Chapter 2(2)

Financial Statements and Cash Flow

Chapter Overview

• Financial statements are essential for financial analysis.

• Understanding cash flow is critical for a firm's financial health.

Learning Objectives

1. Understand the significance of financial statement analysis for financial managers.

2. Overview of company financial statements.

3. Evaluate profitability using the income statement.

4. Use the balance sheet to analyze investments in assets and their financing.

5. Identify sources and uses of cash via cash flow statements.

Importance of Studying Financial Statements

• Financial statements help managers perform three key tasks:

  1. Assess Current Performance

     • Objective: Analyze the firm’s financial condition as perceived by outside investors.

  2. Monitor and Control Operations

     • Use accounting metrics to oversee operations and link performance to executive bonuses.

     • Creditors assess performance to decide on loan terms.

  3. Plan and Forecast Future Performance

     • Saves a universally accepted format for operational descriptions; used in financial planning models.

Basic Financial Statements

• Four fundamental financial statements:

  • Income Statement (or Statement of Comprehensive Income)

  • Balance Sheet (or Statement of Financial Position)

  • Cash Flow Statement

  • Statement of Changes in Equity

Accounting Principles for Financial Statements

1. Accrual Basis

   • Revenues recognized when earned, not received.

   • Expenses recognized when incurred, not paid.

2. Historical Cost Principle

   • Assets and liabilities recorded at their acquisition cost.

Income Statement Overview

• Provides financial performance data over a specific period:

  • Revenue Earned

  • Expenses Incurred

  • Profit Generated

  Formula: Revenue - Expenses = Profit.

Example: H. J. Boswell Ltd Income Statement (2015)

• Sales: $2700 million

• Cost of Goods Sold: $(2025) million

• Gross Profit: $675 million

• Total Operating Expenses: $(292.5) million

• Operating Profit (EBIT): $382.5 million

• Net Profit: $204.75 million

Key Metrics

• Operating and financing costs affect profits:

  • Dividends Paid: $45 million

  • Earnings Per Share (EPS): $2.28

  • Dividends Per Share: $0.50

Understanding Profitability from Income Statement

Measures of Profit

1. Gross Profit: $675 million

2. Operating Profit: $382.5 million

3. Net Profit: $204.75 million

Profitability Ratios

• Gross Profit Margin (GPM): 25%

• Operating Profit Margin: 14.17%

• Net Profit Margin: 7.6%

  This indicates how efficiently a firm converts sales into profits.

Connecting Income Statement to Balance Sheet

• **Net Income Allocation:

  • Dividends:** $45 million

  • Retained Earnings: $159.75 million

• This results in increased retained earnings recorded on the balance sheet.

Balance Sheet Overview

• Includes details on:

  • Assets (resources with future economic benefits)

  • Liabilities (debts)

  • Shareholders’ Equity (owner's investment)

• Financial position snapshot:

  • Equation: Total Assets = Total Liabilities + Shareholders' Equity.

Balance Sheet Example: H. J. Boswell Ltd (2015)

• Total Assets: $1971 million

• Total Liabilities: $1059.75 million

• Shareholders' Equity: $911.25 million

Categories of Balance Sheet Items

• Assets: Current (cash, receivables) & Non-current (property, equipment)

• Liabilities: Current (payables, short-term debt) & Non-current (long-term debt)

• Shareholders' Equity: Ordinary shares, retained earnings, reserves.

Liquidity and Net Working Capital

• Net Working Capital Formula: Current Assets - Current Liabilities

• H.J. Boswell Ltd's liquidity improved from 2014 to 2015:

  • 2014: $184.5 million

  • 2015: $355.5 million

• Importance of maintaining healthy working capital levels considered by lenders.

Cash Flow Statement

• Shows cash movements over a specified period.

• Key Sections:

  • Operating Activities

  • Investing Activities

  • Financing Activities

H. J. Boswell’s Cash Flow Analysis

• Net Cash Generated from Operations: $173.25 million

• Cash Used for Investments: $(175.5) million

• Insufficient cash flow resulted in a deficit of $(4.5) million.

Statement of Changes in Equity

• Offers insights into movements in equity over a specific timeframe.

  • Includes ordinary shares, preference shares, retained earnings, and reserves.