FINANCIAL ACCOUNTING

Prof. Francesco Venuti

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Francesco Venuti
Professor of Accounting
ESCP Business School - Turin

Dean EMBA and GMP

Academic Director EMBA/GMP

for Turin and Paris campuses

Academic Director MSc

Food&Beverage Management

 [email protected]

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WELCOME
Today challenges:

• having fun with

accounting

• learning how to read and

interpret financial
statements.
What can we learn from
reading a Company’s
financial statements?

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Suggestions…
• Try to be as much interactive as possible!

• Try to challenge yourself and have fun!

• Focus more on WHY rather than on WHAT and HOW

• Be ready for…. cold calls!

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Today Agenda… a LONG FULL DAY!

How to tell a story?

Introduction to financial statements

Snapshots and movies

The BS and the IS

Cash is king!
Cash Flow Statement

Work tools
Financial Statements Analysis

Focus on some items

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If you want to know more about these
topics:
• Stolowy H., Ding Y., “Financial Accounting and Reporting. A
Global Perspective”, Cengage Learning, last edition available
(good textbook for MBA)

• Anthony R., “Accounting. Text and cases”, McGraw Hill

(not technical, good for the logic)

• KiesoD., Weygandt J., Warfield T., “Intermediate Financial

Accounting – IFRS Edition”, John Wiley & Sons Inc (advanced)

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7
 Accounting
“The provision of Information to managers and owners so that they can make
business decisions.”

“The process of identifying, measuring and communicating economic

Information to permit Informed judgments and decisions by users of the
Information. ”
(American Accounting Association, 1966)

“It is the art of organizing, mantaining, recording and analyzing financial

activities”

“It is the language of business”

“It translates the accounting information into meaningful terms that are used
by the parties involved”

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Accounting and decision making

• The basic purpose of accounting information is to help

decision makers (insider, outsider or any stakeholder).

• DECISION MAKING (choosing from among a set of alternative

actions in order to achieve some objective) drives the
need for accounting information

• Regardless of WHO is making the decision, understanding

accounting information allows for a more INFORMED BASIS
FOR ACTION.

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The role of accounting

Who uses accounting information?

Every organization, profit and nonprofit, requires the services of

accountants in providing accounting information.

Managers To make appropriate decisions

Investors To evaluate the financial status and future
prospects
Bankers To extend credit
Employees and To be informed about the condition of the
customers organization
Government To account for taxes

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 Who uses accounting data?

INTERNAL
USERS

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Who uses accounting data?

EXTERNAL
USERS

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Financial vs. Managerial accounting

Financial Accounting:

• It is systematic knowledge and the art of recording business transaction

in the books of business. It is a basic accounting which helps the persons
to know financial position of business concern. It deals with
bookkeeping, financial statements, accounting principles, etc.

Managerial Accounting:

• It is the process of identifying, measuring, accumulating, analyzing,

preparing, interpreting, and communicating information that managers
use to fulfill organizational objectives. It deals with cost accounting,
decision making, planning, controlling, etc.

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 Financial vs. Managerial accounting
DIMENSION Managerial Accounting Financial Accounting
1. Necessity Optional Required, compulsory

2. Purpose Supporting management decisions Produce financial statements

3. Primary Users Insiders (managers), Outsiders, relatively large group,

relatively small group, known identity mostly unknown

4. Underlying Varies, according to use of the One basic equation: A = L + E;

structure information double-entry method

5. Source of Whatever is useful to management GAAP

principles
6. Time orientation Historical and estimates of the future Historical (past-oriented)

7. Information Monetary and nonmonetary Primarily monetary

content

8. Information Many approximations Fewer approximations

precision

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 Financial vs. Managerial accounting

DIMENSION Managerial Accounting Financial Accounting

9. Report Varies with purpose: weekly and monthly Annually and quarterly, according
frequency are common to the rules
10. Report Reports issued promptly after end of Delay of weeks or even months
timeliness period covered
11. Report entity Responsibility centers Overall organization

12. Liability Virtually none Few lawsuits, but threat is always

potential present

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The role of Financial accounting

The main objective of financial accounting is to

prepare the financial statements
at least once a year

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FINANCIAL STATEMENTS
• General purpose financial statements are intended to
meet the needs of users who are not in a position to
require an entity to prepare reports tailored to their
particular information needs

• Generally speaking, financial statements provide

information about:
1. Financial position
2. Financial performance
3. Cash flows

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REGULATIONS: ACCOUNTING standards

International Accounting Standards Board

(IASB) http://www.iasb.org/

International Financial Reporting Standards

Financial Accounting Standards Board (FASB)

http://www.fasb.org/

Generally Accepted Accounting Principles (US

GAAP)
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Introduction of IFRS in Europe
2000s – Introduction of IAS/IFRS
1990s – More Globalisation – More Need for Comparability
European Union wanted a single set of rules for the most important European
companies: the listed companies

In 2002, they decided to make mandatory the use of the International Accounting
Standards issued by IASB

Reg. 2002/1606 provides that:

• companies governed by the law of a Member State shall prepare their
consolidated accounts in conformity with the IASs adopted if, at their balance
sheet date, their securities are admitted to trading on a regulated market of any
Member State
• Member States may permit or require:
• the European listed companies to prepare their annual accounts, in
conformity with IASs
• Other companies to prepare their consolidated accounts and/or their
annual accounts, in conformity with IASs
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Use of IFRS around the world

In the European Union IFRS are mandatory

for consolidated statements of listed companies

And EU non-listed companies?

It depends on the different Countries.
In Italy IFRS are mandatory for all listed companies,
all banks and financial institutions (except insurance) and
optional for all the other companies

Rest of world → http://www.ifrs.org/Use-around-the-

world/Pages/Jurisdiction-profiles.aspx

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WHO uses IFRS around the world?

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The role of Financial accounting

What does the accountant keep?

The accountant keeps track of business

transactions

Business transactions are the economic events

that affect the financial condition of the business.

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Accounting process

The accounting process includes

the bookkeeping function.

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 RECORDING TRANSACTIONS

Business documents, such as a sales receipt, a

check, or a bill, provide evidence of the
transaction.

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Recording business transactions
How to record business transactions?

Almost every company in the world uses a system of recording known as

“double entry bookkeeping”.

This name derives from the fact that each individual transaction is
entered at least twice.

For instance, the giving (product or service) and the receiving (money)
aspects.

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Suppose you decided to start a business to deliver food from
restaurants to customers at their home.

• On January 1st
- Receives €60,000 cash from issuing common stock
- Borrows €90,000 from a bank (interest rate 12% annual, paid every
3 months) and buys €100,000 truck that will be used for 48 months,
with a €4,000 salvage (final or recovery) value
- Pays €12,000 cash upfront to rent offices for 1 year

• During the month of January

– Makes deliveries, will get paid €40,000 after 30 days
– Pays employees €10,000 of wages

• January 31st: Bank wants to see your financial statements

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IMPORTANT QUESTIONS:
• How much cash do you have at the end of January?

• How has your business performed during January?

• Did you make a profit or a loss?

• Is your financial position at the end of January better that the one
at the beginning?

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How much cash do you have at the
end of January?

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How much cash do you have at the end of January?

