Financial Accounting 003: Cash Flow Statement

What is Cash Flow Statement

The Cash Flow Statement reports changes in cash due to operating, investing and financing activities over a period of time.

Cash Flow Statement Format

  • Net cash from operating activities +
  • Net cash from investing activities +
  • Net cash from financing activities =
  • Net change in cash balance

Business Activities

Operating activities create transactions related to providing goods and services to customers and to paying expenses to generating revenue.

Investing activities create transactions related to acquisition or disposal of long-term assets, which includes PP&E and intangibles.

Financing activities create transactions related to owners or creditors, such as issuing new stock, payment of dividends and taxes etc.

Receipt of interest or interest payment may be classified in either of the 3 activities, depending on regulations.


Growth Stages of a Company

  1. At the Start-Up stage of a company, operating cash flow is likely to be negative as the company is attempting to gain market share. Outflow of cash for investing will be high to build up capabilities. Inflow of cash from financing will be high in order to keep the business running when the company has yet to become profitable.
  2. If the company is able to move past the Start-Up stage, it will enter the Early Growth stage, where the company will start to make profit, hence it will start to see positive operating cash flow. Investing cash flow will remain negative as the company expands the business. Inflow of cash from financing may not be as high, but the company will likely to continue to borrow money for expansion.
  3. When the company reaches the Mature stage, operating cash inflow will be huge. It will gradually reduce investment spending as the business has already reached optimal scale. This is the stage where the company starts paying back the debts and give dividends to the stockholders. Financing cash will see a net outflow.
  4. Finally at the Decline stage of a company, there will still be cash inflow from operating activities, although not as much as compared to the previous stage. Investing cash outflow will be minimal, just sufficient to maintain the business. Financing cash outflow will be mainly dividend payouts as the company do not need to borrow money for expansion.

Statement of Cash Flow Complications

The change in balance sheet numbers is often not equal to the number on the cash flow statement. This is due to a number of reasons:

  • Non-cash investing and financing activities.
  • Acquisitions and divestitures of business.
  • Foreign currency translation adjustments.
  • Subsidiaries in different industries.

EBITDA

EBITDA is Earnings before Interest, Taxes, Depreciation and Amortisation, is often used as a proxy for cash flow that excludes interest and taxes, but note that it is ultimately an income concept.

Earnings and current cash flow from Operations are good predictor of future cash flow.

Free Cash Flow

FCF is the operating cash flow less cash for long-term investments. There is no standard measure for operating cash flow, and companies may use their custom definitions which include:

  • Cash from operations before interest expense
  • NOPLAT (Net operating profits less adjusted taxes)
    (EBITDA – Cash taxes on EBITDA)
  • NOPAT – increase in working capital
    (Net Income + After-tax net interest expense)
  • Net income adjusted for depreciation and other non-cash items – increase in working capital
  • EBIT + Depreciation
  • EBITDA

 

(Reference: Coursera Wharton Online Introduction to Financial Accounting)

Financial Accounting 002: Income Statement

What is Income Statement

The Income Statement reports the changes in Shareholders’ Equity due to business operations over a period of time.

(Recall that Shareholders’ Equity = Contributed Capital + Prior Retained Earnings + Net Income – Dividend)

The calculation of Net Income is Revenues – Expenses. Note that Net Income is also called Earnings or Net Profit.


Accrual Accounting

Accrual accounting is an approach of recognising revenues and expenses tied to business activities, regardless of whether cash has been exchanged. In other words, accounting for revenues and expenses of businesses is independent of cash flow. This is an important concept to remember.

Revenue Recognition Condition: revenue is only recognised when both

  • It is earned (i.e. goods or services are provided to the customer) and
  • It is realised (i.e. payment received in cash or something that can be converted to a known amount of cash such as promissory note, purchase order etc.).

Expense Recognition Condition: expenses is recognised immediately when either

  • Related revenues are recognised (product costs) or
  • Incurred, if difficult to match with revenues (period costs and unusual events).

As you have observed, there are two underlying principles to the recognition conditions. First, the matching principle, which require the revenue and expense to be recognised when the matching goods or services are provided. Revenue and expense must also be recognised within the same business operating period for periodic revenue (such as subscription services) and periodic costs. Second, the conservatism principle, which require anticipated losses to be recognised immediately, but to recognise gains only when realised.


