CHAPTER 2 FIRM’S FINANCIAL STATEMENT INFORMATION

AND CASH FLOW STATEMENT

Firm’s financial information A firm’s financial information refers to

results of business operation within a specific time period, state in monotery terms and used by both internal and external parties.

The time period for the financial information normally covers from six months to one year of firm business operations.

Example of external parties who use this financial information are:Potential investors and firm shareholdersLenderTax authorities

The internal parties in this case are the firm’s managers themselves. They need the information to see how effectively their firm is being run.

By analyzing the given information, managers could:Detect any deviation between the firm’s

forecasted sales and actual sales of the firm or between the forecasted overhead and actual overhead.

Study those result shown to pinpoint relative strenght and weakness in operation.

Sources of financial information on companies in Malaysia

1. Annual report

2. KLSE handbook

3. KLSE daily diary- Company’s share price

The most widely used source of financial information is the firm’s annual report .

A firm annual report prepared for the shareholder presents two important types of information

1. The 1st is a verbal statement of the company’s recent operating results and its expectations for the coming year.

2. 2nd is the quantitative financial statement parts which report what actually happened to the firm’s financial position, earning, and dividends over the past few years

Presentation of Financial Information The financial information is generally

presented in three forms of reports.1. Profit and loss statement

2. Balance sheet statement

3. Cash flow statement

Each report is audited by external auditors to ensure its completeness and accountability.

Azmi CompanyProfit and Lost StatementFor the period ended 31/12/2002

SalesCost of good sold

RM 10,000,000 <6,000,000>

Gross Margin 4,000,000

ExpenseDepreciation

<1,600,000> <500,000>

Earning before interest and taxesInterest expense

1,900,000 <4,000,000>

Earning before taxTax

1,500,000 <500,000>

Net income RM 1,000,000

Profit and loss statement

The profit and lost statement summarizes the firm’s revenue and expenses over a period of time.

It also gives an indication on how much profit the company has earned during a year (sometime 6 months) of accounting period from its operations.

This value is available once firm’s expenses have been subtracted from the firm’s revenue.

Items on the profit and loss statement

Different methods, such as First in First Out (FIFO) and Last in Last Out (LIFO), can be used to determine the value of ending invetoy

This methods, in turn, affect the reported cost of goods sold and the firm total profit differently.

Example: evaluating ending inventory

Assume a firm makes purchases of an item to be sold every three months. Each purchase consists of 1000 units of goods. Due to rapid inflantonary growth the cost of purchased increases each time. The remaining inventory unsold at the end of the year, was 1000 units.

FIFO method:

LIFO method:

Cost of the ending inventory based on the FIFO method :

1000 units*RM4.00 = RM 4,000

Cost of the ending inventory based on the LIFO method :

1000 units*RM1.00 = RM 1,000

Different method thus give different values of cost of goods sold. In this case, LIFO method of inventory valuation produces higher cost of goods sold value when other factors remain constant.

Balance sheet

This statement shows the firm’s assets and the claims against those assets at a moment in time.

Assets = Liability + Equity

AssetsFirm’s assets are arranged accordingly to their liquidity. Liquidity in this case reflects the time required and the

ease to convert one or a few on the firm’s assets into cash in the event the firm has to generate cash in order to pay off its debt.

The shorter the times it takes and the easier the process of converting those assets, the higher their liquidity.

For instance a firm’s assets such as marketable securities and account payable have higher liquidity level compare to other’s firm assets.

Typically, they ranked second and third behind cash.

A firm’s assets can be divided into two categories:

1. Current assets○ Items expected to become cash within one year.(Shorter

time period)○ Example: Cash, account payable, marketable securities,

and inventory.○ Activities such as selling of inventory, collection of

account receivable from sale made on credit earlier and other firm securities.

Assets Details

Cash Money in the bank’s checking account and foreign currency on hand

Account receivable

Credit sales which have not been paid but are generally expected to be paid soon

Inventory Product held for sale in normal course of doing business.Example: raw materials, work in process, finished goods.

2. Fixed assets○ Assets that are expected to have life, longer

than one year.○ Example: plant machinary, equipment○ At the end of fiscal year, accumulated

depreciation of an asset is subtracted from its fixed cost to give its net books value of the asset.

○ The accumulated depreciation actually represent the total of this year’s depreciation and all the previous year’s depreciation expense.

Liabilities

Liabilities represent company debts or obligations to outsiders.

Can be divided into:○ Long term liability

Longer payback periodConsist of bonds and lon term loans.As the firm uses more debt, the more highly leveraged it

is said to be.

○ Short term liability○ Also known as current liabilities: account payable,

accruals, notes payable,and short term notePayment within one year

EquityEquity represent money that is supplied to the

company by the owners either throuh direct investment or retained earning.

Direct investment in the case of sole proprietorship and joint venture occurs when an owner puts money into a business as starting capital.

On the other hand, direct investment for a corporation occurs when the corporation sells its shares to the public the first time. Such event known as initial public offering (IPO)

Retained earnings come from the profits of a business that are not paid out to owners as dividen. Instead, profit are reinvested back into business. The excess profit is usually used by businesses to acquire assets

Preferred stock is also classified as an equity. It is also instrument that can be used to raise capital.

Preferred stock is included in the balance sheet in the equity section.

Therefore, the total equity is the sum of common stock, preferred stock and retained earning.

Cash flow statement

Statement of cash flows shows the detailed movement of cash in a firm.

The movement is detected by observing where the money came from and what it was used on.

Cash flow statement is constructed from information found in the income statement of the current year and balance sheets from the previous year and the current year.

Asset increase = use of cashPurchase of assets with the firm’s cash.Therefore, this will reduce the firm’s total

cash level

Asset decrese = source of cashSelling of the firm’s asset Generate cash to the firm

Liability increase = source of cashFirm has obtained credit for its purchases or

obtain loan from the financial institutions.There is no cash payment required from the

firm.This will preserved the cash balance for that

period of time.Increase the firm cash reserve.Obtaining loan will increas firm’s cash balance. This because loans are normally given to firm in

cash

Liability decrease = use of cashThe firm has paid all of its credit purchases

made previously or paid off the loan obtained from the financial institutions

Those payment are made of cashThis will reduce the firm’s cash balance.

Developing statement of cash flow To develop a statement of cash flow, it

requires three steps:Determining net cash flow from operating

activitiesDetermining net cash flow from investing

activitiesDetermining net cash flow from financing

actvities

Determining net cash flow from operating activitiesOperating activities are things a company

does on a day to day basis to conduct its business.

Example: buying inventory, producing and selling product, paying expenses and taxes, collecting credit sales.

The end result of all of these activities is reflected by the company net income.

Determining net cash flow from investing activities

Investing activities normally include the purchasing of fixed assets.

Determining net cash flow from financing actvities

Financing activities in general deal with the capital accounts, long term debt and equity.

ABCD Co.Balance Sheet StatementAs at 31/12/2012 (RM)

2001 2002

Cash 1,600 2,000

Account receivable 5,200 12,000

Inventory 15,600 14,000

Fixed assets 20,000 27,000

Accumulate depreciation

<14,400> <16,000>

Total assets 28,000 39,000

Account payable 2,500 3,000

Accrued expenses 1,500 1000

Notes payable-long term

5,000 10,000

Common stock 5,000 5,000

Retained earning 14,000 20,000

Total liabilities and equities

28,000 39,000