Financial Management

Lecture 03

By: Noor ul hadi (Lecturer)Govt College of Management Sciences

Peshawar

Brief History of Accounting and Financial Statement

Thousand years ago, individuals were self-contained in sense that they gathered their own food, made their own cloths, built their own shelters.

Then specialization began, barter system took place.

Money introduced by traders.Business started loans, lenders could

physically inspect assets.

The Annual ReportThe annual report is the most important reports issues

to shareholders. Two types of information are given in this reports.

First, the verbal section contain chairman letter, firms operation, new development plan, and business operation.

Secondly annual report presents four basic type of financial statements that are:1. Balance sheet, 2. Income statement, 3. Statement of Retain Earning4. Cash flow Statement.

The Annual Report• Balance sheet – provides a snapshot of a firm’s

financial position at one point in time.• Income statement – summarizes a firm’s

revenues and expenses over a given period of time.

• Statement of retained earnings – shows how much of the firm’s earnings were retained, rather than paid out as dividends.

• Statement of cash flows – reports the impact of a firm’s activities on cash flows over a given period of time.

Balance SheetIt provides a snapshot of a firm’s financial position at

one point in time.Important Points of Balance sheet:1. Cash versus other assets:• All assets are in term of dollars, only cash is actual money.• Some marketable securities have short time maturity which can be

quickly converted to cash, are also called cash equivalents.• Some securities have long life and its price can not be predictable,

are called short term investment.• Receivables are bills other owes.• Inventories show the dollars invested in raw-material, WIP and

finished goods available for sale. • Fixed Asset shows money invested for long time which need time to

convert into cash.

Balance sheet

• Liabilities versus stockholder equity.Claim against asset are of two type ie. Stockholder

equity and liabilities.1. Stockholders’ equity: (the owners of the co)It is also know known common stock holder equity,

(CSE)CSE= Assets – Liabilities – Prefer stock Decline in assets effect decline in CSE, Bad debt

effect on AR. Depreciation on Fixed asset etc1. Liabilities. (top priority to compensate in case

of insolvency.)

Balance Sheet

Prefer vs Common Stock

Prefer is hybrid type stock or cross between common stock and debt.

Equity refer to common stock.

2nd priority to compensate after liabilities is given to prefer stock in case of insolvency

Balance Sheet

Break off the common equity:Equity section is divided in two accounts.1. Common stock2. Retain earnings. Retain earning account is

built up over time as a firm save a part of earning.

Stockholder want to know sources of earning either by sale or by other sources.

Creditors less concern of sources of equity and only interested in total equity.

Balance Sheet

Inventory Accounting:Using FIFO and LIFOInflation impact on inventory1. Balance sheet inventory are higher than if

used LIFO2. Cost of goods sold lower3. Fluctuation in Higher profit.MicroDrive uses the FIFO method with $615

million of inventory in 2000. when switch to LIFO in 2001 inventory become $585 Billion which reduce earning by 18 millions.

Depreciation Method.

Financial Statements are prepare for two purposes i.e. for stockholder and tax purposes.

Accelerated method for tax purposes.

And straight line method to stockholders.

The time demission

• At a point in time

• Balance sheet vary at different point of time.

• Cash and current assets are frequently changes.

• Inventory depend on season

• Fixed assets change with depreciation and accumulative depreciation.

Income statement

Summarizes a firm’s revenues and expenses over a given period of time.

• Net Sale is always sale at the top.

• Various costs are subtracted to obtain income.

• Cost include operating cost, interest cost and taxes.

Income Statement

• Bottom line of income statement is Earning per Share. (EPS) which is most important tool to analysis the company’s earning.

• Net Income vs Comprehensive Income.• Comprehensive income = Net income+

unrealized gain or loss.**• ** Marketable security value increase or

decrease.Micro-Drive 2000 EPS $2.36 which reduce to

$2.27 in 2001But dividend raised from $1.06 to $1.15

Income Statement

• Depreciation and Amortization are similar and present allocation of costs of assets over their useful lives.

• It is charged annually, Depreciation is charged on Tangible assets. Amortization is charged on intangible assets such as patents, copyrights, trademark and goodwill.

