Computer and Financial Analysis Financial Statements Prepared By Eng. Hani A. Abuamer

Objectives After studying this chapter, you should be able to: 1. Explain the purpose and understand the format of the firm’s three basic financial statements: the income statement, the balance sheet, and the statement of cash flows. 2. Construct each of these statements in Excel with data for any company.

Objectives 3. Link worksheets together so that formulas in one worksheet can reference data in another and update automatically when changes are made. 4. Use Excel’s Outline tool to selectively display or hide parts of a financial statement.

1. Balance Sheet 2. Income Statement 3. Cash Flows Financial Statements 1. Balance Sheet 2. Income Statement 3. Cash Flows

UNDERSTANDING FINANCIAL STATEMENTS Balanced Sheet

Balanced Sheet The balance sheet describes the assets, liabilities, and equity of the firm at a specific point in time. Assets are the (tangible or intangible) things that firm owns. Liabilities are the firm’s debts. Equity is the difference between what the firm owns and what it owes to others. Because the balance sheet is specific to a point in time, it is much like a photograph. What it shows was true when the snapshot was taken, but is not necessarily true when it is viewed.

Excel Principles Principle 1: Make Excel do as much of the work as possible. Whenever possible, a formula should be used rather than entering numbers. In the long run this will minimize errors Principle 2: Format the worksheet so that it is easy to understand. Borders, shading, and font choices are more than just decorations. Properly chosen, they can make important numbers stand out and get the attention they deserve .

Elements of a Balance Sheet A balance sheet, also called the statement of financial position, lists: Assets Liabilities Owners Equity as of a specific date. It gives an idea of what the company is worth. Let us now look at these terms in more detail. $ IN $ OUT ?

Elements of a Balance Sheet $ IN Assets Assets are all those things a company owns which are of value to the business. Assets can be tangible like e.g. a manufacturing plant, computers or cash in the bank. Tangible assets like cash or goods for sale that can easily (i.e. within an accounting year) be converted into cash are called current assets while other assets like properties and equipment are called fixed assets. Assets can also be intangible like e.g. copyrights.

Elements of a Balance Sheet Liabilities Liabilities are all those things for which the company eventually needs to pay. There are two types of liabilities: Current Liabilities need to be paid within one accounting year. Examples are: Outstanding rent, goods bought on credit. Long Term Liabilities are those liabilities which will not be paid during the current accounting year. Examples are: Long term debts, bank loans. $ OUT

Elements of a Balance Sheet Owner’s Equity Owner’s Equity is by definition the difference between the Assets of a company and its Liabilities. Owner’s Equity is the sum of two parts: Contributed Capital is the money that the owners invested in the company. Retained Earnings are those earnings which were not distributed to the owners. These can accumulate to a large sum over the years. ?

Elements of a Balance Sheet Let me stress again: A Balance Sheet must balance the assets, liabilities and owner’s equity. Assets – Liabilities = Owner’s Equity Most commonly, the assets are on top and the liabilities and owner’s equity on the bottom. Let’s now have a look at a balance sheet. $ IN $ OUT

Some Notes Note how the top and bottom parts balance Presentation indeed makes a big difference. In a sense ‘design’ is an important ingredient of financial modeling. After all, what is the use of great information if no-one understands it? Now, let us look at the items in the balance sheet one by one.

Elements of a Balance Sheet $ IN Assets – Current Assets Cash and Cash Equivalents Cash is all the cash the company has, be it in bank accounts or in the cash box. Cash Equivalents are short term investments that can be converted to cash with no or very little delay. Examples of Cash Equivalents are: Money Market Investments, Government Bonds. Accounts Receivable Most businesses do not immediately receive payment for (some or all) of the goods or services they sell. Assuming that payment will indeed be made in the near future, a receivable account is an asset.

Elements of a Balance Sheet Assets:Total Current Assets In this case, of course, its just the sum of ‘Cash and Equivalents’ and ‘Accounts Receivable’, but there could be many more ‘current’ items. Total current assets is an important item since it indicates how much money the company has to run its business.

