Corporate Finance: Financial Statements Study Notes

Chapter 2: Financial Statements

• Source Material: Corporate Finance: A South African Perspective (2nd Edition, 2014).
• Editors: Gideon Els, Pierre Erasmus, Suzette Viviers.
• Authors: Liezel Alsemgeest, Elda du Toit, Sam Ngwenya, Kevin Thomas.
• Introduction: Companies provide an annual report at the end of the financial year. This report provides analysts with critical information and includes a set of financial statements that indicate the financial performance and position of the company for analysis and comparison.

The Objective of Financial Reporting

• Main Objective: To provide a summary of the financial position, financial performance, and changes in the financial position of an entity.
• Financial Position:
  • Influenced by economic resources and the capital structure used to finance these resources.
  • Evaluated by focusing on assets, liabilities, and shareholders’ equity included in the Statement of Financial Position.
• Financial Performance:
  • Defined as the company’s ability to generate income with its available assets.
  • Evaluated by focusing on the revenue and expenses provided in the Statement of Comprehensive Income.
• Change in Financial Position:
  • Depends on investment, financing, and operating activities during the year.
  • The Statement of Cash Flows provides a summary of these activities.

Users of Financial Reporting (Stakeholders)

• Shareholders: Evaluate existing and expected performance.
• Management: Used for planning and control purposes.
• Providers of Debt Capital: Evaluate the capital structure and the company's ability to pay interest.
• Government: Specifically SARS (South African Revenue Service) and organizations collecting economic statistics.
• Other Stakeholders: Includes employees, clients, customers, suppliers, and competitors.

Qualitative Characteristics of Useful Financial Information

• Relevant: The information must be capable of making a difference in decisions.
• Faithfully Represented: Information must accurately reflect the economic phenomena it purports to represent.
• Accurate and Objective: Free from bias and error.
• Comparable: Allows users to identify similarities in and differences between items.
• Verifiable: Different knowledgeable and independent observers could reach a consensus.
• Timely: Having information available to decision-makers in time to be capable of influencing their decisions.
• Understandable: Information is classified, characterized, and presented clearly and concisely.

The Standardisation of Financial Statements

• Need for Comparability: Financial statements need to be comparable across different companies and time periods.
• Challenges: Statements may not be comparable if different accounting guidelines are used. South African companies converted to IFRS (International Financial Reporting Standards), making comparison to previous years (using other guidelines) potentially problematic.
• The Solution: Standardising published financial statements facilitates comparison between companies over time and simplifies the calculation of financial ratios.

Statement of Financial Position (Balance Sheet)

• Definition: A summary of a firm's financial position at a specific point in time.
• Basic Equation:     $\text{Total Assets} = \text{Total Equity} + \text{Total Liabilities}$

Assets

• General: Capital investment where assets are applied to generate revenue.
• Types of Assets:
  • Non-current Assets: Assets applied over a long period (usually more than one year).
    • PPE (Property, Plant, and Equipment) at cost price: Usually indicated at the original purchase price.
    • Accumulated Depreciation: The cumulative depreciation provided on PPE as recorded in the statement of comprehensive income.
    • PPE at Carrying Value: Calculated as $ ext{Cost} - ext{Accumulated Depreciation} $.
    • Assets under Construction: Assets not yet completed; no depreciation is provided for these.
    • Intangible Assets: Includes Goodwill and others like software and licences.
    • Investment in Associate: Occurs when a company owns between $20\%$ and $50\%$ of shares in another company.
    • Other Long-term Assets: Includes loans granted and share investments of less than $20\%$.
    • Deferred Tax Assets: Arise from differences between accounting and tax treatment.
  • Current Assets: Assets expected to be converted to cash or used within one year.
    • Inventories: Required for the operations of the company.
    • Trade and Other Receivables: Credit sales still outstanding and other short-term amounts.
    • Short-term Financial Assets: Financial assets with a lifetime of less than a year.
    • Cash and Cash Equivalents: Most liquid assets.
    • Other Short-term Assets: Includes assets held for sale.
• Distinguishing Factors: The difference between current and non-current is typically based on:
  1. Turnover rate of the capital.
  2. Ease of conversion to cash.
  3. Physical characteristics.

