Understanding Financial Statements Handout Final

Corporate and Professional Services (CaPS)
Understanding Financial Statements Training Program Handbook
Evalueserve.com Pvt Ltd Reading Material for CaPS Participants
Introduction
Training participants are required to go through this module prior to the start of training. The aim of the module is to: Familiarize the reader with the format and basic terminologies of the three financial statements Using financial statements to understand business position of a company Linkage between the three statements Note: The accounting guideline followed in the handbook is US GAAP, unless stated otherwise
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Evalueserve.com Pvt Ltd Reading Material for CaPS Participants
Contents
Introduction...............................................................................................................2 1Income Statement...................................................................................................5

Overview of Income Statement..........................................................................................5 Readings for Income Statement........................................................................................5 Learning Outcomes Income Statement..........................................................................5 1.1Introduction...................................................................................................................6 1.2Basic Components, Format and Terminologies............................................................6 1.3Chapter Summary.......................................................................................................10
2Balance Sheet.......................................................................................................12
Overview of Balance Sheet.............................................................................................12 Readings for Balance Sheet............................................................................................12 Learning Outcomes Balance Sheet..............................................................................12 2.1Introduction.................................................................................................................13 2.2Basic Components, format, and Terminology.............................................................13 2.3Analysis of Balance Sheet..........................................................................................20 2.4Chapter Summary.......................................................................................................23 2.5Answers to the questions............................................................................................23
3Cash Flow Statement............................................................................................25

Overview of Cash Flow Statement..................................................................................25 Readings for Cash Flow Statement.................................................................................25 Learning Outcomes - Cash Flow Statement....................................................................25 3.1Introduction.................................................................................................................26 3.2Basic Components, Format, and Terminology...........................................................26 3.3Cash Flow from Operations (CFO) and Free Cash Flow............................................28 3.4Analysis of Cash flow Statement................................................................................32 3.5Important Cash Flow Ratios.......................................................................................32 3.6Chapter Summary.......................................................................................................34 3.7Answers to the Questions...........................................................................................34 34
4Appendix................................................................................................................35 5Evalueserve Disclaimer........................................................................................36
Understanding Income Statement
Evalueserve.com Pvt Ltd Understanding Income Statement
1 Income Statement Overview of Income Statement

Income statement can reveal a lot of insights on the company, such as how the company has grown in the past, is it able to retain its clients, does it need to offer discounts to sell its products and is it doing better or worse than its peers? Income statement can also help us understand the efficiency of companys operations, its distribution systems, productivity of its employees, etc. This module will help you use the income statement to get insights on a companys business and financial performance.
Readings for Income Statement

Introduction to the Income Statement Components of an Income Statement
Learning Outcomes Income Statement

At the end of this module, you will be able to Understand the format/presentation of the income statement Understand revenue recognition principals Learn to identify revenue drivers Understand operating/non-operating income Learn to analyze a companys Gross and EBIT margins Understand definition/significance of non-recurring items Understand and analyze earnings per share (basic and diluted)
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1.1 Introduction
Income statement is one of the most important financial statements used by companies to report their earnings over a specific period of time, e.g., yearly, quarterly, etc. It is also known as Profit and Loss Statement or Statement of Revenue and Expense.
1.2 Basic Components, Format and Terminologies

