,000

36,000 Long-term Liabilities Notes Payable Bonds Payable Total Long-term 5,500 Liabilities 6,500 180,000 201,000 Total Liabilities (56,000) 337,000 STOCKHOLDERS' EQUITY 105,000 Common Stock 200,000 Retained Earnings 305,000 Less: Treasury Stock Total Stockholders' Equity 3,000 Total Liabilities & $770,000 Stockholders' Equity

481,000

110,000 229,000 (50,000) 289,000 Total Assets $770,000

Other Assets

The Balance Sheet ~ Why do We care?

The balance sheet provides investors with a snapshot of a company's health as of the date provided on the financial statement. Generally, if a company assets are large relative to liabilities, it's in good shape. Conversely, just as you would be cautious loaning money to a friend who is burdened with large debts, a company with a large amount of liabilities relative to assets should be scrutinized more carefully.

The Income Statement ~ What is it?

The income statement measures a company's performance over a specific time frame and presents information about the revenues, expenses and profit that was generated as a result of the business' operations for that period. Components of the Income Statement include: Revenue (how much the company earned) Expenses (how much the company has spent, sort of) Net Income before and after Tax (the profits of the company) This statement contains the information you'll most often see mentioned in the press or in financial reports - figures such as total revenue, net income, or earnings per share.

The Income Statement

Sample Income Statement (in $1,000s) Q2 Sales Revenue Widgets Repair kits Service Total Sales Revenue Sales Costs Widgets Repair kits Service Total Sales Costs Gross Profit (Loss) Operating Expenses General & Administrative Sales & Marketing Research & Development Other Operating Expenses Total Operating Expenses Operating Income Interest Paid Income before Taxes Taxes Net Income from Operations $4,125 143 1,443 5,711 2,204 18 1,189 3,411 2,300 Q1 $4,330 20 1,102 5,452 2,111 4 947 3,062 2,390

292 1,389 214 5 1,900 400 1 399 127 $272

301 1,414 214 7 1,936 454 2 452 144 $308

The Income Statement ~ Why do We care?

The income statement answers the question, "How well is the company's business performing?" Basically, "Is it making money?" Firms with low expenses and high profits relative to revenues are typically more desirable for investment because bringing in more dollars directly benefits you as a shareholder.

The Statement of Cash Flows

~ What is it?

The statement of cash flows represents a record of a business' cash inflows and outflows over a period of time. It is the most sensitive of the statements and focuses on the following cash-related activities:
Operating Cash Flow: Cash generated from day-to-day business operations. Cash from Investing: Cash used for investing in assets, as well as the proceeds from the sale of other businesses, equipment or long-term assets Cash from financing: Cash paid or received from the issuing and borrowing of funds The cash flow statement is important because it's very difficult for a business to manipulate its cash situation. Earnings can be manipulated, but it's tough to fake cash in the bank. For this reason

The Statement of Cash Flows

Cash Flow Statement (dollar figures are in thousands) Net Income Non-cash Adjustments: Depreciation Other Adjustments to Earnings Net Cash provided from Operations Proceeds from Issuing New Stock Payments to Repurchase Stock Stock Dividends Paid Net Cash provided from Financing Additions to Property, Plant & Equipment Net Cash used for Investing Change in cash and equivalents during year Cash and Equivalents, beginning of year Cash and Equivalents, end of year 1997 $ 1,911 1,024 43 2,978 384 (396) (10) (22) (2,478) (2,478) 478 2,260 2,738 1996 $ 1,374 783 (16) 2,141 247 (278) (31) (1,987) (1,987) 123 2,137 2,260

The Statement of Cash Flows ~ Why do We care?

The statement of cash flows is very important to investors because it shows how much actual cash a company has generated. The income statement includes non-cash revenues or expenses, which the statement of cash flows excludes. One of the most important traits to look for is the firm's ability to generate cash. Many companies have shown profits on the income statement but struggled later because of insufficient cash flows.

Analysis of Profitability

Profitability is a subtle and complex concept. Doing well may be measured by different standards. Three concepts of profitability are given by:

Return on assets Return on common equity Earnings per common share

Earnings Per Share or EPS

Most income statements include a calculation of earnings per share or EPS. This calculation tells you how much money shareholders would receive for each share of stock they own if the company distributed all of its net income for the period. To calculate EPS, you take the total net income and divide it by the number of outstanding shares of the company.

Bringing It All Together

The three financial statements we have discussed are all related. The changes in assets and liabilities that you see on the balance sheet are also reflected in the revenues and expenses that you see on the income statement, which result in the companys gains or losses. Cash flows provide more information about cash assets listed on a balance sheet and are related, but not equivalent, to net income shown on the income statement. Therefore, no one financial statement tells the complete story.

Reporting Framework

GAAP starts with a conceptual framework of standards that anchor financial reports to a set of principles (such as materiality- the degree to which the transaction is big enough to matter) and verifiability (the degree to which different people agree on how to measure the transaction). The basic goal is to provide users equity investors, creditors, regulators and the public - with "relevant, reliable and useful" information for making good decisions. Sitting on top of the simple framework is a growing pile of literally hundreds of accounting standards.

Reporting Framework
The reporting frame work is applicable in Pakistan while preparing and presenting of financial statements is as follows:
Applicable Laws and Regulations Listed Companies other than, Insurance, NBFCs, Modaraba and Bank
Companies

Regulating Authority Securities and Exchange Commission of Pakistan (SECP)

Ordinance 1984. International Financial Reporting Framework (IFRS) as applicable in Pakistan Stock Exchange Listing Regulations
International

Banking Companies

Financial Reporting Framework (IFRS) as applicable in Pakistan Companies Ordinance 1984. Stock Exchange Listing Regulations (Particularly Code of Corporate Governance) Banking Ordinance 1962 Prudential Regulations (Corporate, SMEs and Consumers)
International

Securities and Exchange Commission of Pakistan and State Bank of Pakistan.

Insurance Companies

Financial Reporting Framework (IFRS) as applicable in Pakistan Companies Ordinance 1984 Stock Exchange Listing Regulations Insurance Ordinance and Rules

Securities and Exchange Commission of Pakistan.

Reporting Framework
Applicable Laws and Regulations Regulating Authority

Non Banking Finance Companies (Leasing Companies, Investment Companies,

International Financial

Reporting Framework (IFRS). Companies Ordinance 1984. Stock Exchange Listing Regulations (Particularly Code of Corporate Governance) NBFC Rules. Prudential Regulations for NBFCs Prudential Regulations for Leasing Company
International Financial

Securities and Exchange Commission of Pakistan.

Modarba

Reporting Framework (IFRS). Companies Ordinance 1984. Stock Exchange Listing Regulations (Particularly Code of Corporate Governance) Modarba Act and Rules

Securities and Exchange Commission of Pakistan and Registrar of Modarba

User of Financial Statements

User of the financial statements Equity investors (existing and potential) Loan creditors ie, existing and potential holders of debentures and loan stock, and providers of short-term loans Employees (existing, potential and past) Interest of the user They are interested whether buy, hold or sell the shares in hand and also enable them in payment of dividends. The amount will be paid when due and for continuation of the business. Interested in stability and profitability for employment opportunities, remuneration and retirement benefits.

Business contacts including customers, trade creditors, competitors and potential take-over bidders
Government, including tax authorities, government departments and local authorities

Whether the payment of loan will be made in due dates and enable sustainability of business for future business with the enterprise.
Interested in allocation of resources and also to regulate the activities of an enterprise and determining tax policies and as a basis for national income.

Public, including tax payers, ratepayers and environmental groups

Trends and recent development in the prosperity of the entity and range of its activities.