ESSEC Romanian Foundation

Reading Financial Statements

Andrei FILIP (filip@essec.fr)

Financial Accounting and Reporting

1. Understanding the Financial Statements (FS)

2. Oversight of the cash flow statement
3. The SWATCH case

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1 Understanding the Financial Statements (FS)

 A complete set of financial statements is composed of

 A statement of financial position (balance sheet)
 A statement of (comprehensive) income (income statement)
 A statement of changes in equity
 A statement of cash flows
 Notes
 The annual report comprehends the financial statements and
additional information (message from the chairman, organization of
the firm, development of the group, governance, MD&A, interim
reports, etc)

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1 Understanding the Financial Statements (FS)

 Can we be sure that the data is true and fair?

 Forget about being 100% correct !
 Numerous estimations are used
 …and cross the fingers
 Only the financial statements are audited
 The Board of Directors is responsible for the preparation of the
financial statements
 The auditor expresses an opinion on the financial statements:
Auditor’s report
 Who are the auditors?
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1 Understanding the Financial Statements (FS)

Ernst & Young,

PriceWaterhouse,
KPMG, Deloitte, etc.

Andersen…

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1.1 The Balance Sheet

 Explains the financial position of the firm at a certain date

 Asset: a resource from which future economic benefits (f.e.b.)
are expected to flow to the entity (otherwise stated, future inflows
of cash)
 Liability: obligation for the settlement of which an outflow of f.e.b.
is expected to result (otherwise stated, future outflows of cash)
 Equity: the accounting value of the company

Equity = Assets – Liabilities

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1.2 The Income Statement

 Explains the changes in the value of the firm during the period as a
result of operations
 Revenue: increase of e.b. during the period (other than
contributions from the owners)
 Expense: decrease of e.b. during the period (other than
distributions to the owners)

Earnings/Income = Revenues – Expenses

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1.2.1 The Comprehensive Income

 Presented separately or together with the IS

 Comprehensive income =
Net income + Other changes in equity (Dirty Surplus)
Net income Dirty Surplus
BS BS

Gain Gain Gain Gain

IS IS

Gain

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1.2.1 The Comprehensive Income

 Dirty Surplus = Other Comprehensive Income

 changes in revaluation surplus
 actuarial gains and losses on defined benefit plans
 gains and losses arising from translating the financial statements
of a foreign operation
 gains and losses on re-measuring available-for-sale securities
 the effective portion of gains and losses in a cash flow hedge
 The comprehensive income is sometimes called total recognized
income and represents the changes in the value of the firm during
the period as a result of operations

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1.3 The statement of changes in equity

 Explains all the changes in equity (the value of the firm) during the
period
 The statement of changes in equity reconciles the beginning
balance with the ending balance by showing:
 The comprehensive income
 Contributions from the shareholders
 Distributions to the shareholders

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1.3 The statement of changes in equity

Operations in N

Net income N

Equity Equity N-1

end N-1 Retained

Net income N
Equity
Dividends CI end N
Other CI

Net contributions
Shareholders
in N

CI = Comprehensive Income

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1.4 The statement of cash flows

 Explains the changes in the cash and cash equivalents during the
period
 Inflows of cash
 Outflows of cash
Cash Flow = Inflows – Outflows

 Cash equivalents: short term (< 3 months) highly liquid and low risk
instruments

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1.5 The notes to the financial statements

 Comprise a summary of significant accounting policies and other

explanatory information
 Disclose the information required by IFRS that is not presented
elsewhere in the financial statements
 Provide any other information relevant to an understanding of the
financial statements

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Financial Accounting and Reporting

1. Understanding the Financial Statements (FS)

2. Oversight of the cash flow statement
3. The SWATCH case

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2 Oversight of the cash flow statement

 Cash flow presented in 3 categories

 Cash flow from operating activities
 Cash flow from investing activities
 Cash flow from financing activities

 Problems in classifying certain cash flows

 Income tax: operating
 Interests and dividends received: operating or investing
 Interests and dividends paid: operating or financing

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2.1 The operating cash flow

 Presented using
 The direct method
 Or the indirect method
 Direct method (rarely used)
+ Operating cash receipts (cash received from sales, etc)
– Operating cash payments (purchases, wages, taxes… paid)
= Operating cash flow

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2.1 The operating cash flow

 Indirect method: the operating cash flow is obtained by adjusting the

net income
 For this purpose
 Adjustment 1: eliminate non-operating items (financial expenses
and revenues)
 Adjustment 2: eliminate non-cash expenses (depreciation and
provisions) and revenues (reversal of provisions)
 Adjustment 3: take into account changes in working capital

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Adjustment 3
Example of sales Receivables from
Payments received
clients at the beg. of
the period from clients during
the period
(Receipts)
Sales of the period
(Revenue) Receivables from
clients at the end of the
period

Cash inflows = Revenue + Receivables beg. – Receivables end

= Revenue – (Receivables end – Receivables beg.)
= Revenue – Changes in receivables
Same reasoning for all operating assets (inventories, receivables, etc)
and operating liabilities (suppliers)
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Adjustment 3

Operating Operating
assets liabilities
Inventories Suppliers

Receivables from Other short term

clients liabilities

Other short term

receivables Working Capital
(WC)

WC = Operating assets – Operating liabilities

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2.1 The operating cash flow

Net income
– Non operating revenues
+ Non operating expenses Adjustment 1
= Operating income
+ Non cash expenses
– Non cash revenues Adjustment 2
– Changes in working capital Adjustment 3
= Operating cash flow

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2.2 The cash flow statement

Operating cash flow (I)

Receipts from investing activities
– Payments from investing activities
= Cash flow from investing activities (II)
Receipts from financing activities
– Payments from financing activities
= Cash flow from financing activities (III)
Net cash flow (IV = I + II + III)
Cash and cash equivalents at the beginning of the period (CN-1)
Cash and cash equivalents at the end of the period (CN = CN-1 + IV)
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2.3 Understanding the statement of cash flows

A. Change in cash and cash equivalent

B. The operating cash flow
 Internally generated cash
 Changes in working capital
C. The investing cash flow
 The free cash flow
D. The financing cash flow
E. Conclusion

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2.3 Understanding the statement of cash flows

 Internally generated cash = Net income +/- Adjustment 1 and 2

 The ability of the firm to generate “potential” cash
 Independent to earnings management

 Changes in working capital

 Link to the operating activity of the firm
 Increase/decrease of operating assets and liabilities

 The free cash flow = Operating + Investing Cash flow

 The cash flow available for distribution among all the security
holders of the firm

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Financial Accounting and Reporting

1. Understanding the Financial Statements (FS)

2. Oversight of the cash flow statement
3. The SWATCH case

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Swatch Group 2010

CHF Mio. 2010 2009 2008 2007 2006 2005

Sales 6 440 5 421 5 966 5 941 5 050 4 497
Operating profit 1 436 903 1 202 1 236 973 735
Net income 1 080 763 838 1 015 830 621
Equity 7 101 5 981 5 451 5 329 4 967 4 603
Market value 22 537 13 735 7 640 18 331 14 807 10 978

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