Chapter 2

UNDERSTANDING FINANCIAL STATEMENTS

 Financial Statements

 The Four Key Financial Statements

 Income Statement
 Balance Sheet
 Statement of Retained Earnings
 Statement of Cash Flows

 Other
 Sources & Uses of Fund Statement
 Income Statement

 The income statement – measures

performance over a specific period of time
 It reflects the expenses, income & the
profit (earning) of a company for that
particular period
 Usually prepared annually for reporting
purposes
 Income Statement
SALES EBIT = Earning Before
- Cost of Goods Sold Income Taxes
GROSS PROFIT EBT = Earning before tax
EAT = Earning after tax
- Operating Expenses
OPERATING INCOME (EBIT)
- Interest Expense
EARNINGS BEFORE TAXES (EBT)
- Income Taxes
EARNINGS AFTER TAXES (EAT)
- Preferred Stock Dividends
= NET INCOME AVAILABLE
TO COMMON STOCKHOLDERS @ NET PROFIT AFTER
TAX (NPAT) @ NET INCOME (NI)
 Income Statement
SALES
- Cost of Goods Sold
GROSS PROFIT
- Operating Expenses
OPERATING INCOME (EBIT)
- Interest Expense
EARNINGS BEFORE TAXES (EBT)
- Income Taxes
EARNINGS AFTER TAXES (EAT)
- Preferred Stock Dividends
= NET INCOME AVAILABLE
TO COMMON STOCKHOLDERS
 Income Statement
SALES
- Cost of Goods Sold
GROSS PROFIT
- Operating Expenses
OPERATING INCOME (EBIT)
- Interest Expense
EARNINGS BEFORE TAXES (EBT)
- Income Taxes
EARNINGS AFTER TAXES (EAT)
- Preferred Stock Dividends
= NET INCOME AVAILABLE
TO COMMON STOCKHOLDERS
 Balance Sheet

 A balance sheet is prepared as soon as

the income statement is completed
 It shows the financial position of a
company at that point of time
 The balance sheet identity is:

Assets = Liabilities + Stockholder’s Equity

 Balance Sheet
ASSETSts Liabilities (Debt) & Equity

Current Assets Current Liabilities

Cash Accounts Payable
Marketable Securities Accrued Expenses
Short-term notes
Accounts Receivable
Long-Term Liabilities
Inventories Long-term notes
Prepaid Expenses Mortgages
Fixed Assets Equity
Machinery & Preferred Stock
Equipment Common Stock (Par
Buildings and Land value)
Other Assets Paid in Capital
Investments & patents Retained Earnings
 Assets
 Current Assets: assets that are relatively
liquid, and are expected to be converted to
cash within a year.
 Cash, marketable securities, accounts
receivable, inventories, prepaid
expenses.
 Assets
 Current Assets: assets that are relatively
liquid, and are expected to be converted to
cash within a year.
 Cash, marketable securities, accounts
receivable, inventories, prepaid
expenses.
 Fixed Assets: machinery
and equipment, buildings,
and land.
 Assets
 Current Assets: assets that are relatively liquid,
and are expected to be converted to cash within a
year.
 Cash, marketable securities, accounts
receivable, inventories, prepaid expenses.
 Fixed Assets: machinery and equipment,
buildings, and land.
 Other Assets: any asset that is not a current asset
or fixed asset.
 Intangible assets, such as patents and
copyrights.
 Financing
 Debt Capital: financing provided by a
creditor.
 Current liabilities: borrowed money that
must be repaid within the next 12 months.

 Accounts payable, other payables such

as interest or taxes payable, accrued
expenses, short-term notes.
 Financing
 Debt Capital: financing provided by a
creditor.
 Current liabilities : borrowed money that
must be repaid within the next 12 months.
 Accounts payable, other payables such as
interest or taxes payable, accrued
expenses, short-term notes.
 Long-term liabilities: loans from banks or
other sources that lend money for longer
than 12 months.
 Financing
 Equity Capital: shareholders’ investment
in the firm.
 Preferred Stockholders: receive fixed
dividends, and have higher priority than
common stockholders in event of
liquidation of the firm.
 Financing

 Equity Capital: shareholders’ investment in

the firm.
 Preferred Stockholders: receive fixed
dividends, and have higher priority than
common stockholders in event of liquidation
of the firm.
 Common Stockholders: residual owners of
a business. They receive whatever is left
after creditors and preferred stockholders
are paid.
 Statement of Retained Earnings

 It shows the amount of net earnings (income) reinvested

(retained) in the business.

 Retained earnings (inappropriate profit) are funds

reinvested in the business over a period of years and
these funds are not usually held in the form of cash but
invested in other assets (eg: machinery, equipment) of
the company.
 Statement of Retained Earnings
Statement of Retained Earnings for The
Year Ended Dec 31, 2019

Balance of RE Dec 31,2018

(+) EAT 2019
(-) Dividend Payment 2019
Balance of RE Dec 31,2019
 Statement of Cash Flows

 It provides a summary of the cash flows

over the period of concern
 The three components of the statement of
cash flows are:
 Cash flow from operating activities
 Cash flow from investing activities
 Cash flow from financing activities
 Sources & Uses of Fund Statement

 Flow of fund statement

 Where cash come from (sources)

 How it was used (uses)

 The balance sheet & income statement - the most

important documents to construct this statement

 Before constructing the statement – we need to

identify the sources & uses of funds
 Sources & Uses of Fund Statement
Sources of funds Uses of funds
Decrease in asset Increase in asset
Increase in liability Decrease in liability
Increase in equity Decrease in equity
Depreciation Net loss from operation
Fund provided by operation Payment of cash dividend
 Sources & Uses of Fund Statement
Sources & Uses of Fund Statement For The Year Ended Dec 31, 2000

