Analysis of Financial Reports

Session 2

Richard Barker
 The story so far …

Page 2
Sarah’s financials

• How wealthy is Sarah?

• Does Sarah have debts and is she able to pay
them?
Balance Sheet

• Was Sarah’s income greater than her

expenditure over the course of the past year?
• Can Sarah afford to maintain her current level of
spending?
Income Statement

Page 3
 Opening balance 8500.00

Sarah’s Supermarket
Cinema
-32.70
-12.00

Bank Restaurant
New car
-28.65
-8600.00

Statement Mortgage interest payment

Mortgage capital payment
-500.00
-1000.00
Supermarket -94.10
Car insurance -242.00
Salary 3418.19
Interest expense -2.50
Train fare -18.00
Petrol -10.00
Coffee shop -3.59
Supermarket -14.24
Train fare -23.90
Petrol -41.75
Cash withdrawal -200.00
Supermarket -9.99
Coffee shop -6.58
Supermarket -36.99
Music Store -14.99
Vibes Health Club -40.00
Coffee shop -8.50
Restaurant -24.36
Page 4 Closing balance 927.14
Limitations of the bank statement

1. Presentation unclear
Cash Flow
2. Not all cash flows change wealth Statement

3. Not all changes in wealth involve cash flow

4. Only changes in wealth are reported, not levels

Income Statement Balance Sheet

Page 5
Cash Flow Statement

Changes
Operating Receipts 3,418 Wealth
Payments Consumables -415
Travel -336
Leisure -138
Interest -503 2,027
Investing -8600
Financing Changes Composition -1,000
of Net Assets, but not
Change in cash -7,573
Wealth
Opening balance 8,500
Closing balance 927

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Income Statement
Operating Accrual Profit
Cash Flow

Income 3,418 1,200 4,618

Cash expenses -1,391 -1,391
Council tax -150 -150
Depreciation -2,400 -2,400
Loss of bike -500 -500
2,027 -1,850 177

Wealth Change
Change in
in Cash Wealth Change Wealth
in Net Assets
other than Cash
Page 7
Balance Sheet
Assets House 350,000
Bike 500
Bank account 8,500
359,000

Liabilities Mortgage 220,000

220,000

Equity 139,000
Wealth

Page 8
 Putting it all together
Opening ICF FinCF OCF Accrual Closing
Assets House 350,000 350,000
Car 0 8,600 -2,400 6,200
Bike 500 -500 0
Accounts receivable 0 2,000 2,000
Bank account 8,500 -8,600 -1,000 2,027 927
359,000 0 -1,000 2,027 -900 359,127
Cash Flow

Liabilities Mortgage 220,000 -1,000 219,000

Tax payable 0 950 950

220,000 0 -1,000 0 950 219,950

Equity 139,000 0 0 2,027 -1,850 139,177

Profit

Wealth
Page 9
Trading Company
Provision made in 07/08
40

30

20

10
Profit

Provision made in 07/08

0
07/08 08/09

-10

-20

-30
Year

Page 10
Trading Company
40

30

20

10
Provision made in 07/08
Profit

No provision in 07/08
0
07/08 08/09

-10

-20

-30
Year

Page 11
 Session Two

Overview of the income statement, cash

flow statement and balance sheet

Page 12
 The Entrepreneur’s Challenge!

Page 13
The Entrepreneur’s Challenge
The main points …
1. Business starts with a decision to invest (equity or debt). This is a
financing cash inflow.
2. If there is debt finance, the business faces a fixed cost: interest
expense.
3. The investors’ decision to invest in the business is followed by the
managers’ decision to invest in operating assets. This is an investing
cash flow.
4. The operating assets generate a return, the size of which depends
upon market conditions. This return is operating profit, or operating
cash flow.
5. A positive operating cash flow increases the cash balance, creating
the opportunity to buy more operating assets (investing cash flow,
leading to growth in the business) or to repay finance (a financing
cash outflow).
6. Profit is earned if operating profit exceeds interest expense.

Page 14
What happens if assets depreciate?
A definition of depreciation:
The systematic allocation of the depreciable amount of an
asset over its useful life

• useful life: the period over which an asset is expected

to be available for use by an entity
• residual value: the estimated amount … from disposal
of an asset, after deducting the estimated costs of
disposal
• depreciable amount: the cost of an asset less its
residual value

Page 15
 Depreciation
Cost
= €100 100
Annual Depreciation = €15

80

€ 60

Residual
40 Value
= €40
20

2009 2010 2011 2012

Useful Life
= 4 Years
Page 16
Entrepreneur’s Challenge: Depreciation
The main points …

1. Depreciation is a cost of doing business, but it does not involve cash

flow.
a) It causes operating profit and operating cash flow to differ
b) Operating profit is a better measure of financial performance
than operating cash flow
2. Investing cash flow is required just to ‘stand still’, and an amount in
excess of depreciation is required for there to be growth in operating
assets
3. Depreciation is similar to interest expense in that both are fixed costs.

