The subject of financial accounting & reporting:

The 3 basic business activities

Financial Management Winter 2005 1 February to 3 March

Businesses are like Fruit Trees

Fruit

Operating Activities

Net Earnings

Goods & Services

Investing Activities

Reinvested

Investment in Producing Assets

Branches Trunk &

Debt Payment
Financing Activities Dividends

Debt Financing Equity Financing

Roots

Financial Management Winter 2005 1 February to 3 March

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.
2. 3.

Reinvested in the producing assets

Returned to the creditors in the form of debt payments Returned to the owners in the form of dividends Financial Management Winter 2005 1 February to 3 March

The three basic activities of businesses and their financial flows:

Financial boundaries of the corporation Operating costs Operating activities Operating revenues

Purchase of assets

Investing activities

Sale of assets

Dividends, debt payments

Financing activities

Equity, debt

Financial Management Winter 2005 1 February to 3 March

The three basic activities of businesses and their environmental flows:

Environmental boundaries of the corporation

Economic goods & services Raw materials Energy

Operating activities

Economic goods & services

Emissions to air Emissions to water

Land, etc.

Investing activities

Solid waste

Financing activities

Financial Management Winter 2005 1 February to 3 March

The 4 Financial Statements:

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?

Financial Management Winter 2005 1 February to 3 March

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.
Financial Management Winter 2005 1 February to 3 March

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. Financial Management Winter 2005 1 February to 3 March

The three basic activities of businesses and the financial flows of the income statement:
Financial boundaries of the corporation Operating costs Operating activities Operating revenues

Purchase of assets

Investing activities

Sale of assets

Dividends, debt payments

Financing activities

Equity, debt

Financial Management Winter 2005 1 February to 3 March

The Statement of Retained Earnings

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

and how much has been paid out to the shareholders.

Beginning retained earnings balance + Net Income

Dividends
= Ending retained earnings balance

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).

Financial Management Winter 2005 1 February to 3 March

The three basic activities of businesses and the financial flows of the statement of retained earnings:
Financial boundaries of the corporation Operating costs Operating activities Operating revenues

Purchase of assets

Investing activities

Sale of assets

Dividends

Financing activities

Equity, debt

Financial Management Winter 2005 1 February to 3 March

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. Financial Management Winter 2005 1 February to 3 March

The three basic activities of businesses and the financial flows of the statement of cash flows:
Financial boundaries of the corporation Operating costs (Cash flows only) Operating activities Operating revenues (Cash flows only)

Purchase of assets (Cash flows only)

Investing activities

Sale of assets

(Cash flows only)

Dividends, debt payments (Cash flows only)

Financing activities

Equity, debt (Cash flows only)

Financial Management Winter 2005 1 February to 3 March

The Balance Sheet

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. Financial Management Winter 2005 1 February to 3 March

Balance Sheet Classifications 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

Financial Management Winter 2005 1 February to 3 March

The Relationships between the Financial Statements

Statement of Cash Flows1/1/0412/31/04 Net cash flow from operating activities Net cash used by investing activities Net 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 1/1/0412/31/04 Beginning retained earnings balance + Net income Dividends Ending retained earnings balance

Balance Sheet12/31/03 Assets Cash Other current assets Long-term investments Long-lived assets Intangible assets Liabilities and Stockholders Equity Current liabilities Long-term liabilities Contributed capital Retained earnings

Balance Sheet12/31/04 Assets Cash Other current assets Long-term investments Long-lived assets Intangible assets Liabilities and Stockholders Equity Current liabilities Long-term liabilities Contributed capital Retained earnings

Financial Management Winter 2005 1 February to 3 March