Basic understanding
of a company’s
financial statements
September 2020
2PwC | Basic Understanding of a Company's Financials
Table of contents
What are financial statements? 3
Balance sheet 5
Income statement 16
Cashflow statement 24
2
What are financial
statements?
3PwC | Basic Understanding of a Company's Financials
4PwC | Basic Understanding of a Company's Financials
Financial statements are written records that illustrates the business activities and the financial performance of a company. In
most cases they are audited to ensure accuracy for tax, financing, or investing purposes.
A methodically work through of the three financial statements in order to assess the Financial health of a company.
Balance Sheet
Income Statement
Statement of Cash Flows
The financial statements
• Statement of financial position
• Statement of operation/profit and loss
Balance Sheet is a snapshot at a point in time. On the top half you
have the company’s assets and on the bottom half its liabilities and
Shareholders’ Equity (or Net Worth). The assets and liabilities are
typically listed in order of liquidity and separated between current and
non-current.
The income statement covers a period of time, such as a quarter or
year. It illustrates the profitability of the company from an accounting
(accrual and matching) perspective. It starts with the revenue line and
after deducting expenses derives net income.
The cash flow statement look at the cash position of the company .
It answers it answers the questions ; How much of the organisation’s
cash goes to its creditors and shareholders? Does it keep enough for
its own investment and growth? has 3 components cash from
operations, cash used in investing, and cash from financing. It
“undoes” all of the accounting principles and shows the cash flows of
the business.
Source CFI
Balance sheet
5PwC | Basic Understanding of a Company's Financials
6PwC | Basic Understanding of a Company's Financials
Simplified Balance Sheet
Assets
Current assets
Cash 20,000
Accounts receivable 3,000
Inventory 60,000
Prepaid expenses 11,000
Total current assets 94,000
Non current assets
Property plant &
equipment
110,000
Intangible assets 10,000
Total non current assets 120,000
Total assets 214,000
Liabilities
Current liabilities
Accounts payable 2,000
Accrued expenses 1,000
Total current liabilities 3,000
Non current liabilities 11,000
Bank loan 100,000
Shareholder equity
Common shares 89,000
Retained Earnings 11,000
Total liabilities and
shareholders equity
214,000
Current vs non-current
Current
Assets
Balance sheet
The Balance sheet has
3 main categories:
Assets
Liabilities
Equity
Assets
• Expected to be converted into
cash in less than 1 year
• Accounts receivable, inventory
Liabilities
• Will be paid in less than 1 year
• Trade accounts payable
Non-current
Assets
• Expected to be held greater
than 1 year
• Property, plant, and equipment
Liabilities
• Repayment terms longer than
1 year
• Loan repayable over a 5 year
period
Source CFI
7PwC | Basic Understanding of a Company's Financials
See accompanying notes.
Illustrative balance sheet (assets )
Current
Assets
• Expected to be converted into
cash in less than 1 year
• Accounts receivable, inventory
Non-current
Assets
• Expected to be held greater than
1 year
• Property, plant, and equipment
8PwC | Basic Understanding of a Company's Financials
8
Cash and Investments
• Investments in equity or
debt instruments to be
held for capital gain and/or
income
Cash and investments
A company will hold external investments for two reasons:
• Excess cash
• Accumulating cash to make a large purchase
A company can also make internal investments
• (less than year)
Internal
investments
Long termShort term
External
investments
• (more than year)
• Investment in subsidiaries,
associates and joint
ventures
8
Source CFI
9PwC | Basic Understanding of a Company's Financials
Intangible Asset
Intangible assets are items of value that are
used to generate revenues and have no
physical substance.
Unearned/Differed Revenue
Unearned revenue arises when a company
sells something it has not yet delivered e.g.
licenses, subscriptions 12 month
subscription sold for $1,200 in January:
Goodwill
• Non-current asset
• Company has intangible Value
e.g. brand, customers,intellectual capital
If a company is purchased for more than
the fair value of net assets (assets less
liabilities):
Purchase price X
Fair value of net assets acquired (X)
Goodwill X
Earned: $100 $300 $600 $900 $1,200
Jan Mar Jun Sep Dec
Unearned $1,100 $900 $600 $300 $0
Other assets
Trademarks
Patents
Copyrights
Source CFI
10PwC | Basic Understanding of a Company's Financials
Current
Liabilities
• Will be paid in less than 1 year
• Trade accounts payable
Non-current
Liabilities
• Repayment terms longer than 1
year
• Loan repayable over a 5 year
period
Illustrative balance sheet (liabilities)
See accompanying notes.