• On January 1,
– Receives €60,000 cash from issuing common
Cash Flows: stock
Stock 60,000 – Borrows €90,000 from bank and buys
Bank 90,000 €100,000 truck
• Will be used for 48 months, with a €4,000
Truck (100,000) salvage value
Rent (12,000) – Pays €12,000 cash upfront to rent office
Wages (10,000) space for 1 year
Interest 0 • During January
Customers 0 – Deliveries, will get paid €40,000 after 30
days
Cash 28,000 – Pays employees €10,000 of wages

During January NO INTEREST on the loan is paid CASH!!! 32

How much cash do you have at the end of January?
Cash Flows: • On January 1,
Operating – Receives €60,000 cash from issuing
Rent (12,000) common stock
Wages (10,000) – Borrows €90,000 from bank and buys
Customers 0 €100,000 truck
• Will be used for 48 months, with a €4,000
CFO (22,000)
salvage value
Investing – Pays €12,000 cash upfront to rent office
Truck (100,000) space for 1 year
CFI (100,000) • During January
Financing – Deliveries, will get paid €40,000 after 30
Stock 60,000 days
Bank 90,000 – Pays employees €10,000 of wages
CFF 150,000
NET Cash FLOW 28,000

During January NO INTEREST on the loan is paid CASH!!! 33

How has your business performed during January?
• On January 1,
Truck expense
– Receives €60,000 cash from issuing
(“depreciation”) =
common stock
(100,000-4,000)/48
– Borrows €90,000 from bank and buys
€100,000 truck
Rent expense is one month at
• Will be used for 48 months, with a €4,000
€1000/month
salvage value
– Pays €12,000 cash upfront to rent office
INCOME ST. for JANUARY space for 1 year
Revenue 40,000 • During January
Truck Expense (2,000) – Deliveries, will get paid €40,000 after 30
Rent Expense (1,000) days
Wages Expense (10,000) – Pays employees €10,000 of wages
EBIT 27,000
Interest Expenses (900) • At the end of MARCH
Net Income 26,100 – we will pay €2700 interest on the loan,
€900 refers to JANUARY!

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How has your business performed during January?

FINANCIAL POSITION - Balance Sheet at 31st January

ASSETS
Cash 28,000 (Cash in the bank on Jan31st)
Accounts Receivable 40,000 (Cash owed by customers on Jan 31st)
Prepaid Rent 11,000 (Prepaid for 11 months of future space)
Truck 98,000 (100t historical cost – 2t depreciation)
Total 177,000

LIABILITIES + STOCKHOLDER’S EQUITY

Common Stock 60,000 (Stockholder investment as of Jan 31st)
Retained Earnings 26,100 (Net income – Dividends)
Bank Debt 90,000 (Cash owed to the bank on Jan31st)
Accrued Inter. Exp. 900 (January interest we will pay in March)
Total 177,000

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FINANCIAL STATEMENTS: a set of documents
Statem. of Fin. Pos. • Financial statements are
Balance Sheet prepared:
• At least once a year
Income statement
or P&L • The twelve-month period is
called «reporting period»
Cash flow FINANCIAL • The entity for which financial
statement STATEMENTS statements are prepared is
called «reporting entity»
Statement of
• The reporting entity can
changes in equity
prepare «separate financial
statements» or «consolidated
Notes
financial statements»
• The presentation of financial
Other Documents statements depends on the
different standards used by the
entities

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WHERE CAN YOU FIND FINANCIAL STATEMENT DATA?

Company's website
– Look for “investor relations” page

Autorities websites or Stock Exchanges

(SEC Edgar website for U.S. companies, Borsa Italiana, …)

Internet finance site

– Morningstar
– Google Finance
– Yahoo! Finance
– Reuters
– Bloomberg

Databases (subscription)

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THE STATEMENT OF FINANCIAL POSITION
OR BALANCE SHEET

o Reports financial position of an entity at a specific point in time

o Shows assets, liabilities and equity of the entity
o Represents a detailed presentation of the accounting equation
Assets = Liabilities + Equity

o The balance sheet is cumulative in nature: it reports of all financial

activities of the business since its formation. So it does not cover a period of
time but represents a moment in time.

o In the BS, STOCK (or fund) variables are reported.

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BALANCE SHEET

Balance Sheet → records the assets, liabilities and

equity of an entity at a specified date, the end of the reporting period

Balance Sheet as at …. (ex. 31st December )

Equity
Assets – liabilities
Assets (ex. Capital, retained E
(ex. Land and earnings and other
buildings, equipment A reserves)
and machinery,
inventory, Liabilities
receivables, cash, (ex. financial debts,
financial investments) trade payables, tax
L
payables, other debts,
provisions)
A = L + E

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The basic accounting equation

Basic Accounting Equation

• Provides the underlying framework for recording and
summarizing economic events.

• Assets must equal the sum of liabilities and equity.

Assets = Liabilities + Equity

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Balance sheet

Classification according to IFRS

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 Balance Sheet → records the assets, liabilities and
equity of an entity at a specified date, the end of the reporting period
Balance Sheet as at …. (ex. 31st December )

EQUITY
NONCURRENT ASSETS
WHERE the
WHERE the resources
resources are going NONCURRENT LIABILITIES are coming from?
to? (SOURCES)
(USES)
CURRENT ASSETS
CURRENT LIABILITIES

A = L + E 42
Example of a balance sheet

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Assets

They are things that are owned by any firm.

Requirements:
1. They must be “controlled” by the firm;
2. They must provide future economic benefits

CONTROL is the right to possess, use, enjoy and dispose of

the good.

Money value exists if a buyer is willing to pay a sum of

money for the property
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 Balance sheet

Sub-classes

IAS 1 requires companies to distinguish current assets and liabilities from non-
current ones, except in limited situations.

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Balance Sheet → records the assets, liabilities and
equity of an entity at a specified date, the end of the reporting period
Balance Sheet as at …. (ex. 31st December )

NONCURRENT ASSETS: EQUITY

- Intangibles
- Fixed
- Investments

NONCURRENT LIABILITIES

CURRENT ASSETS
- Inventories
- Receivables
- Cash €equivalents CURRENT LIABILITIES

A = L + E 46
 Assets
Types of assets (2)

Generally assets are divided into categories.

Current assets Cash or other assets that can reasonably be Cash, account
expected to be converted in cash with in 1 year receivable and
or less inventory
Investments Are generally of a long-term nature, are not Stocks and
expected to be converted to cash within the bonds
years
Tangible assets Long-term or long-life assets that are used in lands,
the continuing organization and are expected to buildings,
be used by organization for more than one year machinery and
equipment
Intangibles Long-term assets that have no physical Copyrights,
assets substance but are of value. goodwill,
patents, rights,
brand 47
Equity
It represents the proprietor’s ownership in the business.

Equity is the residual interest in the assets of the entity

after deducting all its liabilities (referred to as “residual”
or “net” equity)

There are 2 sources of equity funds:

• The amount provided directly by equity investors
(owners)
• The amount retained from profits (or earnings), called
“retained earnings”.
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48
 Equity classification

Equity

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 Equity

INCREASES DECREASES

Investment by Dividends to
shareholders shareholders
Equity

Revenues Expenses

Investments by shareholders represent the total amount paid in

by shareholders for the ordinary shares they purchase.

