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Understanding financial statements (cash flow statement)

Cash flow statement

Company ABCXYZ Ltd

Year Ended Dec 31, 2013

all figures in US$

Cash flow from operations

Net earnings 4,000,000
Additions to cash
Depreciation 20,000
Decrease in accounts receivable 30,000
Increase in accounts payable 30,000
Increase in taxes payable 4,000
Subtractions from cash
Increase in inventory -60,000

Net cash from operations

4,024,000

Cash flow from investing

Equipment -1,000,000

Cash flow from financing

Notes payable 20,000

Cash flow for Year Ended Dec 31, 2013

3,044,000

The above table is a simple example of a Cash Flow Statement, which is  one of three key financial statements of a company, the other two being Profit & Loss Statement and Cash Balance.

The cash flow statement shows how much cash a company is generating in a given financial period, such as for one financial year. It is divided into three parts:  (1) cash flows from operating activities; (2) cash flows from investing activities; and (3) cash flows from financing activities.

(1) Cash flows from operating activities

Cash flows from operating activities form the first part of the cash flow statement. It shows how much cash a company generated for its business during a financial period, say for a year. This will show how the company’s cash flow changes from year to year. How the company performed in this area is of  interest to stakeholders because it shows the cash-generating power of the company. As the table above shows, the first cash item in operating activities is net earnings or net income. This figure can be obtained from the Profit & Loss statement – in this case, we are assuming that the net earnings figure in the Profit & Loss statement was 4,000,000. We have next to make some additions to cash (including for non-cash items) and some subtractions from cash.  These cash additions or subtractions need some explanation.

The part on  cash additions and subtractions in the given table shows four items as cash additions (inflows) and one item as  cash subtraction:

(a) Depreciation: 20,000

(b) Decrease in accounts receivable: 30,000

(c) Increase in  accounts payable: 30,000

(d) Increase in taxes payable: 4,000

(e) Inventory: -60,000.

Why are the four items from (a) to (d) considered as cash inflows into the company while (e) is considered a cash outflow?  Let’s examine them one by one.

For the depreciation item, assume the company bought an equipment costing 100,000. To simplify matter, assume that the equipment was paid for in cash when it was acquired. If the equipment has a useful life of five years, it means that it will lose 20,000 in value each year under a “straight line” method of depreciation. So the depreciation cost is 20,000 a year. In the profit & loss statement, this 20,000 would have already been deducted as an operating expense in Year 2013  when computing earnings. In reality, the 20,000 depreciation expense did not leave the company as it was a non-cash item. Why was it  so? Remember the company had already paid 100,000 upfront for the equipment? So while depreciation was a cost in Year 2013 and was deducted as an expense, there was no actual outflow. The 20,000 was  therefore treated in the cash flow statement as an addition.

Next, we look at why a decrease in accounts receivable of 30,000 in the Balance Sheet became a cash inflow of 30,000 in the cash flow statement. Accounts receivable are what others owe the company for products sold to them on credit, meaning the buyers were given a grace period to pay later. For Year 2013, accounts receivable payable fell 30,000, so there was a net flow of  30,000 into the company. This item was therefore a plus item in the cash flow statement. If this situation was in reverse, that is there was instead an increase in accounts receivable, there would then be a cash outlfow and the amount of increase will  be a minus item in the cash flow statement.

An increase in accounts payable means the company is owing others more, say for goods supplied to the company. In the example in the table, the increase in accounts payable was 30,000. That meant the company owed 30,000 more to suppliers at the end of Year 2013 than at the end of Year 2012, resulting in a cash inflow for the company and hence was a plus item in the cash flow statement. If it was the reverse, meaning there was instead  a drop in accounts payable, it would have meant money had gone out of the company and had  to be treated as a cash outflow.

The table shows an increase in taxes payable of 4,000 in Year 2013 and this was treated as a cash inflow. This came about because taxes, while accounted as an expense in the profit & loss statement of a financial year , that amount of money did not leave the company immediately.  Let’s assume that in Year 2012 the tax payable was 20,000 and in Year 2013 it was 24,000.   In Year 2013, there was a cash outflow of 20,000 being taxes for Year 2012.  But Year 2013 saw a cash inflow of 24,000 because this amount, while having been deducted in Year 2013 as an expense in the profit & loss statement, would be  be due for settlement the following year in Year 2014.

There was also an increase of 60,000 in inventory in Year 2013 and this was treated as a cash outflow for obvious reasons. When a company buys more stocks, it means more money flows out. It will still be a cash outflow if the goods are on credit term as this mean an increase in accounts payable.

