Financial Statements

Balance Sheet Income Statement Ratios Outline

How valuable are the assets of a firm? Long lives - land and buildings Shorter lives – inventory and cash Assets which are not physical, like patents & trademarks (intangible assets) Balance Sheet

How did the firm raise the funds to finance these assets? Funds of the owners (equity) Borrowed money (debt) Mix (leverage) is likely to change as the assets age Balance Sheet

roduction-balance-sheet/ roduction-balance-sheet/ Accounting Balance Sheet

They are things that an organization owns. Current assets include cash and accounts receivable. Accounts receivable are monies that we are owed for products and services which have been sold on credit and we have not received the cash yet. Assets

Long-term assets include buildings, equipment, machinery and other things which cannot be easily converted into cash. Intangible assets are assets which we cannot see or touch, yet they are owned by the firm. Examples include intellectual property (IP) and brand name Assets

It leads to a future cash outflow or the loss of a future cash inflow. The firm cannot avoid the obligation. Current liabilities include short term loans and accounts payable. Accounts payable are monies that we have not paid yet for products and services which we have already purchased. Long-term liabilities include long term loans. Liabilities

Stockholders’ equity, also called owners’ equity, is the amount that would remain if all liabilities were paid using the organization’s assets. This is the book value of equity estimated using historical costs with accounting adjustments, rather than with expected future cash flows or market value. Equity

Book Value - The original cost of the asset, adjusted upward for improvements made to the asset since purchase and downward for loss in value associated with the aging of the asset. Market Value – The cost we would get for the asset if we sold it today. Accountants like to use book value as they have a preference for underestimating value Book Value Vs Market Value

How profitable are these assets? Is the return (profit) greater than the risk (hurdle rate)? We need to estimate the returns (profits) being made on these investments. Income Statement

Operating, financing, and capital expenses. Operating expenses are expenses that at least in theory provide benefits only for the current period; the cost of labor and materials expended to create products that are sold in the current period is a good example. Expenses

Financing expenses are expenses arising from the non equity financing used to raise capital for the business; the most common example is interest expenses. Capital expenses are expected to generate benefits over multiple periods; for instance, the cost of buying land and buildings is treated as a capital expense. Expenses

Operating expenses should reflect only those expenses that create revenues in the current period. In practice, however, a number of expenses are classified as operating expenses that do not meet this test. Depreciation and amortization. Research and development. Operating lease expenses. Expenses

Depreciation methods can very broadly be categorized into straight line (where the loss in asset value is assumed to be the same every year over its lifetime) and accelerated (where the asset loses more value in the earlier years and less in the later years). Depreciation

For example, we are a pharma firm with a 5 year project with a large upfront investment in R and D and laboratory equipment. We spent $8m on R and D and $2m on equipment before we even start to get any revenues. In year 1 we estimate revenues of $1m, in year 2 $4m, in year 3, $8m in year 4 $10m and in year 5 $10m. Depreciation tax benefit

If we account for R and D and the equipment in year 0 we would show a loss of $10m that year which would give no tax benefit as there were no revenues. For tax purposes it is better to spread out the R and D and depreciation over the 5 year periods equally at $2m a year. This depreciation expense will be subtracted from our revenues each year allowing us to record a lower profit and pay less taxes on the lower recorded profits from years 1 to 5. Depreciation tax benefit

The revenue from selling a good or service is recognized in the period in which the good is sold or the service is performed. For example, we sell our product to another business today but will not receive payment for 3 months. The revenue is recognized today on the income statement. Accrual accounting

Earnings before interest and taxes (EBIT) is operating income from the income statement - that is revenues minus expenses (not including interest payments). EBIT

What does the balance sheet show? What does the income statement show? Where on the balance sheet would you find accounts payable and what does it contain? What is the difference between an operating expense and a capital expense? Questions

You are a firm which has the following estimated revenues, Year 1 $20m, Year 2 $30m, Year 3 $40m. In Year 0 before the start of your project you bought a factory and machinery costing $60m. Are you going to record the factory and machinery as a capital expense of $60m in Year 0 or as depreciation of $20 each year in operating expenses over the 3 years? Why? Question

Long term debt paying ratios – Debt ratio, debt to equity ratio Profitability ratios – ROC, ROE Financial Ratios

The debt ratio compares the amount of assets an organization has to the amount of liabilities. Debt ratio = Total liabilities/Total assets Debt ratio

The D/E Ratio is a debt ratio used to measure a company's financial leverage, calculated by dividing a company’s total liabilities by its stockholders' equity. The D/E ratio indicates how much debt a company is using to finance its assets relative to the amount of value represented in shareholders’ equity. Debt to Equity Ratio = Total Liabilities / Shareholders' Equity Debt to Equity ratio

Return on capital (ROC) measures the return that an investment generates for all its investors, bondholders as well as stockholders. Return on capital = (Net income - Dividends) / (Debt + Equity) ROC

Return on Equity Examines profitability from the perspective of the equity investor by relating profits to the equity investor (net profit after taxes and interest expenses) to the book value of the equity investment. ROE = Net Income Book Value of Common Equity ROE

Calculate the following ratios using the balance sheet and income statement examples sourced from Yahoo finance in the chapter. –Debt ratio = Total liabilities/Total assets = –Debt to Equity Ratio = Total Liabilities / Shareholders' Equity = –Return on assets = Net Income/ Total assets = –Return on Equity = Net Income/Shareholder's Equity = Question