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 Equity
INCREASES DECREASES

Investment by Dividends to
shareholders shareholders
Equity

Revenues Expenses

Dividends are the distribution of cash or other assets to

shareholders.
Dividends reduce retained earnings. However, dividends are
not expenses.

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 Equity

When Assets = Equity?

From the relation described earlier we can develop this simple

equation

To start a business if Mr. Gamma contributed to the business assets to

the value at 10,000 €, the equation would be expressed as:

Assets Equity
10,000 10,000

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Liabilities
The ownership of a sole proprietorship will use the assets
that he or she contributes to the business. In some
circumstances the assets available may be inadequate to
meet the needs of the business.

When this situations occurs it may be necessary to obtain

assets from other sources.

The most obvious way in which additional assets can be

obtained is by borrowing.

LIABILITIES are obligations of the entity to outside (usually

non-owner) parties.
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Liabilities

When cash or any other asset is borrowed, the firm is said

to have incurred a debt or a liability.

Liabilities are defined as amounts due to creditors and other

interested parties. It is the ownership of the assets of a
business by its creditors.

Notice that this definition is identical to the definition of

capital, except for the last word. But, it is not assets or
capital, it is a third category: liabilities.

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The accounting equation
As liability is closely associated with the ownership of the
business assets, it is shown in the equation on the same side
of as capital.

Let’s assume the following information

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The accounting equation

The business borrows € 5,000 from a local bank.

The result will be:

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Revenues and profit
Revenues and Profit

Every business exists primarily to earn a profit. Profit is realized through

revenues earned by an organization as a result of the sales of services
or products.

But revenues and profit are not the same.

Profit represents the income that a business has earned after certain
deductions have been made.

An excess of revenues over expenses represents a profit

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Expenses and loss

They are generally referred to as the costs of doing

business.

If expenses exceed revenues, the result is known as a loss.

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Expanded accounting equation

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 Do it
EXERCISE

From the information listed below, prepare a balance sheet

of Wines Corp. for the year ending December 31.

Cash 2,960 Account payable 1,065

Office equipment 2,005 Truck 2,030
Insurance Expenses 430 Account receivable 125
Wages and salaries payable 60 Mortgage Payable 200
Share Capital 10,000 Furniture and Fixtures 4,500
Wages expenses 605 Net income 400
Dividends 105 Sales revenue 12,000

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 Find out which balance sheet can be referred to each company:
1. Financial services company 3. Football club company
2. Manufacturing company 4. Hypermarket

A B
Long term assets Equity 550 Long term assets
- Intangible assets 530 - Intangible assets 95 Equity 550
- Property, plant and eq. 120 Long-term liabilities - Property, plant and eq. 100
- Financial assets 110 300 - Financial assets 510 Long-term liabilities
300
Current assets Current assets
- Inventories 60 Short-term liabilities - Inventories 5
150 Short-term liabilities
- Receivables 160 - Receivables 265 150
- Cash and equivalents 20 - Cash and equivalents 25

C D
Long term assets Equity 550 Long term assets
- Intangible assets 60 - Intangible assets 160 Equity 550
- Property, plant and eq. 95 Long-term liabilities - Property, plant and eq. 430
- Financial assets 40 300 - Financial assets 120 Long-term liabilities
300
Current assets Current assets
- Inventories 450 Short-term liabilities - Inventories 160
150 Short-term liabilities
- Receivables 105 - Receivables 125 15061
- Cash and equivalents 250 - Cash and equivalents 5
 The income statement

• Reports financial performance over a specific time

period (e.g. month, year, etc.)
• Shows the income and expenses of the period
• Income > Expenses = Profit
• Income < Expenses = Loss
• Sometimes called Profit or Loss (P&L) statement or
Operating Statement
• ACCRUAL PRINCIPLE

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Classification

Income from Operations

Expense Classification

• Reported by

• Nature

• Function

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Expense classification

Nature Function

◆ Cost of materials used ◆ Employee benefits

◆ Direct labor incurred ◆ Depreciation expense
◆ Delivery expense ◆ Amortization expense
◆ Advertising expense

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 Income statement analysis: margins
If expenses presented by Nature
SALES
- Purchases
- Service expense
=Value Added
- Labour cost
=EBITDA
- Depreciation & Amortization
=Operating Income (EBIT)
- Interest Expense
+ Dividend and interest Income
= Income before taxes
- Taxes
=Net Income
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Expense classification

Nature Function

◆ Cost of goods sold

◆ Selling expenses
◆ Administrative
expenses

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 Income statement analysis: margins
If expenses presented by Function

SALES
- Cost of Goods Sold (COGS)
=Gross Profit
- Sales General & Administrative expense (SG&A)
- Research & Development (R&D)
=Operating Income (EBIT)
- Interest Expense
+ Dividend and interest Income
= Income before taxes
- Taxes
=Net Income 67
Example of income statement

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Do it
EXERCISE

From the information listed below, prepare an income

statement of Wines Corp. for the year ending December
31.

Revenues from sales € 250,000, Rent Expenses € 70,000,

Salaries Expenses € 100,000, Service Revenues € 100,000,
Supplies Expenses € 60,000, Advertising Expenses € 10,000,
Depreciation € 20,000, Taxes 35%.

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 The statement of cash flows

• The income statement presents income earned and

expenses incurred – NOT cash flows!
• A statement of cash flows is therefore necessary to
report on the cash inflows and outflows of the entity
• This allows users to assess the sources and
applications of cash
• Also the ability of the entity to remain solvent

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Purpose of the cash flow statement
Primary Purpose: To provide relevant information
about the cash receipts and cash payments of an
enterprise during a period.
The statement provides answers to the following
questions:
1. Where did the cash come from?
2. What was the cash used for?
3. What was the change in the cash balance?
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 Purpose of the cash flow statement
Like an Income
Cash

Statement “under a
Cash Basis”
Ending Cash

OPERATING
Cash Flow
..........
Cash Flow
of the INVESTING Statement
period
FINANCING
Opening
Cash

Period N
0 Time
1/1/N 31/12/N
Cash Basis 72
 Definitions

o Cash flows are inflows and outflows of cash and cash

equivalents.
o Cash comprises:
✓ cash on hand, and
✓ demand deposits (net of bank overdrafts repayable
on demand)
o Cash equivalents: short-term, highly liquid
investments (such as short-term debt securities) that
readily convert to cash and that are subject to an
insignificant risk of changes in value.

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 Types of variables
• As of a specified INSTANT IN TIME (no time
STOCK dimension)
VARIABLES • Like snapshots
(or STATUS • Accumulation of flows
or FUNDS) • i.e. balance sheet

• Cover a specified PERIOD OF TIME (time

dimension)
FLOW VARIABLES • Like a motion picture
• Changes in stocks
• i.e. income statement, cash-flow statement

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The statement of cash flows

The cash flow statement reports the following three

types of activity:

1. Operating activities
2. Investing activities
3. Financing activities

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 Content and format: activity SECTIONS

Operating Investing Financing

Cash inflows Cash inflows Cash inflows
and outflows and outflows and outflows
from from non- from non-
operations. current assets. current
liabilities and
equity.

