ACCOUNTING AND FINANCE

• In a large Co., all the team players – lenders,

shareholders, directors, management and
employees have a stake in the Co.’s success
and all need to monitor its progress. For this
reason the Co. prepares regular Financial
Accounts and arranges for an independent firm
of auditors to certify that these accounts
present a “true and fair view.”
• In this lecture we will study the major financial
statements – balance sheet, income statement,
and the statement of cash flow.
 BALANCE SHEET
• BS represents a snapshot of the firm’s assets
and the source of the money that was used to
buy those assets i.e., BS is a statement that
shows the value of the firm’s assets and
liabilities at a particular time. Assets are listed
on the left hand side of the BS. Some assets
can be turned more easily into cash and known
as liquid assets. The most liquid assets are put
on the top of the list and works down to the
least liquid.
 BALANCE SHEET AS AT 31-12-2014
Assets Liabilities & Shareholders’ Equity
Current Assets: Current Liabilities:
Cash & Equivalents Debt due for repayment
Marketable Securities Accounts Payable
Receivables Other Current Liabilities
Inventories Long-Term Liabilities:
Other Current Assets Long Term Debt
Fixed Assets: Other LT Liabilities
Property, Plant & Equip.
Shareholders’ Equity:
Paid in Capital
Intangible Asssets
Retained Earnings
Other Assets
TOTAL LIAB. & SHARE-
TOTAL ASSETS HOLDERS’ EQUITY
 FOOD FOR THOUGHT

Suppose a Firm borrows Rs.500M by issuing

new long-term bonds. It places Rs.100M of the
proceeds in the Bank and uses Rs.400M to buy
new machinery. What items of the BS would
change? Would Shareholder’s equity change?
 Book Values and Market Value
• International Accounting Standards require that Assets
must be shown on the BS at their historical cost (original)
adjusted for depreciation. These book values are net
worth of the firm according to the BS i.e., they are based
on the past cost of the asset, not its current market price
or value.
• The difference between book value and market value is
greater for some assets. It is zero in the case of Cash but
may be large for fixed assets.
• The purpose of Depreciation is to allocate the original
cost of the asset over its life, and rules governing the
depreciation of asset values do not reflect actual loss of
market value.
• In case of short-term liabilities the BS figure is
closer to the market value of that obligation. In
case of Long-term liabilities (Loans) the market
worth shall be governed by the future interest
rates. In case interest rates rise, the lenders will
not be willing to pay as much the book value but
lesser amount and vice versa.
• The difference between book value and market
value is likely to be greatest for shareholders’
equity. The book value of equity denotes the cash
that shareholders have contributed in the past plus
the profits retained in business in contrast to the
market value that investors place on the shares.
 Market VS Book Value Balance Sheet
• Book Value of the Share is the Shareholders’ equity
divided by No. of outstanding shares whereas stock
price is the market value of shareholders’ equity
divided by No. of outstanding shares.
• The market value BS is forward looking. It depends
on the benefits that investors expect the asset to
provide.
• Usually the shares sell for more than the value
shown in the company’s books.
• The re-invested funds make the Co. more
profitable.
 Income Statement
• A Statement that shows the revenues, epenses and
net income of a firm over a period of time. It
shows how profitable the firm has been during the
past year.
• The operation section of IS reports the firm’s
revenues and expenses from principal operations.
• The non-operating section of IS includes all
financing cost, such as interest expense.
• A separate section reports amount of taxes levied
on income.
• Generally Accepted Accounting Principles (GAAP):
• “The Realization Principle” is to recognize revenue
when the earning process is complete, i.e., revenue is
recognized at the time of sale, which need not be the
same as time of collection.
• “The Matching Principle” dictates that the revenues
be matched with expenses i.e., income is reported
when it is earned even though no cash flow may have
occurred.
Operations Section
Net Sales
Cost of Goods Sold
Selling, Gen. & Admn. Expenses
Depreciation
Operating Income

Other Income
Non Operating Earnings Before Interest & Taxes
Section (EBIT)
Interest Expense
Taxable (Pre-tax) Income
Taxes Section Taxes
NET INCOME

Retained Earnings
Dividends
 Profits VS Cash Flows
• Three reasons why profits and cash are not the
same:
1. The cash payments are divided into two groups –
current expenditure and capital expenditure. Current
expenditure are deducted from current profits.
However capital expenditure is spread over its
forecast life and an annual charge for depreciation is
made. To calculate the cash produced by the business
it is necessary to add back the depreciation charge
(which is not a cash payment) and to subtract the
capital expenditure (which is a cash payment).
2. The cash the company receives is equal to the sales
shown in the income statement less the increase in
unpaid bills.
3. All expenses that are associated with the sale are
deducted from the revenues to calculate profit
even though the expenses may have occurred in
earlier period (Accrual Accounting). The
expenditure in the earlier period cannot be
ignored and therefore will be shown as an
investment in inventories. The cash is paid out
when the goods are manufactured but the
expense is not recognized until the goods are
sold.
 The cash outflow is equal to the cost of goods
sold, which is shown in the income statement,
plus the change in inventories.
 Demonstration Problem
• A firm pays Rs.100 in period 1 to produce some
goods. It sells those goods for Rs.150 in period 2
but does not collect payment from its customers
until period 3. Calculate the Cash Flows to the
firm in each period using the following table:

Period: 1 2 3
Sales
Change in A/C Rec.
Cost of Goods Sold
Change in Inventories
Net Cash Flow
 Statement of Cash Flows
• A firm’s cash flow can be quite different from its net
income at least for the following two reasons:
1. The IS does not recognize capital expenditure as
expenses instead it spreads it over time in the form of
depreciation.
2. The IS uses the accrual method of accounting where
revenues and expenses are recognized as they are
incurred rather than when the cash is received or paid
out.
 The statement of cash flows shows the firm’s cash
inflows and outflows from operations as well as from
its investment and financing activities.
 Where From : Where to
CASH COMES FROM Cash CASH GOES TO
Resources

In Out
1- Profits ----------------------- --------- 1- Losses

2- Sales of Fixed Assets ----- --------- 2- Purchase of Fixed Assets

3- Decrease in Stocks-------- --------- 3- Increase in Stocks

4- Decrease in Debtors ----- --------- 4- Increase in Debtors

5- Capital Introduced ------- --------- 5- Drawings / Dividends

6- Loans Received ----------- --------- 6- Loans Repaid

7- Increase in Creditors ---- -------- 7- Decrease in Creditors

I. Cash provided by Operations:
Net Income
Non Cash Exp. (Depreciation Exp.)
Changes in Working Capital:
Decrease (increase) in Inventories
Decrease (increase) in A/C Receivable
Increase (decrease) in A/C Payable
II. Cash provided (uses) by investments:
Additions to Property, Plant & Equip.
Other Investments (Net)
III. Cash provided (used) by Financing Activities:
Additions (reduction) in debt
Issued of Share Stock
Dividends
NET INCREASE IN CASH
 Demonstration Problem
• Would the following activities increase or
decrease the firm’s cash balance?
1. Inventories are increased
2. The firm reduces its accounts payable
3. The firm issues additional share stock
4. The firm buys new equipment.