Ing. Ivan Souček, Ph.D. Course „Enterprise Economics “ VŠCHT, Ústav ekonomiky a řízení chemického a potravinářského průmyslu

 General introduction - Basic examples  Overview of financial statements  Income Statement  Balance Sheet  Depreciation  Accounting flexibility  Financial ratios  Conclusions 2

Highlights 1) Capital is made by the decision to postpone current consumption and to invest these funds to capital goods 2) Property owned by a business is called an asset. Some assets are used in the business processes gradually and are depreciated and some are used just once 3) For accounting purposes, the business chooses the depreciation based mainly on the economic life of long term assets; law about income taxes defines the use of depreciation as a tax deductible expense 4) Company’s assets are covered either by resources put in by the owners or resources created during the business process (equity) or by resources provided by outside subjects (liabilities) Entrepreneurs- individuals do not have to keep accounts when fulfilling the legal conditions, they only keep tax evidence. 3

Property and Capital structure of a business Up until now, we were talking about the legal framework, which defines business. In the next chapters, we will talk about a business as an economic entity. From this point of view, we can define a business as a system, whose function is to change inputs into outputs. The goal of every business is to maximize the benefits for its owners. We can look at the benefits for owners from many aspects. The owners’ goals can be to maximize profits, to maximize the company’s value, which means to produce the best product with the lowest possible expenses. Definition of Capital In order to start a business, you need some investment at the beginning. This investment can be cash, land, machinery, or our own knowledge and skills. When the capital is created, there is a decision to defer current consumption for the future. But that is not enough. Somebody has to make an investment that is able to increase the work productivity. 4

Displaying basic economic changes in a business At the beginning of this chapter, we defined business as a system, whose goal is to change inputs into outputs. Inputs can be buildings, machines, material, human potential and output is then some product or a service. In order to quantify or to compare against each other or among the industry the individual inputs, parts, and the results of processes, we need to convert all of them to a universal value. This value is money. The way this is done is called accounting. We talked about establishing companies in chapter 1.3. The founders have to give an initial capital to the company in order for the company to start doing business. For some type of companies, the minimal amount of initial capital is given by law. This initial input is called registered capital of the company. This deposit can be made with cash, or if legally allowed, with property (land, buildings, material,...). Example: Imagine that a limited liability company was founded by 2 enterprenuers, when the first deposited 8 mill. CZK to the initial capital and the second2 mill. CZK. The initial capital is then 10 mill. CZK. After the company has been registred with the business register, an accounting company writes down this information, which is called starting Balance Sheet (in thousands CZK): Assets10 000Liabilities Current Assets Equity Bank Account Basic capital

We can define: - Assets as property owned by company. - Liabilities then represent the way of covering the sources by which Assets are covered. Assets and liabilities are shown in one of the basic accounting reports which is Balance sheet. The Balance sheet is a status report that shows the state of business assets and how are they covered to a certain date. Example: Imagine that then the limited liability company called Enterpreuner, llc. decided to acquire production facility by 5 mill. CZK and initial stocks of raw materials by 2 mill. CZK using own capital. After that they can start production and developing further business and consequently company Balance Sheet. Post-starting Balance sheet will look as follows (in thousands CZK) : Assets10 000Liabilities Fixed Assets Current Assets Equity Inventories Bank Account Basic capital

In general we could characterize company financing as an activity to provide financial sources (Capital and Money) for foundation and operation of the company in sufficient volume, required time and structure under the condition of optimal cost for their obtaining and defined price for their use (Cost of Capital, WACC). Sources of financing: ◦ equity (own sources) ◦ Liabilities (external sources) Example: Imagine that then the limited liability company decided to further expand of its production facility by additional 15 mill. CZK using bank loan. After that they can furher develop their business and consequently company Balance Sheet. Post-starting Balance Sheet will look as follows (in thousands CZK) : Assets25 000Liabilities Fixed Assets Equity Current Assets Basic capital Inventories 2 000Liabilities Bank Account Bank loan

Revenues − Expenses = Earnings/profit

Assets − Liabilities = Equity capital Assets = Liabilities + Equity capital

Assets − Liabilities = Equity capital or Assets = Liabilities + Equity capital

Depreciation

Market growth Market size Market share Price Administration Amortisation and depreciation Non-current assets Inventories Receivables Operating cash Operating liabilities Turnover rate Invested capital Profit Margin ROIC Production Marketing Distribution Revenue The firm’s competitive edge EVA WACC Financial leverage Creditors’ required rate of return Investors’ required rate of return The information disclosed in the annual report does not typically allow for a more detailed analysis of the profitability at the following levels: Location Product (group) Customer (group)

16 Depreciation impact on Cash and Profit Net profit becoming Retained earnings and Depreciation in simplified manner form Cash availability of the Company. Excluding other impacts, we could see on our example: Depreciation/Amortisation: 4+10=14 Cash: 84 Profit=Retained Earnings: 70

 ROA (Return on Assets): ◦ EBIT / Assests  ROE (Return on Equity): ◦ Net Profit/ Equity  ROS (Return on Sales): ◦ Net Profit/ Revenues

 Return on Assets ◦ Assets / (Revenues / 365)  Return on Inventory ◦ Inventory / (Revenues / 365)  Time of collection of Receivables ◦ Receivables / (Revenues / 365)

 Equity Ratio ◦ Equity/ Assets  Debt Equity Ratio ◦ Liabilities/ Equity  Interest Coverage ◦ EBIT/ Interests

 Current Liquidity ◦ Current Assets/ Short-term debts  Quick Liquidity ◦ (Short-term receivables + Financial assets) / Short-term debt  Cash Liquidity ◦ Financial Assets / Short-term debts

 All transactions must include (at least) one debit and one credit record and the total amount in debit must match the total amount in credit  Income (revenues, other income and gains), liabilities and equity are credit transactions. Expenses (costs and losses) and assets are debit transactions  Financial statements summarise all recorded transactions in a firm  The income statement measures a firm’s earnings capacity over a period of time: The difference between income and expenses  The balance sheet represents a firm’s assets, liabilities and equity at a point in time  Statement of changes in equity highlights how equity changes from the beginning of the period to the end of the period  Adjustments to financial statements are essentially bookkeeping records.  Income statement and Balance sheet are basic source for calculation and analysis of financial indicators

 Results of performance analysis of selected Czech companies in the period

Profitability ratios

Vývoj ukazatelů rentability Profitability ratios

Activity ratios Return on Assets Return on Inventory Time of collection of Receivables (Days)

Return on AssetsReturn on Inventory Time of collection of Receivables Activity ratios - days

Ratios of long-term financial stability Interest Coverage

Ratios of long-term financial stability

Current LiquidityQuick LiquidityCash Liquidity Ratios of payment ability

Current LiquidityQuick LiquidityCash Liquidity Ratios of payment ability