INTRODUCTION TO FINANCIAL STATEMENTS

1. Balance Sheet -> summarizes a company’s net worth

ASSETS = LIABILITIES + STOCKHOLDER’S EQUITY

• ASSET: economic resource with probable future benefits:

o CURRENT: short-term assets, can be liquified quickly (within a year) and used for
immediate needs
o NON CURRENT: long-term assets, their full value won’t be recognized until at least a year
• LIABILITY: economic obligations to outsiders
o CURRENT: short-term obligations due within one year of normal operating cycle
o NON CURRENT: long-term obligations not due for more than a year
• EQUITY: owner’s residual interest / the value of the shares issued by a company
o SHARE CAPITAL: to amounts received by the reporting company from transactions with
shareholders
o RETAINED EARNINGS RE: cumulative net earnings or profits of a company after
accounting for dividends
▪ RE(new)=RE(old)+NI-Dividends

A BALANCE SHEET MUST ALWAYS BALANCE!

2. Income Statement -> Describes the company’s financial performance for any current year

The Income Statement is the summary of financial performance during a given period.

Basic Income Statement format:

ELEMENTS OF THE IC

• REVENUE OR SALES
o Are the benefits due to selling the company’s goods / product
o Usually in cash or receivables (cash not collected immediately but still recorded in the
statement)
• OPERATING EXPENSES: normal expenses for a firm
o Cost of Sales: COGS
o All items that represent a cost of operating the firm:
▪ Cost of producing and selling goods
▪ R&D research and development
▪ marketing
▪ rent
▪ employee
▪ taxes
▪ interests paid to a bank
• GROSS PROFIT OR MARGIN
o Gross profit is a company's profit after deducting the costs associated with making and
selling its products and services. It can be calculated by subtracting the Cost of Goods
Sold (COGS) from Revenue (sales)
• OPERATING INCOME
o Amount of profit realized from a business's operations after deducting operating
expenses
• OTHER INCOME, GAIN/LOSS
o Gains and losses produced through a company’s non-primary operations
• INTEREST INCOME/EXPENSE: a NON-OPERATING EXPENSE
o Interest income is the amount paid to an entity for lending its money or letting another
entity use its funds
o Interest expense is the cost incurred by an entity for borrowed funds
• INCOME BEFORE INCOME TAXES
o Income before taxes is a business's net income after all operating expenses—but not
taxes—have been paid. This is a useful metric for comparing business performance
because it removes the variable of taxes, which changes over time and across
jurisdictions.
• INCOME TAX EXPENSE
o Tax expenses are the total taxes owed by an individual, corporation, or other entity to a
taxing authority. Income tax expense is estimated by multiplying taxable income by the
effective tax rate.
• EBIT: Earnings Before Interest and Taxes
o EBIT is used to analyze the performance of a company's core operations without the costs
of the capital structure and tax expenses impacting profit.
• NET INCOME NI
o Net Income = Revenues – Expenses + Gains – Losses
o Represents the economic performance of the firm during a fixed period usually 1jahr
RELATION BETWEEN BALANCE SHEET AND INCOME STATEMENT

WHEN ARE REVENUES RECORDED?

• When we deliver the goods, and receive the cash (sales cycle complete)
• When we deliver the good, and cash is in the form of a receivable
• When we sign the contract
• When we have a verbal agreement
• When we have an indicator that our inventory will be sold
• When we are producing the inventory
• When we purchase the raw materials
• When we build the factory
• When we imagine building a factory
• When we imagine developing a product

WHEN ARE REVENUES REALIZED?

a revenue is recognized when:

1. Earned
1. Delivery of goods has occurred or services have been rendered
2. Realized or realizable
1. There is evidence of an arrangement for customer payment
2. The price is fixed or determinable
3. Collection is reasonably assured

WHEN DO WE RECOGNIZE AN EXPENSE?