Statement helps users evaluate liquidity, solvency,

and financial flexibility.
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Example of cash flow statement

77
Content and format

78
78
Stock (fund) variables and flow variables

T1 T2

FLOW
+ 3,000
Stock (fund) at T2
13,000
Stock (fund) at T1

10,000

FLOW = T2 – T1 = 13,000 – 10,000 = + 3,000

79

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Stock (fund) variables and flow variables
INFLOW: + 850.000

13,000

10,000

OUTFLOW:
- 847.000

FLOW = INFLOWS – OUTFLOWS = +850,000 – 847,000 = + 3,000

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 Preparing the cash flow statement
• CASH FLOW FROM OPERATING activities
Direct method Indirect method
Cash received from 20 000 Income 6 000
Customers
Cash payments to (9 000) + Depreciation charges 1 000
suppliers
Cash paid to employees (5 000) Decrease (Increase) in inventory (500 )

Other cash payments (500) Decrease (Increase) in receivables (1200)

Increase (decrease) in payables 200

Net cash inflow from Net cash inflow from

operating activities 5 500 operating activities 5 500
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CASH FLOW STATEMENT - #1

BALANCE SHEET INCOME STATEMENT

ASSETS LIABILITIES N+1

Sale Revenues 1,000

N N+1 N N+1 Purchases -300
Wages and salaries -120

Account
Inventories 0 0 0 0 Other expenses -50
Payables
Depreciation -200

Account Provisions -30

0 0
receivables
Net profit 300

Cash 100 630

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CASH FLOW STATEMENT - #1 DIRECT METHOD
CASH INFLOWS 1,000
Cash from sales 1,000
CASH OUTFLOWS -470
From Purchases -300
From wages and salaries -120
From other monetary expenses -50
Cash flow from operating activ. +530
Cash flow from financing activ. 0
Cash flow from investing activ. 0
NET CASH FLOW +530

Cash at the beginning 100

Cash at the end 630
NET CASH FLOW +530
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CASH FLOW STATEMENT - #1
INDIRECT METHOD
NET PROFIT 300
Depreciation expenses +200
Provisions +30
Cash flow from operating activ. 530
Cash flow from financing activ. 0
Cash flow from investing activ. 0
NET CASH FLOW +530

Cash at the beginning 100

Cash at the end 630
NET CASH FLOW +530

84
CASH FLOW STATEMENT - #2

BALANCE SHEET INCOME STATEMENT

ASSETS LIABILITIES N+1

Sale Revenues 1,000

N N+1 N N+1 Purchases -300
Wages and salaries -120

Account
Inventories 0 0 0 0 Other expenses -50
Payables
Depreciation -200

Account Provisions -30

0 100
receivables
Net profit 300

Cash 100 530

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CASH FLOW STATEMENT - #2 DIRECT METHOD
CASH INFLOWS 900
Cash from sales (1,000 – 100) 900
CASH OUTFLOWS -470
From Purchases -300
From wages and salaries -120
From other monetary expenses -50
Cash flow from operating activ. +430
Cash flow from financing activ. 0
Cash flow from investing activ. 0
NET CASH FLOW +430

Cash at the beginning 100

Cash at the end 530
NET CASH FLOW +430 86
CASH FLOW STATEMENT - #2
INDIRECT METHOD

NET PROFIT 300

Depreciation expenses +200
Provisions +30
Increase in accounts receivable -100
Cash flow from operating activ. 430
Cash flow from financing activ. 0
Cash flow from investing activ. 0
NET CASH FLOW +430

Cash at the beginning 100

Cash at the end 530
NET CASH FLOW +430
87
CASH FLOW STATEMENT - #3

BALANCE SHEET INCOME STATEMENT

ASSETS LIABILITIES N+1

Sale Revenues 1,000

N N+1 N N+1 Purchases -300
Wages and salaries -120

Account
Inventories 0 0 0 200 Other expenses -50
Payables
Depreciation -200

Account Provisions -30

0 100
receivables
Net profit 300

Cash 100 730

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CASH FLOW STATEMENT - #3 DIRECT METHOD
CASH INFLOWS 900
Cash from sales (1,000 – 100) 900
CASH OUTFLOWS -270
From Purchases (300 – 200) -100
From wages and salaries -120
From other monetary expenses -50
Cash flow from operating activ. +630
Cash flow from financing activ. 0
Cash flow from investing activ. 0
NET CASH FLOW +630

Cash at the beginning 100

Cash at the end 730
NET CASH FLOW +630 89
CASH FLOW STATEMENT - #3
INDIRECT METHOD
NET PROFIT 300
Depreciation expenses +200
Provisions +30
Increase in accounts receivable -100
Increase in accounts payable 200
Cash flow from operating activ. +630
Cash flow from financing activ. 0
Cash flow from investing activ. 0
NET CASH FLOW +630

Cash at the beginning 100

Cash at the end 730
NET CASH FLOW +630
90
CASH FLOW STATEMENT - #4

BALANCE SHEET INCOME STATEMENT

ASSETS LIABILITIES N+1

Sale Revenues 1,000

N N+1 N N+1 Purchases -300

Changes in +50
inventories (unsold
Account merchandise)
Inventories 0 50 0 200
Payables Wages and salaries -120

Account Other expenses -50

0 100
receivables
Depreciation -200
Provisions -30
Cash 100 730
Net profit 350
91
CASH FLOW STATEMENT - #4 DIRECT METHOD
CASH INFLOWS 900
Cash from sales (1,000 – 100) 900
CASH OUTFLOWS -270
From Purchases (300 – 200) -100
From wages and salaries -120
From other monetary expenses -50
Cash flow from operating activ. +630
Cash flow from financing activ. 0
Cash flow from investing activ. 0
NET CASH FLOW +630

Cash at the beginning 100

Cash at the end 730
NET CASH FLOW +630 92
CASH FLOW STATEMENT - #4 INDIRECT METHOD
NET PROFIT 350
Depreciation expenses +200
Provisions +30
Increase in accounts receivable -100
Increase in accounts payable 200
Changes in inventories (unsold items) -50
Cash flow from operating activ. +630
Cash flow from financing activ. 0
Cash flow from investing activ. 0
NET CASH FLOW +630

Cash at the beginning 100

Cash at the end 730
NET CASH FLOW +630 93
 Cash Flow from OPERATING ACTIVITIES

Basically, with a minor simplification:

CFO = EBIT + Depreciation&Amortiz. - Increases(+Decreases) NWC

94
Cash flows from INVESTING activities :

• Cash payments to acquire properties, plants and

equipment, intangibles and other long-term assets
• Cash receipts from sales of properties, plants and
equipment, intangibles and other long-term assets
• Cash payments to acquire equity or debt instruments of
other entities and interests in joint venture
• Cash receipts from sales of equity or debt instruments of
other entities and interests in joint venture
• Cash payments and cash receipts from advances and
loans made to other parties

95
Cash flows from FINANCING activities :

• Cash receipts from issuing shares, stocks or other equity

instruments
• Dividends paid to stockholders
• Cash receipts from issuing debentures, loans, notes, bonds,
mortgages and other short-term or long-term borrowings
• Cash repayments of amounts borrowed (ex. Cash for loans
repayments)

96
 Free cash flow

FCF = CFO – CapEx – Dividends

The amount of discretionary cash flow a company has for

purchasing additional investments, retiring its debt,
purchasing treasury stock, or simply adding to its liquidity.