11PwC | Basic Understanding of a Company's Financials
New buildings
Building
improvements
Leasehold
improvements
Other liabilities
Commitments
Commitments are future obligations that a company agrees to.
Contingencies
Contingencies are liabilities that may or may not happen, depending
on circumstance.
e.g. lawsuit
The liability must be recorded if:
1.A loss will be suffered in the future
2.The loss amount can be reasonably estimated
If not, just disclose a note.
Contingent gains are never recorded in financial statements.
Source CFI
12PwC | Basic Understanding of a Company's Financials
Illustrative balance sheet (statement of shareholder’s equity)
See accompanying notes.
13PwC | Basic Understanding of a Company's Financials
Common shares
• Allow for participation in the profits of the
company
– Comes in the form of a dividend
• Allow for voting rights in a company
– One vote for every share held
• If dissolved, any residual amount after
everyone else is paid would go to the
common shareholders
Preferred shares
Authorised shares
• The total number of shares a
company can sell
Common vs preferred shares
Outstanding (Issued) shares
• The total number of shares a
company has sold/issued
• Offer investors a fixed dividend
– It may not be paid annually
• Will accumulate/pay before common share
dividends
• Most businesses don’t issue because they
are viewed as debt with a tax disadvantage
– Dividends do not reduce taxable income
See accompanying notes.
Source CFI
14PwC | Basic Understanding of a Company's Financials
Aspects of the Equity
Par Receives
Contributed surplus
Paid-up share capital (180,000 x 25¢) $45,000
Contributed surplus (180,000 x 15¢) $27,000
e.g. 180,000 shares 40¢/each 25¢/par
Aspects of the equity
Contributed Surplus Other comprehensive income
Other comprehensive income (OCI):
• certain company gains and losses that are not always recorded
through the income statement
e.g. unrealised gains and losses on investments and hedging
instruments
Source CFI
Understanding the
income statement
and cash flow
15PwC | Basic Understanding of a Company's Financials
Income statement
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17PwC | Basic Understanding of a Company's Financials
The Income statement has 3 main sections:
Income Statement
Revenues
Expenses
Profit or loss
18PwC | Basic Understanding of a Company's Financials
VS
Single step vs multi-step income statements
Single Step Multiple Step
Source CFI
19PwC | Basic Understanding of a Company's Financials
Operating
Profit
EPS –Investor
Ratio
Net Operating
Profit
OCI-other
gains and
losses
The Illustrative income statement
20PwC | Basic Understanding of a Company's Financials
(e.g. materials used in manufacturing)
Cost of goods sold or Cost of sales:
• May be shown as summarised line item
• May be broken Down to its expense items
Direct Materials
Direct Labor
Direct overhead
(e.g. professional services delivered)
(to the production of the goods or services)
Cost of sales
Source CFI
21PwC | Basic Understanding of a Company's Financials
Advertising and
promotion cost
Legal, Insurance and
accounting expenses.
Office supplies Other related
expenses.
Selling, general and administrative expenses.
Selling, general and administrative, or SG&A contains a large number of expense items such as:
Source CFI
22PwC | Basic Understanding of a Company's Financials
Gains and losses
Gains and losses may appear separately or grouped after all
operating items under “other income or expenses”. They are related
to activities that are incidental to operations such as:
Sale of Investments
Foreign exchange translations
Financial Instrument transactions
Source CFI
23PwC | Basic Understanding of a Company's Financials
Other aspects of the Income Statement
Other comprehensive income (OCI):
• certain company gains and losses that are not always recorded
through the income statement
e.g. unrealised gains and losses on investments and hedging
instruments
Other comprehensive income
Source CFI
Cashflow statement
24PwC | Basic Understanding of a Company's Financials
25PwC | Basic Understanding of a Company's Financials
The cash flow statement
Day-to-day business operations;
Revenues and expenses that have been
collected and paid during the year
Depreciation and amortisation are not included.
Non-current assets that support the business:
• Property, plant and equipment
• Business acquisitions
Transactions regarding shares or debt.
