1
This lecture introduces accounting concepts and constructs that are widely used to
describe the financial performance of companies. They form the vocabulary that
you will need if you want to follow and understand the discussion concerning
business performance. Within a single lecture, we can only scratch the surface of
accounting issues.
The income statement, the balance sheet and the statement of cash flows are the
primary financial statements. In detail, there are several formats to construct these
statements although the key principles are the same. Accounting standards and
regulations articulate the formats to use in practice but studying these standards is
not your objective in this course. The formats that you should follow, for example
in the group work, are given in the respective course material.
Although people often refer to financial statements and performance indicators
separately, it is vitally important to understand how the statements and indicators
are interconnected.
Accounting is concerned with recording, analyzing and reporting financial
information. The purpose is to assist various decision makers inside and outside
the firm. Financial statements and their accompanying notes provide public
information for everybody interested in the company. General standards for
financial accounting and reporting regulate the preparation and disclosure of
information in order to guarantee the reliability of the information. Management
accounting provides additional non-public information for managers and
decision makers inside the company.
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Official financial statements aggregate the data that consists of numerous actual
financial transactions between the company and other parties. The easiest way to
get a grasp of this process is to look at transactions in your bank account.
The monthly statement of your bank account is a plain statement of cash flows. It
tells how much money you had in the beginning of the period and how much you
have in the end. It also lists the various transactions that have decreased or
increased your account balance.
Liquidity means that you can pay your bills and other obligations in due time. To
be certain of not running out of money, you should be able to anticipate future
cash flows. One way of doing this is classifying past transactions. Many of them
occur frequently and the sum of the transactions does not vary much from month
to month. Besides these recurrent cash flows, there are more specific expenditures
or incomes. If the cash balance and income flow does not cover all the
expenditures, one can borrow money, which is a financing transaction. In the
official statement of cash flows, the main classification separates cash flows from
operating activities, investing activities and financing activities.
This type of simple classification resembles a chart of accounts that has been
created for a specific purpose, i.e., produce useful information from a vast
amount of transactions. The detailed chart of accounts is a tool for recording
transactions. Discrete accounts form hierarchies and the lines in financial
statement represent the highest level of these hierarchies.
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The following example illustrates the difference of cash flow and profit.
In the beginning of November, a retailer obtained 150 000 units of merchandise
for 3 M€. He intends to sell the batch by the end of January at 28 € per unit. So,
the total expected gain or profit of selling the batch will be 1,2 M€ (= 28
€/unit*0,15 Mkpl – 3 M€) if everything goes as planned.
The retailer’s fiscal year ends December 31 and he has to report the profit of the
year. By that date, he has sold 100 000 units and received 2,8 M€ from customers.
(At this point, we assume that customers pay immediately.) On the other hand, he
has originally paid 3 M€ for the batch. The simple end-of-the-year balance of this
trade operation is -0,2 M€. This cumulative cash flow is not the accounting profit
of the year, however.
The logic of calculating profit resembles the following: The purchase cost of the
merchandise was 20 €/unit. Sales price being 28 €, each unit sold generates a
profit of 8 €. Therefore, the profit earned by selling 100 000 units is 0,8 M€. In
other words, the retailer has received 2,8 M€ from customer the end of December
but only the purchase cost of 100 000 units is deducted from this sum (expensed
in accounting terminology) this year.
The remaining 50 000 units will be sold next year, and the corresponding portion
of the total acquisition cost of 3 M€ will be deduced from the next year’s sales
income. The total gain of the entire operation equals the cumulative cash flow if
the retailer sells the remaining inventory at 28 €/unit in January.
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Customers do not always pay immediately as we assumed previously. The second
main difference between cash flow and profit concerns the time when revenue is
recognized. The amount of money received from customers during an accounting
period is not directly the sales revenue taken into account when calculating profit.
