Understanding balance sheet and cash flow statement


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Very useful for CFA and FRM level 1 preparation candidates. For a more detailed understanding, you can watch the webinar video on this topic. The link for the webinar video on this topic is http://youtu.be/7e9t9cMA22g

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Understanding balance sheet and cash flow statement

  1. 1. Webinar onUnderstandingBalance Sheet andCash Flow Statement
  2. 2. 2
  3. 3. Session Agenda• Part I- Understanding the Balance Sheet– Balance Sheet Components and Presentation Formats– Current and Non-Current Assets and Liabilities– Measurement of Assets and Liabilities– Treatments for marketable and non-marketable financial instruments– Shareholders Equity3• Trading Strategies– Cash Flow Classifications– Key differences in cash flow statements prepared under GAAP and IFRS– Direct and Indirect Method for Cash Flows– Cash flow link to income statement and balance sheet– Cash Flow Analysis– Free Cash Flow to Firm and Free Cash Flow to Equity– Cash flow ratiosPart II- Understanding the Cash Flow StatementExpect around 5-8 questions in the CFA level 1 exam from today’s webinar
  4. 4. Part-I: Understanding theBalance Sheet
  5. 5. Balance Sheet Components• Balance sheet: Also called “Statement of financial position” or “Statement of financial condition”• Equation that governs this Financial statement:• Assets: Provide economic benefits to the entity– Current Assets• Cash and cash equivalents• Accounts receivable• Inventory• Prepaid expenses– Property, plant and equipment– Investments– Intangible assets– Deferred tax assets5EquitysrShareholdesLiabilitieAssets 
  6. 6. Balance Sheet – Liabilities & Equity Accounts• Liabilities: Obligations for an entity; occurred from historical transactions and to be paid in future– Current liabilities• Accounts payable• Accrued expenses• Unearned revenues– Bank Loan– Bonds– Pension obligation– Deferred tax liabilities• Owner’s Equity:– Capital stock– Additional paid-in-capital (capital in excess of par)– Treasury stock– Retained earnings– Accumulated other comprehensive income6
  7. 7. Balance sheet presentation formats• Generally two formats are common– Account Format : layout in which assets are present on left –hand side & liabilities & equity are presenton right-hand side– Report Format: assets, liabilities & equity are presented in one column• Classified Balance Sheet:– Current and non-current assets are reported separately, as are current and non-current liabilities• Liquidity based format:– Assets and Liabilities are presented in the order of their liquidity7
  8. 8. Assets / liabilities and accrual process• Assets / liabilities are also created using accrual concept in addition to acquisition through cash• For Example:– If an income (rent / interest income) is earned but not received in cash, accrued income is created and isshown in current assets– If an expense is accrued but not paid, it creates a liability for the firm and is shown in accrued expenses8
  9. 9. Current and non current assets and liabilities• Current Account is a balance sheet account that represents the value of all assets thatare reasonably expected to be converted into cash within one year in the normal course of business.This include cash, accounts receivable, inventory, marketable securities, prepaid expenses and otherliquid assets.• Non Current assets are held for long term purpose to operate business activity and does not meetcurrent assets definition• Current liabilities are obligation which needs to be paid within a year. These are generally short termdebt, accounts payable, accounts payable, accrued liabilities and other debts.• Working Capital– Current assets minus current liabilities equals working capital– Not enough working capital may indicate liquidity problems– Too much working capital may be an indication of inefficient use of assets9
  10. 10. Measurement of assets and liablitlies• Assets and liabilities are shown either at– Historical value (cost – verifiable through historical records)– Fair Value (Subjective)• To value a firm, an analyst must adjust accordingly to understand firms investment potential10
  11. 11. Inventory and Tangible Assets• Inventory contains items held for sale or to be used in manufacturing process– Raw Material– WIP– Finished Goods• Inventory is reported at the lower of– Cost which includes direct labor, direct material and overheads but does not include abnormal wastage,admin overheads and selling costs– Net realizable value: selling price of inventory less the estimated cost of completion and disposal costs• Costs can be assigned using standard costing (predetermined costs) or retail methods (sale price lessprofit)• Tangible Assets:– Shown at Costs less accumulated depreciation– Costs include all costs incurred till assets is ready for use – installation costs as well11Imp
