R.HARIHARAN AP/EEE. Balance sheet structure A balance sheet presents a picture of the company’s finances at the end of the financial year, and the assets.

MG 2452-EEFAUNIT-V - FINANCIAL

ACCOUNTING R.HARIHARAN

AP/EEE

Balance sheet structure

A balance sheet presents a picture of the company’s finances at the end of the financial year, and the assets which it has acquired and which have not yet been consumed within the business

A balance sheet can be presented according to two basic formats:◦ Horizontal balance sheet◦ Vertical balance sheet

Company X – Balance sheetat 31 December 20X2

Resources =

Assets =

Sources of finance

“Equities”

Owners’equity Liabilities

(interests of owners) (interests of creditors)

Horizontal balance sheetFourth EC Accounting DirectiveAssets Liabilities and equity Intangible assets 943 Ordinary shares 2,455 Tangible assets 1,988 Reserves 982 Investments 213 Retained profit 947

Fixed Assets 3,144 Shareholders’ equity 4,384 Stocks 1,589 Provisions 520 Debtors 973 Financial liabilities 1,500 Cash at bank 881 Trade liabilities 359 Deferred charges 176 Total 6,763 Total 6,763

Horizontal balance sheet US formatAssets Liabilities and equity Cash at bank 881 Trade payables 359 Deferred charges 176 Debt 1,500 Receivables 973 Provisions 520 Inventory 1,589 Fixed assets: Equity Investments 213 Ordinary stock 2,455 Tangible assets 1,988 Reserves 982 Intangible assets 943 Retained profit 947 Total 6,763 Total 6,763

Horizontal balance sheet Left-hand side - the assets:

◦ Fixed assets: used over a period of more than one year Tangible assets (e.g. physical plant and machinery) Intangible assets (patents, brand names, licences) Investments (shares of and loans to other

companies) ◦ Other (current) assets: constantly changing

during accounting period Inventories Receivables (amount due from customers) Cash

Horizontal balance sheet (cont.) Right-hand side - the financing:

◦ Share capital: put into the company by the owners

◦ Provisions: a liability to pay in the future, but amount or timing is uncertain

◦ Financial Liabilities: loans made by banks and financial markets

◦ Trade liabilities: debts due to suppliers

Balance sheet – vertical format € ’000 € ’000

Intangibles 943 Tangible assets 1,988 Investments 213 3,144 Fixed assets Stocks 1,589 Debtors and prepaid1 1,149 Cash at bank 881 Current assets 3,619 Creditors due in less than one year (359) Net current assets 3,260 Creditors due in more than one year (1,500) Provisions (520) 4,384 Capital Ordinary shares 2,455 Reserves 982 Retained profits 947 4,384

Vertical balance sheet Same content but different presentation Liabilities are shown as a deduction from

assets Liabilities are split according to when they are

due for payment, with current liabilities deducted from current assets

Capital (or equity) is shown as the residual: it is more a proprietary approach (focusing on the interests of the owners) while the horizontal presentation follows an entity approach (company presented as an economic whole)

The basics of accounting measurement Accounting measurement is based on a

set of assumptions and conventions which automatically limit the information content◦ Generally accepted accounting principles◦ Conventional measurement bases

Accounting measurement necessitates extensive use of estimates, which make it a subjective process

Generally accepted accounting principles A set of assumptions, conventions and rules

underlying financial accounting, necessary to make financial statements comparable and useful, but introducing significant constraints on their content

Different Generally Accepted Accounting Principles (GAAP)-sets exist, such as European GAAP and related national GAAP, US GAAP, IFRS GAAP,...

The ‘true and fair view principle’ (or fair presentation) of financial statements is pragmatically linked to the proper application of ‘generally accepted accounting principles’

Financial Ratios

FOUR BASIC TYPES - most commonly used for each - can be used for some financial companies.

LIQUIDITY • Current ratio = Current Assets / Current Liabilities

Not so relevant for financial firms - most assets liquid.

MANAGEMENT SKILL• Total Asset Turnover = Sales / Total Assets

Again, not so relevant because traditional sales are typically not very large. Interest and investment income is more relevant.