Income statement reports the effect of a companys current operations on its financial performance. It summarizes the revenues earned, the expenses incurred and the net profit generated for a given period of time. Income statement can be presented in the following two formats: Format A where items are clubbed in respective heads such as COGS, selling expenses, and administrative expenses Format B where items are presented separately such as raw material cost, employee cost, and transportation expenses
FORMAT A PARTICULARS Sales Less: Cost of Goods Sold Gross Profit Less: Selling, general, and Administration Expenses Operating Income before Depreciation and Amortization (EBITDA) Less: Depreciation, Amortization Operating Profit or Earnings before Interest & Taxes (EBIT) Less: Interest Expense Non-Operating Income Less: Non-Operating Expenses Pretax Accounting Income/Earnings Before Taxes (EBT) Less: Income Taxes Net Income $ MN 8,000 3,000 5,000 1,500 3,500 300 3,200 100 300 200 3,200 700 2,500 Less: Less: Less: Less: Less: Less:
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FORMAT B PARTICULARS Sales Raw Material Cost/Labor Cost Marketing and Administrative Cost R&D Cost Other (Income) Expenses Pretax Income Interest Expenses Income Tax Net Income $ MN 9,000 3,750 1,500 133 256 3,361 110 390 2,861
Following are the terminologies which are related to the Income statement:
LINE ITEMS DEFINITION The first line item on any Income Statement is Revenue or Sales. It pertains to the sales a business generates from selling goods or rendering services during the specified time period for which the income statement is prepared. For instance, a firm prepares customized research reports for its clients by charging $25 per hour of effort spent. If the firm spends 160 hours a month on making those reports, then the revenue for that month would be $4,000. It is also known as Top Line.
Revenue or Sales
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LINE ITEMS
DEFINITION Cost of Goods Sold or Cost of Sales refers to the total of direct expenses incurred by a company to produce/sell a product. This refers to costs that can be directly associated to the production of a good or service. It includes the purchase price of raw material and expenses incurred in turning the raw material into a finished product, e.g., expenses incurred for raw materials, labor, and other manufacturing overheads used in the production of goods/services.
Cost of Goods Sold (COGS) or Cost of Revenue or Cost of Sales
Gross Profit
Gross Profit reflects the total revenues less the cost incurred in generating that revenue (cost of goods sold). In other words, it refers to the amount that a company can generate as profits if it does not pay other expenses besides direct costs. Gross Profit = (Total Revenue) (Cost of Goods Sold) Operating Expenses means costs incurred by the company during the course of operating/running the business. Apart from direct costs, it also includes the following:
Operating Expenses
Research and Development Costs (R&D costs) Selling, General, and Administrative Expenses: includes expenses such as salaries,
commissions, travel expenses, and advertising and promotion expenditure. Earnings Before Interest, Tax, Depreciation, and Amortization (EBITDA) refers to the income generated by the company from its operations. Note that it does not include line items such as income from investment in other businesses. It is calculated after the deduction of Cost of Goods Sold and Operating Expenses from the Total Revenues figure. EBITDA = (Gross Profit) (Operating Expenses) Depreciation is an expense allocated to the asset costs, which is spread across the useful life of the asset. It can be calculated using straight line (SLM) method or written down value method (WDV). SLM calculates depreciation by taking the purchase price of an asset less its salvage value divided by the total productive years the asset can be reasonably expected to benefit the company (useful life). For example if an asset worth $100 is expected to be used for 5 years, at the end of which it will have zero value, its depreciation will be $ 20 per year. WDV method calculates depreciation by charging a fixed rate on the reducing balance of the asset. In the above example, lets say the fixed rate is 20% then the first years depreciation will be $20, the second years depreciation will be ($100 $20) * 20%, i.e., $16, and the third years ($100 $20 $16) * 20%, i.e., $12.8.Similarly, it can be calculated for the rest of the years. It refers to the allocation of costs of intangible assets, such as patents and copyrights, over the life of such assets. For example, a pharma company buys a patent for the manufacture of a vaccine for $30 million. The patent will last for 15 years. The amortization expense to be charged every year for the next 15 years will be 30/15= $2 million per year. The intangible assets with a finite life are amortized and assets with infinite life are impaired. For example, goodwill is tested for impairment, whereas patents/copyrights, etc., are amortized. Profit Profit earned from ordinary business activities before the deduction of interest expenses and income tax expenses is called Operating Profit. It is also known as Earning Before Interest and Taxes. Expense incurred by the company on its borrowings (debt) is called Interest Expense.
Operating Income before Depreciation/EBIT DA
Depreciation
Amortization
Operating (EBIT)
Interest Expense
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LINE ITEMS
DEFINITION As can be inferred from the name, these are either unusual or infrequent, but not both. The example includes asset impairment, gain/loss on sale of asset, and restructuring cost. These items are reported before tax. Impairment refers to the decline in the value of asset below its fair-market value. Impairment takes place due to a change in product demand, technology, or a decline in the operational efficiency of the asset. For example, a bank provided a housing loan to an individual. The individual failed to payback the entire loan amount. The part of the loan amount not paid by the individual forms the part of impairment losses for the bank. It refers to the income generated from activities other than the regular operations of the business, for instance, profit from the sale of a building/land. Deducting the Interest Expense from the Operating Income leads to the Pretax Income. It is also referred to as Earnings Before Tax (EBT) or Profit Before Tax (PBT). As the name suggests, these earnings are arrived at prior to the deduction of income taxes. It refers to the estimated tax liability for the year. This is usually different from the actual tax paid by a company, which is determined by a countrys tax rules. There are three important terms pertaining to taxes as follows: Income tax expenses Expenses based on current period pretax income (PBT in the financial statements) Current taxes Taxes actually paid/to be paid by the company Deferred tax Difference between income tax expense and current taxes Net Income refers to the amount that the company has actually earned or lost during the accounting period, net of all costs, including depreciation, interest, and taxes. It is the money attributable to equity shareholders of the company after deducting for preferred dividends, if any. Items that are both unusual and infrequent in nature are called extraordinary items. For example losses on early retirement of debt and losses due to natural disasters. Extraordinary items are presented as net of taxes, after income from continuing operations. A payment made to preference stock holders for investments made by them in the business is called Preferred Stock Dividends. Preference stock: Preferred stock is regarded as a security, which has features similar to stocks and bonds. While it entitles owner a stake in the company, just like a common stock, it also pays a fixed dividend like a bond. Preference shares can also be convertible preference shares and these can convert into a certain number of equity shares at a specific date. Preference shareholders usually do not have voting rights but carry a preferential right over common stockholders to receive dividend. Preference shares are usually issued by companies that do not want to dilute their shareholding. Minority interest is the part of PAT that belongs to minority share holders. Minority interest appears in the consolidated accounts and reflects the share of profit of subsidiaries that is not owned by the parent company. According to the US GAAP as well as IFRS guidelines, companies need to show the minority interest separately and show the profit after accounting for minority interest. Professors note: Minority interest is only an accounting concept, for the calculation of a companys net worth, we consider minority interest as a part of the net worth. Profit that is redistributed to shareholders is called dividends. While the companys profit after tax ideally belongs to shareholders, companys management has discretion to decide how much they want to distribute to shareholders. Part of profit that is distributed as dividend (Dividend/PAT) is called dividend pay out ratio. Dividends are very powerful tools to understand the financial health of a company, because dividends (except stock dividend) are paid in cash and can not be manipulated through accounting gimmicks.
Unusual or Infrequent Items
Non-Operating Income Pretax Accounting Income (EBT)
Income Taxes
Net Income or Net Profit (PAT) Extraordinary items
Preferred Dividends
Stock
Minority interest
Dividend
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1.2.1
Operating and Non-operating Section of Income Statement
Income statement can be further sub-divided into two parts operating and non-operating. While the operating section reveals information about revenues and expenses arising out of day-to-day regular business operations, the non-operating section provides revenue gain and expense/loss due to activities not directly linked to the companys regular operations. For example, a chemical manufacturing company may report income on the sale of land or a profit on the sale of investment; these items are not directly related to its operations. Similarly, the company could report nonoperating expenses such as loss on sale of land and loss on an investment. Some of the non-operating items, such as sale of investment, are very regular and may appear every year. Operating and Non-Operating section of Income Statement: Given below is the example of Acer limited, which clearly mentions the operating and non-operating items in the income statement: (Note: NT$ = Currency is New Taiwanese Dollar)
Operating Section: This includes the line items like revenue, COGS, GP, SG&A, R&D etc. All these line items are closely related to day to day operations. So these items are classified as operating items
Non-Operating Section: This includes an income/ gain or losses/ expenses related to items not closely related to day to day operations. E.g. interest expenses/ income, gain/ losses on purchase or disposal of assets, etc.
Source: Company Annual Report 2008
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1.3 Chapter Summary

Income statement reports the effect of a companys current operations on its financial position. It summarizes the revenues earned; expenses incurred, and measure net profit for a given period of time. Income statement can be presented in two formatsone where items are clubbed in respective heads such as COGS, Selling expenses, administrative expenses and other where items are presented separately such as raw material cost, employee cost, and transportation expenses. Some of the key terms related to P&L include revenue, COGS, depreciation, interest, non-recurring items, EBIT, PAT, and EPS. Revenues refer to the sales generated by a company for a particular period, COGS refers to the direct cost incurred for revenue generation, and selling expenses denote marketing costs incurred to make sales. Depreciation is an expense that is recorded in the P&L to allocate the cost of fixed assets over its useful life. Interest refers to the interest paid/to be paid on a companys debt obligations. EBIT, EBT are various terms used to denote the profitability of a company. Revenues on the income statement are recognized when sales are made or services are performed and not when cash is received. Once the revenue has been recognized, expenses pertaining to the revenues that have been recognized are shown in the P&L, and if the company has incurred expenses for which revenue has not been recognized, they are shown as assets. Expenses are recognized regardless of whether any payment has been made towards those goods or services. It does not reflect cash receipts or cash disbursements. Components of COGS vary depending on what the direct costs of running the business are, for example For a manufacturing company COGS will include raw material costs and labor costs For a service provider, such as consulting company, COGS will only include employee cost For a company with significantly automated operations, COGS will only have raw material cost and depreciation Following are the measures of a companys profitability: Gross margins (Sales COGS)/sales indicates the profitability after direct expenses have been met PBIT profitability after all operating expenses have been met PBT profitability after accounting for operating and non-operating expenses PAT profit after accounting for all costs, including taxes EPS earnings per share, this denotes the amount of profits attributable to equity shareholders While analyzing profitability one should try to understand the following: How absolute profits have changed over years? How profit margins have changed over years? How are profit margins compared to peers?
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Understanding Balance Sheet
Evalueserve.com Pvt Ltd Understanding Balance Sheet
2 Balance Sheet Overview of Balance Sheet

While the Income Statement provides an overview of companys profitability over a period of time, Balance Sheet provides a snapshot of the financial strength/financial position/financial condition of a company at a given point of time (usually at the end date of an accounting period, year or a quarter). In this module, you will learn about the important components of a balance sheet and their accounting treatment. You will also learn about the ratios that are helpful in analyzing the balance sheet.
Readings for Balance Sheet