Company raises funds by either borrowing or
issuing shares.
Statement of cash flows demonstrates:
• Where cash is being generated
• Where cash is being used in the business
Operating
Investing
Financing
Source CFI
26PwC | Basic Understanding of a Company's Financials
Statement of Cash Flows
The transactions are sorted by activity type:
Operating
Investing
Financing
The closing cash balance
All cash transactions
The opening cash balance
Source CFI
27PwC | Basic Understanding of a Company's Financials
Direct method
Direct method of cash flow starts with cash transactions.
(Transactions are separated into cash received and cash
paid.)
Indirect method
Indirect method of cash flow starts with net income.
(Non-cash adjustments are then added.)
Direct method vs Indirect method
Source CFI
28PwC | Basic Understanding of a Company's Financials
Net cash provided by
operating activities
Changes in working capital
PPE Investment
Financing
requirement/surplus
Represents operating ‘lifeblood’ of business after paying necessary outgoings for financing
and tax
Shows whether business is absorbing funds for working capital or releasing them. Trend
may indicate ether financial stress or loose control over working capital
Companies must invest in PPE to maintain their productive capacity.
A downward trend may indicate a declining company. Identify the necessary sustainable
level of expenditure.
Shows whether internally generated funds are sufficient to cover investments made in fixed
assets and businesses. Continuous deficits indicate that growth depends on regular
injections of external finance.
Key elements in a cash flow statement
Source CFI
29PwC | Basic Understanding of a Company's Financials
See accompanying notes.
For full disclosure:
Notes are provided to allow the
reader of the financial statements to
understand and make judgements of
financial activities of the company.
The Full Disclosure Principle
30PwC | Basic Understanding of a Company's Financials
Indirect Information
Company
accounting
standards
How inventory &
investments are
valued
Financial
instruments
Revenue is
recognized
Property, plant &
equipment is
amortized
Any other
policies
A breakdown of the
types of investments
Debt and financial
instruments
What is included in:
Inventory Intangible assets
PP&E Income taxes
Notes of indirect information:
• Help provide the entire financial picture of
an organisation
• Not related to the numbers in the financial
statements
Commitments Contingencies
Stock based
compensation plans
Three Key Financial Statements Notes
Significant Accounting Policies Direct Information Indirect Information
Source CFI
31PwC | Basic Understanding of a Company's Financials
Performance Ratio
• Net Profit margin,
• return on assets (ROA)
• return on equity(ROE)
• return on capital employed (ROCE),
• gross margin ratios
• Efficiency (
• Solvency Ratios
• Current ratio= Current assets/Current
liabilities
• Leverage or Gearing
• Operating cash flow/Interest paid
• Operating cash flow/Dividends paid
• Operating cash flow/Operating profit
• Dividend yield,
• P/E ratio,
• earnings per share (EPS),
• dividend payout ratio
Ratio Analysis
The Ratio analysis is a quantitative method of gaining insight into a company's liquidity, operational efficiency, and profitability by studying its
financial statements such as the balance sheet and income statement. Ratio analysis is a cornerstone of fundamental equity analysis.
Solvency Ratios Investor Ratios
32PwC | Basic Understanding of a Company's Financials
The benefits of an annual report
The annual report contains a significant amount of information:
Financial
• Management discussion &
analysis(MD&A)
• Financial statements
• Notes to financial statements
• Messages from the Chair, CEO
• Corporate profile
• MD&A
• Risk and control processes and analysis
Non-financial
Operational
performance
Financial
performance
Strategic
direction
Source CFI
33PwC | Basic Understanding of a Company's Financials
Letters to the
shareholders
01.
Business description
02.
Management’s
Discussion and
Analysis (MD&A)
03.
Reporting on internal
controls
04.
Audit report
05.
Balance sheet,
Income Statement
and Statement of
Cash Flows
06.
Notes to the financial
statements
07.
Earnings per share
08.
Earnings per share
Listing of directors of
the company
09.
Contents of an annual report
The annual report will always include:
Source CFI
34PwC | Basic Understanding of a Company's Financials
Acts as sort of variance
analysis
Explains company
performance
Lists future actions to be
taken
Identifies the key risk
facing the organization
Management discussion and analysis
MD&A provides information regarding past performance and future strategic direction
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