CHAPTER 3 Financial Statements Key Financial Statements Balance sheet Income statements Statement of cash flows

Financial Statements The Financial Statements give a snapshot of a company’s worth at the end of a particular period, as well as a view of the company’s operations and whether it has made a profit.

Financial Statements Key group of people who rely on financial statements Investors: need information to judge whether or not the company is a good investment. Analysts: need information to develop analytical reviews for clients considering the company for investments. Creditors: need information to determine whether to risk lending more money to the company Competitors: need information to formulate a competitive business strategy.

Financial Statements Key group of people who rely on financial statements. Executive and Managers. They need to know how well they are meeting or exceeding the organization’s target. Also they need to get information about problems areas of the operations and how to improve. They need to know how well the company is doing financially

Financial Statements As well as an annual report, listed companies need to produce the following: Interim report ( currently at the 6 month stage) Notification of materials: events such as major business acquisitions, contracts awarded, major restructuring of business operations, etc. Notification of major changes in the shareholdings.

Financial Statements Example of Notification of materials reports

The annual report The Basic Parts of an Annual Reports Chairman statement: A report from the chairman about the progress during the preceding years and prospects for the future. Operating review: This report is by the key directors of the main divisions of the company, giving management’s view on progress. ie. The finance director and the CFO, write the finance part of the report. Auditor’s report: a statement by the auditor regarding the findings of their audit of the company’s book 7

The annual report The Basic Parts of an Annual Reports Financial statements: These include the balance sheet, income statement and the statement of the cash flows. Notes to the financial statements: The notes give additional information about the contents of the financial statements Corporate governance report: This report is about how the company applies the principles of good corporate behavior as outlined in the companies act. List of major shareholders: 8

The annual report Balance sheet provides a snapshot of a firm’s financial position at one point in time. Items on firm’s Balance sheet Assets Accounts L-Term assets: are assets that will be held more than 12 months Land, Buildings, Motor vehicle, Plant & Machinery, Furniture & fixtures, and etc.

Balance sheet: Assets Cash A/R Inventories Total CA Gross FA Less: Dep. Net FA Total Assets 2009 7,282 632,160 1,287,360 1,926,802 1,202,950 263,160 939,790 2,866,592 2008 57,600 351,200 715,200 1,124,000 491,000 146,200 344,800 1,468,800

The annual report Items on firm’s Balance sheet S-Term assets: are assets that will be used up in the next 12 months. Inventory ( or stock) of products a company has available for sale, or to be used in manufacturing a product. Account receivable Cash in banks or on hand( or petty cash) Marketable securities, shares of other companies purchase using firm’s excess funds. Intangible assets, assets which have value to the company but difficult to measures.

The annual report Items on firm’s Balance sheet Intangible assets, assets which have value to the company but difficult to measures. Goodwill: Arise when a company that purchase another company pays more than the actual value of its assets minus liabilities. The premium paid, which may account for things such as customers loyalty, exceptional workforce, and great location, is listed on the books as goodwill. Intellectual property: it is a form of copyright and patents, on product or services which the company has been granted exclusive rights.

Balance sheet: Liabilities and Equity Accts payable Notes payable Accruals Total CL Long-term debt Common stock Retained earnings Total Equity Total L & E 2009 524,160 636,808 489,600 1,650,568 723,432 460,000 32,592 492,592 2,866,592 2008 145,600 200,000 136,000 481,600 323,432 203,768 663,768 1,468,800

The annual report Items on firm’s Balance sheet Liability accounts S-Term liabilities : include money owed in the next 12 months. Account payable Notes payable, it includes all the payments to banks that are due less than a year Accruals

The annual report Items on firm’s Balance sheet Liability accounts L-Term liabilities : include money due beyond the next twelve months Loan payable: This account keep tracks of mortgages, long term financial loan, commercial papers loan. Bond payable: This account keep tracks of corporate bonds that have been issued for a term longer than a year. Bonds are a type of debt sold on the market that must be repaid in full with interest.

Firm’s Long Term Financing Long Term debt(Bond) Bond (IOU) “Coupon interest” Funds (capital) Firms Creditors

The annual report Long Term debt(Bond certificate sample)

The annual report Items on firm’s Balance sheet Equity accounts Share capital. This account reflects the nominal value of the ordinary share in issue. Each share represents a portion of ownership. Share premium. If when purchasing shares, the shareholders pay more than the nominal value, then the excess ( or premium ) is recorded in this account. Preference shares. These shares fall between bonds and ordinary shares in terms of characteristics.

The annual report Items on firm’s Balance sheet Equity accounts Retained earnings. These numbers reflect earnings retained rather than paid out as dividends to shareholders.