Components of the balance sheet Accounting of balance sheet items Analyzing liquidity & working capital Analyzing capital structure
Learning Outcomes Balance Sheet

At the end of this module, you will be able to Understand the format/components of the balance sheet Understand important balance sheet concepts and classifications Understand components of shareholders equity Learn to analyze liquidity, working capital using turnover ratios Learn to analyze capital structure using leverage ratios Understand definition/significance of Invested Capital
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2.1 Introduction
Balance sheet is one of the important financial statements used by a company to report its financial position or financial condition on a particular date, which is called a Balance Sheet date. Balance sheet date is usually the end of an accounting period, which could be a year, or a quarter, e.g., Balance Sheet as on December 31, 2009. However, some companies adopt a fiscal year ending, i.e., a date other than December 31, 2010, e.g., Balance Sheet as on March 31, 2010.
Authors Note
The fact that the balance sheet is prepared on a particular date is significant. For example, cash & cash equivalents (which are usually the first line item on the Balance Sheet) represent the amount of cash & cash equivalents on December 31; the amount could be materially different on December 30 or January 1. By definition, the account balances on a Balance Sheet must tally, i.e., the total of all assets must be equal to the sum of liabilities and stockholders equity. This is because, from an economic perspective, each dollar of assets must be funded by a dollar of liabilities or equity. Therefore, the Balance Sheet equation is expressed as follows: Asset = Liabilities + Stockholders Equity
2.2 Basic Components, format, and Terminology

Balance Sheet has three major components what the company owns (assets), what it owes to outsiders (liabilties) and to internal owners (stockholders equity). These are explained as follows:
Balance Sheet
Assets
Liabilities
Equity
It refers to the resources that are controlled and owned by an entity, these resources have future economic value that can be measured and expressed in a monetary value for financial reporting purposes. Asset can be of two types non-current assets or current assets. Current Assets An asset which can be converted into cash within a period of one year, e.g., receivables, inventory, cash & cash equivalent. Non-Current Assets Asset which can not be classified as current asset and which can not be easily converted into cash in a period of one year is a non-current asset. Noncurrent assets can be of two types tangible assets (land, machine, etc.) and Intangible assets (goodwill).
It refers to the present obligations of an entity. Its settlement results in the outflow of the cash/funds. Liabilities can be of two types non-current liabilities and current liabilities. Current Liabilities Liabilities which are to be paid off with in a period of one year, e.g., account payables, current portion of long -term debt, etc. Non-Current Liabilities Liabilities which a company owes for a period of more than one year, e.g., long-term debt, deferred tax liabilities, etc.
It is the residual interest of the owners in the assets of the entity after deducting all the liabilties.It is also known as Net Worth or Net Assets. It comprises the following: Share Capital Funds raised by the company by issuing shares to the public. Retained Earnings It is the cumulative net income which is retained by the company after distributing dividends. Reserves These are created out of retained earnings to meet future fund requirements, such as contingencies, etc. Comprehensive Income Changes in the value of balance sheet items that do not flow through the P&L are reflected here.
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Account format: The assets are presented on the left hand side and liabilities and equity are presented on the right hand side.
ACCOUNT FORMAT - SAMPLE BALANCE SHEET OF ABC LIMITED AS ON 31ST DECEMBER 20XX ASSETS Current Assets Fixed Assets Intangible Assets Financial Investment $ MN 5,000 8,000 1,200 1,000 LIABILITIES & STOCKHOLDERS EQUITY Current Liabilities Other Liabilities Long-Term Debt Deferred Taxes Total Liabilities Owners Equity Total Assets 15,200 Total Liabilities and Stockholders Equity 7,000 200 11,200 4,000 15,200 $ MN 4,000
Report format: The assets, liabilities, and equity are presented in one single column, starting with assets and then moving to assets and liabilities.
REPORT FORMAT SAMPLE BALANCE SHEET OF ABC LIMITED AS ON 31ST DECEMBER 20XX ASSETS Current Assets Fixed Assets (tangible) Intangible Assets Financial Investments Total Assets LIABILITIES & STOCKHOLDERS EQUITY Current Liabilities Other Liabilities Long-term Debt Deferred Taxes Total Liabilities Stockholders Equity Total Liabilities and Stockholders Equity 7,000 200 11,200 4,000 15,200 4,000 5,000 8,000 1,200 1,000 15,200 $ MN $ MN
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Accountants usually prepare classified balance sheets. Classified means that the balance sheet accounts are presented in distinct groupings, categories, or classifications. Given below are the definitions of some important classifications/categories:
LINE ITEMS Asset DEFINITION Assets are the economic resources which are controlled by the company. They can be tangible or intangible in nature. These are the items which can be converted into cash or be used up completely within 12 months (one year) or within the firms operating cycle1 (which is generally one year). Current assets are presented in the order of liquidity (ease of convertibility to cash), i.e., cash, marketable securities, short-term investments, accounts receivable, inventory, prepaid insurance. Cash and cash equivalents include cash in any form (cash awaiting deposit or in a bank account) and cash substitutes (e.g., marketable securities or short-term investments), which reflect cash that is not needed immediately in the business and is temporarily invested to earn a return. These investments are in instruments with short-term maturities (less than one year) such as treasury bills, certificates, notes, bonds and commercial paper (unsecured promissory notes of large business firms), and shares and mutual funds The cash is available with the company but it is not allowed to use it. This could be in the form of minimum cash balance that a company is required to keep at all times as a part of its agreement with its lenders. It could also be a fixed deposit that has been pledged to raise money. Accounts receivables are the amounts due from customers on account of credit sales and are reported on the balance sheet as their net realizable value, that is, the actual amount of the account less an allowance for doubtful accounts. The allowance for doubtful accounts can be important in assessing earnings quality. Therefore, management must estimate based on factors such as past experience, knowledge of customer quality, the state of economy, the firms collection policies, etc. The estimation of this account will affect both the valuation of accounts receivables on the balance sheet and the recognition of bad debt expense on the income statement. The analyst must pay attention to changes in the allowance account both relative to level of sales and the amount of accounts receivables outstanding and to the justification for any variations in the past.
Current Assets
Cash & equivalents
Cash
Restricted cash CURRENT ASSETS Accounts Receivables
Inventory
Inventory refers to raw materials, work in progress or finished goods that are there with the company at a point in time. While a manufacturing firms inventory is in the form of raw materials, a retailers inventory is largely the finished items that are stocked in the showrooms. These include expenses which are paid in advance such as insurance premium, advance tax, etc. For example, companies are required to pay part of the tax in the beginning (usually first quarter). Assets which produce economic benefits for more than one year are non-current assets. They are of the following two types: Tangible Non-Current Assets Those non-current assets which have physical substance are known as tangible non-current assets, e.g., property, plant and equipment, investment properties building given on rent, etc. Tangible assets are depreciated each year. Intangible Non-Current Assets These include non-current assets which are not physical in nature. These assets do not have any physical value but are very valuable, e.g., copyrights, patents, trademarks, and goodwill. These represent the funds invested by the company into various financial instruments such as bonds and notes. Financial Instruments can be simple (equity or bonds, etc.) or complex (derivatives, foreign currency instruments, etc.). This could also represent companys investment in another company where it holds less than 51% ownership.
Prepaid Expenses ASSETSNON CURRENT