Elements of a Balance Sheet Assets: Fixed Assets Plant and Equipment In order to run a business one usually will need to buy some equip- ment (even when one is in the service business) like e.g. machines and computers. The total cost price of the bought equipment is listed in this item (note, the fact that equipment becomes worth less is accounted for in the next item). Accumulated Depreciation Naturally, when one uses equipment it will get old and thus become worth less. It is therefore necessary to subtract a certain amount from the original equipment value every year. Since one would like to keep the original value listed above, one needs to ‘accumulate’ i.e. sum up all the previous year’s depreciations.

Elements of a Balance Sheet Assets: Net Fixed Assets In this case the net fixed assets are ‘Plant and Equipment’ minus ‘Accumulated Depreciation’, but there could be many more items. Note that having a lot of fixed assets does not necessarily mean that the company is ‘rich’. It is also important to realize that fixed assets do not provide cash for running the business (though they could be use as collateral for a loan).

Elements of a Balance Sheet Assets: Total Assets Total Assets = Current Assets + Net Fixed Assets Note: While total assets in a sense represent the current value of the business, they do not necessarily represent the resale value or the liquidation value of the business. The total assets are the value of the business as seem from the perspective of a continuation of the currently operating business.

Elements of a Balance Sheet $ OUT Liabilities: Current Liabilities Accounts Payable Just as there are accounts receivable, there are also accounts payable. Businesses usually do not need to pay immediately upon delivery but have e.g. 30 or 60 days ‘credit-terms’. In other words, ‘accounts payable’ are unpaid bills due soon. Other Current Liabilities All the liabilities which are due within one accounting year and which are not separately listed (in this case only accounts payable) are lumped together here. Examples are: unpaid salaries, interest, short term loans.

Elements of a Balance Sheet Liabilities: Total Current Liabilities The total current liabilities are an important indicator of how much money a company will need in the near future. If the total current liabilities are much bigger than the total current assets great caution is warranted.

Elements of a Balance Sheet Liabilities: Long Term Liabilities Long Term Debt While in daily life having debts (especially credit card debts!) is usually not a good thing, the proper use of long term loans is an essential part of many business activities. It is for example very rare that a company has enough cash to build a new state of the art manufacturing plant. The idea is of course that you earn more than you pay in interest. (This is somewhat similar to buying a condo with a mortgage). Other Long Term Liabilities All other liabilities which do not need to be returned within one accounting year and which are not separately listed. E.g. Royalties, asbestos claims.

Elements of a Balance Sheet Liabilities: Total Liabilities Total Liabilities = Total Current + Long Term Liabilities Note: If the Total Liabilities exceed the Total Assets, the company is almost certainly in some sort of danger. But there are exceptions to this! (Especially companies in new hot industries like e.g. dot.coms or genetics).

Elements of a Balance Sheet Liabilities: Shareholder’s Equity Common Stock When a corporation is set up or when it needs money and desires to do so, it can issue common stock. The amount received is entered under this item. Note that the value printed on the stock certificate may be quite different from what one actually pays. Retained Earnings At the end of an accounting year, a company can have a profit or a loss. The profit or loss (in case of loss, naturally with a minus sign) is added to the retained earnings. The retained earnings sum up all the profits and losses since the inception of the company (minus paid out dividends).

Elements of a Balance Sheet Liabilities: Total Shareholder’s Equity This is the amount the company ‘owes’ its shareholders. Note that from an operational point of view, these debts have no impact on the daily running of the business since they do not need to be repaid.

Elements of a Balance Sheet Liabilities: Total Liabilities and Owner’s Equity As such this item is mainly a cross check for the accuracy of the balance sheet. It must be exactly the same number as the total assets or something is wrong!

Key Points of the Day Assets – Liabilities = Owner’s Equity The Balance Sheet provides a snapshot of the assets and liabilities of a company. The Balance Sheet is one of the most important financial statements. Remember: Assets – Liabilities = Owner’s Equity $ OUT $ IN And again: Assets – Liabilities = Owner’s Equity

UNDERSTANDING FINANCIAL STATEMENTS INCOME STATEMENT

Income Statement Revenues less Expenses = Net Income Also called the Statement of Earnings Comparative financial statements enable users to analyze performance over multiple periods and identify significant trends. Consolidated financial statements combine the financial results of a “parent company” with its subsidiaries.