• Definition: Outflow of assets and/or incurrence of liabilities from delivering or producing goods,
rendering services, or other activities that constitute the ongoing major or central operations of the
firm
• Prepaid expense (outflow of assets): Paying for marketing campaigns to be conducted next year, is
not an expense! (it is a prepaid asset!)
• Accrued expense (incurrence of liabilities): If employees work for you this month, but you do not pay
them, it is still an expense!
• Record expense in the same period as related revenue (matching)
 3. Cash Flow Statement -> Shows a firm’s cash transactions How much cash was generated/disbursed
from various activities
1. Cash Flows from operating activities:
i. Cash from business activities encompasses all the sources and applications of cash
related to a company's operational endeavours. This metric illustrates the amount of
cash generated by a company through its products or services.
2. Cash Flows from investing activities
i. Sources and applications of cash associated with a company's investment activities.
This category includes the purchase or sale of assets, loans extended to vendors or
received from customers, and any payments related to mergers and acquisitions
(M&A).
3. Cash Flows from financing activities
i. Inflows of cash from investors and banks, along with the various methods by which
cash is distributed to shareholders. It encompasses dividends, payments made for
stock repurchases, and the repayment of debt principal (loans) carried out by the
company.

RELATION BETWEEN NET INCOME AND CASH FROM OPERATIONS

• Accruals are the difference between revenues / expenses and cash inflows / outflows
o Net Income = Cash From Operations + Total Accruals
o Net Income –Total Accruals = Cash From Operations
• Cash From Operations can be indirectly derived from Net Income

REMINDER: INCOME IS NOT FULLY BASED ON CASH

• Revenues could be done on credit (receivables!)

• Expenses could be done without accompanying cash payments (payables!)

CASH FLOW FROM OPERATIONS (FROM NI)

Reconciles NI to CFO

Net Income:

• Adjust non-cash items included in Net Income:

o Add (subtract) non-cash expenses (revenues)
o Add (subtract) losses (gains) on sale of equipment, investments
• Adjust for changes in current assets and liabilities (i.e., accruals):
o Add (subtract) decreases (increases) in current assets
o Add (subtract) increases (decreases) in current liabilities

Only used for Operating Activities; the direct method is always used for Investing and Financing Activities

CFS REVISION
RECEIVABLES AND INVENTORY

AR are amounts owed to a company for goods or services delivered or used but now yet paid for by the
consumer.

• AR are recorded in the BALANCE SHEET as CURRENT ASSETS

o Increase in AR = the company’s sales are paid on credit rather than in cash
o Decrease in AR = the company has recovered cash payments for credit purchases

AP (Account Payables) are the customer’s point of view of AR

• AP appear on the BALANCE SHEET as CURRENT LIABILITY

AP and AR are ACCRUALS!

BAD DEBTS

Bad debt is the account receivable that we’re not sure will be collected.

In the INCOME STATEMENT we record an expected amount of bad debt as an allowance in the ASSETS

If a borrower defaults on the loans: write-off. A write-off increases the allowance for doubtful accounts

HOW DO WE ESTIMATE BAD DEBTS?

• Percentage of Account Receivables

o Focus on the Balance Sheet
o Estimates the ending balance of the ALLOWANCE
o Allowance = (historical allowance / historical gross AR) Current gross AR
• Percentage of sales
o Focus on the Income Statement
o Estimates the provision for uncollectible accounts
o Provision = (historical provision / historical sales) Current sales

Typically we estimate in both ways and then choose the best estimation
INVENTORIES

Raw materials used in production as well as goods produced that are available for sale and stored within the
company

• Finished goods held for sale in the ordinary course of business

• Goods in the course of production
• Raw materials to be consumed in the course of production

Often inventories is the largest working capital account on the Balance Sheet, COGS (cost of goods sold) is
usually the largest expense on the Income Statement

Inventory turnover = COGS / average inventory

Cost Flow Assumptions

• Inventory is valued at the Lower of Cost or Market (LCM)

• Market is the current replacement cost
• Cost is the purchase price determined accordingly to:
o Specific identification
o Average cost
o FIFO first in first out
o LIFO last in first out
• GAAP ( generally accepted accounting principles) doesn’t require the cost flow assumption to
correspond to the actual physical flow of inventory

To better understand FIFO vs LIFO:

LONG TERM ASSETS

IMPAIRMENTS

It’s a permanent reduction in the value of an asset, it is accounted as a loss on the income statement

GROWING INVENTORIES

Two reasons why inventories grow:

1. Inventory growth as a sign of growth: the company is producing many goods

to sell in the next future
2. Company has difficulties selling the products and they therefore sit in
warehouses