PROFITABILITY • Operating profit margin = Operating Profit/Sales• Return on Revenues = Net Income (or EBIT)/Tot. Assets• Return on Assets = Net Income (or EBIT)/Total Assets • Return on Equity = Net Income/Equity

These are measures of top-line profitability and bottom-line profitability, respectively. Similar for financial firms.

FINANCIAL RISK • Debt Ratio = Debt / Assets • Times Interest Earned = Net Operating Income /

Interest ExpenseLeverage and interest-paying ability - used for financials.

Financial Statements

• National-charter banks must submit uniform accounting statements to the Comptroller of the Currency.

• State charter banks submit accounting statements to their state regulator.

LIQUIDITY RISK - different than typical liquidity ratios

• Liquidity ratio = (Cash+short-term securities)/Assets• Loans to Deposits = Loans/Deposits• Deposits Times Capital = Deposits/Equity A mixture of profit potential and risk measures.

MANAGEMENT EFFICIENCY

• Earning Assets to Total Assets = Assets-(Cash+Fixed Assets+Non-earning Deposits) / Total Assets

• Burden = (Noninterest Exp.-Nonint. Inc.)/Tot. Assets

• Efficiency = Nonint. Exp./(Nonint. Inc. + Net Int. Inc.)

• Asset Utilization = Total Operating Income / Total Assets

PROFITABILITY Interest Margin to Earning Assets = (Interest Income-Interest Expense)/Earning Assets • Profit Margin = Net Income/Total Operating Income• Return on Earning Assets = Net Income/Earning Assets • Return on Equity = Net Income/Equity

Traditional SCF Life-Cycle Phases

Each cash flow activity will increase or decease over time depending upon the life-cycle of the company’s products.

Here is the most common pattern for revenues, net income, and cash flows.

Cash Flow Analysis

Analyzing Cash Flow InformationCash flow analysis can be used to address a variety of

questions regarding a firm's cash flow dynamics: How strong is the firm's internal cash flow generation?

◦ Is the cash flow from operations positive or negative?

◦ If it is negative, why?◦ Is it because the company is growing?◦ Is it because its operations are unprofitable?◦ Or is it having difficulty managing its working capital

properly? Does the company have the ability to meet its short-

term financial obligations, such as interest payments, from its operating cash flow?◦ Can it continue to meet these obligations without

reducing its operating flexibility?

Analyzing Cash Flow Information

How much cash did the company invest in growth?◦ Are these investments consistent with its business strategy?◦ Did the company use internal cash flow to finance growth, or

did it rely on external financing? Did the company pay dividends from internal free

cash flow, or did it have to rely on external financing?◦ If the company had to fund its dividends from external

sources, is the company's dividend policy sustainable? What type of external financing does the company

rely on?◦ Equity, short-term debt, or long-term debt?◦ Is the financing consistent with the company's overall

business risk? Does the company have excess cash flow after

making capital investments?◦ Is it a long-term trend?◦ What plans does management have to deploy the free cash

flow?

Recasting the SCF Although it is possible to answer these

questions using the GAAP SCF format, recasting the SCF makes answering these questions easier.

In addition, using a standard format makes comparison between companies easier.

Here is the model that we will use in this class.

Traditional SCF Format

Net Income+ Depreciation and Amortization± Deferred Taxes± Gains/Losses± Changes in Working Capital

= Cash Flow from Operating Activities

- Purchases of Long Term Assets+ Sales of Long Term Assets

= Cash Flow from Investing Activities

+ Sale of Stock+ New Borrowing - Debt Payments - Dividends - Stock Repurchases= Cash Flow from Financing Activities

Cash Flow from Operating Activities+ Cash Flow from Investing Activities+ Cash Flow from Financing Activities= Net Change in Cash

Recast SCF Format

Net Income+ Interest Expense (Net of Tax)+ Depreciation and Amortization± Deferred Taxes± Gains/Losses= OCF before Working Capital Investments± Changes in Working Capital

= OCF before Investment in Long Term Assets - Purchases of Long Term Assets+ Sales of Long Term Assets

= FCF Available to Debt and Equity - Interest Expense (Net of Tax) - Debt Payments+ New Borrowing

= FCF Available to Equity+ Sale of Stock - Dividends - Stock Repurchases= Net Change in Cash

OCF = Operating Cash FlowFCF = Free Cash Flow

Operating Cash Flow

Operating Cash Flow is broken up into two components, OCF before working capital investments and OCF before investments in long term assets.

