CHAPTER 2

FINANCIAL REPORTING AND

ANALYSIS
OBJECTIVES

• Explain and analyze the main items in the

financial statements.
• Identify off-balance-sheet financing
• Discuss the component under the cash flow
statement and free cash flow.
• Describe the link under financial statement and
types of footnote.
INTRODUCTION

• Important things when looking at the financial

statements are dates indicated at the top of the
statements.
• It is particularly critical when you start comparing
results among companies.
• Economic conditions are certainly different, and
the comparison doesn’t give you an accurate
view of how well the companies competed in
similar economic conditions.
Financial Statements
BALANCE SHEET
INCOME STATEMENT
CASH FLOW STATEMENT
TYPES OF FINANCIAL STATEMENT:
(1) BALANCE SHEET

Assets = Liabilities + Shareholders' Equity

• Assets represent the resources that the business owns or

controls at a given point in time. This includes items such
as cash, inventory, machinery and buildings.
• Liabilities represent obligations, which must be paid
back.
• Equity represents the value of money that the owners
have contributed to the business - including retained
earnings, which is the profit made in previous years.
• The balance sheet tells investors a lot about a
company's fundamentals:
– How much debt the company has,
– How much it needs to collect from customers (and how
fast it does so),
– How much cash and its equivalents it possesses and
what kinds of funds the company has generated over
time.
Main Items in the Balance Sheet
• Assets
– Current Assets are resources likely to be used up or
converted into cash within one business cycle - usually
treated as twelve months. Three important current asset
items found on the balance sheet are:
• Cash - Any item of economic value owned by an individual or
corporation, especially that which could be converted to cash.
Examples are cash, securities, accounts receivable, inventory,
• Inventories - The raw materials, work-in-process
goods and completely finished goods that are considered to be the
portion of a business's assets those are ready or will be ready for
sale
 Beginning Inventory 75,000
Purchases 250,000
Plus: Freight-in 10,000
Less: purchase discounts (5,000)
Returns and allowances (15,000)
Net delivered cost of purchases 240,000
Total goods available for sale 315,000
Less: Cost of goods sold (255,000)
Ending inventory 60,000

• Accounts receivables - Money owed by customers (individuals

or corporations) to another entity in exchange for goods or
services that have been delivered or used, but not yet paid for

– Long-term or Non-Current Assets are defined as

resources that not classified as current asset. This
includes items that are fixed assets, such as property,
plant and equipment (PP&E).
• Liabilities
– Current Liabilities are obligations the firm must pay
within a year, such as payments to suppliers. Current
liabilities appear on the company's balance sheet
and include short-term debts, accounts payable,
accrued liabilities and other debts.
– Non-current Liabilities are those obligations of the
business that are not expected to be paid for at least
one year from the date on the balance sheet. Typically,
non-current liabilities represent bank and bondholder
debts.
• Equity

Equity = Total Assets – Total Liabilities

– Equity represents what shareholders own, so it is often called

shareholder's equity. The two important equity items are:
• Paid-in capital is the amount of money shareholders paid for
their shares when the stock was first offered to the public. It
basically represents how much money the firm received when
it sold its shares
• Retained earnings are the money the company has chosen
to reinvest in the business rather than pay to shareholders (in
terms of dividend). Investors should look closely at how a
company puts retained capital to use and how a company
generates a return on it.
• Off-Balance-Sheet Financing
– A form of financing in which large capital expenditures are kept off
of a company's balance sheet through various classification
methods. Companies will often use off-balance-sheet financing to
keep their debt to equity (D/E) and leverage ratios low,
especially if the inclusion of a large expenditure would break
negative debt covenants.

– Contrast to loans, debt and equity, which do appear on the balance

sheet. Examples of off-balance-sheet financing include joint
ventures, research and development partnerships, and
operating leases (rather than purchases of capital equipment).

– Operating leases are one of the most common forms of off-balance-

sheet financing. In these cases, the asset itself is kept on the
lessor's balance sheet, and the lessee reports only the required
rental expense for use of the asset. Generally Accepted Accounting
Principles and IRB have set numerous rules for companies to follow
in determining whether a lease should be capitalized (included on
the balance sheet) or expensed.
 ABC Corp
Comparative Balance Sheet December 31
(RM in millions)

2007 2006

Assets 95.8 80.0

Current assets 227.2 192.4
Cash 103.7 107.5
Receivables 73.6 45.2
Inventories
Other current assets

Total current Assets 500.3 425.1

Noncurrent Assets 771.2 646.6
Gross Property, plant, & equipment (372.5) (379.9)
Accumulated depreciation & depletion 398.7 316.7
Net Property, plant, & equipment 42.2 19.7
Other noncurrent assets