LONG-TERM ASSETS / FIXED ASSETS

Fixed assets vs current assets

• Fixed assets:
o Tangible or intangible assets, that will benefit the company in one year or more (reflected in
the balance sheet:
▪ Company’s plant and equipment PPE
▪ Real estate
▪ Land
▪ Vehicles
▪ Patents
▪ Goodwill
▪ Trademarks
• Current assets
o Will benefit the company in less than one year
▪ Surplus cash
▪ Account receivables
▪ Inventory
▪ Short-term investments
▪ Raw materials

DEPRECIATION AND AMORTIZATION

Fixed assets:

• Straight line basis

• Accelerated depreciation

Intangible assets:

• Finite life: amortized

• Infinite life: yearly impairment test

Mineral assets ():

• Depleted

Unique assets:

• Depends on the units of production

INTANGIBLE ASSETS

Requires separate recognition for the different categories, an asset to be recognized needs to be purchased!

Reminder: internally generated intangible assets do not show up on the financial statements

RESEARCH AND DEVELOPMENT R&D

Research and development could be either purchased or internally produced

R&D Purchase: purchased with cash= -cash, +asset

R&D Conduction: conduction of R&D costs money, therefore a company might as well buy it directly from a
third party.

SELLING AN ASSET

need to balance for depreciation and apply it to the sale value, need to behave with respect of the selling
method (credit or debit).

Selling at a minus:

Selling at a plus:

IMPAIRMENT OF AN ASSET

An asset is impaired when consequently to damage or whatever it loses value

LIABILITIES

Interest is an expense in the income statement that has to be accounted for also as Equity and as a Cash Flow
Operation.

Example: Debt with periodic interest payment

Example: Debt with deferred interest payment

DEFERRED REVENUE

Is a payment a company received before the effective delivery of the bought goods / services

PROVISIONS AND RESERVES

A liability account is recorded for expected (not guaranteed) future cash outflows, they often involve
estimation and uncertainty:
LEASES

Being a Liability, Alease can either be

• Operating, for less than 1 year

o E.g. renting a car for 1 year at 10’000.- a year

• Financial / Capital, for more than 1 year

o E.g. renting a car for 5 years at 10’000.- a year

Let’s break it down more thoroughly:

CONTINGENCIES

A contingency is an existing condition, situation, set of circumstances that involves uncertainty as to possible
gain or loss to an enterprise that will ultimately be resolved when one or more future events occur or don’t.

Six kinds of contingencies, classified by likelihood of payment:

When a contingency is a Gain Contingency, there are three kinds of it:

1. Possible receipts of money from gifts, donations, bonuses

2. Possible refunds from taxes etc.
3. Pending court cases with a probable favourable outcome.

Gain contingencies are not recorded, disclosed only if probability of receipt is high.
EQUITY

CAPITAL STOCK OR SHARE SYSTEM

In the absence of restrictive provisions, each share carries the following rights:

• To share proportionally in profits and losses

• To share proportionally in management
• To share proportionally in assets upon liquidation
• To share proportionally in any new issues of stock of the same class
o Pre-emptive right

CORPORATE CAPITAL

A corporation has two primary sources of equity:

• Corporate capital
o Common stock
o Preferred stock
• Retained earnings

ISSUING STOCK

Par value:

• Previously the par value was the stated price at which a new corporation’s stock would be issued
• For investors, pas value served as a guarantee that other investors would not receive shares on more
favorable terms
• It now has little meaning and is often set at a trivial amount (1.- or 0.01.-)

Issuing stock, example:

In general, the formula for total issuance:

Total Issuance = Paid in capital + Par Value

• Stocks that are repurchased are held under ‘Treasury’

• Treasury shares are a contra-equity account
Example:

TREASURY STOCK

Stocks that are repurchased are held under ‘Treasury’, they are also called treasury shared and are a Contra
Equity Account.

How are gains or losses on the re-issuance of treasury treated?

• They do not generate an accounting gain or loss

• Transactions between owners and the company do not generate profit / loss
• Paid-in capital is adjusted directly for any difference between the original price paid to repurchase
shares and the proceeds from the re-issuance

Example:
PAYING DIVIDENDS

After a company makes payments to clients, a company records the dividends in both Retained Earnings and
Cash Balance.