Adjusting Entries

Recall that for an accounting cycle, at the end of each accounting period, Adjusting Entries will be performed. Adjusting entries are internal transactions that update account balances in accordance with accrual accounting. They record deferred revenues and expenses, as well as accrued revenue and expenses.

  • Deferred Expenses – assets that have been “consumed” in the period, e.g. expending prepaid rent, prepaid insurance, depreciation and amortisation.
  • Deferred Revenues – liabilities that have been fulfilled by delivery of goods or services, e.g. unearned rental revenue, deferred subscription revenue.
  • Accrued Expenses – expenses that have been accumulated in the period, e.g. income taxes payable, interest payable, salaries and wages payable.
  • Accrued Revenues – revenues accumulated in the period, e.g. interest receivable, rent receivable.

Note: the purpose of Depreciation and Amortisation is to allocate the cost of a long-lived asset (longer than one accounting period) over the entire useful life of the asset. Tangible assets require depreciation. Intangible assets require amortisation.

Here is a cheat sheet showing the relationship between cash transaction and revenue / expense recognition. It all depends on whether the cash transaction happens before or after the associated business activity take place.

adjusting-entries

Overview of Adjusting Entries


Preparation of Financial Statements

Let us appreciate how the financial statements are prepared. The Income Statement will be prepared first. Using the Net Income recorded in the income statement, the Retained Earnings will be updated. Second, the Balance Sheet will be prepared. Lastly, the Statement of Cash Flow and Statement of Stockholders’ Equity will be prepared.

These are some of the example formats provided by the online course:

Income Statement Format

  • Revenue (or Sales)
  • [less] Cost of Goods Sold (COGS)
  • [give] Gross Profit
  • [less] Operating (SG&A) Expense
  • [give] Operating Income
  • [less] Interest, Gains, and Losses
  • [give] Pre-tax Income
  • [less] Income Tax Expense
  • [give] Net Income

 

Balance Sheet Format: Assets

  1. Current Assets (benefits to be enjoyed within the next year)
    • (ordered by liquidity)
    • Cash
    • Accounts Receivable
    • Inventory
    • Prepaid Assets
  2. Non-Current Assets
    • Tangible Assets
    • Intangible Assets

 

Balance Sheet Format: Liabilities and Stockholders’ Equity

  1. Current Liabilities (obligations to be fulfilled within next year)
    • (Ordered by liquidity)
    • Bank Borrowings
    • Accounts Payable and Other Payable
    • Deferred Revenues and Other Non-Cash
  2. Non-Current Liabilities
    • Bank Borrowings and Bonds
    • Other types of Liabilities (deferred taxes, pensions)
  3. Stockholders’ Equity
    • Contributed Capital
    • Retained Earnings

 

(Reference: Coursera Wharton Online Introduction to Financial Accounting)

Financial Accounting 001: Financial Statements

Definition

Financial Accounting is a system for recording information about business transactions to provide summary statements of a company’s financial position and performance to external stakeholders.

For U.S. companies, the financial reports are prepared in accordance to Generally Accepted Accounting Principles (GAAP). Although it is slightly different from our local standards, it is still relevant to learn about if you intend to dabble with the U.S. stock markets. The Securities and Exchange Commission (SEC) requires the filing of 10-K annual reports, 10-Q quarterly reports, as well as 8-K current reports for major events that share holders ought to know.

The management of the company is responsible for preparing the financial statements, which allows for creative manipulation to make the company appear in a better state than the actual performance. Therefore, the Audit Committee of the Board of Directors is supposed to oversee this process, and external auditors will also be engaged to verify that the preparation of the statements is in accordance with accounting standards.

 


accounting-cycle

The Accounting Cycle

The accounting cycle describes all the accounting activities performed by a company throughout one accounting period.

  • Start of the period and during the period – Any transactions made by the company is being analysed by the accountant to decide how it should be journalised and posted in the accounting books.
  • End of period – An unadjusted trial balance will be performed to ensure that the records did not have any math errors or mistakes.
  • Adjusting entries – entries in the books are adjusted to account for changes that did not relate to any transactions in the current period, such as depreciation. Another adjusted trial balance will be performed to eliminate errors.
  • Generate financial statements – after adjusting entries, the financial report will be prepared.
  • Closing entries – finally the accounts will be closed and a new period can begin.