Total Noncurrent assets 440.9 336.4

Total Assets 941.2 761.5
Liabilities and Stockholders’ Equity 114.2 82.4
Current liabilities 174.3 79.3
Account payable 85.5 89.6
Short-term debt
Other current liabilities

Total Current liabilities 374.0 251.3

Noncurrent liabilities 177.8 190.9
Long-term debt 94.9 110.2
Other noncurrent liabilities

Total noncurrent liabilities 272.7 301.1

Total liabilities 646.7 552.4
Stockholders equity 92.6 137.6
Common shares 201.9 71.5
Retained earnings

Total equity 294.5 209.1

Total Liabilities and Stockholders’ equity 941.2 761.5
(2) INCOME STATEMENT

• Income statement measures a company's

performance over a specific time frame
• The income statement presents information about
– Revenues
– Expenses
– Profit
• It also contains the numbers most often
discussed when a company announces its results
- numbers such as revenue, earnings and
earnings per share.
• It also shows:
– how much money the company generated (revenue)
– how much it spent (expenses)
– the difference between the company’s return (profit) over a
certain time period

• Revenue as a signal
Known as sales - represents all the money a company brought in
during a specific time period, although big companies sometimes
break down revenue by business segment or geography.

The best way for a company to improve profitability is by

increasing sales. Consistent sales growth has been a strong
driver of company’s profitability.

The best revenues are those that continue year in and year out.
Temporary increases, such as those that might result from a
short-term promotion, are less valuable and should garner a lower
price-to-earnings multiple for a company.
What is Expenses?

• Two most common are:

– Cost of goods sold (COGS) - the expense most directly involved
in creating revenue. It represents the costs of producing or
purchasing the goods or services sold by the company
For example, if Mydin pays a supplier RM4 for a box of soap, which it sells to customers for
RM5. When it is sold, Mydin’s cost of goods sold for the box of soap would be RM4.

– Selling, general and administrative expenses (SG&A) - marketing,

salaries, utility bills, technology expenses, other general costs
associated with running a business, depreciation and
amortization( a cost of replacing worn out assets), costs of taxes
and interest payments.
What is Profit?

Profits = Revenue - Expenses

• Several commonly used profit subcategories that tell

investors how the company is performing.

Gross Profit = Revenue - COGS

– Gross profit is calculated as revenue minus cost of sales.

Operating Profits = Gross Profit – Operating Expenses

– Operating profit - the profit a company made from its actual

operations, and excludes certain expenses and revenues that
may not be related to its central operations.
What is net income?
• The company's profit after all expenses, including financial
expenses, have been paid.

• Often called the "bottom line" and is generally the figure people
refer to when they use the word "profit" or "earnings".

• When a company has a high profit margin, means that it has more
advantages over its competitors. Companies with high net profit
margins have a bigger cushion to protect themselves during the
hard times.

• Companies with low profit margins can get wiped out in a downturn.

• Companies with profit margins reflecting a competitive advantage

is able to improve their market share during the hard times - leaving
them even better positioned when things improve again.
 ABC Corp
Income statements
Fiscal year ended December 31
(RM in millions)

2007 2006

Net sales 1,938.0 1,766.2

Cost of goods sold 1,128.5 1,034.5

Gross operating profit 809.5 731.7

Selling, administrative, and other 497.7 445.3

operating expenses 77.1 62.1
Depreciation & authorization 0.5 12.9
Other income, net

Earnings before interest & taxes 234.2 237.2

Interest expense 13.4 7.3

Earning before taxes 221.8 229.9

Income taxes 82.1 88.1

Net profit after tax 138.7 116.0

Dividends paid per share
Earnings per share (EPS) 0.15 0.13
Number of common shares 2.26 2.17
outstanding ( in millions) 61.8 65.3
(3) STATEMENT OF CASH FLOW

• Three core activities:

– Cash is raised from the capital suppliers - cash flow
from financing, (CFF)
– Cash is used to buy assets - cash flow from investing
(CFI)
– Cash is used to create a profit - cash flow from
operations (CFO)
 “Natural” Cash Flow Statement
Cash Flow Classifications

Sell Equity Issue Sell Equity Financing

Debt Issue Debt (CFF)
< Pay Dividend >
< Buy Assets >
< Buy Assets > Investing
< Buy Inventory >
(CFI)
Make Sales!
Make Sales! < Buy Inventory >
< Pay Costs > < Pay Costs > Operating
< Pay Taxes > < Pay Taxes > (CFO)
< Pay Interest >
< Pay Dividend >
< Pay Interest >
= NET CASH FLOW
• Statement of cash flows is broken into three sections:
– Cash flow from financing (CFF) includes cash received
(inflow) for the issuance of debt and equity. As expected,
CFF is reduced by dividends paid (outflow).
– Cash flow from investing (CFI) is usually negative because
the biggest portion is the expenditure (outflow) for the
purchase of long-term assets such as plants or machinery.
– Cash flow from operations (CFO) naturally includes cash
collected for sales and cash spent to generate sales. This
includes operating expenses such as salaries, rent and
taxes. But notice two additional items that reduce CFO: cash
paid for inventory and interest paid on debt.