Revenue measures the inflow of economic benefits arising for the ordinary
operations of a business, i.e. sales of products (goods and services). Revenue is
entered in the accounting records at the time the product is delivered to a
customer. This is called the accrual basis in accounting. The customer receives
an invoice that also tells how much time the customer has to pay for the delivery.
So, the cash transaction changing the balance of the bank account occurs later.
From the time of delivery until the time of payment, the customer owes money to
the company. This debt is called receivable in the company’s accounting records.
In order to keep track of customers’ liabilities, the company records the delivery
transactions and respective cash transactions of each customer. Together, these
records form the accounts receivable, which tell how much all the customers
owe to the company at a specified moment, for example, in the beginning of a
fiscal year or any other accounting period.
Each delivery during the period adds accounts receivable by the invoiced sum
(value of the delivery), and each payment by a customer decreases receivables.
The aggregate effect of these transactions results to the sum of accounts
receivable at the end of the period.
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In order to make products, a company acquires various resources (material,
people, equipment, utilities) and combines them in the production process. It
must pay for the resources (pay an invoice, wages, rent). An expenditure is
recorded at the time the resource is received. So, the accrual basis applies here, as
well, and the flow of transactions resembles the one concerning revenue.
From the time of receiving until the time of payment, the company owes money
to a supplier (a party providing the resource). This debt is called payable in the
company’s accounting records. In order to keep track of debt to suppliers, the
company records the receiving transactions and respective cash transactions
concerning each supplier. Together, these records form the accounts payable,
which tell how much the company owes to its suppliers at a specified moment,
for example, in the beginning of a fiscal year or any other accounting period.
Each receiving transaction during the period adds accounts payable by the
invoiced sum, i.e. the acquisition cost of a resource, and each payment by the
company decreases payables. The aggregate effect of these transactions results to
the sum of accounts payables at the end of the period.
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Profit is a result of matching realized revenues with the costs of earning those
revenues. Revenue for the financial year is recognized in the profit calculation
(income statement, profit and loss account) according to the accrual basis (when
the product is delivered to the customer). Only the portion of a financial year’s
expenditures that is not likely to generate income in the future is deducted from
revenue as an expense. The remaining portion of the expenditures, which is likely
to generate further revenue is capitalized in the balance sheet.
Valuation of inventories is a straightforward example of this principle. The
purchase cost of 3 M€ represents the expenditure of acquiring 150 000 units of
merchandise. By the end of the year, ⅔ of this batch, i.e. the portion delivered,
has generated revenue. The residual is likely to generate further revenue.
Inventories include various items called stock-keeping units (SKU). One can
formulate a material balance for each SKU.
Amount in the opening inventory + Amount received during the period
= Amount used during the period + Amount in the closing inventory
Multiplying the quantities by unit purchase price per unit, we transform an SKU’s
material balance into monetary terms. Now, we can add up the SKU-specific
balances and write an equation for the value of inventories:
Opening inventory + Acquisition costs = Material expenses + Closing inventory.
Because Closing inventory – Opening inventory = Increase in Inventory,
Material expenses = Acquisition costs – Increase in Inventory
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We have introduced several accounting concepts and equations in order to explain
the difference between profit and cash flow. Now, we combine these equations.
Working capital is a measure of a company’s operational efficiency, i.e. how
much money is needed to fund the daily operations.
Working capital = Accounts Receivables + Inventory – Accounts Receivable.
Increase (or change) in any element of the working capital is simply the
difference between closing value and opening value. Now, we can write
Revenue – Expenses
= Received Payments – Payments to Suppliers + Increase in Working Capital
The story is not complete, however. Inventory refers to material resources that the
company acquires and consumes frequently during the fiscal year. The same
principle of matching revenue and expense (resources that do not generate
income in the future) applies to machines, equipment and other property that the
company acquires less frequently. Such long-term assets generate revenue during
multiple fiscal years.