  12. 12. Intangible assets• Identifiable: purchased with finite life like patents, trademark etc.• Unidentifiable: not purchased separately with infinite life like goodwill– Goodwill is excess value paid over the fair value of a business acquired– Internally generated goodwill – expenses when incurred; can only be recognized on acquisition• R&D Costs– Under US GAAP• Except for certain legal costs, intangible assets that are created internally including research anddevelopment costs, are expensed as incurred– Under IFRS, a firm must• Expense costs during the research stage but• Can capitalize Costs during the development stage• Under GAAP, all of the following should be expensed as incurred:– Start-up and training costs.– Administrative overhead.– Advertising and promotion.– Relocation and reorganization costs.– Termination costs.12Imp
  13. 13. Treatments for marketable and non-marketablefinancial instruments• Reporting assets and liabilities at fair value is known as marking-to-market• Marketable investment securities are classified as either held-to-maturity, trading, or available- for-sale– Dividend and interest income, and realized gains and losses on sales are recognized in incomestatement for all three classifications of securities13Imp
  14. 14. Marketable securities• Held-to-maturity securities– Debt securities acquired to hold till maturity– Reported at amortized cost on the Balance Sheet– Not adjusted for subsequent changes in market value• Trading securities– Debt and Equity securities acquired to profit over the near term– Reported at Fair Value on the Balance Sheet– Changes in the market value (Unrealized gains and losses) are reported in the income statement.• Available-far-sale securities– Debt and equity securities that are not expected to be held to maturity or traded in the near term.– Reported at Fair Value on the Balance Sheet– Any unrealized gains and losses are not recognized in the income statement but are rather reported inother comprehensive income as a part of stockholders equity14
  15. 15. Example: Classification of Securities• Company ABC purchased a 5% annual coupon bond, 10 years maturity, with a face value of $100and market value $100,000 on Dec 31 2011. Interest is paid on every 31st March. The market valueon purchase is $100. On March 31 2012, its YTM is 6% and it is to be reported on ABC’s balancesheet.• Describe the impact on financial statements if the bond were to be classified as:I) Held to MaturityII) Available for SaleIII) Held for Trading15
  16. 16. Solution: Classification of SecuritiesHeld to Maturity•The bond is reported at amortized price, which is $100 and has a market value of $100,000 which isreported on the balance sheet.•The coupon income, that is accrued till that date, 0.25*5%*100,000 = $1250 is reported in the incomestatement.Available for Sale•The Bond Price on March 31st 2012 is $92.7486 and thus its market value is $92,749 which is reportedon the balance sheet.•Coupon income $1250 is reported on the income statement.•The unrealized loss of 100,000-92,749 = $7,251 is reported in under Other Comprehensive Income aspart of Shareholder’s Equity.Held for Trading•The Bond Price on March 31st 2012 is $92.7486 and thus its market value is $92,749 which is reportedon the balance sheet.•The loss 100,000-92,749 = 7,251 and the coupon income $1250 are reported on the income statement16
  17. 17. Shareholders Equity• Types of Common Shares– Authorized shares• Shares that a firm maximum can issue under the firms articles of incorporation.– Issued shares• Shares that have actually been sold to shareholders– Outstanding shares• Issued shares less shares reacquired by the firm (i.e., treasury stock)• Contributed Capital:– Amount paid by common + preference shareholders• Retained earnings: Cumulative earnings from operations till date17
  18. 18. Common-size Balance Sheets• Common size statements normalize the balance sheet and allow the analyst to more easily compareperformances across firms and for a single firm over time.• Vertical common side balance sheets express all balance sheet accounts as a percentage of totalassets.• Vertical Common-size balance sheet ratios• Horizontal Common-size balance sheet – the divisor is the first year values, so all first year values are1.0 by contrsuction18AssetsTotalaccountsheetBalance
  19. 19. Vertical Common Size Balance Sheet example2009 2010 2011AssetsCash 9% 7% 7%A/R 3% 2% 3%Inventories 29% 33% 37%Net Fixed Assets 59% 58% 53%Total Assets 100% 100% 100%LiabilitiesA/P 6% 5% 5%S.T. Debt 18% 18% 17%L.T. Debt 35% 33% 30%EquityPreffered Stock 12% 18% 17%Common Stock 29% 27% 31%Liabilities + Equity 100% 100% 100%19