(2) Cash flow from investing activities

These activities involve acquiring or dispensing of property, plant and equipment (PP&E), corporate acquisitions and any sales or purchases of investments. In the table given, the company spent 1,000,000 on equipment in Year 2013, so 1,000,000 was treated as a cash outflow.

(3) Cash flow from financing activities

Financing activities include transactions with the company’s owners or creditors. In the example in the table, the company issued 20,000 notes to raise funds. The 20,000 notes payable are considered a cash inflow. Some other examples of items that fall under this part of the cash flow statement are:

(a) dividends;

(b) issuance/purchase of common stocks;  and

(c) issuance/repayment of debt.

Recommended reading:

(1) The Five Rules for Successful Stock Investing: Morningstar’s Guide to Building Wealth and Winning in the Market

(2) Analysis for Financial Management, 10th Edition

(3) Financial Statements: A Step-by-Step Guide to Understanding and Creating Financial Reports

Understanding financial statements (Profit & Loss Statement)

To be able to identify solid companies, an investor needs, among other things, to have knowledge of three financial statements: the balance sheet, the income statement and the statement of cash flows.

This post looks at what a Profit & Loss statement  is.

Here is a simple example of a Profit & Loss statement:

ABCXYZ Co

Profit & Loss Statement

For the Year Ending Dec 31, 2010

Sales……………………………………………..$1,000,000

Cost of Goods Sold……………………………..$500,000

Gross Profit………………………………………$500,000

Selling & Administrative Expenses……………..$250,000

Depreciation………………………………………$80,000

Operating Profit (EBIT)…………………………..$170,000

Interest……………………………………………$30,000

Earnings Before Taxes………………………….$140,000

Taxes……………………………………………..$56,000

Net Profit………………………………………….$84,000

 

Unlike a balance sheet, which tells how much a company owns and how much it owes at a point of time, a profit and loss statement (also known as an income statement) tells how much money a company is making (or losing) for a specified period, which can be a quarter, a half year, nine months  or a full year.

At the top line is the sales (or revenue) figure. In the simple example given above, sales for the year 2010 were $1,000,000.

Before a company can sell a product, it has first to acquire the product or to manufacture the product itself. Costs are involved in this process – such as costs of raw materials and labour costs (for manufacturers) and wholesale price of goods (for retailers). These costs come under of cost of goods sold. In this example, the cost of goods sold was $500,000.

After deducting cost of goods sold from the total sales, we arrive at gross profit. This is called the gross profit because there are other expense items to be deducted from gross profit before we finally arrive at net profit (or net income). In the given example, gross profit was $500,000.

From the gross profit, we deduct selling & admininstrative expenses ($250,000) and depreciation costs ($80,000) to arrive at operating  profit or earnings before interest and taxation (EBIT) of $170,000. Examples of selling & administrative expenses – known also as operating expenses – include marketing, administrative salaries and sometimes research and development.  When a company buys an asset that lasts for a long time, such as a new building or a new piece of machinery, it charges a portion of the cost of the asset on its profit and loss statement (or income statement)  over a series of periods.  This is known as the depreciation charge. Assuming the company buys an $800,000 machine and it spreads the cost of this over ten years. The depreciation for each of the 10 years works out to $80,000.

A company sometimes takes loans to help in its operations. It has then to pay interest on the loans. In the example given, interest cost was $30,000. After deducting this interest cost from operating profit, the company was left with earnings before taxes of $140,000.

Taxes for 2010 was $56,000. After deducting this amount from earnings before taxes, we arrive at the bottom line – which is net profit (also known as net income) – of $84,000.

Recommended reading:

(1) The Five Rules for Successful Stock Investing: Morningstar’s Guide to Building Wealth and Winning in the Market

(2) Analysis for Financial Management, 10th Edition

(3) Financial Statements: A Step-by-Step Guide to Understanding and Creating Financial Reports

Understanding financial statements (Balance Sheet)

balancesheetexample
The three balance sheet segments tell us what the company owns (assets) and owes (liabilities) and the amount invested by its shareholders (equity).

To be able to identify solid companies, an investor needs, among other things, to have knowledge of three financial statements: the balance sheet, the income statement and the statement of cash flows.

This post looks at what a balance sheet is.

The balance sheet, which is like a credit report, has three segments: a company’s assets, its liabilities and its shareholders’ equity at a specific point in time. Notice that the balance sheet is a snapshot of these segments at a specific point of time (it can be at the end of a financial year or the end of a financial quarter). That’s why a balance sheet is sometimes referred to as a statement of financial position. The three balance sheet segments tell us what the company owns (assets) and owes (liabilities) and the amount invested by its shareholders (equity).