Equity and Liabilities

• Total Equity: A breakdown of different forms of equity capital used to finance assets. It is important to distinguish between contributions of different shareholder types.
  • Share Capital: Proceeds from the sale of ordinary shares.
  • Reserves: Includes share-based payments and share repurchases.
  • Retained Earnings: Accumulated retained profits reinvested into the company.
  • Preference Share Capital: Proceeds from the sale of preference shares.
  • Shareholders’ Equity: Total capital invested by all shareholders.
  • Non-controlling Interest: Included when financial statements of subsidiary companies are consolidated.
• Liabilities: Breakdown of debt capital types.
  • Non-current Liabilities (Long-term debt):
    • Interest-bearing Borrowings: Long-term loans, mortgages, and debentures.
    • Post-retirement Obligations.
    • Deferred Tax Liabilities.
  • Current Liabilities (Short-term debt):
    • Trade and Other Payables: Outstanding amounts on credit purchases and other short-term obligations.
    • Short-term Debt: Loans to be redeemed in the next financial year.
    • Short-term Financial Liabilities.
    • Tax Payable to SARS.
    • Bank Overdraft.
    • Other Current Liabilities: Liabilities in disposal groups, short-term provisions, and short-term deferred income.

Statement of Comprehensive Income (Income Statement)

• Definition: A summary of financial performance for the financial year matching income against expenses.
• Standard Format and Components:
  1. Turnover (Revenue): Income received for products or services rendered during the financial year.
  2. Cost of Sales and Services Rendered: All costs directly incurred to generate turnover (inventory purchases, transport, customs).
  3. Gross Profit: Calculated as $\text{Turnover} - \text{Cost of Sales}$.
  4. Other Operating Income: Income items not part of sales activities but generated via operating activities.
  5. Operating Expenses: Expenses supporting primary activities (depreciation, employee costs, R&D, lease charges).
  6. Operating Profit (EBIT): Result of primary activities; excludes items not part of normal business activities.
  7. Investment Income: Income generated by financial investments (dividends and interest received).
  8. Finance Cost: Interest paid on debt financing.
  9. Profit Before Tax.
  10. Tax: Calculated based on profit before tax.
  11. Profit After Tax.
  12. Non-controlling Interest: Portion of profit belonging to non-controlling shareholders.
  13. Preference Share Dividends: Dividends paid to preference shareholders (paid before ordinary dividends).
  14. Attributable Earnings: Amount available for ordinary dividend payments after all other expenses and allocations.
  15. Ordinary Dividends: Total amount paid to ordinary shareholders.
  16. Retained Earnings (for the year): Profit reinvested rather than paid out. Reinvested funds are transferred to reserves and belong to shareholders as part of equity.

Case Study: Sasol Ltd Statement of Comprehensive Income (Extracts)

Statement of Cash Flows

• Definition: A summary of a firm’s cash inflows and outflows for the financial year.
• Equation Structure:     $\text{Cash from Operating} + \text{Cash from Investing} + \text{Cash from Financing} = \text{Movement in Cash}$$\text{Cash at Beginning} + \text{Movement in Cash} = \text{Cash at End}$

Components of Cash Flow

1. Cash Flow from Operating Activities: Cash from normal operations.

   • Cash received from customers: Actual cash payments for sales/services.
   • Cash generated by operating activities: $\text{Cash received from customers} - \text{Cash paid to suppliers and employees}$.
   • Finance income received: Income from investments.
   • Finance expenses paid: Interest on debt.
   • Tax paid: Cash paid to authorities.
   • Cash available from operating activities: Indicates if cash flow covers dividends. If negative, dividends require external cash.
   • Dividends paid: Cash payments to shareholders.
   • Cash retained from operating activities: If negative, implies no surplus for reinvestment/expansion; persistent negative values indicate serious financial problems.

2. Cash Flow from Investing Activities: Cash used for or provided by the company's investment in assets.

   • Additions to Non-current Assets: Cash spent on PPE, assets under construction, and intangibles.
   • Sale of Non-current Assets: Proceeds from disposals.
   • Business Acquisitions/Disposals: Cash effects of buying or selling business units.
   • Investment Transactions: Purchase or sale of share/financial investments.

3. Cash Flow from Financing Activities: Cash flows related to the company's capital structure.

   • Inflows: New share capital issued, new long-term debt obtained, short-term debt proceeds.
   • Outflows: Share capital repurchased, repayments of long-term and short-term debt, dividends paid to non-controlling interests.

Case Study: Sasol Ltd Statement of Cash Flows (Extracts)

Operating Activities

Investing Activities

Financing Activities and Cash Balances