Income reported on income statement is based on Accrual Accounting, all revenues earned in the year & all expenses incurred in that year (NOT on the cash generated or cash paid during accounting period) Income Statement may be presented in the multi-step or single step form.

Income Statement Single-step Multiple-step All operating revenues and gains are reported first, followed by all operating expenses and other losses. No separate section is prepared for COGS and gross profit. Multiple-step Divided into separate sections, various subtotals are reported. Involves separate sections for gross profit, operating income, other income/losses, income before income taxes, and net income. Gross Profit Operating Income Other Income/losses

Focus on Multi-step format (it has more detail and is more useful) Income Statement Focus on Multi-step format (it has more detail and is more useful) NET SALES: A firm’s sales are usually reported as Sales less Sales Returns less Sales Allowances the major source of revenue for most Companies trends are important

Income Statement (continued) Net Sales Less: Cost of Goods Sold (COGS) Cost to seller of products sold to customers. If purchased, then price plus freight-in. If manufactured, then DM, DL, Manf. Ovhd. The relationship between COGS and sales is an important one. = Gross Profit Key analytical tool in analyzing firm’s operating performance. Gross profit percentage equals Gross profit/Sales

Income Statement (continued) Gross Profit Less: Operating Expenses Selling Expenses: Advertising expenses Salesmen’ salaries General and Administrative Expenses: Office and officer salaries Payroll taxes Depreciation expense Repairs & maint. Insurance expense Rent expense Lease expense Bad debt expense Research and Development Supplies = Operating Income (or Operating Profit or Income from Operations) Measures overall performance of company’s operations Operating Income Percentage=Operating Income/Sales

Income Statement (continued) Operating Income +/- Other Income/Expense Interest income Gain from sale of equipment Gain from sale of investments Interest expense Loss from sale of equipment Loss from sale of investments Loss from write-down of inventory Earnings before income taxes Less: Income taxes Net Earnings or Net Income (or Income from Continuing Operations) FOR SALE

Income Statement (continued) Income from Continuing Operations +/- Income from Discontinued Operations (net of tax) +/- Extraordinary Gains and Losses (net of tax) +/- Cumulative Effect of a Change in Accounting Principle (net of tax) Net Earnings or Net Income Net Earnings Percentage =Net Earnings/Sales

Income from Discontinued Operations Income (loss) from operations of discontinued operations (from 1/1 to measurement date) Less: Income tax Gain (loss) from sale of discontinued operations (a)Income (loss) from operations (after measurement date) (b)Gain (loss) on disposition of segment of assets Net Income from Discontinued Operations

No “cumulative effect” of the change Changes in estimates Estimates are made using the BEST available information at the statement date. Changes in estimates should be reflected in the current period (date of the revision) and in future periods, if any, that are affected. No “cumulative effect” of the change

Comprehensive Income Beginning in 1998, companies required to report COMPREHENSIVE INCOME Comprehensive income includes ALL changes in stockholders’equity during a period except those resulting from investments by owners and distributions to owners Does not include: Dividends to stockholders Issuance of stock Treasury stock transactions

Net Income (from Income Statement) Comprehensive Income Net Income (from Income Statement) +/- Foreign currency translation adjustments +/- Unrealized gains/losses on available-for-sale securities +/- Additional pension liabilities +/- Changes in fair market value of cash flow hedges = Comprehensive Income/Loss

Comprehensive Income may be reported in one of three ways: on the face of the income statement in a separate statement of comprehensive income in a statement of stockholders’ equity

Common size Balanced Sheet and Income Statement Analytical tool to compare firms with different level of sales. Used to facilitate structural analysis of a firm, to evaluate trends and make industrial comparisons. Expresses each income statement category as a percentage of net sales.

UNDERSTANDING FINANCIAL STATEMENTS Financial Cash Flow

Businesses are like Fruit Trees Fruit = Operating Activities Trunk & Branches = Investing Activities Roots = Financing Activities

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Just Like Balancing a Check Book These are Linked Beginning Cash Balance + Inflows - Outflows = Ending Cash Balance

Signs of Cash Flows for the Statements of Cash Flow   Direction of Changed Order of Subtraction Type of item increased decreased Assets - + Older- Newer Liability or Equity Newer - Older