Paying dividends both reduces the cash on hand for a company and makes use of retained earnings, so
accountants debit both books equal to the total cost of the dividends.

STOCK REPURCHASE

Reasons for stock repurchase:

• Employee stock option plans

• Stock is undervalued
• Distribute cash to owners
• Protect against a hostile takeover
• Manipulate EPS (Earnings Per Share)
• Meet demands of convertible securities

How do companies buy back stock?

• Open market purchase

• Fixed-price tender offer
• Dutch auction tender offer

PREFERRED STOCK

Preference shares, more commonly referred to as preferred stock, are shares of a company's stock with
dividends that are paid out to shareholders before common stock dividends are issued. If the company enters
bankruptcy, preferred stockholders are entitled to be paid from company assets before common
stockholders.

Why do companies issue preferred stock?

1. It’s less risky to the corporation than debt, this might appeal to financially weak companies.
a. More risky than debt for investors since payoffs are uncertain
2. Preferred stock is treated like equity rather than debt on the financial statements, therefore avoiding
issues related to debt covenants ( a sort of agreement)
3. Dividends paid do not serve to reduce Net Income NI like interest expense would
a. The downside is that dividends paid are NOT tax-deductible like an interest debt, not an issue
if the company is in financial trouble (?)
EARNINGS PER SHARE – EPS

EPS = (Income) / (#Shares)

Basic EPS:

- Income available to common shareholders dividends by weighted average number of common shares
outstanding
- Ignores the potential dilution from securities that could be converted into common stock

Diluted EPS

- Denominator increased to include the number of common shares outstanding assuming dilutive
convertible securities had been converted at the beginning of the year
- Numerator adjusted for the income effect(s) of dilutive convertible securities

Disclosure

- Report Basic and Diluted EPS on face of Income Statement

- Reconcile numerator and denominator used in Basic EPS calculation to those used in Diluted EPS
calculation

OTHER ISSUES

STOCK DIVIDENDS

Giving stock dividends serves to reduce the market price of stock which may make it more attractive to a
greater number of investors.

Example:

STOCK SPLITS

They have the same purpose as a stock dividend, reduce the market price of the stick in a “tradable range”
which may make it more attractive to a greater number of investors.
NEGATIVE EQUITY

Reasons:

• Company is incredibly successful: it doesn’t matter if equity goes negative, all profits go anyway to
buybacks and dividends
• Overdebitness: a company might have higher liabilities than asserts
• Company is a startup: the future is bright but atm we are negative
• Underestimation of intangible assets: the fair value of the intangibles might exceed the book
recordings
• Long-term assets depreciated too fast or with higher fair value: accounting rules require many assets
to be recorded at historical costs, some may actually sell in the market for more

Problem: some ratios such as WACC or the market/book value might be distorted

Solution: analysts suggest taking the fair value of equity to make an analysis comparison possible.
FINANCIAL ASSTES

Investment can be made through financial assets, three different kinds:

1. < 20%
a. Short term: Trading Securities
b. Long Term: Available for Sale Securities
2. 20% < Ownership < 50%
a. Equity investments
3. > 50%
a. Consolidation

TRADING SECURITIES

Cash from Dividends can be recorded in two different ways based on the accounting standard we follow:

• US GAAP: Under CFO

• IFRS: under CFO or CFI

EQUITY METHOD INVESTMENT

TRADING SECURITIES TO EQUITY METHOD INVESTMENT

What happens when you pass from TS to EMI?

1. Stock price volatility doesn’t affect your assets or income anymore

2. A proportion of income (loss) of the target company is stated in the books of the parent company

FINANCIAL PANIC

How does it start?

If a bank has invested the deposits and those investments don’t pay as expected, when the clients eventually
want to withdraw their money, the bank doesn’t have the money to give: the bank is INSOLVENT:

How do we save an insolvent bank?