Page 17
 Recording transactions and
events in the accounts

Page 18
Debit Credit

Increase in an asset Decrease in an asset

Decrease in a liability Increase in a liability
Decrease in equity Increase in equity
Expense Income
Loss Profit

Page 19
General Ledger

The general ledger comprises Example: ‘T’ account for PPE

source data for financial
statements: debits and credits for Date Description Debit Credit
all transactions and events, (DR) (CR)
categorised into separate accounts.
1 Jan Balance b/f 1200
The separate accounts will be 4 Apr Cash (asset 150
maintained at a level of detail purchase)
required to keep track of the entity’s
activities – for example, separate 31 Dec Depreciation 130
accounts for each customer. expense

31 Dec Balance c/f 1220

Page 20
 “Each of the entries made in the journal
must be posted twice in the ledger, one to
the debit and the other to the credit . . .
(and) you shall also have an account for
profit and loss . . . (which is) necessary to
every business so that the businessman will
always know what his capital is, and at the
end of the period, how it is progressing.”

Luca Pacioli (1494)

Page 21
SARAH’S Equity Mortgage Tax House Car Accounts Cash
payable receivable
GENERAL LEDGER
DR CR DR CR DR CR DR CR DR CR DR CR DR CR

Opening balance 139000 220000 0 350000 0 8500

Operating cash inflow 3418 3418

Operating cash outflow 1391 1391

Investing cash flow 8600 8600

Financing cash flow 1000 1000

Accrual: credit sales 2000 2000

Accrual: depreciation 2400 2400

Accrual: loss of bike 500

Accrual: tax payable 950 950

Closing balance 139177 219000 950 350000 6200 2000 927

Page 22
Consulting Firm General Ledger

Page 23
Consulting Firm
Based upon the information below,
1. Complete the firm’s general ledger
2. Prepare the firm’s primary financial statements

• At the beginning of the year (1 Jan), the firm has share capital of 100
and cash of 100.
• The firm completes two projects during the year. The first, worth 90, is
invoiced to the client and then subsequently paid during the year. The
second, worth 60, is invoiced during the year but remains unpaid at
the end of the year.
• The firm’s consultants are paid 130 during the year.
• The firm’s profits are taxable at 40%. No tax is paid during the year.

Page 24
Balance Sheet
Equity Assets:
200
Summary
of changes Non-cash
– Income 450
Statement
Cash Summary
50
of changes
Liabilities – Cash
300 Flow
Statement

Page 25
Changes to the Balance Sheet
Opening Change Closing
Balance Balance
Cash
Flow
Non-cash assets 450 (30) 420

Cash 50 75 125

Profit
Liabilities 300 20 320

Equity 200 25 225

Page 26
A Summary of Balance Sheet Changes
Cash Net Assets excluding
Cash

Equity 1. Operating cash flow 3. Accruals

2. Financing cash flow
(transactions with
shareholders)

Net 5. Financing cash flow 4. Change to one

Assets (excluding transactions asset/liability offset by
excluding with shareholders) change to another
Cash
6. Investing cash flow

Page 27
EXAMPLE Opening Changes to the balance sheet Closing
Balance Balance
Sheet Sheet
1 2 3 4 5 6
Operating Financing Accrual Inventory Financing Investing
cash flow cash flow: acquired cash flow: no cash flow
change in on credit change in net
net assets
assets
PPE 150 -5 5 150

Inventory 0 15 15

Accounts 40 25 65
receivable
Cash 20 -10 -2 35 -5 38

Assets 210 -10 -2 20 15 35 0 268

Bank loan 70 35 105

Accounts payable 30 15 45

Net Assets 110 -10 -2 20 0 0 0 118

Share Capital 100 100

Retained profit 10 -10 -2 20 18

Equity 110 -10 -2 20 0 0 0 118

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 Learning Outcomes
• How do borrowing decisions, investing decisions
and operating performance affect the financial
statements?
• What is the meaning of debit and credit?
• How does a general ledger function?
• How are the primary financial statements related
to one another?

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