 


Financial Report Overview

A financial report is required to contain these 4 statements:

  1. Balance Sheet – this is the financial position on a specific date, listing all the resources and obligations of the company.
  2. Income Statement – the results of company operations over a period of time using accrual accounting, to recognise the true business activity as far as possible. (accrual means accounting for activities when they occur, with or without cash transactions).
  3. Cash Flow Statement – Sources and uses of cash over a period of time.
  4. Statement of Stockholders’ Equity – Changes in stockholders’ equity over a period of time.

The following is a short introduction of balance sheet to kick start the learning of financial reports.

 


Balance Sheet

To understand the balance sheet, we must first learn the balance sheet equation.

  • Assets = Liabilities + Stockholders’ Equity

Another way to look at this is what ever resources that the company holds, the resources either belongs to creditors that the company is liable to, or to the owners of the company. Essentially this is what a company is: a bundle of resources that aims to generate more value. One other note, the equation must always balance.

As balance sheet reflects the financial position of a specific date, changes between two balance sheets over a period of time are summarised in the respective Income Statement, Cash Flow Statement, and Statement of Stockholders’ Equity. Here is a great diagram to visualise this concept:

balance-sheet-1

Relating all financial statements in a single diagram.

And here is a breakdown of the balance sheet equation into slightly finer details for better understanding.

balance-sheet-2

This is a breakdown of the balance sheet equation into slightly finer details.

 

Assets

An asset is a resource that is expected to provide future economic benefits (i.e. generate future cash inflows or reduce future cash outflows). An asset is recognised when:

  1. It is acquired in a past transaction or exchange.
  2. The value of its future benefits can be measured with a reasonable degree of precision.

 

Liabilities

A liability is a claim on assets by creditors that represents an obligation to make future payment of cash, goods, or services. A liability is realised when:

  1. The obligation is based on benefits or services received currently or in the past.
  2. The amount and timing of payment is reasonably certain.

 

Stockholders’ Equity

Stockholders’ Equity is the residual claim on assets after settling claims of creditors. It is also called net worth, net assets or net book value. There are 2 sources of Stockholders’ Equity:

  1. Contributed Capital – which includes the value of common stock (par value), additional paid-in-capital (excess over par value), and treasury stock (stock repurchased by the company).
  2. Retained Earnings – which is the accumulation of net income, less dividend, since the start of business.Note, dividends are distributions of retained earnings to shareholders and are not considered expenses, but liabilities instead.

 

(Reference: Coursera Wharton Online Introduction to Financial Accounting)

Financial Accounting 004: Ratio Analysis

Before embarking on ratio analysis, do keep in mind that ratios are contextual and you have to decipher the underlying activity that the ratios represent. Also, the absolute value of the ratios are useless; ratios have to be observed over a period, or be compared across the industry, to paint a meaningful picture of the company.

Common Pitfalls

There is no common standard for calculating ratios across companies, therefore be careful when comparing the figures.

Ratios can be disrupted by major changes in a company, reducing the effectiveness of time series analysis, and if the changes cause the company to pivot from the original industry and market, it will also disrupt cross section analysis.

Ratios can be manipulated by management, so do look at multiple ratios to get a complete picture.


1. Return on Equity (ROE)

ROE = Net Income / Average Shareholders’ Equity (of beginning and ending balances).

ROE measures the return on investment. Typically with higher risks, the investment will provide higher ROE.

There are 2 drivers of ROE, one is the operating performance of the business, and the other is the level of financial leverage.

2. Return on Assets (ROA)

ROA = Net Income / Average Assets.

ROA measures the effectiveness of the company in generating profit from existing company resources.

3. Financial Leverage

Financial Leverage = Average Assets / Average Shareholders’ Equity.

This ratio can only exceed the value of 1 with leverage. This particular measure is more effective for analysing ROE.

This measures how much of the existing company resources are funded by debts.

ROE Drivers

ROE = ROA x Financial Leverage.

Increasing either ROA or Financial Leverage will improve ROE.


A Closer Look at Return on Assets

There are also 2 drivers of ROA, one is the profitability of the company, while the other is the efficiency in generating sales.

4. Return on Sales (ROS)

ROS = Net Income / Sales

This measures the profit generated per dollar of sales.

5. Asset Turnover (ATO)

ATO = Sales / Average Assets

This measures the amount of sales generated based on the existing available resources.

ROA = ROS x ATO.

To look at the operating performance more objectively, it would be wise to use de-levered net income in all the calculations, so that the after-tax interest expense had been compensated. This reflects the true efficiency and profitability of the business regardless of the capital structure.