97
 Free cash flow

The amount of discretionary cash flow a company has for

purchasing additional investments, retiring its debt,
purchasing treasury stock, or simply adding to its liquidity.

98
 Financial Statements
• Balance Sheet or Statement of Financial Position
– Financial position (i.e., listing of resources and obligations)
on a specific date
– Assets = Liabilities + Stockholders’ Equity
– This accounting equation always balance!

• Income Statement or P&L

– Results of operations over a period of time
– Based on accrual accounting (i.e., recognition tied to business
activities)
– Net income = Revenues – Expenses

• Statement of Cash Flows

– Sources and uses of cash over a period of time
– Operating, Investing, and Financing Activities

99
BALANCE SHEET – STATEMENT OF FINANCIAL POSITION

Asset
– a resource controlled by the entity as a result of past events and from which future economic
benefits are expected to flow to the entity.
– can be CURRENT or NONCURRENT

Liability
– a present obligation of the entity arising from past events, the settlement of which is expected
to result in an outflow of the entity's resources.
Claims on assets by “creditors” (non-owners) that represent an obligation to make future
payment of cash, goods, or services
– can be CURRENT or NONCURRENT

Stockholders’ Equity
– the residual interest in the assets of the entity after deducting all of its liabilities
– Claims on assets by owners of business
– Two main components:
• Contributed Capital (arises from sale of shares)
• Retained Earnings (arises from operations)
– Increased by Revenues
– Decreased by Expenses and Dividends
100
EXAMPLES OF ASSETS ACCOUNTS
• Cash & Cash equivalents:
– Cash plus short-term, liquid investments
• Accounts Receivable: Amounts owed by customers
– Sales already recorded; cash collection in future
• Inventory: Cost of goods available for sale
– Cash already paid; expense (COGS) in future
• Prepaid Expenses: Operating costs paid in advance
– Cash already paid; expense in future
• Land: Carried at historical cost; not depreciated!
• Tangible assets (Property, Plant & Equipment, PP&E):
Carried at depreciated cost
– Accumulated Depreciation: Sum of past depreciation
– Net PP&E = PP&E – Accumulated Depreciation
• Intangible assets:
Contractual rights like patents or trademarks
Amortized & impaired
101
EXAMPLES OF LIABILITIES & EQUITY ACCOUNTS
• Accounts Payable: Amounts owed to suppliers on
purchases
– Inventory already recorded; cash payment in future
• Notes Payable: Amounts owed to banks on loans – Split
between current (due w/in year) and long-term
• Accrued Payables: Operating costs (wages, salaries,
interest, taxes) not yet paid in cash
– Expense already recorded; cash payment in future

• Common Stock and Additional Paid-in-Capital:

Proceeds from issuing shares of stock
• Retained Earnings: Sum of all prior net income less
dividends
• Treasury Stocks: Company’s own stock repurchased
- with MINUS
102
INCOME STATEMENT

Revenues
– Increases in stockholders’ equity from providing goods or services
– recognised when it is probable that future economic benefits will flow to
the entity and those benefits can be measured reliably.

Expenses
– Decreases in stockholders’ equity incurred in the process of generating
revenues
– recognized in the same period as the revenues to which they relate. If this
were not the case, expenses would likely be recognized as incurred,

Net Income (or Earnings or Net Profit) = Revenues - Expenses

=> DOES NOT EQUAL CHANGE IN CASH!!!

103
EXAMPLES OF INCOME STATEMENT ACCOUNTS
• Sales or Revenue: Value of goods delivered to customers
during the period (using sales price)
• Cost of Goods Sold (COGS): Cost of goods or services
delivered to customers during the period (using historical cost
of acquiring goods)
• Selling, General, and Admin (SG&A) Expenses: Operating
costs incurred during the period

• Interest Expense: Interest incurred during the period (cost

of financing)
• Other gains/losses: Non-operating gains and losses usually
from long-term asset sales (e.g., equipment, investments)

• Income Tax Expense: Taxes owed based on pre-tax income

104
CASH FLOW STATEMENT

• Summarizes cash transactions during the period

CASH at the end - CASH at the beginning = CASH FLOW of the period

Operating Activities
– Transactions related to the provision of goods or services and other normal
business activities

Investing Activities
– Transactions related to the acquisition or disposal of long-lived productive
assets

Financing Activities
– Transactions related to owners or creditors

105
A glimpse on financial
statements analysis

106
Fs analysis: users

External Internal

Financial Analysis
Perspectives

Past Future
Budgets & Forecasts
FS Analysis Stock Markets

107
 Users of financial information
• Internal users
– How much profit is being earned?
– What products should be produced?
– What resources are available?
– What is the most efficient production process?
– What is the cost to reduce carbon emissions?
– What will be the effect of increasing or decreasing selling
prices?
– How much profit is owing to outsiders?
– Will cash be available to pay debts as they fall due?
– What are benefits of owning vs leasing?
108
 Users of financial information

• External users
– Should I invest money in this business?
– Will the business be able to repay money lent to
it?
– What are the business’s earning prospects?
– Is the business financially sound?
– Is the business providing products that are
socially and environmentally friendly?

109
Purpose of Financial Statement analysis

The overall objective of a business is to create value for its

shareholders while maintaining a sound financial position.

Financial results cannot be evaluated in isolation.

To properly analyze the information reported in financial
statements, you must develop appropriate comparisons:
• with other companies (“companies comparison”); and
• over a period of time (for each company, in comparison to
others) (“time comparison”).

110
 Purpose of Financial Statement analysis

Financial Statement analysis of a company is made both:

• vertically (assets/investments and funds/liabilities and equity

composition): expressing each item on one financial statement as a
percentage of some base amount, revealing the sizes of the various
items on that statement – COMMON-SIZE FINANCIAL STATEMENTS);

• horizontally (relation between different classes of investments and funds

or comparing amounts through time).

111
 FS ANALYSIS
• WHY?
Analyse the past (3-5 years) to better predict the future
(forecasting function of FS!)

• WHAT?
Different priorities depending on WHO is doing the
analysis
- Short-term creditors: Liquidity
- Long-term creditors: Solvency
- Shareholders (ST or LT?): Profitability…

• HOW?
1) Prepare the FS for analysis (structure the BS, IS,
CFS)
2) Calculate (ratios etc.)
3) Benchmark (competitors, industry etc.)
112
 RATIO ANALYSIS

Ratio analysis expresses the relationship among selected

items of financial statement data.

Financial Ratio Classifications

Profitability Solvency Liquidity

Measures the Measures the ability Measures short-

financial of the company to term ability of the
performance or survive over a long company to pay its
operating success of period of time. maturing obligations
a company for a and to meet
given period of time. unexpected needs
for cash.
113
Ratio analysis
A ratio is a simple mathematical expression
of the relationship between one item and another.

Along with dollar and percentage changes,

trend percentages, and component percentages,
ratios can be used to compare:

Past performance to Other companies to

present performance. your company.

CAUTION!
Using ratios and percentages without considering the
underlying causes may be very dangerous! 114
115
 SOLVENCY

Is the company in the long run able to pay back its

financial debt?
DEBT or GEARING RATIOS
•Help to determine the overall level of financial risk
faced by a company and its shareholders.
•Define the capitalization or financial structure of a
company.
•Analyze the level of (financial) debt .