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The acquisition cost of a long-term asset is depreciated during the asset’s planned
useful life. In principle, the company estimates how much the asset will lose its
revenue-generating capability during each year of the useful life. A corresponding
proportion of the acquisition cost is deducted from that year’s revenue. Year by
year, the book value of the asset decreases. The non-depreciated proportion of the
acquisition cost is recognized in the balance sheet (capitalization). We shall call
the acquisition cost of this kind of long-term assets as capital expenditures
(CapEx)
Companies typically use fairly simple methods to calculate depreciation. In this
course, we use the straight-line depreciation (SLD), where the same amount of
money is depreciated each year.
SLD = Acquisition cost of an asset / useful life in years
A company has several discrete assets that may have a separate depreciation
plans. As in the case of inventories of various SKU’s, we can add up the detailed
accounts. So, the following equation is used for a category of discrete assets at the
company level:
Opening value – Depreciation of the period + CapEx of the period = Closing
value
In accounting terminology, depreciation is used in the context of tangible assets.
A corresponding process for intangible assets is called amortization. In both
cases, the main points is matching realized revenues with the costs of earning
those revenues.
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We have now gone through the two main principles (accrual basis and matching)
and related key concepts that explain the difference between profit and cash flow.
Now it is time to look at the structure of the income statement (a.k.a. profit and
loss account).
First, we define operating profit: sales revenue less operating expenses, i.e. the
expenses associated with generating sales. Operating profit indicates the
profitability of the firm’s business. It provides a basis for assessing the success of
a company apart from its financing and investing activities and separate from tax
considerations.
Revenue contains income obtained from the sale of goods and services. Revenue
does not include value added tax and other taxes directly linked to the amount of
sales, however. This course does not consider these kind of taxes. Revenue may
also be called net sales because sales discounts and returns have been deducted
from the gross sales income.
Typically, cost of sales is separated from other operating expenses. Cost of sales
shows costs directly related to produce the goods and services sold, such as
manufacturing costs. It consists of several cost elements (materials, personnel
costs, rents, purchased services, depreciation). Gross profit is revenue less cost of
sales. In addition to production expenses, there are other operating expenses
related to the ordinary course of running the business (sales and marketing,
administration, research and development).
Now, we can compress the difference between profit and cash flow in the
equation at the bottom of the slide.
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There are several ways to categorize operating expenses in the official income
statement and for internal use, companies use more detailed formats. For
understanding why cash flow is not profit, it is important to remember three
points: 1) Distinguish expenditures from cash payments (accrual basis). 2)
Identify expenditures that are not expensed immediately (acquisition cost of
inventories, capital expenditure. 3) Notice that there are also expenditures that are
expensed at the same financial year they occur (e.g. marketing and administrative
costs).
Interest expenses and income taxes are deducted after calculating operating
profit. Therefore operating profit is also called Earnings Before Interest and
Taxes (EBIT). To be precise, there are small differences between operating profit
and EBIT but we shall use them as synonyms.
Interest represents financial expenses. A company may also have financial income
coming from financial (non-operating) investments. The basis for income tax is
profit before tax (PBT). In this course, we use a simple formula calculate income
tax (=PBT*tax rate)
The bottom line of the income statement show the profit or loss of the financial
year. It is also called net income or (net) earnings. In literature, terms income,
earnings and profit are used interchangeably.
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The balance sheet is a statement of financial position at a given point of time (end
of the financial year = beginning of the next financial year). The balance sheet
equation states the elementary structure of the statement. The assets show how
the firm uses its capital (its investments); whereas liabilities and shareholders’
equity show the sources of capital. Liabilities denote the firm’s financial
obligations to creditors (suppliers, debt holders). Shareholders’ equity is an
accounting measure of the firm’s net worth, i.e. how much of the firm’s asset
value belongs to the owners.
It is important to understand the fundamental difference between debt and equity.
A firm that fails to make the required interest or principal payments on the debt is
in default. Thereafter, debt holders get certain rights to the assets of the firm. In
the extreme case, the debt holders take legal ownership of the firm’s assets in a
bankruptcy process. The firm’s assets may be sold to take care of the obligations.