Income Statement

• EBITDA, is refer to Earning before interest, taxes, depreciation and amortization. And net income is usually refer when interest, tax, depreciation and amortization is deducted, and more concisely net income in corporation refer to EBITDA – preferred dividend

Income Statement

Earning Per Share (EPS) =

Net Income / Common share outstanding

=113500000/50,00,000

= $2.27

Income Statement

Dividends per Share DPS=

=Dividend paid to common stock holder /

common share outstanding

=57500000/50000000

=1.15

Income Statement

Book value per Share

= Total common equity / common shares outstanding

=896000000/50000000

=17.92

Income statement

Cash flow per share=

=(Net income + depreciation + amortization)/ common share outstanding

=213500000/50000000

=4.27

Statement of Retained Earning.

The statement of retained earning shows the change in retained earnings between balance sheet data, Retained earning represent a claim against assets that is not divided in share holders.

The retained earning in balance sheet do not shows cash and are not available for the payment of dividend.

Retained earnings are kept to reinvesting purpose to expand the business.

Net Cash Flow

Net Cash-flow refers to business’s net cash flow generated in one financial period.

It is differs from accounting profit because of the revenues and expenses listed on the income statement were not paid in cash during the year not received.

Net Cashflow = Net Income – NonCashRevenue +Non Cash charges.

Net Cash flow.

Noncash charges are depreciation and amortization. These items reduce the net income.

Depreciation and amortization are noncash chares, so they must be added back to net income to obtain net cash flow.

Statement of Cash flow.

The statement of cash flows reports the effect of operating, investing, and financing activates on cash flows over an accounting period.

It is different from the profit, the company profit may be higher than its cash (showing as an asset in balance sheet at the end of year). The reason is this that companies don’t keep all income as cash but used in variety of ways. Such as dividend, inventory, account receivable etc.

Statement of Cash flow

Cash position may be effected by

1. Net IncomeNet income increase cash flow if it is not utilizes

for other sources.

2. NonCash Adjustment to net income.• Adjustment of NonCash charges such as

depreciation and amortization.

Statement of Cash flow (con’t)

Cash position may be effected by

3. Changes in working capital

Increase in current assets other than cash decrease cash. And decrease in current assets increase cash.

Increase in current liabilities increase cash whereas decrease in current liabilities decrease cash.

Statement of Cash flow (con’t)

Cash position may be effected by

4. Fixed Assets

Investment in fixed asset will reduce the company cash position, and sells of fixed asset increase cash flow.

Purchase of fixed assets decrease cash flow and sell of fixed asset increase cash flow.

Statement of Cash flow (con’t)

Cash position may be effected by

5. Security Transactions.

If a company issues stock or bonds during the year, the fund raised will increase its cash position. On the other hand, if the company uses cash to by back outstanding stock or to pay off debt, or it pays dividend will reduce cash.

Statement of Cash flow Factors effecting Cash position are categories below:

Activities of Cash Flow

Operating Activities Investment Activities Financing Activities

Categories of Cash flow Activities1. Operating Activities.

• Operating Activities includes net income, depreciation and changes in current assets and current liabilities other than cash, short term investment and short term debt.

2. Investment Activities.• Which includes investments in or sales of fixed asset.

3. Financing Activities.• It includes raising cash by selling short-term

investment or by issuing short term debt, long term debt, or stock. Payment of dividend and buy back outstanding share or bond reduces company cash.

MicroDrive Statement of Cash Flow 2001 (Millions of Dollar)

Operating Activities

Net Income 117.50

Adjustment:

Non-Cash Adjustment:

Depreciation 100.00

Due to changes in net working capital

Increase in Account receivable (60.00)

Increase in inventory (200.00)

increase in Account payable 30.00

increase in Accruals 10.00

Net cash provided by operating activities (2.50)

Long term investing Activities

Cash used to acquire fixed assets (230.00)

Financial Activities

Sale of short term investment 65.00

Increase in note payable 50.00

increase in bonds outstanding 174.00

payment of dividend (61.50)

Net cash provided by financing activities 227.50

Net change (5.00)

Cash at beginning of the years 15.00

Cash at the end of year 10.00