  20. 20. Horizontal Common/ Cross Sectional Size Balance Sheet202009 2010 2011AssetsCash 1.0 1.1 1.5A/R 1.0 1.0 2.2Inventories 1.0 1.7 2.3Net Fixed Assets 1.0 1.5 1.7Total Assets 1.0 1.5 1.9LiabilitiesA/P 1.0 1.2 1.5S.T. Debt 1.0 1.5 1.8L.T. Debt 1.0 1.4 1.6EquityPreffered Stock 1.0 2.3 2.8Common Stock 1.0 1.4 2.0L + E 1.0 1.5 1.9
  21. 21. Questions for practice1. Which of the following R&D expenses need to be expensed as per IFRSA. All expenses incurred during research stageB. All expenses incurred during development stageC. All expenses must be incurred except certain legal costs2. Which of the following securities needs to be reported at amortized cost in BSA. Held for tradingB. Held to maturityC. Available for sale3. Contributed capital equals toA. Amount paid by common shareholders plus retained earningsB. Amount paid by common shareholders plus preference shareholdersC. Amount paid by common shareholders only21
  22. 22. Solutions1. A.– Under IFRS, a firm must expense costs during the research stage but can capitalize costs duringthe development stage2. B.– Held-to-maturity securities are debt securities acquired to hold till maturity and reported atamortized cost in BS3. B.– Contributed capital is amount paid by common shareholders plus preference shareholders.22
  23. 23. Part-II: Understanding theCash Flow Statement
  24. 24. Cash flow• Cash flow can be used to know whether– Regular operations generate enough cash to sustain the business– Enough cash is generated to payoff existing debts as they mature– The firm can acquire new business opportunities in future– The firm is likely to need additional financing– Unexpected obligations can be met• All receipts / payments of cash flows are classified in 3 following activities:– Cash flow from operating activities– Cash flow from investing activities– Cash flow from financing activities24
  25. 25. U.S. GAAP Cash Flow Classifications25• Cash flows related to firms day to day normal business activitiesOperating Activities Cash flowCash InflowCash Sales / cash revenuesCash collected from customersInterest and dividends receivedCash collected on sales of trading securitiesCash OutflowCash purchasescash paid to supplierscash paid to employeesCash paid on buying trading securitiescash paid for other expensescash paid as interestcash paid for taxes
  26. 26. U.S. GAAP Cash Flow Classifications26• Cash flows related to purchasing and selling non current assets – Income generated frominvestments are operating activities (dividends / interest received)Investing Activities Cash flowCash InflowCash collected on sales of debt and equity investmentsCash collected on sales of long lived assetsReceived principals on loansCash OutflowCash paid on buying debt and equity investmentsCash paid on buying long lived assetsLoans made to others
  27. 27. U.S. GAAP Cash Flow Classifications27• Cash flows related to capital structure of the companyFinancing Activities Cash flowCash InflowCash received on issuance of equity and related cash flowsCash received on issuance of debt and related cash flowsCash received on issuance of preferred shareholdersCash OutflowCash paid on buying back equityPrincipal paid on debtCash paid on redemption of preferred shareholdersDividend paid to shareholders
  28. 28. Non cash activities• Noncash investing and financing activities are not reported in the cash flow statement as non cashdoes involve inflows and outflows of cash– Exchange of debt for equity– Stock dividend• Must be disclosed in either a footnote or supplemental schedule to Cash Flow statement28
  29. 29. Key differences in cash flow statementsprepared under GAAP and IFRSThe difference is in the treatment of dividends, interest paid & taxes:• U.S. GAAP:– Dividends paid to the firms shareholders are reported as financing activities while interest paid isreported in operating activities– Interest received and dividends received from investments as operating activities• IFRS:– Dividends or interest received may be classified as either operating or investing activities– Dividends or interest paid may be classified as either operating or financing activities29Imp
  30. 30. Key differences in cash flow statementsprepared under GAAP and IFRSTaxes:• U.S. GAAP– All taxes paid are reported as operating activities• IFRS– Firm can report a investing inflow net of taxes under investing activity• For example, Paramount industries sells one of its buildings with a book value of $3 Million, for a priceof $4 Million. The taxes on the profit of the sale is $350,000.• Under US GAAP, the company shows a CFI inflow of $4 Million and a CFO outflow of $350,000 forthe income tax.• Under IFRS, the company, these two cash flows are netted and a CFI inflow of $3,650,000 isreported.30Imp