116
 SOLVENCY: DEBT OR GEARING RATIOS (I)
“Static” ratios, based on the balance sheet only, analyze the
level of debt compared to assets or equity

Debt (to assets) = Total Liabilities

ratio Total Assets

Debt-to-Equity = Net (financial) debt (D)

ratio (D/E) Total equity (E)

Capitalisation Total assets

= Total equity
ratio

117
 FINANCIAL LEVERAGE: DEBT RATIO

Total debts (P+p)

Debt-to-assets ratio = x 100
Total Acquired Capital (K)

Total debts = Current liabilities + Non-current liabilities

The higher the ratio, the more debt is

assumed by the company to finance its assets.

118
 FINANCIAL LEVERAGE: DEBT-TO-EQUITY

Total Debt (D)

Debt-to-Equity Ratio = x 100
Equity (N)

It compares the funds provided by creditors to the funds

provided by shareholders.
As more debt is used, the Debt to Equity Ratio will
increase. Since the company incurs more fixed interest
obligations with debt, risk increases.
On the other hand, the use of debt can help improve
earnings since we get to deduct interest expense on the tax
return.
So we want to balance the use of debt and equity such that
we maximize our profits, but at the same time manage our
risk.

119
 FINANCIAL LEVERAGE

Total Debt (D)

Debt-to-Equity Ratio = x 100
Equity (N)

EXAMPLE — We have total liabilities of $ 75,000 and total

shareholders equity of $ 200,000. The Debt to Equity Ratio
is 37.5%, $ 75,000 / $ 200,000 = .375. When compared to
our equity resources, 37.5% of our resources are in the
form of debt.

KEY POINT — As a general rule, it is advantageous to

increase our use of debt (trading on the equity) if earnings
from borrowed funds exceeds the costs of borrowing.

120
FINANCIAL LEVERAGE: CAPITALIZATION RATIO

Total assets (K)

Capitalization Ratio = x 100
Equity (N)

The higher the proportion of assets financed by

debt, the higher the financial leverage ratio.
Conversely, the higher the proportion of assets
financed with stockholders’ equity, the lower the
ratio.

121
 CAPITALIZATION RATIO

Several situations emerge:

• a ratio of 1.00 indicates the company has no liabilities;
• a ratio of 2.00 means the company uses debt and equity
financing equally to acquire assets;
• a ratio above 2.00 suggests a heavier reliance on debt than
equity.

122
 SOLVENCY: DEBT OR GEARING RATIOS (II)

“Dynamic” ratios include income statement or cash

flow statement information and analyze the capacity
of the company to reimburse

Debt = Net (financial) debt

coverage EBITDA

Cash Flow Cash from Operations

=
Adequacy Total Liabilities

123
124
 LIQUIDITY

• Measures the ability of a company to pay off its

short-term liabilities when they fall due.
• Analysis of the working capital (current assets and
current liabilities)
• Analysis of the cash cycle of the operations

125
 LIQUIDITY

Net Working
Capital (NWC) = Current Assets – Current Liabilities

Net Net
Working Working
Capital Capital

126
 LIQUIDITY RATIOS

Current Current assets

=
ratio Current liabilities

Quick ratio or Current assets- Inventories

=
acid test ratio Current liabilities

127
 LIQUIDITY AND SHORT TERM SOLVENCY

Net Working
= Current Assets (C) – Current Liabilities (p)
Capital

Current Assets (C)

Current ratio = x 100
Current Liabilities (p)

Net Working Capital is the excess of current assets over

current liabilities.

Current assets may include inventories of raw materials, work-

in-progress and finished goods, short-term trade receivables,
short-term investments and cash.
Current liabilities may include short-term trade payables,
overdrafts and short-term loans.
128
 NET WORKING CAPITAL
The level of current assets is a key factor in a company’s liquidity position.
A company must have or be able to generate enough cash to meet its short-term
needs.
The greater the extent to which current assets exceed current liabilities, the
more solvent or liquid a company is likely to be.
Some researchers said that companies should have a current ratio more than 2
(due to some difficulties to sell the inventories).
NWC and CURRENT RATIO can measure:
1. CURRENT LIABILITY COVERAGE: the higher the amount of current assets to
current liabilities, the grater assurance we have in current liabilities being
paid
2. BUFFER AGAINST LOSSES: the larger the buffer, the lower the risk. The
NTW/CR shows the margin of safety available to cover shrinkage in noncash
current asset values when ultimately disposing or liquidating them.
3. RESERVE OF LIQUID FUNDS: measure of the margin of safety
against uncertainties and random shocks to a company’s cash flows.
129
 NET WORKING CAPITAL

CURRENT RATIO may be NOT reliable when:

1. stagnation of sales
- Increase in receivables
- Decrease in sales -> increase in inventories (unsold items)
-> less provisions -> less payables
2. industry-specific crisis: increase in receivables and decrease in
provisions
CAN THE CURRENT RATIO MEASURE AND PREDICT THE PATTERN OF
FUTURE CASH INFLOWS AND OUTFLOWS?
OR MEASURE THE ADEQUACY OF FUTURE CASH INFLOWS TO
OUTFLOWS?

130
 LIQUIDITY MARGIN AND QUICK RATIO

Liquidity
= Current Assets (C) – Inventories (M) – Current Liabilities (p)
margin

Quick ratio Current Assets (C) – Inventory (M)

x 100
(or acid ratio) = Current Liabilities (p)

The liquidity of a company is usually of particular interest to

its short-term creditors, since it is the firm measures of its
ability to pay those creditors.

When using the liquidity margin, the focus is on the ability to

cover short-term accounts payables with liquidity and short-
term receivables (without selling the inventories).
131
 LIQUIDITY MARGIN AND QUICK RATIO
These indicators measure how many times you can cover your current
liabilities without selling any inventory.
It’s a more “severe” measure of liquidity.
Quick assets include those current assets that apparently can be quickly
converted to cash (as short-term investments, and accounts receivable).
Unlike the current ratio, the quick ratio does not consider inventory.
The reason for exclusion of inventory is due to some difficulties to sell it and
because of the uncertainty of the timing of cash flows from its sale.
The quick ratio is a measure of the safety margin that is available to meet a
company’s current liabilities.
The acceptable benchmark for quick ratio is 1:1.
This ratio indicates a firm’s capacity to maintain operations as usual with
current cash or near cash reserves in bad periods.

132
 LIQUIQITY: CASH CYCLE FOCUS
Payment of Suppliers Collections from Customers

Inventory Raw Mat. Production process Inventory Fin. Prodcts

Time

Purchase Sale

CASH CYCLE

Days Days
Days Inventory Sales
Payables Oustanding (DIO) Oustanding (DSO)
Outstanding (DPO)

133
 CASH CYCLE RATIOS

Avg. Inventory
Avg. DIO = Cost of Goods Sold
x 365

Avg. DSO = Avg. Acct Receivables x 365

Sales Revenue

Avg. DPO = Avg. Acct Payables x 365

Purchase Costs

134
135
 PROFITABILITY ANALYSIS

Profitability ratios
• Measure a company’s ability to generate return
relative to sales, assets and equity (or other form
of capital employed).

• Highlight the efficiency with which the business

activity turns into results.

