Lesson 1: Balance Sheet, Income Statement and Statement of Cash Flows

BALANCE SHEET
Balance sheet (or the Statement of Financial Position) is
like a snapshot of the corporation as it shows the balance
of its assets liabilities and equity at a given point in
time.  The example above shows the balance of the
assets, liabilities and equity of Jones Consulting Group
as of December 31, 2013 only.
The left side of the balance sheet contains all the
company's resources called assets. Assets are classified
as current when it is expected to be realized within one
year, otherwise, it will be classified as noncurrent. 
While on the right side you will see where the assets
came from, either from borrowings (liabilities) or from
the equity of the owners. Liabilities are classified as
current when it is expected to be paid within one year,
otherwise, it is will be classified as noncurrent.  The
difference between total assets and total liabilities is the
residual interest in the firm called the stockholder's
equity.

NET WORKING CAPITAL

Net working capital is the difference between a firm's current assets and its current liabilities or:
Net working capital = current assets - current liabilities
A positive net working capital is an indication of a healthy firm. It means that the company has
sufficient funds to meet its current financial obligations and invest in other activities. 
 
INCOME STATEMENT

If the balance sheet is like a snapshot of the corporation, the income statement on the other hand
is like a video because it shows the financial performance of the company over a period of
time. Take note of the headings of these two financial statements and you will notice that the
balance sheet used the phrase as of December 31 while the income statement  used the
phrase for the year ending December 31. That is why the balance sheet is like a snapshot
because it reports the balances of assets, liabilities and equity as of that date only. While the
income statement reports the financial performance for the year that ended on December 31,
meaning from January 1 up to December 31.

The first thing reported on an income

statement would usually be revenue and
expenses from the firm’s principal operations.
Subsequent parts include, among other things,
financing expenses such as interest paid. Taxes
paid are reported separately. The last item is
net income (the so-called bottom line). Net income is often expressed on a per-share basis and
called earnings per share (EPS).
 
STATEMENT OF CASH FLOW

One of the several principles in finance is "Cash is King".  Management's goal is to maximize the
value of the firm's stock and the value of any asset is based on cash flows the asset is expected to
produce and not income. 
To better illustrate this principle, assume that you are in the automobile business. Usually, before
any vehicle can be bought by installment, strict credit investigation is being implemented to
ensure that the customer is capable of paying. But by laxing this credit process or having no
credit policy at all, the company will surely boost its sales and therefore its income. But does it
also boosts the company's value? The answer is no. Even though income is high, the cash that are
expected to flow to the company from their inventories and receivables is low and thus, will just
force the company to recognize losses in the future. So in finance, income alone does not
measure value but the cash flows that are expected to be produced by the company's assets. 

Statement of Cash Flows - is a financial

statement that shows how much cash the firm
is generating. It also shows how items that
affect the balance sheet and income statement
affect the firm's cash flows.
PREPARING THE STATEMENT OF
CASH FLOWS USING THE INDIRECT
METHOD
To illustrate how to prepare financial
statements using the indirect method, we will
use the following balance sheet and income
statement of ABC Company:

 Steps in Preparing the Statement

of Cash Flows using the Indirect
Method:
1. Begin by adding back to net
income all non-cash expenses such
as depreciation and amortization.
Non-cash item - expenses charged
against revenues that do not directly
affect cash flow. Non-cash items such
as depreciation and amortization are added back to the net income because it reduces the net
income without actual decrease in cash. Remember that for a financial manager, it is the actual
timing of cash inflows and outflows that is critical and non-cash items in the income statement
are the primary reason why accounting income differs from cash flow.
2. Trace the changes of each accounts (except cash) in the balance sheet and determine its
effect to cash.
Using the information on ABC Company, Inc.'s balance sheet, we determine the changes on each
account as follows:

After computing for the

changes of each account,
we shall determine the
effect of these changes to
balance sheet. 
a. Increase in accounts
receivable - If ABC
chooses to sell on credit
when it makes a sale, it will not immediately get the cash that it would have received when it
sells in cash.  To stay in business, it must replace the inventory that it sold on credit, but it won't
yet have received cash from the credit sale. So if the firm's accounts receivable increase, this will
amount to a use of cash (negative cash flow). On the opposite, if the firm's receivable decrease,
this would be shown as a positive cash flow.
b. Increase in inventories - To make or buy inventory items, the firm must use cash. It may
receive some of this cash as loans from its suppliers and workers (payables and accruals), but
ultimately, any increase in inventories requires cash. So if the firm's inventories increase, this
will amount to a use of cash (negative cash flow) and vice versa.
c. Increase in property, plant and equipment -net - the net increase in property, plant and
equipment is 130,000. However, take note that this is net of depreciation which is a non-cash
item. We can make a T-account to determine how much cash was actually used to purchase
additional property, plant
and equipment.
Therefore, the actual
amount of cash used to
purchase additional
property, plant and
equipment is 230,000. 

d. Increase in trade and other payable - trade and other payables represent borrowings from
suppliers. ABC Company, Inc.  Bought goods on credit, and its payables increased by 30,000
this year. That is equivalent to 30,000 increase in cash on line. If ABC had reduced its
receivables, what would have required the use of cash. 
e. Increase in accrued expense - the same logic as with trade and other payables. The increase in
accrued expense will also increase the available cash.
f. Increase in notes payable - ABC's notes payable increased by 50,000. It means it borrowed an
additional 50,000 this year which increases cash.
g. Increase in long-term bonds - the same logic as notes payable. Increase in long-term bonds
means that the company borrowed during the year and therefore increases cash.
h. Increase in retained earnings - ABC's
balance sheet shows that there is an increase
in retained earnings of only 60,000. But you
will also notice that the net income is
117,500 so why is there only 60,000 increase
in retained earnings? It means that the
company actually paid the difference
of 57,500 as dividends as illustrated in the T-
account below.

So in relation to the retained earnings, the decrease in cash is 57,500.

To better understand, here is a summary of the rules in determining the effects in cash of the
changes in the different balance sheet accounts (except cash):
1. Increases in assets will result in decrease in cash and vice versa.
2. Increase in liabilities or equity will result to increase in cash and vice versa.
3. Non-cash items should
always be considered.
Presented below is the
summary of the effects of
changes of the different
balance sheet accounts to
cash:
3. Classify the identified
changes in cash into
operating, investing or
financing activities.
The statement of cash
flows is divided into three sections, as follows:
 Operating Activities - this section deals with items that occur as part of normal ongoing
operations.
 Investing Activities - all activities involving long-term assets. It also includes the
purchase and sale of short-term investments, other than trading securities and lending and
collecting on notes receivables.
 Financing Activities - include transactions involving long-term debt, equity and
dividends.

4. Prepare the Statement of Cash Flow.

 After doing steps 1-3, you now have the complete data to
prepare the Statement of Cash Flows.  The Statement of
Cash Flow for ABC Company, Inc. for the year ended
December 31, 2019 is shown below:
Notice that the cash at end of year to be shown at the
bottom line of the Statement of Cash Flow should tally
the Cash and Cash Equivalents account in the current
year Balance Sheet. 
By looking at the Statement of Cash Flow, you can see
that the company raised huge amount of cash through its
financing activities specifically through borrowings.
However, huge amount were also spent to buy properties
and equipment and to pay dividends to stockholders. The
operations of the company should improve since it
generated a negative cash flow which forced the company
to borrow money and resulted to a decrease in cash for
the period.