1
Non-Current Assets
Investments
The Operating Cycle is the time required to purchase or manufacture inventory, sell the product, and collect cash. For most companies, the operating cycle is less than one year, but in some industries such as tobacco and wine it is longer.
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LINE ITEMS Deferred Assets Liability Current Liabilities Tax
DEFINITION It measures the assets that the firm expects to get in future periods for overpaying taxes in current and past periods. Deferred tax asset on a company's balance sheet may benefit the company by lowering future income taxes. It refers to the obligation of a company, settlement of which results in cash outflow. It is of two typesCurrent and Non Current. Current liabilities are the claims against assets, which are expected to be settled within 12 months or one operating cycle. It includes accounts payable, short-term debt, current portion of LT debt, accrued liabilities, etc. Accounts payable is an amount that must be paid off within the credit period provided by the seller against the goods or services. The long-term debt that is to be paid off within the current year qualifies under Current Portion of Long-Term Debt. These are result of recognition of the expenses in financial statements prior to its payments. For example, salaries of the employees recognized as expenses at the end of the financial year. For instance, let us assume that a company pays salary on January 1, however on December 31 the salaries will be accrued and will reflect in the balance sheet under accrued liabilities. Sometimes a company collects the cash in advance for the goods or services which it promises to render to its customers in the future. Such collected money is known as Deferred Revenue or Unearned Revenue. Examples of such transactions can be advance payments by the customers for the magazine subscription, etc. It measures the liability that the firm sees in the future as a consequence of underpaying taxes in the current or past periods. The liability will take the form of higher taxes in future periods (and a higher effective tax rate) This represents the money which a company has borrowed for more than one year and qualifies under long-term debt (financial liability) or non-current liabilities. Share capital is the fund raised by the companies by issuing common2 or preferential3 shares to individuals or institutional investors. Paid-in Capital is the difference between the issue price and the face value of a share. It is also called Contributed Capital or Capital Surplus. For Example, if a share has a face value of $15 and is issued at $20 and 100 such shares are issued Share capital = $15 * 100= $1500 Paid in capital/share premium = $5 * 100 = $500 These are the shares which are bought back by the issuing company; it reduces the number of outstanding stocks in the market. The company may buy back the stock because it has cash, and it believes that its own shares are good investment. These are the undistributed earnings of the company after meeting out the requirements such as paying dividend. Retained earnings are calculated as follows: RE (Current Year) = RE (Beginning of the Year) + Net Income Dividends Paid Retained earnings should not be confused with unused cash, since these are the funds which a company elects to reinvest in the operations of the business. These are created from retained earnings for meeting future requirements, such as bad debt, warranty, and restructuring requirements. Unrealized gains/losses in the market value of investments in available-for-sale securities, changes in the value of certain derivative instruments, and adjustment related to foreign currency translations are reported as part of comprehensive income. Liabilities that could result in cash outflow for the company, subject to occurrence of certain events. For example, a pending court case, a guarantee given on behalf of a subsidiary etc. These are not recorded in the financial statements but are detailed in the notes to the financial statements.
Accounts Payables CURRENT LIABILITY Financial Liabilities (Current Portion)
Accrued Liabilities
Deferred Revenue
Deferred Liability (DTL)
Tax
Financial Liabilities (Long Term)
EQUITY
Share Capital Paid-in Capital
&
Treasury Stock
Retained (RE) EQUITY
Earnings
Reserves Accumulated other Comprehensive Income Contingent Liabilities
Common Shares is an equity instrument through which companies raise capital from the Stock Market. By issuing common stock, owners sell a part of their ownership in the company to others. 3 Preferential Shares is as a security which has features similar to stocks and bonds. While it entitles owner a stake in the company, just like a common stock, it also pays a fixed dividend like a bond.
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2.2.1
Exercise
Operating results for a period Financing position at a point in time Financing and investing activities for a period Profit at a point in time
1. Balance sheet summarizes:
2. What is common between Current assets and Current Liabilities? Current assets are claims against current liabilities If current assets increase, then there will be a corresponding increase in current liabilities Current assets and current liabilities can be converted into cash Current assets and current liabilities are those items that will be satisfied and converted into cash, respectively, in one year or one operating cycle, whichever is longer 3. Which of the following items could cause the recognition of accrued liabilities? Sale, interest income, rent Sale, interest income, taxes Salaries, rent, insurance Salaries, interest income, interest expense 4. Which of the following can be classified as long-term debt? Mortgages, current maturities of long-term debt, bonds Mortgages, long-term notes payables, bonds due in 10 years Account payables, bonds, obligations under leases Accounts payables, long-term notes payables, long-term warranties 5. What does the additional paid-in capital indicates? The difference between par and stated value of the common stock The price changes that result for stock trading subsequent to its original value The market price of all common stocks issued The amount by which the original sales price of the stock exceeds the par value 6. What do the retained earnings account measure? Cash held by the company since inception Payments made to the shareholders in the form of cash or stock dividends All undistributed earnings Financial resources currently available to satisfy financial obligations 7. What accounts are most likely to be found in shareholders equity section? Common stock, long-term debt, preferred stock Common stock, additional paid-in capital, liabilities Common stock, retained earnings, dividends payable Common stock, additional paid-in capital, retained earnings
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2.2.2
Non-Current Assets
Non-current Assets
Assets which produce economic benefits for more than one year
Tangible Assets
Assets having physical existence, e.g., plants, properties, equipment, machines, etc. How they are recorded in Balance Sheet? Tangible Assets are recorded as Book Value of the Asset Accumulated Depreciation Where, Book Value of the assets includes Purchase price Costs related to bringing the assets to its location Installation costs Borrowing costs
Intangible Assets
Assets which do not have any physical existence, e.g., goodwill, copyright, etc. How they are recorded? Intangible Assets are recorded as Separately Acquired Intangible Assets (for example, patents) Recognized at purchase price + attributable costs Acquired in Business Acquisition (e.g.,. license acquired as a part of running business) Recognized at fair value at acquisition date
Depreciated over their useful life Assets are
Amortized over their useful life
Impairment if the book value becomes lower than the fair value
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2.2.3
Understanding Debt Short-term (current) and long-term (non-current)
Debt
Debt is amount which is borrowed by the company for a specified period of time. If the period is less than one year then it is classified as current debt else non-current debt.
Loan
It is a type of debt which is an agreement between two parties a borrower and a lender in which a sum of money is borrowed fom the lender with the condition that it be returned or repaid at a later date ,along with the interest charges
Debt (Bond) Securities

The securities are sold to more than one party. The borrower is the seller of the security and lenders are the buyers
Both the types can be current or non-current in nature depending on the term of liability.
2.2.4
Shareholders Equity
Shareholders Equity and its Components

Treasury Stock Share & Paid-in Capital
Capital raised via equity market has two components one share capital, which is the face value of the stock and the other is paid-in capital, which is - the premium paid by the investors for the stock. These are shares that a company purchases back from the open market. The companies retire it or keep it for future issuance. If the company keeps the share for future reissuance, it creates contra equity account generally a negative number which reflects the stocks purchased (account with negative numbers) and hence are not retired.
Retained Earnings
Cumulative Net Income left after paying the dividends to the investors. Sometimes part of retained earnings is set aside as contingency reserves such as bad debt.
Accumulated Comprehensive Income Unrealized

gains/losses in the market value of investments, foreign currency translation gains losses are reflected here
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Please refer to the following snippet of the Shareholders Equity Section of the Balance Sheet:
2.3 Analysis of Balance Sheet