The residual belongs to the owners. Therefore, we can also interpret equity as the
difference between the firm’s assets and liabilities.
There are two important links between the income statement and the balance
sheet. First, the part of the financial year’s acquisition costs that is not expensed
in the income statement is recognized as the book value of assets in the balance
sheet. Second, the net income of the financial year increases the equity.
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Current assets include assets that could be converted into cash within one year
(next 12 months, short-term).
Cash refers to the money in bank accounts and cash equivalents, i.e. short-term,
low-risk investments that can be easily sold and converted to cash.
Besides accounts receivable, a company may have other short-term receivables
that the debtors will pay within 12 months. In bookkeeping terms, they borrowed
money from the company because of normal business conventions. For example,
if the company has paid an insurance fee in advance, the insurance company
owes the money for a while. It is not short-term financial investment made by the
company.
Inventories are composed of raw materials as well as work-in-progress and
finished goods. The detailed principles of valuing different inventories is an issue
that we don’t consider in this course.
Assets such as property or machinery that produce benefits for more than one
year are called non-current assets (a.k.a. fixed assets). We can further divide non-
current assets into tangible assets (plant, property, machinery), intangible assets
(patents, licenses, trademarks and similar rights) and other non-current assets
(long-term financial investments).
To be precise, depreciation is a method applied to tangible assets whereas a
corresponding method for intangible assets is amortization. Financial instruments
are recognized at fair value (market value). Their market value changes during
the financial year but they are not depreciated or amortized.
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Liabilities are also divided into current (short-term) and non-current (long-term)
liabilities. Current liabilities will be satisfied within one year. In addition to
accounts payable, there are similar accrual items, such as salary or taxes, that are
owed but not yet paid. These items are basically non-interest bearing liabilities,
and they belong to the elements of working capital.
In contrast, short-term debt mean loans that must be repaid in the next year. Any
repayment of non-current debt that will occur within the next year belongs here as
current maturities of long-term debt. These items are interest-bearing debt.
Long-term debt is any loan or interest-bearing debt obligation with a maturity of
more than a year. When a firm needs to raise funds to purchase assets, it may
borrow those funds.
The main elements of the shareholders’ equity are paid-in capital and retained
earnings. Paid-in capital means that owners give money to the company. This
happens typically when companies sell new shares to investors. Retained earnings
show the sum a company has earned since its inception, less any payments made
to shareholders in the form of dividends. Retained earnings is the link between
the income statement and the balance sheet.
Beginning retained earnings + Net income – Dividends = Ending retained
earnings.
A common mistake is to confuse retained earnings and cash.
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The above group of equations summarizes the connections between balance sheet
and income statement. Elements of cash flow and profit explain the change in
balance sheet items between the beginning and the end of the financial year.
Look at the horizontal equations. Depreciation and amortization decrease the
value of long-term assets whereas new investments (CapEx) increases the value.
Net working capital (NWC) = Current Asset – Current non-interest bearing
liabilities. It is an extension of working capital introduced earlier. Increase in net
working capital (ΔNWC) is the ending value less the beginning value. (Likewise,
ΔCash denotes increase in Cash.)
Debt refers to all interest-bearing debt. New loans increase debt and repayments
decrease it. The equation for retained earnings was in the previous slide.
A company may raise new equity capital from investors. This is denoted by ΔPIC
(PIC = paid-in capital).
The balance sheet equation must hold in the beginning and in the end. It follows
that the following must also hold
– Depreciation + CapEx + ΔNWC + ΔCash
=
– Repayments + New loans + Profit – Dividends + ΔPIC
By rearranging the items of this equation we get the basic structure of the
statement of cash flows.