BAILOUT:

1. Investors or government (respectively, Investor injection and Government bailout) make a cash
injection, the larger the better. This ensures that the fire-selling stops and depositors do not panic
and stand in line.
2. Normally, all existing shareholders are zeroed out, the new investors become the owners and
rationally would install new management to replace the incompetent one.
3. After some time the investors sell the bank at a higher price, getting a nice profit.
MERGERS & ACQUISITIONS (M&A)

A basic example:

GOODWILL

When a big company acquires a smaller company for a sum higher than the equity of said company, therefore
paying a PREMIUM to smaller shareholders: this premium is accounted for as ‘Goodwill’ in the assets

There are different methods of Goodwill Computation:

• Full acquisition – 100%

Goodwill = Price Paid – BV Acquired
• Partial acquisition - < 100%
o Partial Method or Net Assets Method

Goodwill = Price Paid - % of BV Acquired

Minority Interests = % Not Acquired * BV

o Full Method or Fair Value Method

Goodwill = Price Paid at 100% - BV Acquired

Minority Interests = % Not Acquired * (BV + Goodwill)

What is price paid at 100%? It’s the price that we would pay if we were to acquire the 100% of the
company: If ‘Big’ buys 80% of ‘Small’ at a price of 25.- , how much would it cost to acquire the other
company as whole?

Price at 100% = (Price at 80%)/80%

Partial Goodwill - Partial Acquisition example:

NCI: Non-Controlling Interest

Full Goodwill – Partial Acquisition example:

NCI: Non-Controlling Interest

RATIO ANALYSIS

Ratio analysis is a group of techniques employed to analyze the financial health of companies.

Income Statement Ratios:

• Gross Margin: Gross Profit / Net Sales

o To understand the distribution of fixed costs to variable cost
• Cost of Selling:
o Selling Expenses / Sales
o (Operating Expenses – Depreciation) / Sales
• Cost of Financing:
o Interest Expenses / Sales
o Operating Expenses / EBI (Earnings Before Interest)
• Cost of Fixed Assets:
o Depreciation / Net Fixed Assets
o Accumulated Depreciation / Gross Fixed Assets

Performance Ratios:

• Return on Sales:
o Net Income / Sales
• Return on Assets ROA:
o Net Income / Assets
• Sales Turnover:
o Sales / Assets

Balance Sheet Ratios

• Short Term Liquidity Ratios:

o Current Assets / Current Liabilities
• Innovation Strategy
o R&D / Assets
o Investment in Intangibles / Assets
o Intangible Assets / Assets
• Financial Strategy
o Long Term Debt / Assets
o Long Term Debt / Equity

INTERPRETATION OF ‘INTANGIBLE’ CAPITALIZATION

TAXES

Tax Rate is almost never the statutory rate, there are some Permanent Differences.

Tax expense is almost never paid in the same time period:

• Temporary differences:
o Deferred tax assets – paid earlier
o Deferred tax liability – paid later

Some examples:

Temporary Differences (D. T. A.)

Temporary Differences (D. T. L.)

PERMANENT DIFFERENCES:

Differences between GAAP pre-tax income and taxable income that are never reversed are called Permanent
Differences.

Lower Tax Rates (i. e. Higher Income):

• Revenue reported for GAAP but not for taxes:

o Municipal Bonds and other tax-exempted income
o Dividends received from other corporations
• Expenses reported to IRS but not for GAAP:
o Tax Credits (investment, foreign etc)

Higher Tax rates (i. e. Lower Income):

• Revenues reported to IRS but not for GAAP

• Expenses reported for GAAP but not to IRS
o Goodwill impairment
o Entertainment expenses (only 50% is deducted, some are non-deductible such as club
memberships)

Some examples:

1.

In this case the Effective Tax Rate:

ETR = Tax Paid / EBT

 2.

Using the formula above… ETR

HOW TO INCENTIVIZE GOOD BEHAVIOR

To elicit desired behavior:

• Lower tax rate on revenues

o Ex. Sales of solar panels
• Increase deductions on expenses
o Ex. ESG expenses and R&D

To reduce undesired behavior:

• Increase tax rate on revenues

o Ex. Sales of pollutants
• Decrease tax rate on expenses
o Ex. Production process involves pollutants
FORECASTING

Forecasting is a technique that uses historical data as inputs to make informed estimates that are predictive
in determining the direction of future trends.

Forecasting is always for the future!

FORECASTING – BALANCE SHEET

FORECASTING – INCOME STATEMENT

FORECASTING – CASH FLOW STATEMENT

Reminder:

It’s important to understand what is permanent and what is transitory, for each item we shall also predict the
relationship to sales in a forward-looking perspective using stable percentages from past data.