2.3.1
1. 2. 3. 4. 5.
Balance Sheet Analysis
Balance sheet should be analyzed to seek the following information: Asset quality Liquidity condition (adequacy of the cash) Funding mix Operational efficiency Returns
Note: We will learn to analyze the balance sheet in the classroom session, but we need to familiarize ourselves with the following ratios before we discuss analyzing balance sheet. For the analysis of Balance Sheet, one needs to have an idea of certain important ratios. These ratios are an important part of the balance sheet analysis; given below is the explanation of some of the important ratios:
RATIOS DEFINITION/INTERPRETATION This number indicates the number of days a company takes to covert its inventory (inventory includes the work in progress inventory) into sales. Its formula is DSI = 360/Inventory Turnover where, Inventory Turnover = Cost of Goods Sold/Average Inventory Interpretation: A Lower DSI vis--vis peer is, generally, good for the company; it means inventory gets replaced with newer one in less time than the industry. It indicates that inventory is quickly getting converted into finished good and getting sold. If a company has DSI of 15 days, it indicates on an average it takes the company 15 days to convert its inventory into sales. High DSI vis--vis peers means company is not able to replace its inventory quickly; it could be because sales are decreasing due to which inventory is kept for a long time. This number indicates the number of days a company takes to collect the revenue after the sale of product or service. Its formula is DSO = 360/Account Receivables Turnover where, Account Receivables Turnover = Net Revenue/Average Accounts Receivables Interpretation: Lower DSO vis--vis industry indicates that a company takes less time to collect its revenues High DSO vis--vis industry indicates that a company gives more credit period to its customers; this has to be investigated further. This number indicates the number of days a company takes to pay outstanding to the suppliers, from which the inventory or finished goods has been purchased. Its formula is DPO = 360/Account Payables Turnover where, Account Payables Turnover = Cost of Goods Sold/Average Accounts Payables Interpretation: Less DPO indicates that a company pays the cash to its suppliers quickly or a company has short payment cycle. High DPO indicates that a company has longer credit period. If DPO is very high vis--vis industry average, one needs to investigate the reasons. Sometimes, if a company is facing financial difficulties, it may not be able to pay its suppliers on time. Page 20 of 36
Days Sales of Inventory (DSI)
Days Sales Outstanding (DSO)
Days Payable Outstanding (DPO)
RATIOS
DEFINITION/INTERPRETATION This is measured in days indicating the number of days a company takes to convert its resources into cash. Its formula is CCC = DSI + DSO DPO Interpretation: CCC measures the time between cash outflow and inflow. It is an extremely important measure of the efficiency of the retailers and similar businesses. It basically measures How fast a company can convert its products into cash through sales. The shorter the cycle, the less time capital is tied up in the business process, and thus the company has more cash available to spend on its growth. It is a liquidity measure of the companys ability to pay short-term obligations. It is calculated as Current Ratio = Current Assets/Current Liabilities Interpretation: Current ratio greater than one is an indication that a company has enough liquidity to meet shortterm liabilities. However, sometimes companys current ratio could look higher because it has obsolete inventory and old debtors. Since some of the inventory and debtors could be non current (old and not liquid), current ratio is not a very helpful measure of liquidity. It is another liquidity measure which takes into account only those current assets which are most liquid in nature to the short-term obligations. It is calculated as Quick Ratio = (Cash & Cash Equivalent + Marketable Securities + Account Receivables)/Current Liabilities Interpretation: Higher the quick ratio better will be the companys ability to meet its short-term liquidity needs, which is good for the creditor. It is another liquidity measure which takes into account only cash and cash equivalent as current assets to the short-term obligations. It is calculated as Quick Ratio = Cash & Cash Equivalent/Current Liabilities Interpretation: It further refines the Current and Quick Ratio. This is seen by the most conservative investors. It measures the amount of profit the company is able to make by using its assets. It is calculated as ROA = Net Income/fixed assets Interpretation: ROA gives an idea of how effectively a company can convert its invested money into net income. If the return on assets is showing an improving trend, it indicates that the company is able to utilize its assets more efficiently. It is another profitability measure which talks about the returns a company is generating for its share holders. ROE = Net Income/Average Shareholders Equity Interpretation: It measures how much profit a company generates with the money shareholders have invested. It is calculated by PAT/Average equity ROE can be further broken down into three components, and such analysis is known as DU-Pont Analysis ROE = (Net income/sales)* (sales/assets)* (assets/equity) = Net profit margin * Asset Turnover * Leverage ROE is a function of its profitability, efficiency of using assets, and use of leverage. Higher leverage results in the deployment of lower equity and therefore improves return on equity. However, leverage is optimal only up to a point, because excessive leverage would mean that creditors would not provide further capital and also interest expenses would increase and profitability would decrease. It measures operating profits generated out of total invested capital. It is more comprehensive than ROE because unlike ROE it considers both debt and equity in the denominator. ROIC = EBIT/(Average Total Assets Average Current Liabilities) This ratio is known as working capital productivity ratio. It is an indicator of the working capital intensity of companys operations. WC / TS = [ (Debtor + Inventory + Prepaid Assets) - (All current liabilities except short term debt) ] / Total Sales
Cash Conversion Cycle (CCC)
Current Ratio
Quick (Acid Test) Ratio
Cash Ratio
Return on Asset (ROA)
Return on Equity (ROE)
Return on Invested Capital (ROIC) Working Capital/Total Sales Ratio
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RATIOS
DEFINITION/INTERPRETATION It quantifies the relationship between the capital invested by owners & investors and the funds provided by creditors. D/E = Debt/Equity Interpretation: The higher the ratio, the greater the risk to a current or future creditor. A lower ratio means a company is more financially stable and is probably in a better position to borrow now and in the future. However, one needs to remember that usage of debt (in optimal amount) enhances returns (so long as cost of debt is lower than the returns generated by the business), hence some amount of debt is desirable. It indicates the percentage of the debt in the capital structure of the company or proportion of assets financed by debt. Capital structure. D/E = Debt/ Debt + Equity) It determines the ability of the company to pay interest on the outstanding debt out of its operating income. It can be calculated as ICR = EBITDA(normalized)/ Interest Expense Normalized EBITDA: It is calculated by adding back non-recurring expenses Interpretation: If the ratio exhibits a declining trend and falls below one, it indicates that a companys operating earnings are not sufficient to meet the interest charges.
Debt to Equity Ratio (D/E)
Debt to Total capital ratio
Interest Coverage Ratio (ICR)
2.3.2
1.
Exercise
It has been managing its inventory efficiently Sales may be slowing down It may be giving higher credit period to its customers
If the DSI have been rising for a company, it indicates
2.
The cash conversion cycle is DSI + DSO DPO DSI DSO + DPO DSI + DSO + DPO
3.
The flaw of the current ratio is That it may not depict liquidity position accurately It may not depict solvency position adequately Both of these None of these
4.
ROIC the denominator is Shareholders equity Debt + equity Debt +equity + current liabilities
5.
Higher debt equity vis--vis industry average ratio indicates Increasing creditworthiness Increasing credit risk None of these
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2.4 Chapter Summary

