EC3348 –

CORPORATE FINANCE
Lecture 4: Company Financial Statements
 Why are Financial Statements important
• Reading a company's financial statements is
essential for smart investment choices.
• Four sections to a company's financial
statements: the balance sheet, the income
statement, the cash flow statement, and the
explanatory notes.
 Why are Financial Statements important
• Prudent investors should review the detailed
financial report the company files with the U.S.
Securities and Exchange Commission (SEC), or the
UK’s LSE.
• Smart review of non-financial information that
could impact a company's return:
• the state of the economy,
• the quality of the company's management,
• the company's competitors.
 Disclosure of Financial Information
• Financial Statements
• Firm-issued accounting reports with past
performance information
• Filed with the regulator
• Quarterly
• Annual
• Must also send an annual report with financial
statements to shareholders
 Disclosure of Financial Information
• Preparation of Financial Statements
• Generally Accepted Accounting Principles (GAAP)
• UK GAAP is the body of accounting standards published by the
UK’s Financial Reporting Council (FRC).
• International Financial Reporting Standards (IFRS)
• GAAP is rule-based, whereas IFRS is principle
-based
 Disclosure of Financial Information
• GAAP is rule-based, whereas IFRS is principle-based

• GAAP is standardised
• Companies and their accountants must adhere to
the rules when they compile their financial
statements.
• Easier for investors to compare and contrast the
financial information of different companies.
 Disclosure of Financial Information
• IFRS is principle-based

• Adjust accounting principles to a company’s

transactions rather than adjusting a company’s
operations to accounting rules
• The IFRS states that a company’s financial
statements must be understandable, readable,
comparable, and relevant to current financial
transactions
 Disclosure of Financial Information
• GAAP is rule-based, whereas IFRS is principle-based
• Complex rules can cause unnecessary complications
in the preparation of financial statements.
• And having strict rules means that accountants may
try to make their companies more profitable than
they actually are because of the responsibility to
their shareholders.
 Disclosure of Financial Information
• GAAP is rule-based, whereas IFRS is principle-based
• Having a set of rules can increase accuracy and
reduce the ambiguity that can trigger aggressive
reporting decisions by management.
• Without a rules-based accounting system,
companies could report only the numbers that
made them appear financially successful while
avoiding reporting any negative news or losses.
 Disclosure of Financial Information
• GAAP is rule-based, whereas IFRS is principle-based
• Complex rules can cause unnecessary complications
in the preparation of financial statements.
• Strict rules means that accountants may try to make
their companies more profitable than they actually
are because of the responsibility to their
shareholders.
• Eg – the collapse of energy company Enron in 2001.
Shareholders lost $75 bn because the executives hid
debt and overstated revenue
 Disclosure of Financial Information
• Auditor
• Neutral third party that checks a firm’s financial
statements
• Not always neutral though!
• The defunct company, Arthur Andersen was one of
the ‘Big Fives’. In 2002, it relinquished its license to
operate. It was found guilty of serious crimes in
reporting finances in the Enron case
• In the UK, BHS, Carillion, London Capital & Finance,
and Thomas Cook all collapsed. Auditors collected
vast fees and delivered little of any value.
 Important Accounting Statements
• Position – Balance Sheet
• Performance – Income Statement
• Prospects – Cash Flow Statement
 Overview

Three Important Accounting Statements

The Statement of The Income

Financial Position Statement

The Cash Flow

Statement
The Statement of
Financial Position
What are the firm’s assets and
how are they funded?
 The Statement of Financial Position

The Accounting Equation

Shareholders’
Liabilities Assets
Equity
 Balance Sheet (cont'd)

Assets What the company owns

Liabilities What the company owes

Stockholder’s The difference between the value

Equity of the firm’s assets and liabilities
 Balance Sheet (cont'd)

• Assets
– Current Assets: Cash or
expected to be turned into
cash in the next year
• Cash
• Marketable Securities
• Accounts Receivable
• Inventories
• Other Current Assets
– Example: Pre-paid
expenses
 Balance Sheet (cont'd)