Over the long run OCF must be positive, but firms in the early stages of development, growing rapidly, or investing heavily in research and development, marketing and advertising, and other future growth opportunities will have negative OCF.

Free Cash Flow

If cash flow after investing in long term assets is not positive then the firm did not generate enough cash from operations to pursue long-term growth opportunities and must rely on external financing.

These firms have less flexibility than firms that can generate the necessary funds internally.

Cash flow after long term investments is cash flow available to both debt and equity holders.

Free Cash Flow

Payments to debt holders include interest and principal payments.

Firms with negative free cash flow after investments in long term assets must borrow additional funds to meet their interest and principal payments.

They can also reduce their investments in working capital, long term investments, or issue additional equity.

Free Cash Flow

Cash flow after payments to creditors is free cash flow available to owners.

Payments to equity holders include dividends and stock repurchases.

If firms pay dividends despite negative cash flows available to equity holders then they are borrowing to pay dividends. This is not sustainable in the long term.

Summary

Examine cash flow from operations before investment in working capital to verify the company is able to generate a cash surplus from its operations.

Examine cash flow from operations before investment in long term assets to how the firms working capital is being managed and to see if the company can invest in long-term assets for future growth.

Summary

Examine free cash flow to debt and equity holders to asses a firm’s ability to meet its principal and interest payments.

Examine free cash flow to equity holders to asses a firm’s ability to sustain its dividend policy.

All cash flow analysis must be done taking into consideration the company’s business, its growth strategy, and its financial policies.

Analyzing Quality of Income The Quality of Income Ratio is calculated as Cash Flow from Operations Net Income

OR Cash Flow from Operations Net Income + Depreciation This ratio should be > 1 for a healthy firm.

Analyzing Quality of Income If there are significant differences between

net income and operating cash flow ask the following questions:◦ What are the sources of the difference?◦ Is it due to accounting policy?◦ Is it due to one-time events or on-going activities?

Is the relationship changing over time?◦ If so, why? (see above for possible reasons).◦ Is it because of changes in business conditions or

accounting policies and estimates?

Analyzing Quality of Income What is the time lag between recognition of

revenues and expenses and the receipt or payment of cash?◦ What uncertainties are there regarding cash

collection or cash payments (e.g. bad debts, contingent liabilities, etc.)

Are the changes in working capital accounts normal?◦ If not, is there an adequate explanation for the

changes?

MEANING OF FUNDS FLOW STATEMENT

The Funds flow statement (FFS) is a financial statement which reveals the methods by which the business has been financed and how it has used its funds between the opening and closing Balance-Sheet dates. It studies – from where the funds have been received and where the funds have been used.

IMPORTANCE OF FUNDS FLOW STATEMENT

1. Financial Analysis and Control2. Financial Planning and Budget preparation3. Useful to Bankers and Money Lenders4. Helpful in Comparative Study5. Knowledge of Managerial Policies6. Knowledge of Business Problems7. Dividend Policy

Non-accounting majors, especially, should relate well to this chapter

It looks at accounting information from users’ perspective

Relates very closely to topics you will study in your finance course

Therefore, we will use a somewhat broader brush on this chapter

What is financial statement analysis?”Tearing apart” the financial statements and looking at the relationships

Financial Statement Analysis

Horizontal AnalysisVertical AnalysisCommon-Size StatementsTrend PercentagesRatio Analysis

Methods ofFinancial Statement Analysis

Horizontal Analysis

Using comparative financial statements to calculate dollar or percentage changes in a financial statement item from one period to the next

Using comparative financial statements to calculate dollar or percentage changes in a financial statement item from one period to the next

Vertical AnalysisFor a single financial statement, each item

is expressed as a percentage of a significant total, e.g., all income statement items are expressed as a percentage of sales

For a single financial statement, each item

is expressed as a percentage of a significant total, e.g., all income statement items are expressed as a percentage of sales

Common-Size Statements

Financial statements that show only percentages and no absolute dollar amounts

Financial statements that show only percentages and no absolute dollar amounts

Trend PercentagesShow changes over time in given financial statement items (can help evaluate financial information of several years)

Show changes over time in given financial statement items (can help evaluate financial information of several years)