Sources
EAT RM x
(+) Depreciation x
(+) Increase in liability x
(+) Decrease in asset x
Total xxx

Uses
Increase in asset RM x
Decrease in liability x
Payment of cash dividend x
Total xxx
 UNDERSTANDING FINANCIAL STATEMENT
( contd )

Financial statements includes :

a)Income Statement
-An income statement is actually a combination of
trading and profit and loss a/c but in statement
form.
-It reflects the expenses, income and hence the
profit (earning) of a company for that particular
period.
-It can be prepared for a period as long as a year
or as short as a day. But normally it is prepared
monthly, quarterly, semiannually and yearly.
b) Balance Sheet
- A balance sheet is prepared as soon as the
income statement is completed. It shows the
financial position of a company at that point of
time.
- This means that a balance sheet will show the
total amount of assets, liabilities and equities of
the company at particular time.
- It also shows the total amount of a/c
receivables (debtors) and a/c payable
(creditors) of the company.
c) Statement of Retained earning
- This statement actually show the amount
of net earnings ( income) reinvested
( retained ) in the business.
- Retained earning ( inappropriate profit)
are funds reinvested in the business over
a period of years and these funds are not
usually held in the form of cash but
invested in other asset, ( eg. Machinery,
equipment) of the company.
d) Sources and uses of fund statement
- This statement is also known as statement of
change in the financial position of a company or
flow of funds statement.
- It indicates on a historical basis where cash came
from ( sources ) and how it was used ( uses). This
statement can be developed from the balance
sheets and income statement.
 Sources and Uses of funds statement
 Provide a summary of how funds flow in a firm over a certain
accounting period.
 Evaluation will be made regarding how firm use their
resources and evaluate the uses of those funds and it will give
an insight of how the firm finances it day to day operations.
 This information will be useful tool for the financial manager to
ensure the firm will continue to have sufficient funds and to
use the excess funds to make more investment.
 The balance sheet and income statement are the most
important documents when one wants to construct a
statement of change in financial positions.
 Before constructing the statement, the identification of sources
and uses of funds must be done.
 Identification of sources and uses of funds
Sources of Funds
 Decrease in asset
( when an asset is sold by a firm,
the cash from sales will be
included as an inflow )
 Increase in liability
( when a company borrows money
from external sources it will
increase the funds in the firm )
 Net profit after tax
( This is the profit from the firm’s
operations )
 Sales of stock
( Selling of stock is a means for
firms to generate funds
externally)
Uses of Funds
 Decrease in liabilities
( it is regarded as use because we
use the funds to pay off the debt
)
 Increase in asset
( when we purchase assets we use
funds to pay for it)
 Retirement / purchase
( Funds will be used for the
purchase of shares)
 Cash dividends
( part of the funds will be used to
pay for it )
 Format :
Sources and Uses of Funds Statement

ABX Company
Sources and Uses of Fund Statement for the year ending …

Sources Uses
Funds from operations
EAT ( earning after tax) RM x Increase in assets
RM x
Add: depreciation x Decrease in liability
x
Add: Increase in liability x Payment of cash dividend
x
Decrease in asset x

XXX
XXX
 Exercises
Construct statement sources and uses of fund based on these
information.
DaDiDu Company
Balance sheet as at December 31, 2004 and 2005 ( in millions of RM)

2004 2005
Assets
Cash 10 5
Marketable securities 25 15
Net receivable 15 30
Inventories 25 35
Gross fixed assets 150 175
Less : accumulated depreciation (40) (50)

Net fixed asset 110 125

Total Asset 185 210
Contd..
2004
2005
Liabilities and Equities
A/c payable 10 6
Notes payable 15 10
Other current liabilities 10 14
Long term debt 60 70
Preferred stock 10 10
Common stock 50 60
Retained earnings 30 40

Total liabilities and equities 185

210
 Income statement of
DaDiDu Company for 2004 ( millions)

Sales 300
Less : Cost excluding depreciation 270
30

Less: depreciation 10
Net income before tax 20
Less : tax 8
Net income after tax 12
 DaDiDu Company
Sources and uses of fund for the year ended 31 st December 2005

Sources Uses
Funds from operation
EAT ( earning after tax ) Increase in gross fixed asset
12 25
Add : depreciation* Increase in net receivable
10 15
Increase in inventories 10
Decrease in a/c payable
Decrease in cash 4
5
Decrease in notes payable
Decrease in marketable securities 5
10 Payment of cash dividend**
Increase in other current liabilities 2
4
Increase in long term debt
10
Proceeds from sale of common stock
10 Total Uses
61
Note (*)
• Depreciation :
It can be obtained from the income statement or balance sheet .
However if it is be taken from balance sheet then we must take
the difference between the accumulated depreciation for the
two years and this will give the depreciation for 2005.

Accumulated Depreciation ( 2004 ) RM 50

Accumulated Depreciation ( 2005) 40
Depreciation 10

** Payment of cash dividend

EAT / net income after tax RM 12
Less : retained earnings( 2005:40 – 2004;30) 10
Payment of cash dividend 2
If gross fixed asset figure is not available in the balance sheet and only
the net fixed assets figure is available to calculate change in gross
fixed assets use the following formula :

Change in gross fixed assets

= ( Net fixed asset 1 – Net fixed asset 0) + Depreciation
= ( RM 125 – RM 110 ) + RM 10
Increase in gross fixed assets = RM 25.

If figure obtained is –ve, then it will be a decrease in gross fixed assets.