• Used as proxies of the Company’s performance

to compare within its market and industry.
136
 MAIN PROFITABILITY RATIOS

Operating Margin = Operating Income (EBIT)

Sales

Return on Assets (ROA) = Net Income or EBIT

Total Assets

Net Income
Return on Equity (ROE) =
Total Equity

Return on Capital Employed (ROCE) = Operating Income (EBIT)

Capital employed*
*Capital employed = Non-current assets + working capital
OR = Equity + long-term (financial) debt
137
 MARKET BASED RATIOS

MARKET BASED RATIOS • Relate accounting

data to market data

• P/E = Stock price / Earnings (E = net income per share)

• P/BV = Stock price / Book value (BV = equity per share)
• P/CF = Stock price / Cash Flow from Operations
• P/S = Stock price / Sales
• Earnings per Share (EPS) =Total Earnings / Oustanding
shares
• Dividend Yield = Dividend per share / Stock Price
• Etc.
138
DUPONT RATIO ANALYSIS FRAMEWORK

139
140
 ROA could measure operating performance
-> independent of the company’s financing decisions
But, the numerator of ROA, Net Income, includes Interest Expense
More leverage => higher Interest Expense => lower Net Income

To truly remove all financing effects from ROA, we must de-lever Net
Income

ROA = De-Levered Net Income / Avg. Assets

De-levered Net Income = Net Income + (1-t) x Interest Expense

De-levering Net Income removes the effects of capital structure

(financing decisions)

141
DuPont Ratio Analysis Framework

142
No more ratios, please!

143
A focus on some specific
items

144
The rise of intangible assets

145
 Accounting for intangible assets

Goodwill
❑ represents the future economic benefits arising from the other
assets acquired in a business combination that are not individually
identified and separately recognized

❑ Includes exceptional management, desirable location, good

customer relations, skilled employees, high-quality products, etc.

❑ Only recorded when an entire business is purchased.

❑ Goodwill is recorded as the excess of purchase price over the fair

value of the net assets acquired.

❑ Not amortised (to be tested for impairment each year).

146
 ACCOUNTING FOR INTANGIBLE ASSETS

Goodwill
❑ Conceptually, represents the future economic benefits arising from
the other assets acquired in a business combination that are not
individually identified and separately recognized.

❑ Includes exceptional management, desirable location, good customer

relations, skilled employees, high-quality products, etc.

❑ Only recorded when an entire business is purchased.

❑ Goodwill is recorded as the excess of purchase price over the fair value of
the net assets (assets less liabilities) acquired.

Fair 147

Value Price
 ACCOUNTING FOR INTANGIBLE ASSETS

Goodwill

❑ Not amortised (to be tested for impairment each year).

❑ Goodwill is recorded ONLY when an entire business is
purchased.

Internally created goodwill should NOT be capitalized.

Fair 148

Value Price
RECORDING GOODWILL

Illustration: Multi-Diversified, Inc. decides that it needs a parts division

to supplement its existing tractor distributorship. The president of Multi-
Diversified is interested in buying Tractorling Company. The illustration
presents the statement of financial position of Tractorling Company.

149
RECORDING GOODWILL

Illustration: Multi-Diversified investigates Tractorling’s underlying

assets to determine their fair values.

Tractorling Company decides to accept Multi-Diversified’s offer of

$400,000. What is the value of the goodwill, if any?

150
RECORDING GOODWILL

Illustration: Determination of Goodwill.

151
RECORDING GOODWILL

Illustration: Multi-Diversified records this transaction as follows.

Cash 25,000
Accounts Receivables 35,000
Inventory 122,000
Property, Plant, and Equipment 205,000
Patents 18,000
Goodwill 50,000
Liabilities 55,000
Cash 400,000

152
 DO IT
Global Corporation purchased the net assets of Local Company for
$300,000 on December 31, 2014. Global Corporation purchased the net
assets of Local Company for $300,000 on December 31, 2014. The balance
sheet of Local Company just prior to acquisition is:
Assets Book value Fair Value
Cash $ 15.000 $ 15.000
Receivables 10.000 10.000
Inventories 50.000 70.000
Equipment 80.000 130.000
Total $ 155.000 $ 225.000 FMV of Net Assets
= $200,000
Liabilities and Equities
Accounts payable $ 25.000 $ 25.000
Common stock 100.000
Retained earnings 30.000
Total $ 155.000 $ 25.000
153
RECORDING GOODWILL
Example: Global Corporation purchased the net assets of Local Company
for $300,000 on December 31, 2014. The value assigned to goodwill is
determined as follows:

Book Value = $130,000

Revaluation
$70,000
Fair Value = $200,000
Goodwill
$100,000
Purchase Price = $300,000

154
RECORDING GOODWILL
Example: Global Corporation purchased the net assets of Local Company
for $300,000 on December 31, 2014. The value assigned to goodwill is
determined as follows:

Calculation of Goodwill:
Cash $ 15,000
Receivables 10,000
Inventories 70,000
Equipment 130,000
Accounts payable (25,000)
FMV of identifiable net assets 200,000
Purchase price 300,000
Goodwill $ 100,000

155
156
 DEPRECIATION & AMORTISATION

❑ Future economic benefit of

Fixed assets will be received
over two or more accounting
periods, therefore their cost must
be allocated in a systematic
manner.

Allocating costs of Non-Current Assets:

▪ Fixed Assets = Depreciation expense
▪ Intangibles = Amortisation expense
▪ Mineral resources = Depletion expense

157
 DEPRECIATION DEFINED

Process of allocating to expense the cost

of a fixed asset over its useful (service) life
in a rational and systematic manner.
❑ Process of cost allocation, not asset valuation.
❑ Applies to land improvements, buildings, and
equipment, not land! (at least in some Countries)

❑ Depreciable, because the revenue-producing ability of

asset will decline over the asset’s useful life.

158
159
 FACTORS IN COMPUTING DEPRECIATION

Cost: all expenditures

necessary to acquire
the asset and make it
ready for use

Useful life: estimate of the

expected life based on need
for repair, service life, and
vulnerability of obsolescence

Residual Value (or Salvage

value): estimate of the asset’s
value at the end of its useful
life.
160
 DEPRECIATION METHODS

Management selects the method it believes best

measures an asset’s contribution to revenue over its
useful life.
Examples include:
(1) Straight-line method
(2) Units-of-activity method
(3) Declining-balance method

161
 DEPRECIATION METHODS

Illustration: Bob’s Florist purchased a small delivery truck on

January 1, 2017.
Cost €13,000
Expected residual value €1,000
Estimated useful life in years 5
Estimated useful life in miles 100,000

162
 STRAIGHT-LINE METHOD

❑ Allocates an equal amount of depreciation to

each full accounting period in asset’s useful
life

Depreciable cost Annual

=
Useful life Depreciation

163
STRAIGHT-LINE METHOD

❑ Expense is same amount for each year.

❑ Depreciable cost = Cost less salvage value.

