FINANCIAL STATEMENTS, CASH FLOW, TAXES

I. BALANCE SHEET

The balance sheet is a snap-shot of the condition of the firm at the close of business on the
last day of the fiscal year. We should keep in mind that some firms will "dress up" the
balance sheet prior to reporting results to stockholders. The most important use of the B/S is
the information it provides on how the firm financed its asset structure, and the distribution
of that investment in current and fixed assets.

Long-Term Assets

(Left-hand side)

1. Gross Fixed Asset

Current Assets
2. -Accumulated
Depreciation
1. Cash

3. N
2. Marketable Securities e
t

3. Accounts Receivable f
i
x
4. Inventory
e
d
5. Prepaid expenses a
s
s
Total Current Assets
e
t
s
 Other Assets

(Right-hand side)
1. Patents, copyrights

Current Liabilities
2. Goodwill

3. Stock in other cos. 1. Accounts payable

4. _________________ 2. Notes payable (bank loans)

Total Assets 3. Accrued expenses

4. Current portion of l-t debt

________________________

Total Current Liabilities

Long term Liabilities

1. Long term debt (bonds)

2. Deferred taxes

Stockholders' Equity
1. Preferred stock (if issued)

4. Retained earnings
2. Common stock (outstanding)

Total Liabilities & Equity

3. Paid-in-capital

Stockholders' equity is a frequent source of confusion. The common stock account represents the
number of shares outstanding times the par value of the stock. Paid-in-capital or "capital surplus"
or "paid-in surplus" represents the amount above the par value at which the stock was sold; i.e., a
stock with a par value of $1 may have been sold originally for $10. In that case, we would have
$1 in common, and $9 in paid-in capital for each share sold. We can use these two accounts to
determine the average price for which company shares were sold. Preferred stock is an equity
investment. However, from the point of view of the common stockholder, the residual owner of
the firm, preferred is viewed very much like long-term debt.

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II. INCOME STATEMENT (PROFIT & LOSS)

The income statement is a flows statement. Net Sales are sales revenues net of allowances for
returns and adjustments. The cost of goods sold captures the impact of labor and materials costs.
Selling costs include all the cost associated with selling. Administrative expenses reflect the cost
of the corporate staff. General expenses are items like rent, phone bills, etc. Depreciation
expenses are an important means for sheltering cash flow from the tax collector. In theory,
depreciation expenses recognize the wearing out of assets over their economic life. Empirically,
depreciation is an important as a strategy for managing cash flow. Interest expenses record how
much the company paid in interest on borrowed funds. Interest income reflects funds earned via
investing in short-term fixed income securities (mostly t-bills). Taxes include federal, state, and
foreign.

Net Sales (gross sales minus allow for returns.)

minus Cost of Goods Sold (direct labor, materials, o/h burden.) (COGS)

= Gross profit (contribution to overhead expenses.)

minus Selling, Administrative, and General expenses (SGA)

= Operating Income before depreciation, etc. (EBITDA) minus

Depreciation/Depletion/Amortization of goodwill, etc.

= Net Operating Income (EBIT = earnings before interest and taxes.)

minus Interest Expense (cost of borrowed funds.)

plus Interest Income (interest earned on s-t investments.)

 = Earnings Before Taxes. (EBT)

minus Taxes (includes federal, state, and foreign taxes.)

= Net Income before extraordinary items and discontinued operations

Earnings per share (EPS) =Net Income Shares Outstanding

± Charges for Extraordinary Items, Discontinued Operations1

= Net Income Including Extra. Items and Discontinued Operations

minus Preferred Stock Dividends (if preferred stock is issued).

= Earnings Available For Common Stockholders.

minus Cash Dividends To Common Stockholders (if paid).

= Retained Earnings (reinvested in the business)

Firms sometimes sell unneeded assets or close obsolete facilities. They take charges against current
revenues to reflect the impact on these decisions on corporate assets and cash flows. They are
always net of tax effects.

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 1. Earnings Per Share (EPS);

a. Primary EPS; before potential dilution of ownership.

b. Fully Diluted EPS;

III. STATEMENT OF CASH FLOWS (INDIRECT METHOD)

Up until 1986, corporations generated a sources and uses statement. Sources

were increases in liability accounts (RHS) or decreases in asset accounts (LHS);
uses were increases in asset accounts (LHS) or decreases in liability accounts. No
real distinctions were made as to whether funds were generated by operating
activities, financing activities, or investing activities. FASB #95 addressed that
distinction. The differences are important; they tell us where the cash is really
coming from and where it is going.

A. Cash Flows from Operating Activities;

1. Net income; what's left after expenses and taxes.

2. Adjustments to determine operating cash flows;

a. + Depreciation expense; (a non-cash expense)

b. - Increases in current asset accounts.

+ Decreases in current asset accounts.

c. + Increases in current liability accounts.

 - Decreases in current liability accounts.

3. Net Cash Flows from Operating Activities

4. B. Cash Flows from Investing Activities;

1. - Increases in investments (buying securities).