• Assets
– Long-Term Assets
• Net Property, Plant, & Equipment
• Book Value
= Acquisition cost - Depreciation (and
Acc. Depreciation)
• Goodwill and intangible assets
• Other Long-Term Assets
– Example: Investments in Long-
term Securities
 Balance Sheet (cont'd)

• Goodwill is a premium paid over the fair value

of assets during the purchase of a company.
• It is tagged to a company or business and
cannot be sold or purchased independently
– Eg intellectual property
• Other intangible assets like licenses, patents,
etc. can be sold and purchased independently.
 Balance Sheet (cont'd)

• Liabilities
– Current Liabilities: Due to be paid within the next
year
• Accounts Payable
• Short-Term Debt/Notes Payable
• Current Maturities of Long-Term Debt
• Other Current Liabilities
– Taxes Payable
– Wages Payable
 The Statement of Financial Position

Centrica plc 2018

Non-Current Assets £m Non-Current Liabilities £m

Property, Plant and Equipment 4,059 Bank Loans and other Borrowings 4,359

Intangible Assets 2,009 Other Long-Term Liabilities 4,234

Interests in Joint Ventures 1,727 8,593

Goodwill 2,678 Current Liabilities

Other Non-Current Assets 1,779 Trade Payables 4,995

12,252 Other Current Liabilities 1,749

Current Assets Bank Overdrafts and Loans 898

Trade Receivables 4,524 7,642

Inventories 347 Total Liabilities 16,235

Other Current Assets 1,597 Total Shareholders’ Equity 4,023

Cash and Cash Equivalents 1,538

8,006

Total Assets 20,258 Total Assets 20,258

 The Statement of Financial Position

Important Characteristics of Statements of Financial

Position

Current Current
and Non- and Non-
Current Current
Assets Liabilities

Net
Equity Working
Capital
 Balance Sheet (cont'd)

• Equity
– Book Value of Equity
• Book Value of Assets – Book Value of Liabilities
– Could possibly be negative

– Market Value of Equity (Market Capitalization)

• Market Price per Share x Number of Shares Outstanding
– Cannot be negative
 Example 1
• Suppose the firm Global has 3.6 million shares outstanding.
• These shares are currently trading at $14 per share.

• What is Global’s market capitalization? If Global equity value on

balance sheet is $22.2 million, how do these two items compare?
Example 1 (cont'd)
The Income Statement
AKA the Profit and Loss Account
How has the firm performed over
the previous period?
 The Income Statement

The Income Equation

Revenues Expenses Income

 The Income Statement

Centrica plc 2018

£m
Revenue 15,321
Expenses 14,617
Profit Before Interest and Taxes 704
Finance Costs 289
Profit Before Tax 415
Tax 177
Profit After Tax 238
Number of Shares 5667
EPS 0.042
 The Income Statement

Important Characteristics of Income Statements

Variable
Non-Cash
and Fixed
Items
Costs

Operating
Profit and
Tax
Net
Income
Taxes
How to calculate tax
 Taxes
Average vs. Marginal Tax Rates

Average Tax Marginal Tax

Rate Rate
• Tax paid/profit • Tax (%) you pay if
before taxes you earn one
more unit of
currency
 Taxes
Average vs. Marginal Tax Rates
The first €200,000 earned by Dutch firms pay 16 per cent tax; extra earnings pay 22.25 per
cent tax.

Suppose Dutch corporation has taxable income of €400,000.

Tax Paid Tax Rates

• 16% × €200,00 + • Average= 76.5/400
22.25% × €200,000 = 19.125%
= €76,500 • Marginal=
22.25%
Net Working Capital
How to calculate net working
capital
 Net Working Capital

How to Calculate Net Working Capital

Net
Current Current
Working
Assets Liabilities
Capital
 Net Working Capital

Centrica plc 2018

The Cash Flow Statement
Where has the cash come from
and what has the firm spent?
 The Cash Flow Statement

Centrica plc 2018