Formula for straight-line method

164
 STRAIGHT-LINE METHOD

Straight-line depreciation
Illustration: schedule

Depreciable Annual Accum. Book

Year Cost x Rate = Expense Deprec. Value

2017 € 12,000 20% € 2,400 € 2,400 € 10,600

2018 12,000 20 2,400 4,800 8,200
2019 12,000 20 2,400 7,200 5,800
2020 12,000 20 2,400 9,600 3,400
2021 12,000 20 2,400 12,000 1,000

165
UNITS-OF-ACTIVITY METHOD

❑ Companies estimate total units of activity to calculate

depreciation cost per unit.
❑ Expense varies based on units of activity.
❑ Depreciable cost is cost less residual value.
Formula for units-
of-activity method

166
 UNITS-OF-ACTIVITY METHOD

Units-of-activity depreciation
Illustration: schedule

Units of Cost per Annual Accum. Book

Year Activity x Unit = Expense Deprec. Value
2017 15,000 € 0.12 € 1,800 € 1,800 € 11,200
2018 30,000 0.12 3,600 5,400 7,600
2019 20,000 0.12 2,400 7,800 5,200
2020 25,000 0.12 3,000 10,800 2,200
2021 10,000 0.12 1,200 12,000 1,000

167
 DECLINING-BALANCE METHOD

❑ Accelerated method: Decreasing annual depreciation

expense over the asset’s useful life.
❑ Twice the straight-line rate with Double-Declining-Balance.
❑ Rate applied to book value.

Formula for declining-balance method

168
 DECLINING-BALANCE METHOD

Double-declining-
Illustration: balance depreciation
schedule
Declining
Beginning Balance Annual Accum. Book
Year Book value x Rate = Expense Deprec. Value

2017 € 13,000 40% € 5,200 € 5,200 € 7,800

2018 7,800 40 3,120 8,320 4,680
2019 4,680 40 1,872 10,192 2,808
2020 2,808 40 1,123 11,315 1,685
2021 1,685 40 685* 12,000 1,000

* Computation of €674 (€1,685 x 40%) is adjusted to €685 to result in Book value=residual value

169
 COMPARISON OF METHODS

Comparison of
depreciation methods Annual depreciation varies considerably among the
methods, but total depreciation expense is the same
(€12,000) for the five-year period. 170
COMPARISON OF METHODS

Patterns of depreciation
171
172
IMPAIRMENTS DO HURT SOMETIMES!
The Kraft Heinz Company 2018

2015: Heinz acquired Kraft foods for 52 bn $ (incl. brand names 50bn, goodwill 29 bn)
Impaired goodwill relates mainly to Kraft
Impaired brand names: Kraft, Philadelphia etc.
173
April 2019: Kraft Heinz CEO “leaves” the company
 IMPAIRMENT

A non-current asset is impaired when a company is not

able to recover the asset’s carrying amount either through
using it or by selling it.
On an annual basis, companies review
the asset for indicators of
impairments—that is, a decline in the
asset’s cash-generating ability through
use or sale.

174
 IMPAIRMENTS

• Impairments represent losses of value related to assets

• Accounting for impairments is based on the principle of prudence (or
conservatism):
- when there are 2 values for an asset, you should systematically choose
the lower value (no overstatement of assets)
- losses have to be recognized as soon as they are
probable (profits can only be recognized when they are realized)
• Accounting for impairments makes the financial statements “right”
- Balance sheet: show the “right” asset value
- Income statement: since the loss is “generated” (the loss making
event happened) in the current year, it has to influence profit/loss of
the current year

175
 IMPAIRMENT FOR NON-CURRENT ASSETS

A non-current asset is impaired when a company is not

able to recover the asset’s carrying amount either through
using it or by selling it.

=Net
Book
Value
(NBV)

176
 IMPAIRMENT FOR NON-CURRENT ASSETS

Value in use is the incremental value from continuing use of the

item:
Estimate the future net cash flows expected to arise from the
continuing use and ultimate disposal of the item and discount these to
Present Value.
More subjective and unique to the item

Benefits from continuing Use

Start Periods

Purchase or NET PRESENT VALUE

Construction 177
 IMPAIRMENT FOR NON-CURRENT ASSETS

Example: Assume that Cruz Company performs an impairment test

for its equipment. The carrying amount (NBV) of Cruz’s equipment is
€200,000, its fair value less costs to sell is €180,000, and its value-in-
use is €205,000.
€200,000 €205,000 No
Impairment

€180,000 €205,000 178

 IMPAIRMENT FOR NON-CURRENT ASSETS

Example: Assume the same information for Cruz Company except

that the value-in-use of Cruz’s equipment is €175,000 rather than
€205,000.

€200,000 €180,000 Impairment

Loss €20,000

=Net
Book
Value

€180,000 €175,000 179

 IMPAIRMENT FOR NON-CURRENT ASSETS

Example: Assume the same information for Cruz Company except

that the value-in-use of Cruz’s equipment is €185,000 rather than
€175,000.

€200,000 €185,000 Impairment

Loss €15,000

=Net
Book
Value

€180,000 €185,000 180

181
IMPORTANCE OF FINANCIAL ASSETS: AIRBUS
31% of total assets! 37%

182
182
 WHY CORPORATIONS HOLD FINANCIAL
ASSETS?
Corporations hold financial assets as part of their operations:
cash, accounts receivable …

Corporations also buy financial assets for one of three reasons:

1. Corporation may have excess cash.
2. To generate earnings from investment income.
3. For strategic reasons.

183
183
 ACCOUNTING CATEGORIES OF FINANCIAL
ASSETS AND THEIR MEASUREMENT
Categories of financial assets for accounting purposes are
“intention based”: What is the intention that the company
pursues with the financial asset?

3 intentions possible (when using IFRS): Measurement

1. Trading FVTPL
2. Held-for-collection (held-to-maturity) Amortized cost
3. Neither trading, nor held-to-collection FVTOCI
(both possible)

184
184
 CATEGORIES OF FINANCIAL ASSETS

Trading financial assets

❑ Companies hold trading financial assets with the
intention of selling them in a short period (generally less
than a month).

❑ Trading means frequent buying and selling.

❑ Companies report trading financial assets at fair value

through profit and loss (FVTPL), i.e. changes in the FV
from last year are recognized in the income statement.

❑ Classified as current asset.

185
185
 CATEGORIES OF FINANCIAL ASSETS
Held-for-collection (or held-to-maturity)
❑ Intention of the company is to collect contractual cash flows;
only debt type financial instruments (i.e. bonds, accounts
receivable).

❑ Measured at amortized cost:

Book value = Purchase price
- reimbursement
- impairment (expected loss)
+/- discount or premium.

❑ All changes in fair value are ignored.

❑ These financial assets can be classified as current assets or

186
non-current, depending on the maturity of the financial asset 186
 CATEGORIES OF FINANCIAL ASSETS
Neither trading, nor held-for-collection
❑ Ex: liquidity reserves/cash management.
❑ Companies report these financial assets at fair value through
other comprehensive income (FVTOCI), i.e. changes in the FV
from last year are recognized as a component of equity (other
comprehensive income).
❑ When the financial assets are sold or come to maturity, the
corresponding OCI item may be included (reclassified) in profit
or loss (in case the asset is a debt instrument) or not (in case the
asset is an equity instrument)
❑ These financial assets can be classified as current assets or as
non-current assets, depending on the intention of management
(how long will the asset be held?). 187
187
IMPACTS OF FINANCIAL ASSETS ON THE INCOME STATEMENT

incl. fair value gains on financial assets

188
188
IMPACTS OF FINANCIAL ASSETS ON THE INCOME STATEMENT

189
189