+ Decreases in investments (selling securities).

+ Interest/dividends received from investments.

Firms frequently hold the securities of other firms as investments OR they may be acquiring
another firm's stock in preparation for a merger or acquisition attempt. These investments
are different from the short term investments made to optimize the presence of excess cash
balances in the business.

2. - Increases in plant, property, and equipment (PP&E).

+ Decreases in plant, property, and equipment.

Firms invest most of their capital in new or additional plant, property, and
equipment. Increases in PP&E represent outflows; sales of PP&E are inflows.

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 3. Net Cash Flows from Investing Activities

4. C. Cash Flows from Financing Activities (obtaining capital);

1. + Increase in bonds outstanding (selling bonds).

- Decrease in bonds outstanding (retiring bonds).

2. - Payments of interest on bonds sold by the firm.

3. + Increases in common stock (selling common shares).

- Decreases in preferred and/or common stock (buying back co. shares).

- Payment of dividends on preferred and/or common stock.

4. Net Cash Flows from Financing Activities

5. D. Total Cash Flows (= net change in Cash Balance)

TCF = Algebraic sum of the net flows from operations, investing, and
financing.

IV. ACCOUNTING INCOME VERSUS CASH FLOW

A. Firm Value and Cash Flow Relationship;

1. Value as a function of cash flow

 2. Cash flow volatility and riskiness of the firm

3. Maximization of value maximizing cash flow while minimizing volatility

B. B. Role of Depreciation.

1. Recognition of economic wear and tear

2. Important Tax Shield

3. Driving force behind Capital Maintenance

a. Firms must maintain the quality of their productive assets.

b. Failure to maintain quality results in increased operating costs.

C. Operating versus Non-Operating Cash Flow Cycle

1. Operating: Cash to Inventory to Accounts Receivable to Cash etc.

2. Non-operating: Capital investments, capital servicing,

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V. OTHER ANNUAL REPORT ITEMS

A. Net Worth, Book Values;

Net worth is a method for assessing the net value of the firm. The notion is simply to
assume sale of the company's assets at book value and retirement of the firm's debt at
the same. What is left is the net worth of the company. This calculation is typically
done on a per [common] share basis. The usual term for this is book value (per share).
The most important use of book value is to compare it to the market valuation of the
firm's common stock.

1. Net worth = total assets - total liabilities.

a. Common stockholders consider preferred like debt.

b. Liabilities = total debt plus preferred stock.

2. Book value = net worth number of shares outstanding. B.

Marginal versus Average Tax Rates

3. Marginal rate; rate paid on the last dollar of income.

4. Average rate = Total taxes paid earnings before taxes.

STATEMENT OF CASH FLOWS

(IAS 7)

1. Learning objectives

 Describe the scope of IAS 7

 Segregate the cash sources and applications by operating, investing and financing
activities
 Earmark disclosure requirements
 use of indirect method

2. Meaning of cash

Cash means cash on hand and demand deposits

Cash equivalents means short term highly liquid investments easily convertible to cash

3. Purpose of statement of cash flows is to trace inflows and outflows of cash and its equivalent
to reconcile the cash position.

4. Format of cash flows

5. Segregation of sources and applications of cash

 Operating activities
Principal revenue generating other than investing and financing
  Investing activities
Acquisition and disposal of fixed assets and other investments, other than cash and
equivalents
 Financing activities
Changes in equity and long-term debt

6. There are two approaches

 Direct method
 Indirect method

Both methods are allowed in the reporting.

However direct method requires use of ledgers and trial balance

7. Indirect method on the cash flow from operating activities:

Net profit

Adjustments

Add depreciation (non-cash item)

Add increase in provision for bad debts

Changes in current assets

 Inventory
 Receivables
 Prepayments

Changes in current liabilities

 Payables
 Accruals

Sources from operating activities

7. Example 1
 Ksh
31.12.2017 31.12.2018 ∆
Property, plant and 1,000 1,100
equipment
Receivables 100 50
Inventory 300 550
Cash 200 100
Total assets 1,600 1,800
Equity 500 600
Liabilities 300 350
Payables 200 100
Bank loan 600 750
1,600 1,800

Required:

Establish the changes in cash.

Reconcile it.
8. Format of statement of cash flows( indirect method)

Xyz

Statement of cash flows

For the year ended 31 December, 2018

Cash from operating activities

Net profit

Adjustments:

Depreciation xx

Increase/decrease in current assets xx

Increase/decrease in current liabilities xx

Net cash from operating activities xx

Cash from investing activities

Purchase of fixed assets xx

Disposal of fixed assets xx

Acquisition of investments xx

Retirement of investments xx

Net cash from investing activities

Cash from financing activities

Increase in equity (sale of additional shares) xx

Acquisition of long-term debt xx

Retirement of long-term debt xx

Payment of dividends xx

Payment of taxes xx

Net cash from financing activities xx

Add cash at beginning xx

Cash at end. xx