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Unit 2 (Understanding Financial Statements and Cash Flows)
Unit 2 (Understanding Financial Statements and Cash Flows)
REVIEWING FINANCIAL
STATEMENTS
- Chapter 2
Introduction
• Current Assets
• Normally convert into cash within a year.
• Cash (and marketable securities)
• Accounts Receivable
• Inventory
Assets
• Non-current Assets (Fixed Assets)
• Useful life exceeding one year.
• Physical (tangible) assets (e.g. plant and
equipment, machinery, computers etc.)
• Non-physical (intangible) assets (e.g.
software, patents, trademarks, intellectual
properties etc.)
• Other immovable long-term assets (e.g.
fixtures and fittings etc.)
Liabilities
Cash
Cash Outflows
Inflows
Sources and Uses of Cash
• Statement of Cash Flows reflects :
• Operating Activities
• Investing Activities
• Financing Activities
• Net Change in Cash and Cash Equivalents
(e.g.Marketable Securities etc.)
Cash Flows from Operating Activities
• Represents items directly associated
with producing and selling the firm’s
products.
Cash Flows from Investing Activities
• Represents cash flows associated with
buying or selling fixed or other long-
term assets.
• Reflects the firm’s investment in fixed
assets.
Cash Flows from Financing Activities
• Cash flows from debt and equity
financing transactions. Examples :
• Issuing short- or long-term debt
• Issuing stock
• Using cash to pay dividends
• Using cash to pay off debt
• Using cash to buy back stock
Net Change in Cash and Cash Equivalents (e.g.
short-term deposits, marketable securities etc.)
-
Free Cash Flow (cont.)
• Firms with positive Free Cash Flow
(FCF) have funds available for
distribution to investors and lenders.
• Potential negative FCF implications for
firms :
• Experiencing operating or managerial problems.
• Investing heavily in operating capital to support
growth.
• Note: FCF might be negative while OCF is positive
Statement of Changes in Equities
(Statement of Retained Earnings)
• Shows detailed changes in retained
earnings during the reporting period.
• Reconciles net income and dividends
paid with changes in retained earnings
from one period to the next.
Cautions in Interpreting Financial Statements
• Preparation of financial statements are required to
comply with accounting standards such as IFRS in
Hong Kong and GAAP in US.
• Firms may explore possibilities of loop holes in these
accounting standards and to do some “earnings
management” e.g.:
• “Smooth” earnings
• Use different depreciation methods
- Chapter 3
Introduction
• Uses of Financial Statements
• Analyze firm performance.
• Develop plans to improve performance.
• 1) Liquidity
• 2) Asset Management
• 3) Debt Management
• 4) Profitability
• 5) Market Value / Investment
1) Liquidity Ratios
• Relationship between firm’s current
assets and current liabilities.
• Common liquidity ratios :
• Current ratio
• Quick (or Acid-Test) ratio
• Cash ratio
Current Ratio
• Broadest liquidity measure.
• Measures current assets available to
pay current liabilities.
Quick Ratio
• Excludes inventory (which is usually
not very liquid) in the numerator.
• Measures a firm’s ability to pay short-
term obligations without inventory
sales.
Cash Ratio
• Measures ability of the firm to pay
short-term obligations only with
available cash and marketable
securities.
2) Asset Management Ratios (Efficiency Ratios)
Or Credit
purchases
(after depr.)
• Debt Ratio
• Measures percentage of total assets financed
with debt.
Debt vs. Equity Financing
• Debt-to-Equity Ratio
• Measures dollars of debt financing for every
dollar of equity financing.
Net