The subject of financial accounting & reporting:

The 3 basic business activities

Financial Management – Winter 2005 – 1 February to 3 March

 Fruit
Businesses are like Fruit Trees…

Net Goods &

Earnings Services
Operating
Activities

Reinvested Investment
Investing in Producing Branches
Activities Assets Trunk &

Debt
Payment Debt
Financing Financing
Activities Roots
Dividends Equity
Financing

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. 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

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 revenues

Operating
activities

Purchase of assets Investing Sale of assets

activities

Dividends, debt payments Financing Equity, debt

activities

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 Operating Economic

goods & services activities goods & services

Raw materials Emissions to air

Energy Emissions to water

Investing
Land, etc. 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 revenues

Operating
activities

Purchase of assets Investing Sale of assets

activities

Dividends, debt payments Financing Equity, debt

activities

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 revenues

Operating
activities

Purchase of assets Investing Sale of assets

activities

Dividends Financing Equity, debt

activities

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
company’s cash account. (Note that accounting flows are not necessarily cash flows)

Operating activities + Cash collection

Investing activities
Financing activities
(1) + (2) + (3) = Increase (decrease) in cash balance
− Cash paid
= Net cash increase (decrease) from operating activities (1)
− Purchases of securities or property
+ Sales of securities or property
= Net cash increase (decrease) from investing activities (2)
+ raised capital from issuing equity or entering debt
− Dividends or debt payments
= Net cash increase (decrease) from financing activities (3)
+ Beginning cash balance
= Ending cash balance

The cash balance provides important information on a company’s 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 Operating revenues

Operating
(Cash flows only) activities (Cash flows only)

Purchase of assets Investing Sale of assets

activities
(Cash flows only) (Cash flows only)

Dividends, debt payments Financing Equity, debt

activities
(Cash flows only) (Cash flows only)

Financial Management – Winter 2005 – 1 February to 3 March

 The Balance Sheet
The balance sheet provides a picture of the company’s financial situation at one point
in time. It is based on the fundamental accounting equation:

Assets = Liabilities + Equity

The shareholders own the company. It’s 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 firm’s 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 Liabilities

•Current assets •Current liabilities

• Cash • Accounts payable
• Short-term investments • Other payables
• Accounts receivable • Current maturities of long-term debt
• Inventory • Deferred revenues
• Prepaid expenses
• Long-term liabilities
• Long-term investments • Notes payable
• Notes receivable • Bonds payables
• Land • Mortgage payable
• Debt securities
• Equity securities Equity

• Property, plant equipment • Contributed capital

• Intangible assets • Retained earnings

Financial Management – Winter 2005 – 1 February to 3 March

 The Relationships between the Financial Statements

Statement of Cash Flows–1/1/04–12/31/04

Net cash flow from operating activities
Balance Sheet–12/31/03 Net cash used by investing activities Balance Sheet–12/31/04
Net cash provided by financing activities
Assets Change in cash balance Assets
Cash Beginning cash balance (12/31/03) Cash
Other current assets Ending cash balance (12/31/04) Other current assets
Long-term investments Long-term investments
Long-lived assets Long-lived assets
Income Statement–1/1/04–12/31/04
Intangible assets Intangible assets
Revenues
Liabilities and − Expenses Liabilities and
Stockholders’ Equity = Net income Stockholders’ Equity
Current liabilities Current liabilities
Long-term liabilities Long-term liabilities
Statement of Retained Earnings
Contributed capital 1/1/04–12/31/04 Contributed capital
Retained earnings Beginning retained earnings balance Retained earnings
+ Net income
− Dividends
Ending retained earnings balance

Financial Management – Winter 2005 – 1 February to 3 March