This is the balancing formula:

Assets = Liabilities + Shareholders’ Equity

Assets consist of current assets (those that are likely to be used up or converted into cash within one year or one business cycle) and non-current assets (those that are not likely to be used up or converted into cash within one year or one business cycle).

Likewise, liabilities comprise current liabilities (money that the firm owes and expects to pay out within one year) and non-current liabilities (money the firm owes but which is not due for payment within a year).

As said earlier, a balance sheet must balance, hence:

Assets = Liabilities + Shareholders’ Equity

Alternatively, the formula can be:

Assets – Liabilities = Shareholders’ Equity

Let’s put in some numbers to understand the equation better.

Assume a firm has assets of $200m, liabilities of $40m and equity of $160m.

Thus $200m (assets) = $40m (liabilities) + $160m (equity).

Remember assets are what the firm owns, liabilities are what it owes and equity is what the shareholders put in.

If the firm decides to issue $20m in bonds, its liabilities will go up by $20m, bringing total liabilities to $60m. This in turn raises the assets of the firm by $20m, bringing total assets to $220m.

The equation thus becomes: $220m (assets) = $60m (liabilities) + $160m (equity).

Assuming the firm decides to issue new shares to raise $30m. Equity thus becomes $190m and assets become $250m.

The equation now reads: $250m (assets) = $60m (liabilities) + $190m.

Got it?

Earlier on, we said that assets comprise current assets and non-current assets and that liabilities consist of current liabilities and non-current liabilities. To recapitulate, current assets are those likely to be used up or converted into cash within one year and current liabilities are money the firm expects to pay out within a year.

Let’s now look at examples of the assets and liabilities.

Examples of current assets: (a) cash and equivalents and short-term investments (b) accounts receivable (c) inventories.

Examples of non-current assets: (a) property, plant and equipment (b) investments (c) intangible assets.

Examples of current liabilities: (a) accounts payable (b) short-term borrowings.

Examples of non-current liabilities: long-term debt, such as bonds and bank loans.

Examples of equity: (a) money raised from the issue of new shares (b) retained earnings.

Now let’s examine the components of the abovementioned examples to understand what they are.

(a) Cash and equivalents and short-term investments: Cash itself needs no explanation. The cash equivalents refer to money market funds or anyting that can be easily liquated and turned into cash. Examples of short-term investments are bonds that have less than a year to maturity.

(b) Accounts receivable: This is money owed to the company resulting from a sale and which the firm is expecting to receive payment soon. Let’s illustrate. When a company makes a sale and ships the goods ordered, it records the amount of sale as revenue in its profit and loss statement (more about profit and loss statement in subsequent postings) .Let’s say the order is $2 million. The recorded revenue is $2 million. But the sale does not mean that the company now has $2 million in cash in its hands. The company may allow the customer to pay the money within 60 days. So until the bill is collected, the amount of $2 million remains an accounts receivable. There is a potential red flag here: if the accounts receivable is growing much faster than the firm’s sales, it may mean the company is more easy going on credit terms for customers in order to boost its revenue. The risk of payment default is higher in such a case.

(c) Inventories: raw materials, partiall finished products and finished products.

(d) Property, plant and equipment: land,buildings, factories, furniture, equipment and the like. These are long-term assets that a firm needs to run a business.

(e) Intangible assets: normally refers to goodwill. How does this come about? Let’s say firm ABC is acquiring full control of XYZ. The tangible value of XYZ is say $80m. But because XYZ is well-known as a brand, ABC is prepared to pay above the tangile value. Let’s say ABC pays $130m to acquire XYZ. The difference between $130m and $80m is the intangible assets – known as goodwill in this case – of $50m.

(f) Accounts payable: This is the reverse of accounts receivable. Accounts payable are bills the firm owes others and are expected to be paid up within a year. Let’s say the firm buys $20,000 worth of raw materials and the supplier gives the firm a credit period of 60 days to pay up. This bill of $20,000 will be recorded as accounts payable.

(g) Short-term borrowings: A firm may have short-term needs and borrow money with repayment expected to be made within a year. The borrowing could be in the form of a bank overdraft. Short-term borrowings could be a portion of a long-term debt that is due for repayment within a year.

(h) Long-term debts: this is money the firm owes and where repayment is expected after at least one year. The debt can be in the form of bonds issued by the company or it can be long-term borrowing from banks.

Recommended reading:

(1) The Five Rules for Successful Stock Investing: Morningstar’s Guide to Building Wealth and Winning in the Market

(2) Analysis for Financial Management, 10th Edition

(3) Financial Statements: A Step-by-Step Guide to Understanding and Creating Financial Reports