Equity Shares (ownership) “Dividend” Funds (capital) Shareholders Firms Shareholders

The annual report Income statement summarizes a firm’s revenues and expenses over a given period of time. Items on firm’s Income statement Sales of goods and services ( Revenue) Cost of goods sold: costs directly related to the sale of goods or services Purchase discount Purchase returns and allowances

Income statement Sales COGS Other expenses EBITDA Depr. & Amort. EBIT Interest Exp. EBT Taxes Net income 2009 6,034,000 5,528,000 519,988 (13,988) 116,960 (130,948) 136,012 (266,960) (106,784) (160,176) 2008 3,432,000 2,864,000 358,672 209,328 18,900 190,428 43,828 146,600 58,640 87,960

The annual report Items on firm’s Income statement Expense accounts: Any costs not directly related to the generating revenue Operating expanse, ie. advertising, insurance, legal and accounting fees, office expense, utilities, etc Interest expense, interest paid on company’s debt. Depreciation expense on tangible goods and Amortization on intangible goods. Taxes

The annual report Statement of retained earnings shows how much of the firm’s earnings were retained, rather than paid out as dividends.

Statement of Retained Earnings (2009) $203,768 (160,176) (11,000) $32,592 Balance of retained earnings, 12/31/08 Add: Net income, 2009 Less: Dividends paid earnings, 12/31/09

Other data No. of shares EPS DPS Stock price 2009 100,000 -$1.602 $0.11 $2.25 2008 $0.88 $0.22 $8.50

The annual report Statement of cash flows It gives the financial report reader a map of cash receipt, cash payments, and changes in cash that arise from the operations of the company. In addition, the statement looks at money that flows into or out of the company through investing and financing activities. Why we need Statement of cash flows ? Cash is company’s lifeblood Accrual accounting makes it hard to pinpoint exactly how much cash a company actually hold.

Statement of Cash Flows (2009) OPERATING ACTIVITIES Net income Add (Sources of cash): Depreciation Increase in A/P Increase in accruals Subtract (Uses of cash): Increase in A/R Increase in inventories Net cash provided by ops. (160,176) 116,960 378,560 353,600 (280,960) (572,160) (164,176)

Statement of Cash Flows (2009) (711,950) 436,808 400,000 (11,000) 825,808 (50,318) 57,600 7,282 L-T INVESTING ACTIVITIES Investment in fixed assets FINANCING ACTIVITIES Increase in notes payable Increase in long-term debt Payment of cash dividend Net cash from financing NET CHANGE IN CASH Plus: Cash at beginning of year Cash at end of year

A/c data for investors and management decision NOPAT NOWAC FCF EVA MVA

Net operating after taxes (NOPAT) NOPAT = EBIT (1 – Tax rate) NOPAT09 = -$130,948(1 – 0.4) = -$130,948(0.6) = -$78,569 NOPAT08 = $114,257 31

What effect did the expansion have on net operating working capital? NOWC = Operating - Non-interest current assets bearing CL NOWC09 = ($7,282 + $632,160 + $1,287,360) – ($524,160 + $489,600) = $913,042 NOWC08 = $842,400 32

What effect did the expansion have on operating capital? Operating capital = NOWC + Net Fixed Assets Operating Capital09 = $913,042 + $939,790 = $1,852,832 Operating Capital08 = $1,187,200 33

Economic value added (EVA) EVA = NOPAT – Annual dollar cost of capital In order to generate positive EVA, a firm has to more than just cover operating costs. It must also provide a return to those who have provided the firm with capital. EVA takes into account the total cost of capital, which includes the cost of equity. 34

Sales xxx COGS (xxx) Depreciation (xxx) EBIT xxx Interest Expense (xx) xxx Tax (xx) Net Income xxx

What is the firm’s EVA? Assume the firm’s after-tax percentage cost of capital was 10% in 2008 and 13% in 2009. EVA05 = NOPAT – (A-T cost of capital) (Capital) = -$78,569 – (0.13)($1,852,832) = -$78,569 – $240,868 = -$319,437 EVA04 = $114,257 – (0.10)($1,187,200) = $114,257 – $118,720 = -$4,463 36

Did the expansion increase or decrease MVA? MVA = Market value __ Equity capital of equity supplied During the last year, the stock price has decreased 51%. As a consequence, the market value of equity has declined, and therefore MVA has declined, as well. 37

Equity Capital Shares Market Value Book Value x x Current price Shares outstanding Initial issue price Shares outstanding

Equity Capital Supplied Initial capital supplied-IPO (RM)= 4.6/ share Equity supplied= 100,000 shares Equity supplied (RM)= 460,000

Market Value Equity Market price of share= RM2.25/ share Equity outstanding= 100,000 shares Market value equity= RM225,000

MVA MVA= Market value – Equity capital equity supplied = RM225,000 - RM460,000 = - RM235,000 225,000 – 460,000 = - 0.51 ≈ - 51% 460,000