CFF + CFI + CFO = net cash flow.

• A statement of cash flows focuses on the following
cash-related activities:
– Operating Cash Flow (CFO): Cash generated from day-
to-day business operations

– Cash from investing (CFI): Cash used for investing in

assets, as well as the proceeds from the sale of other
businesses, equipment or long-term assets

– Cash from financing (CFF): Cash paid or received from

the issuing and borrowing of funds
IMPORTANT!
• Accrual accounting requires companies to record
revenues and expenses when transactions occur, not
when cash is exchanged. At the same time, the income
statement often includes non-cash revenues or
expenses, which the statement of cash flows does not
include.

• Because it shows how much actual cash a company has

generated, the statement of cash flows is critical to
understanding a company's fundamentals. It shows
how the company is able to pay for its operations and
future growth.
 Cash Flow Statement
Company XYZ
FY Ended 31 Dec 2007
All figures in RM

Cash Flow From Operations

Net earnings 2,000,000

Additional Cash

Depreciation 10,000
Decrease in Accounts Receivable 15,000
Increase in Accounts Payable 15,000
Increase in Taxes Payable 2,000
Subtractions From Cash

Increase in Inventory (30,000)

Net Cash From Operations 2,012,000
Cash Flow From Investing

Equipment (500,000)
Cash Flow From Financing

Notes Payable 10,000

Cash Flow for FY Ended 31 Dec 2007 1,522,000
STATEMENT OF RETAINED
EARNINGS

Below is the example of Statement of Retained Earnings:

 
Statement of Retained Earnings: 2007
Balance of retained earnings,
12/31/2006 203,768
Add: Net income, 2007 95,136
Less: Dividends paid, 2007 (11,000)
Balance of retained earnings,
12/31/2007 97,632
 
FINANCIAL STATEMENT LINKS
• The notes to the financial statements (sometimes called
footnotes) tie up any loose ends and complete the overall
picture of financial statement.

• If the income statement, balance sheet and statement of

cash flows are the heart of the financial statements, then
the footnotes are the arteries that keep everything
connected. Therefore, if you aren't reading the footnotes,
you're missing out on a lot of information.

• The footnotes list important information that could not be

included in the actual ledgers.
• Two types of footnotes:
– Accounting Methods - This type of footnote identifies
and explains the major accounting policies of the
business that the company feels that you should be
aware of.

– Disclosure - provides additional disclosure that simply

could not be put in the financial statements.
• The Auditor's Report -the auditors' job is to express an
opinion on whether the financial statements give a “true
and fair” of the state of affairs of the firm. This is the
purpose behind the auditor's report, which is sometimes
called the "report of independent accountants".

• By law, every company that is registered with the

Company Commission of Malaysia (CCM) must have its
financial statements being audited by an audit firm.

• An auditor's report is meant to scrutinize the company and

identify anything that might undermine the integrity of the
financial statements.
• Auditor's report is almost always broken into
three paragraphs and written in the following
fashion:
Independent Auditor's Report
Paragraph 1
Recounts the responsibilities of the auditor and directors in general and lists the
areas of the financial statements that were audited.

Paragraph 2
Stresses on the use of the generally accepted auditing standards (GAAS),
assesses the generally accepted accounting principles (GAAP) applied and the
overall financial statement presentation.

Paragraph 3
Provides the auditor's opinion on the financial statements of the company being
audited. This is simply an opinion, not a guarantee of accuracy.
How truthful are the accounting
numbers?

• Financial statements are prepared using the approved

accounting standards, in Malaysia, known as Financial
Reporting Standards (FRSs).

• Compliance with FRSs is mandatory as stipulated in the

Companies Act (1965). However, it is not a guarantee that
the financial statements are truthful.

• Because corporate managers who prepare the financial

statements possess inside information which is either “too
private” to be shared with the general public or the
information, if disclosed, would end up in the managers
looking bad.
• Thus, managers have the tendency to “manipulate” the
financial statements either to hide the information or to
make them look good.

• The term that is often used is “earnings management”

because the objective of the manipulation is to make
earnings (or the bottom line) appear to be strong than it
should be without manipulation.