Balance sheet is the statement of financial position (SOFP) of the company till date. It represents the assets owned by the company and the liabilities that a company owes. Liabilities are divided into two parts debt and equity. Following are the important terms related to Balance Sheet: Shareholders Equity: The capital provided by the owners and the profit generated by the company Current Liability: The obligations which are due within a year Long-term Liability: Obligations that are for a period longer than a year Current Assets: Items which can be converted into cash within 12 months period Fixed Assets: Assets which consist of physical substance e.g., property, plant, equipment, etc. While analyzing the balance sheet following ratios are helpful: Working capital ratios: Days Inventory, Debtor Days, Payable Days, Working capital/Sales Liquidity: Current ratio, Quick ratio Leverage: Debt/Equity, Debt to Total Capital Return ratios: Return on Asset, Return on Invested Capital, and Return on Equity
2.5 Answers to the questions

Section 2.2.1 Answer 1: Option 2 Answer 2: Option 4 Answer 3: Option 3 Answer 4: Option 2 Answer 5: Option 4 Answer 6: Option 3 Answer 7: Option 4 Section 2.3.2 Answer 1: Option 2 Answer 2: Option 1 Answer 3: Option 1 Answer 4: Option 2 Answer 5: Option 2
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Understanding Cash Flow Statement
Evalueserve.com Pvt Ltd Understanding Cash Flow Statement
3 Cash Flow Statement Overview of Cash Flow Statement

Cash flow statement helps understanding the cash generating capabilities of a company over a period of time. The cash generated can be different (more or less) than the profit made by a company. This module will help you understand important terms related to cash flow statement; it will also acquaint you with the different formats of cash flow statement and will help you in interpreting cash flow statement to get more insights on the operational efficiency and financial soundness of a firm.
Readings for Cash Flow Statement

Analyzing Operating cash Analyzing Free Cash Flow
Learning Outcomes - Cash Flow Statement

At the end of this module, you would be able to Understand the format/presentation of the cash flow statement Understand how to analyze the three basic sections of cash flow statement Find the line items which are contributing and consuming the cash Understand the characteristics of cash generation for different industries, e.g., capital intensive, labor intensive. Understand the free cash flow and its different types with respect to firm and equity
Page 25 of 36
3.1 Introduction
Cash flow statement conveys the information on cash generated/spent in one operating cycle from various activities, these activities are divided under three basic headsoperating activities, investing activities, and financing activities. Cash flow statement can also be used to extract information on how much cash has been generated from operations and how has it been utilized. Cash flow statement captures the income statement and various line items of the balance sheet. While making a financial model, cash flow statement serves as an important link between P&L and balance sheet.
Authors Note
Q: Why do we need the cash flow, we already have P&L statement which gives information on the profitability of a company? The net profits generated by the company can be different from the cash generated by it. This is on account of accrual method for accounting where the revenues are recognized even though the cash has not been received and expenses are recognized even when cash has not been spent. So, net income represents the periodic earnings of the company where as cash flow statement represents the actual cash generated by the company in the said period.
3.2 Basic Components, Format, and Terminology

LINE ITEMS Cash Flow from Operations Cash Flow From Investing Cash Flow From Financing Non Cash Charges DEFINITION Cash generated from operating activities, which includes all the activities which are related to the businesss operations For example, if a company that sells food items generates $100 of cash from sale of land, $100 will not be included in cash flow from operating activities. Cash generated of investing activities where investing activities are related to purchase/sale of fixed assets, investments in financial market products or other companies Cash generated of financing activities where financing activities are related to issuing capital (bond or common shares/any other instrument, repayments of the debt, repurchase of the companys stock (treasury stocks), dividend payment, etc. These are expenses which do not require actual cash outlay. Example of such charges is depreciation and amortization. Cash which is available to the companys debt and equity holders after meeting all the operations related expenses. It can be calculated as FCFF = Net income + Non-cash charges + Interest * (1 Tax) CAPEX Working Capital Or FCFF = Cash flow from operations + Interest * (1 Tax) CAPEX Cash which is available to the companys equity holders after meeting all the operations related expenses and expenses related to creditors. It can be calculated as FCFE = CFO CAPEX + New Debt Issued Debt Repaid
Free Cash Flow from Firm
Free Cash Flow from Equity
3.2.1
Preparation of the Cash Flow Statement
There are two methods for preparing the cash-flow statement: Direct method Indirect method Direct method for creating a cash flow includes major gross cash receipts and payments. While preparing the cash flow statement, it is important to identify the cash inflow and outflow items and separate them under respective activities heads.
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The direct method for preparing the cash flow actually removes the effect of accruals. Indirect method Starts with the Net Income (which is taken from Income statement) and is adjusted with all the transactions related to non-cash items and further this number is adjusted with the changes in the working capital to arrive at Cash from Operations. An increase in an asset account is deducted from net income, and an increase in a liability account is added back to net income. This method converts accrual-basis net income (or loss) into cash flow by using a series of additions and deductions.
3.2.1.1
Format of Cash Flow Statement Direct Method and Indirect method

DIRECT METHOD FORMAT INDIRECT METHOD FORMAT 2009 CASH FLOW STATEMENT (IN $ MILLION) Cash flows activities: 149,661 838 -99,936 -26,382 -21,350 -2,277 -4,321 -3,767 140,25 2 738 -83,035 -25,498 -20,848 -1,274 -4,706 5,629 Net Income from operating 5,910 5,896 2008 2009
CASH FLOW STATEMENT (IN $ MILLION) Cash flows activities: from operating
2008
Cash received from customers Interest received Cash paid to suppliers for inventory Cash Paid to employees Cash paid for other OPEX Interest paid Taxes Paid Change in cash from operating activities Cash flows activities: from investing
Adjustments to reconcile net income to cash Depreciation and amortization Deferred income taxes Cash provided (used) by CA & CL Accounts receivable Inventories Prepaid Expenses Accounts payable Account Liabilities Change in cash from operating activities Cash flows activities: from investing -4,773 0 -4,773 -3,982 0 -3,982 -3,339 -7,006 295 -1,051 -1,696 -3,767 -448 -2,331 -82 902 -927 5,629 2,984 136 2,501 118
Additions to PP&E Other investing activities Change in cash from investing activities Cash flows activities: from financing
-4,773 0 -4,773
-3,982 0 -3,982
Additions to PP&E Other investing activities Change in cash from investing activities Cash flows activities: from financing
Sale of common stock Increase (decrease) borrowings in ST
183 1,854 7,882 -1,593 -1,862 6,464
124 1,326 629 -127 -1,841 111
Sale of common stock Increase (decrease) in ST borrowings Additions to long term borrowings Reductions of long term borrowings Dividend Paid Change in cash from financing activities
183 1,854 7,882 -1,593 -1,862 6,464
124 1,326 629 -127 -1,841 111
Additions to long term borrowings Reductions of long term borrowings Dividend paid Change in cash from financing activities Change in equivalents cash and cash at
-2,076 12,462 10,386
1,758 10,704 12,462
Change in cash and cash equivalents Cash &cash equivalents at beginning of year Cash & cash equivalents at end of the year
-2,076 12,462 10,386
1,758 10,704 12,462
Cash &cash equivalents beginning of year
Cash & cash equivalents at end of the year
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Note: Indirect method of cash flow statement is much more prevalent than direct method primarily because in most of the reporting formats indirect method of reporting is preferred. So, in our further discussions, we will consider indirect method.
3.2.2
Treatment of some items in US GAAP while preparing cash flow statement:

