FM-3-06 (1)

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Financial Management Winter 2005 1 February to 3 March

The 3 basic business activities

The subject of financial accounting & reporting:

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Equity

Financing

Debt

Financing

Investment

in Producing

Assets

Goods &Services

NetEarnings

Operating

Activities

Investing

Activities

Financing

Activities

Reinvested

DebtPayment

Dividends

Businesses are like Fruit Trees

Roots

Branches

Trunk &

Fruit

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The 3 basic activities involved in conducting a business are:

Financing activities (Roots):

- Owners contribute cash and receive equity shares in return.

- Creditors loan cash in return for the promise of interest and principal payments.

Investing activities (Trunk and branches):

Once the capital is collected it is invested in producing assets, like buildings,

equipment, machinery and vehicles.

Operating activities (Fruit):The assets are operated to produce goods & services which are sold to customers.

The Net Income of these sales can be used in three ways:

1. Reinvested in the producing assets

2. Returned to the creditors in the form of debt payments

3. Returned to the owners in the form of dividends

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The three basic activities of businesses and theirfinancial flows:

Operating revenuesOperating costs

Sale of assetsPurchase of assets

Operating

activities

Investing

activities

Financing

activities

Equity, debtDividends, debt payments

Financial boundaries of the corporation

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The three basic activities of businesses and theirenvironmental flows:

Emissions to air

Economic

goods & services

Energy

Operating

activities

Investing

activities

Financing

activities

Solid wasteLand, etc.

Environmental boundaries of the corporation

Emissions to water

Raw materials

Economic

goods & services

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What information is contained in the 4 financial statements

How are the financial flows of the 3 basic business activities

reflected in the 4 financial statements?

The 4 Financial Statements:

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The Financial Statements are designed to measure different aspects

of the business (the fruit tree):

The Balance Sheet

Is a picture of the tree (fruit, branches, trunk & roots) at a certain point in time.

It includes assets (inventory of goods and producing assets) and financing sources(equity, debt and reinvestments from net income) of the business.

The Income Statement

Accounts for all activities involved in the operation of the business (growing and

selling the fruit) over a period of time. It contains a list of all operating expenses and

revenues of the business.

The Statement of Retained Earnings

Reports how much of the net income from the operating activities are retained by the

business and how much paid as dividends.

The Statement of Cash Flows

Details all the cash inflows and outflows that occurred over a period of time

associated with the operating (fruit), investing (trunk and branch) and financing (roots)

activities of the business.

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The Income Statement

measures operating performance over a particular period of time.

Operating Revenues

Operating Expenses

= Operating Income

+ Other Revenues

Other Expenses= Net Income before Taxes

Income Taxes

= Net Income after Taxes

/ Number of Shares

= Income per Share

Net income is the most important number disclosed on the financial statements.

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The three basic activities of businesses and the financial flows

oftheincome statement:



Operating

activities

Investing

activities

Financing

activities



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The Statement of Retained Earnings

Beginning retained earnings balance

+ Net Income

Dividends

= Ending retained earnings balance

tells us how much of the net income has been retained by the company

and how much has been paid out to the shareholders.

Companies retain profits to finance operations and capital expenditures

and to pay off debt.

The rest is usually returned to the shareholders in the form of dividends.

Retained earnings is a cumulative measure of the amount of company assets

that comes from profitable operations rather than fund raising (debt or equity).

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The Statement of Cash Flows

The statement of cash flows is a summary of the financial flows into and out of a

companys cash account. (Note that accounting flows are not necessarily cash flows)

Operating activities + Cash collection

Cash paid

= Net cash increase (decrease) from operating activities (1)

Investing activities Purchases of securities or property

+ Sales of securities or property= Net cash increase (decrease) from investing activities (2)

Financing activities + raised capital from issuing equity or entering debt

Dividends or debt payments

= Net cash increase (decrease) from financing activities (3)

(1) + (2) + (3) = Increase (decrease) in cash balance

+ Beginning cash balance

= Ending cash balance

The cash balance provides important information on a companys solvency.

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The three basic activities of businesses and the financial flows

ofthe statement of cash flows:



Operating

activities

Investing

activities

Financing

activities



(Cash flows only)

(Cash flows only)

(Cash flows only) (Cash flows only)

(Cash flows only)

(Cash flows only)

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The balance sheet provides a picture of the companys financial situation at one point

in time. It is based on the fundamental accounting equation:

Assets = Liabilities + Equity

The shareholders own the company. Its net worth is (Assets Liabilities) = Equity.

This is called book value of the company and different from its stock market value.

Assets:

Items and right acquired through objectively measurable transactions that can be used

in the future to generate economic benefits.

Liabilities:

Primarily a firms debt and payables. The total amount of liabilities is the portion of

assets that a firm has borrowed and must repay.

Stockholders Equity

consists of contributed capital and retained earnings.

The balance sheet is called classified if assets and liabilities are grouped into

classifications, and consolidated if it contains all divisions and subsidiaries of the firm.

The Balance Sheet

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Assets

Current assets Cash

Short-term investments

Accounts receivable

Inventory

Prepaid expenses

Long-term investments

Notes receivable

Land

Debt securities

Equity securities

Property, plant equipment

Intangible assets

Liabilities

Current liabilities Accounts payable

Other payables

Current maturities of long-term debt

Deferred revenues

Long-term liabilities

Notes payable

Bonds payables

Mortgage payable

Equity

Contributed capital

Retained earnings

Balance Sheet Classifications

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The Relationships between the Financial Statements

Balance Sheet12/31/03

Assets

Cash

Other current assets


Long-lived assetsIntangible assets

Liabilities and

Stockholders Equity

Current liabilities


Contributed capitalRetained earnings

Balance Sheet12/31/04

Assets

Cash

Other current assets


Long-lived assets

Intangible assets

Liabilities and

Stockholders Equity

Current liabilities


Contributed capitalRetained earnings

Statement of Cash Flows1/1/0412/31/04

Net cash flow from operating activities

Net cash used by investing activitiesNet cash provided by financing activities

Change in cash balance

Beginning cash balance (12/31/03)

Ending cash balance (12/31/04)

Income Statement1/1/0412/31/04

Revenues

Expenses

= Net income

Statement of Retained Earnings

1/1/0412/31/04Beginning retained earnings balance

+ Net income

Dividends

Ending retained earnings balance

FM-3-06 (1)

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