  31. 31. Direct and Indirect method for cashflow• Direct method - Remove impact of accruals and shows only cash receipts and paymentsOperating Activities Cash flow - Direct Method AmountCash InflowCash Sales / cash revenues 5100Cash collected from customers 10000Interest and dividends received 500Cash collected on sales of trading securities 100Cash OutflowCash purchases (4000)cash paid to suppliers (6000)cash paid to employees (3000)Cash paid on buying trading securities (100)cash paid for taxes (500)cash paid for interest (500)Operating Activity Cash flow 160031
  32. 32. Direct Method• Cash Collections = Sales + Opening balance (OB) of a/c receivable – Closing Balance (CB) of a/creceivable• Cash paid to supplier: COGS + (CB of inventory – OB of inventory) + (OB of a/c payable – CB of a/cpayable)• Cash paid for expenses: Expenses incurred + OB of outstanding Exp – CB of o/s expenses• Cash taxes: tax expense + OB of tax payable – CB of tax payable + OB of deferred tax liability – CBof DTL• Value of PP&E Sold = Book Value + Gain ( or - loss) on sales– Book Value of assets sold = Historical cost of assets sold – accumulated depreciation for the assets– Historical cost of assets sold = OB of Gross PP&E – CB of Gross PP&E + Capital expenditures– Accumulated Depreciation (AD) of assets sold = OB of AD – CB of AD + Depreciation charged inP&L32Imp
  33. 33. Cashflow – Indirect method33• Indirect method: Without requiring specific cash transactions, adjusts net income to calculateoperating cash flow . Adjustments are done for:‫־‬ Financing or investing activity cash flow‫־‬ Non cash items‫־‬ Changes in working capitalOperating Activities Cash flow - Indirect Method AmountNet Income 4900Depreciation 2000Loss on sale of assets 100Deferred income taxes 500Increase in accounts receivable (3000)Decrease in inventory 1000Decrease in accounts payable (2000)Increase in prepaid expenses (2000)Increase in Taxes Payable 100Operating Activity Cash flow 1600
  34. 34. Direct and Indirect method• Direct method presents the firms operating cash receipts and payments• Indirect method only presents the net results of these receipts & payments• Thus, direct method provides more information• Indirect method focuses on net income & operating cash flow providing a link to income statementwhen forecasting future operating cash flow34
  35. 35. Cash flow link to income statement and balance sheet• Income statement: Net Income• Balance Sheet– Linkage with each assets and liabilities– Changes in current assets and liabilities to calculate cash flow from operations– Changes in non current assets to investing activities– An increase in the assets is cash outflow while cash inflow for decrease in assetsCash paid for assets = Ending balance – beginning balance + depreciation + costs of assets sold– An increase in the liability is cash inflow while outflow in case it increases– Changes in common shares and bonds to financing activities35
  36. 36. Cash Flow analysis• Negative operating cash flow – question mark on sustainability of business• Comparison of earnings with operating cash flows: stable the better• Low cash flow compared to earnings: aggressive revenue recognition policies• Selling assets to generate cash flow from investing activity– Size, trends – if huge can be a question mark on future• Investing / financing activity can show uses of debt:– Debt should be used in productive activities– Not in paying dividends or acquiring stocks• Common size Cash flow– Shows as a percentage of revenue– Cash inflow as a percentage of total inflows– Cash outflow as a percentage of total outflows36Imp
  37. 37. Common Size Cash Flow37Net Revenue 1,032,000Cash Flow from Operating ActivitiesNet Income 258,000 25%Depreciation 102,000 10%Gain on Sale of Equipment 35,000 3%Increase in Accounts Receivable (20,040) -2%Increase in Inventory (75,740) -7%Increase in Accounts Payable 5,400 1%Net Cash provided by Operating Activitites 304,620 30%Cash Flow from Investing Activities 0%Cash from Sale of Equipment 10,700 1%Cash paid for Equipment (54,000) -5%Net Cash provided by Investing Activitites (43,300) -4%Cash Flow from Financing Activities 0%Cash paid to retire long term debt (56,000) -5%Cash paid for dividends (38,000) -4%Net Cash provided by Financing Activitites (94,000) -9%Net Increase/Decrease in Cash 167,320 16%