TREATMENT Dividend Paid Dividend Received Interest Paid Interest Received Income tax Paid Financing Activity Operating Activity Operating Activity Operating Activity All taxes paid as classified as Operating Activity U.S. GAAP
3.3 Cash Flow from Operations (CFO) and Free Cash Flow
3.3.1 Cash Flow from Operating Activities (CFO)
It reports the cash generated from sales and the cash used in the production process and sale process. The items for this segment are derived from Income Statement and working capital accounts (current assets and current liabilities in balance sheet). Examples of Balance Sheet items classified as operating cash flows include changes in the following: Receivables Reported as current assets in Balance Sheet Inventories Reported as current assets in Balance Sheet Prepaid expenses Reported as current assets in Balance Sheet Taxes, interest and miscellaneous payables Reported as current liabilities in Balance Sheet Deferred taxes Reported as current assets or current liabilities depending on the nature of deferred taxes Examples of Income Statement items classified as operating cash flows include the following: Cash sales Cash cost of sales Cash general and administrative expenses Cash taxes Interest paid and received Dividends received
Page 28 of 36
Let us understand with an example How to prepare cash flow statement from income statement and balance sheet statement?
INCOME STATEMENT (IN $) Sales Expenses COGS Wages Depreciation Interest Total expenses EBIT Gain from sale of land Pretax income Provision of taxes Net income Dividends Paid 90,000 5,000 5,000 500 100,500 99,500 7,000 106,500 31,950 74,550 6,500 Liabilities Current liabilities Accounts Payable Wages Payable Interest Payable Taxes Payable Dividends Payable Non current liabilities Bonds Deferred Taxes Stock holders equity(SHE) Common Stock Retained Earnings Total Liabilities & SHE 50,000 54,000 150,000 48,000 122,050 242,550 10,000 15,000 20,000 25,000 5,000 8,000 3,000 4,000 1,000 10,000 5,000 3,500 5,000 4,000 2007 (CY) 200,000 BALANCE SHEET (IN $) Assets Current assets Cash Accounts receivable Inventory Non current assets Land Gross PP&E Accumulated Depreciation Net PP&E Goodwill Total assets 50,000 70,000 9,000 61,000 10,000 150,000 40,000 100,000 14,000 86,000 10,000 242,550 10,000 9,000 10,000 79,550 12,000 15,000 2006 (PY) 2007 (CY)
Solution
CASH FLOW STATEMENT (IN $) PAT Gain from sale of land Depreciation Working capital Increase in receivable Increase in inventories Increase in payable Decrease in wages payable Increase in interest payable increase in taxes payable Increase in deferred taxes Change in working capital 2011 Evalueserve Ltd. All Rights Reserved 2007 74,550 (7,000) 5,000 NOTE: (3,000) (5,000) 5,000 (3,000) 500 1,000 10,000 5,500 Page 29 of 36 COMMENTS From Income Statement Net Income From Income Statement Gain from sale of land (one time gain) Adding Back Non-Cash Charges taken from Income Statement for Assets - the change is calculated as from (Previous year, PY Current Year, CY) for Liabilities the change is calculated as from (CY PY) From Balance Sheet - for Assets : (PY CY) From Balance Sheet - for Assets : (PY CY) From Balance Sheet - for Liabilities : (CY PY) From Balance Sheet - for Liabilities : (CY PY) From Balance Sheet - for Liabilities : (CY PY) From Balance Sheet - for Liabilities : (CY PY) All taxes are considered operational activity
CASH FLOW STATEMENT (IN $) Cash flow from operations Cash flow from investing Cash from sale of land Capital expenditure Cash flow from Investing Cash flow from financing Increase in borrowing Change in common stock Cash dividends Cash flow from Financing Change in Cash Cash at the beginning of the year Cash at the end of the year
2007 78,050 (A)
COMMENTS
17,000 (30,000) (13,000)
From Balance Sheet difference between the value of Land and adding to it the gains from sale of land From Balance sheet difference in the Gross PP&E (B)
10,000 (2,000) (3,500) 4,500 69,550 10,000 79,550
From Balance sheet difference in the value of the Bond From Balance sheet difference in the value of Common Stock value From Income Statement Dividends = 6500, From balance Sheet there are some dividend payables which have increased by 3000 that means from current declared dividends company had only paid 6500 (4000-1000) = 3500, so a (3500) will come as dividends paid (C) (D) = (A) + (B) + (C) PY cash taken from Balance Sheet - Cash of 2006 Adding (D) to Beginning Cash to get ending Cash balance for the year
3.3.2
Understanding Free Cash Flow (FCF)
Free Cash Flow

It is a measure of the cash that is available after mandatory/compulsory cash requirements of a firm have been met. FCF is the cash that is left after deploying all the money required to run a business (buying raw material, paying salaries, spending for maintenance expenditure for running a business, etc)
Free Cash Flow to Firm (FCFF)

Cash flow available to the companys suppliers of capital (both equity and debt holders) after meeting all the expenses and necessary investments
Free Cash Flow to Equity (FCFE)
Cash flow available to the companys equity holders after meeting all the expenses
Page 30 of 36
3.3.2.1
How to interpret FCFF?
Free Cash Flow to Firm

Positive and growing
Firm is able to meet its interest/dividend payment obligations. It can then be allocated for growing and expanding the business. Management has a lot of flexibility in its decision making. It can internally finance new projects.
3.3.2.2
Negative
Stable
If a company is experiencing negative flow, it will have to look elsewhere for funds to think about growing the business. It could be there for a firm which is in the rapid growth phase.
It indicates that the company is mature.
Example of computing free cash flow:
The following are selected numbers from the financial statements of XYZ Inc. for 2009 and 2010 (in USD millions)
(IN USD MILLIONS) 2009 Revenues (Less) Operating Expenses (Less) Depreciation = Earnings before Interest and Taxes (Less) Interest Expenses = Pre Tax Income (Less) Taxes (@ 30%) = Net Income Working Capital 544.0 (465.1) (12.5) 66.4 (16.4) 60.0 (18.0) 48.0 175.0 (IN USD MILLIONS) 2010 620.0 (528.5) (14.0) 77.5 (17.5) 70.0 (21.0) 49.0 240.0
The working capital in 2008 was USD 180 million During Fiscal 2009, the company has raised debt of USD 10 million, while it raised USD 15 million debt in fiscal 2010. The company has also paid debt of USD 5 million and USD 7 million in 2009 and 2010, respectively. The firm had capital expenditure of USD 15 million in 2009 and USD 18 million in 2010. Determine the value of FCFF & FCFE in 2009 and 2010 based on the above given information?
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Solution: FCFF in 2009
FCFE in 2009
FCFF in 2010 FCFE in 2010
= Net income + Non-cash charges + Interest * (1 Tax) CAPEX Working Capital = USD (48.0 + 12.5 + 16.4 (1 - 0.3) 15 (175 180)) = USD 61.98 = FCFF + New Debt Issuance Debt Repayments = USD (61.98 + 10 5) = USD 66.98 = USD (49.0 + 14 + 17.5 (1 0.3) 18 (240 175)) = USD 7.75 = FCFF + New Debt Issuance Debt Repayments = USD (-7.75 + 15 7) = USD 0.25
Note: FCFF & FCFE are different from each other mainly because of differences in the capital structure. FCFE is calculated when the companys capital structure is not volatile. On the contrary, if a company has negative FCFE and significant debt outstanding, FCFF should be used to compute the free cash flow and for the same reason it is preferred over FCFE.
3.4 Analysis of Cash flow Statement