De-levered net income = net income + ( interest expense x (1-tax rate) )

However, ROE should use levered net income instead as you want to take into account the effect of leverage. Therefore when analysing ROE and all its component, consider the effect of leverage.


DuPont Ratio Analysis

DuPont Analysis

The DuPont formula equates Return on Equity to the drivers mentioned above:

ROE = (Net Income / Sales) x (Sales / Assets) x (Assets / Equity)
ROE = Profitability x Efficiency x Leverage

When evaluating companies using this analysis, you should be mindful of the business strategy to ensure that you are making an apple-to-apple comparison. Huge retail discount stores for example, typically have low profitability but high efficiency. Luxury retails on the other hand has low efficiency but high profitability.

Common Size

Common-sizing the financial statements can help to reduce the effect of growth and other volatility on the numbers and make it easier for us to identify trends.

  • Balance sheet numbers can be expressed as a percentage of total assets
  • Income statement can be expressed as a percentage of total sales

Profitability in Details

To make better analysis, we can look at more detailed ratios of sales and expenses.

  • Gross Margin = (Sales – COGS) / Sales
    The extra premium charged for the goods above the cost of production.
  • SG&A to Sales = SG&A Expenses / Sales
    Selling, General and Administration (Operating) cost compared to sales.
  • Operating Margin = Operating Income / Sales
    Earnings before interest and taxes compared to sales.
  • Interest Expense to Sales = Interest Expense / Sales
    Cost of borrowing compared to sales.
  • Effective Tax Rate = Income Taxes / Pre-tax Income
    Amount of income paid to taxes.

Asset Turnover in Details

To have a closer look at asset turnover, we can start from the following ratios.

  • Accounts Receivables Turnover = Sales / Avg. Accounts Receivable
  • Inventory Turnover = COGS / Avg. Inventory
  • Accounts Payable Turnover = Purchases / Avg. Accounts Payable
    (Purchases = Ending Inventory – Opening Inventory + COGS)
  • Fixed Asset Turnover = Sales / Avg. Net PPE

The equivalent of the above, from the perspective of days outstanding ratios, are the following.

  • Days Receivables = 365 / Accounts Receivables Turnover
    The average number of days company have to wait to receive payment from customers, after delivering the goods.
  • Days Inventory = 365 / Inventory Turnover
    The average number of days the company took to turn incoming raw materials into goods and deliver it to customers.
  • Days Payable = 365 / Accounts Payable Turnover
    The average number of days the company took to pay off suppliers.
  • Net Trade Cycle = Days Inventory + Days Receivable – Days Payable
    This is the average number of days of cash shortfall, during which the company will have to borrow to pay off suppliers while waiting to receive payments from customers.

Other Ratios

Short-term liquidity ratios help us to gauge if the company has sufficient cash to pay off short term liabilities.

  • Current Ratio = Current Assets / Current Liabilities
    Measures if current assets are able to cover current liabilities. But not all components of current assets can be quickly converted to cash.
  • Quick Ratio = (Cash + Receivables) / Current Liabilities
    Measures if the company has sufficient cash to cover current liabilities.
  • CFO to Current Liabilities = Cash from Ops / Avg. Current Liabilities
    Measures if cash generated from operations is able to cover current liabilities.

Short-term interest coverage ratios  help us to gauge if the company has sufficient cash to cover for interest payments.

  • Interest Coverage = (Operating Income before Depreciation) / Interest Expense
    This measures if the income from operations is able to cover interest payment.
  • Cash Interest Coverage = (Cash from Ops + Cash Interest Paid + Cash Taxes) / Cash Interest Paid
    This measures if the cash from operations able to cover interest payment.

Long-term Debt Ratios describes how the company finance growth and is a measure of bankruptcy risk.

  • Debt to Equity = Total Liabilities / Shareholders’ Equity
    This measures for every dollar of shareholders’ investment, how much did the company borrow to finance itself. Sometimes, total assets is used in the denominator is SE is too small.
  • Long-Term-Debt to Equity = Total Long-Term Debt / Total Shareholders’ Equity
    This measures how much long-term borrowing the company took as compared to shareholders’ investment.
  • Long-Term Debt to Tangible Assets = Total Long-Term Debt / (Total Assets – Intangible Assets)
    This compares the amount of borrowings with the amount of assets that can be collaterised.

 

(Reference: Coursera Wharton Online Introduction to Financial Accounting)