  38. 38. Free Cash Flow• Free Cash Flow to the Firm:• Free cash flow to the firm (FCFF) is the cash available to all investors, both equity owners and debtholders• FCFF can be calculated by starting with either net income or operating cash flow.• FCFF = net income + noncash charges (depreciation and amortization) + [Interest expense x (1 - taxrate)] - fixed capital investment (net capital expenditures) – working capital investment• FCFF = cash flow from operations + [Interest expense x (1 - tax rate)] - fixed capital investment (netcapital expenditures)• Free Cash Flow to Equity:• Free cash flow to equity (FCFE) is the cash available to equity owners• FCFE = cash flow from operations - fixed capital investment (net capital expenditures) + debt issued -debt repaid38
  39. 39. Questions for practice1. Calculate cash paid to suppliers given following information (in $mn)– Cost of Good Sold = $100– Inventory => At the beginning of year = $10; At the closing of year = $12;– Suppliers => At the beginning of year = $8; At the closing of year = $6;A. $100 B.$104 C.$962. Given following information (in $mn), cash flow from operations is– Dividend Paid to common shareholders = $10– Retained Earnings => Opening Balance = $100; Closing Balance = $120– Accounts Receivable =>Opening Balance = $50; Closing Balance = $60– Account Payable => Opening Balance = $40; Closing Balance = $50– Net Plant and Equipment =>Opening Balance = $100; Closing Balance = $80A. $20 B.$30 C.$503. Under US GAAP, cash outflow on buying trading securities will be classified asA. Operating activityB. Investing activityC. Financing activity39
  40. 40. Questions4. Given following information (in $mn), calculate amount of plant and equipment a company sold– Gross Plant and Equipment =>Opening Balance = $100; Closing Balance = $90– Accumulated depreciation => Opening Balance = $20; Closing Balance = $25– Capex incurred => $10– Depreciation charged => $7– Gain on sale of equipment => $2A. $20 B.$22 C.$255. Under IFRS dividends received and interest paid will be classified inDividend Received Interest PaidA. Operating OperatingB. Operating FinancingC. Either operating or investing Either operating or financing6. Given following information, free cash flow to firm will be closest to– Net Income: $8000; Depreciation = $2000; Interest Expenses = $1000– Capital Expenditures= $3000; Increase in a/c receivables = $2000; Decrease in a/c payables = $1000Tax Rate = 30%A. 6,700B. 4,700C. 11,70040
  41. 41. Solutions1. B.– Cash paid to supplier: COGS + (CB of inventory – OB of inventory) + (OB of a/c payable – CB ofa/c payable) = $100 + (12-10) + (8-6) = $1042. C.– Net Income = Change in retained earnings + dividend paid = $20+$10 = $30;– CFO = Net Income + Depreciation + Increase in payables – increase in receivables => $30 + (100-80) +(50-40) – (60-50) = $503. A.– US GAAP treats cash outflow on trading securities as operating activities as these are related to day today business activities41
  42. 42. Solutions4. A.– Amount received on sale = Book Value + Gain (loss) on sales– Book Value of assets sold = Historical cost of assets sold – accumulated depreciation for assets– Historical cost of assets sold = OB of Gross PP&E – CB of Gross PP&E + Capital expenditures– Accumulated Depreciation (AD) of assets sold = OB of AD – CB of AD + Depreciation charged in P&L– Hence => Historical cost of assets sold = 100 – 90 +10 = 20– AD on assets sold = 20 – 25 + 7 = 2– Book Value = 20 – 2 = 18– Sale Receipt = 18 + 2 = 205. C.– IFRS provide freedom to firms to report dividends or interest received as either operating or investingactivities and dividends or interest paid as operating or financing activities6. B.– FCFF = net income + noncash charges (depreciation and amortization) + [Interest expense x (1 - taxrate)] - fixed capital investment (net capital expenditures) – decrease in A/c payable – increase in A/creceivable– FCFF = 8000 + 2000 + 1000 *(1-30%) – 3000 – 1000 - 2000= 4,70042
  43. 43. Other WebinarsHere are the links for the blogs of the other recent webinars on our website tohelp you with CFA/FRM preparationLinear regression analysis (11/04/2013)Blog: http://www.edupristine.com/blog/demystifying-linear-regression-analysis-for-frm-level-1-exam/Understanding Income statement (12/04/2013)Blog: http://www.edupristine.com/blog/cfa-tutorial-understanding-income-statement-from-cfa-perspective/Hedging strategies using futures (13/04/2013)Blog: http://www.edupristine.com/blog/frm-tutorial-hedging-strategies-using-futures-for-frm-level-1-exam/You can find many more blogs on our website: www.edupristine.com/blog43
  44. 44. Upcoming WebinarsLook forward to more webinars from our side on the topics of your choice!! Justdrop a mail to us to suggest a topic! You can check for updates on our site:http://www.edupristine.com/webinarsClassroom Training in New York, Boston, Chicago in US and Londonin UK for CFA and FRM programsFOR MORE DETAILS, VISIT:http://www.edupristine.com/ca/courses/cfa-program/http://www.edupristine.com/ca/courses/frm-program/44