Questions that are answered from the Cash flow Statement: Is company generating cash from operations? Trends in CFO, PAT versus CFO How much cash is generated and consumed for working capital needs? How has company funded its growth Internal generation / funded, Refinance, Borrowings, Equity Analyze the following ratio: CFO/Capex Net borrowings versus Capex, Debt repayment versus fresh debt
What is the cash left for shareholders after the company has met its growth needs? FCFE/FCFF Note: We will learn to analyze the cash flow statement in the classroom session, but we need to be familiar with the interpretation of cash flow before we discuss analysis of cash flow statement.
3.5 Important Cash Flow Ratios

3.5.1
1. 2.
Performance Ratios
There are certain ratios which are helpful in analyzing the cash flow better, lets understand the important ones: Cash flow to revenue: CFO/Revenues It measures the amount of operating cash flow generated for each dollar of revenue. Cash to income : CFO/Operating Income also CFO to PAT It indicates the capability of the company to generate cash from the operations. It also determines how much earnings are cash earnings and is an important indicator of earnings quality of a company. Cash Flow Adequacy Ratio: CFO/(CAPEX + Debt Repayment + Dividend Payment) It measures how well a company can cover annual payments of items such as debt, CAPEX and dividend. It is an important indicator to judge liquidity position of a company.
3.
Page 32 of 36
3.5.2
1. 2. 3.
Coverage Ratios
Debt Coverage: CFO/Total Debt It measures the financial risk and leverage Interest Coverage: (CFO + Interest Paid + Tax Paid)/Interest Paid It measures the companys ability to meet interest obligations Dividend payment: CFO/Dividend paid It measures the companys ability to pay the dividend
3.5.3
Questions
Q1. How it is possible for a firm to be profitable and still go bankrupt? If earnings have increased more rapidly than sales If the firm has positive net income but has failed to generate cash from operations If net income has been adjusted for inflation If sales have not improved even though credit policies have been eased Q2. Which of the following statement is false? A negative cash flow can occur in a year in which net income is positive An increase in account receivable represents accounts not yet collected in cash An increase in account payable represents accounts not yet collected in cash To obtain cash flow from operations, the reported net income must be adjusted Q3. Which of the following would lead to cash flow problems? Obsolete inventory, account receivables of inferior quality, easing of credit by suppliers Slow moving inventory, account receivable of inferior quality, tightening of credit by suppliers Obsolete inventory, increasing notes payable, easing of credit by suppliers Obsolete inventory, improved quality of account receivables, easing of credit by suppliers Q4. Which of the following is false? FCFF is a more popular measure than FCFE for valuing a company. FCFF can never be smaller than FCFE. If there are no debt holder, FCFF will be equal to FCFE. Interest costs are not deducted in calculation of FCFF.
Page 33 of 36
3.6 Chapter Summary

Cash Flow statement provides the information on the actual cash inflows and outflows during a period. It segregates the information on cash flow movement under three activitiesoperating activities, investing activities and financing activities. There are two methods of the representation known as Direct Method and Indirect Method. In general, most of the companies report the cash flow statement using indirect method. The users of cash flow statement are interested in knowing the trends in free cash flow (FCF); Free Cash flow refers to the cash that is left for equity and debt holders after meeting necessary expenses to run a business. While analyzing the cash flow statement one need to take care the following: Trend in the Cash generated from operations (CFO) Compare CFO with Net Income How company is funding its growth plans by CFO or by external sources of capital Analyze the Free cash flow
3.7 Answers to the Questions

Section 3.5.3 Answer 1: Option 2 Answer 2: Option 3 Answer 3: Option 2 Answer 4: Option 2
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4 Appendix
Earnings_per_Share
Page 35 of 36
5 Evalueserve Disclaimer
The information contained herein has been obtained from sources believed to be reliable. Evalueserve disclaims all warranties as to the accuracy, completeness or adequacy of such information. Evalueserve shall have no liability for errors, omissions or inadequacies in the information contained herein or for interpretations thereof.
Financial Modeling
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Understanding Financial Statements Handout Final

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Corporate and Professional Services (CaPS)

Understanding Financial Statements Training Program Handbook

Evalueserve.com Pvt Ltd Reading Material for CaPS Participants

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Evalueserve.com Pvt Ltd Reading Material for CaPS Participants

Introduction...............................................................................................................2 1Income Statement...................................................................................................5

3Cash Flow Statement............................................................................................25

4Appendix................................................................................................................35 5Evalueserve Disclaimer........................................................................................36

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Understanding Income Statement

Evalueserve.com Pvt Ltd Understanding Income Statement

1 Income Statement Overview of Income Statement

Readings for Income Statement

Learning Outcomes Income Statement

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Evalueserve.com Pvt Ltd Understanding Income Statement

1.2 Basic Components, Format and Terminologies

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Evalueserve.com Pvt Ltd Understanding Income Statement

Cost of Goods Sold (COGS) or Cost of Revenue or Cost of Sales

Operating Income before Depreciation/EBIT DA

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Evalueserve.com Pvt Ltd Understanding Income Statement

Unusual or Infrequent Items

Non-Operating Income Pretax Accounting Income (EBT)

Net Income or Net Profit (PAT) Extraordinary items

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Evalueserve.com Pvt Ltd Understanding Income Statement

Operating and Non-operating Section of Income Statement

Source: Company Annual Report 2008

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Evalueserve.com Pvt Ltd Understanding Income Statement

1.3 Chapter Summary

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Understanding Balance Sheet

Evalueserve.com Pvt Ltd Understanding Balance Sheet

2 Balance Sheet Overview of Balance Sheet

Readings for Balance Sheet

Learning Outcomes Balance Sheet

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Evalueserve.com Pvt Ltd Understanding Balance Sheet

2.2 Basic Components, format, and Terminology

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Evalueserve.com Pvt Ltd Understanding Balance Sheet

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Evalueserve.com Pvt Ltd Understanding Balance Sheet

Cash & equivalents

Restricted cash CURRENT ASSETS Accounts Receivables

Prepaid Expenses ASSETSNON CURRENT

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Evalueserve.com Pvt Ltd Understanding Balance Sheet

LINE ITEMS Deferred Assets Liability Current Liabilities Tax

Accounts Payables CURRENT LIABILITY Financial Liabilities (Current Portion)

Deferred Liability (DTL)

Financial Liabilities (Long Term)

Share Capital Paid-in Capital

Retained (RE) EQUITY

Reserves Accumulated other Comprehensive Income Contingent Liabilities

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Evalueserve.com Pvt Ltd Understanding Balance Sheet

1. Balance sheet summarizes:

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Evalueserve.com Pvt Ltd Understanding Balance Sheet