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The statement of cash flow utilizes the information from the income statement
and balance sheet to determine how much cash the firm has generated and how it
has allocated that cash. The sum of all cash flows equals change in cash and cash
equivalents (ΔCash).The statement of cash flow has three sections: operating
activities, investment activities, and financing activities.
Calculating the cash from operating activities starts with net income. This number
is adjusted by adding back non-cash entries, such as depreciation. The second
adjustment concerns change in net working capital (ΔNWC). This adjustment
transfers entries following the accrual basis to cash basis.
Capital expenditures represent the actual amount of money that the firm has paid
for its long-term investments. Capital expenditures do not appear immediately as
expenses on the income statement. The firm depreciates these assets and deducts
depreciation expenses over time. Because depreciation creates no cash-flow, it
was added back earlier.
The last section shows the cash flows from financing activities. Concerning debt
funding, it shows how much the firm has borrowed and how much the firm has
spent money to repay old debt. Concerning equity funding, it shows how much
the firm has paid dividend to the owners and how much the firm has raised new
equity capital. Note that interest is not included in this section because it is an
expense considered in net income. On the other hand, dividend is not an item on
the income statement.
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The financial ratios are indicators calculated from the data of financial
statements. They give a compressed view of the firm’s financial condition in
terms of profitability, liquidity and leverage.
Profitability ratios use the information of the income statement and balance sheet.
Profit margin is just a ratio of some profit line to revenues (sales). For example
operating margin = EBIT/Sales. The more elaborate ratios show how efficiently
the firm has used capital in earning profit. A direct measure of profit from the
income statement is divided by capital employed. Return on equity is an
important ratio for the owners. It is the ratio of net income to equity.
Liquidity ratios compare the firm’s current liabilities and its current assets (or
some part of current assets). Current liabilities cause cash payments during the
next 12 months. Current assets convert into cash during the same period and are
available for the payments.
Leverage means the firm’s capital structure, i.e. the proportions of debt and
equity. One can also use net debt, where cash reserves are deducted from debt
because the firm may use cash to repay debt.
The literature defines numerous financial ratios, and different books may use
different variants of the same indicator. The objective of this course is not to learn
the formulas of ratios by heart. One can always use some “handbook” to check
the formula. When firms report their success with financial ratios, they typically
also articulate the formula they have used.
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In order to understand the financial condition or success of a firm, one needs to
interpret several indicators. Relying on a single ratio may lead to poor decisions,
whether you are a manager or an investor.
The above equation is known as the DuPont identity (named for the company that
popularized its use). It expresses return on equity in terms of profitability (net
profit margin), asset efficiency (asset turnover) and capital structure (equity
multiplier). Asset turnover measures how efficiently the firm is using its assets to
generate sales. Firms in highly competitive businesses may have to face low
profit margins but such a firm may still be lucrative for investors, if it uses assets
efficiently (small inventories, no excess capacity).
Equity multiplier is the reciprocal of equity-to-capital ratio (=E/D+E). The higher
the firm’s reliance on debt funding, the higher the equity multiplier will be. So,
increasing the use of debt seems to improve the firm’s ROE. This is numerically
correct interpretation but investors may not be satisfied with the improved ROE.
Increasing debt increased the risk for owners, and risk is reflected in the return
that the investors expect to earn on their investment. ROE is higher but that it also
what the investors expect.
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It is not straightforward to set accurate reference levels for financial ratios. The
above figures illustrate the challenges. The figures were published in a Finnish
business magazine (Talouselämä, No 21/2018).
The official balance sheet does not recognize all the intangible assets of the
company. Wholesalers run a huge logistic operation and have significant
inventories and other tangible assets. Software companies have less tangible
assets. Therefore, there are fundamental differences across industries.
Furthermore, companies classified in the same industry do not have identical
operations. Supercell and Rovio sell their product to consumers, which justifies
the unrefined industry class. Both companies are in mobile game business. Rovio
is a mobile game developer whereas Rovio has two business units: games and
brand licensing.
Supercell’s financial success is undeniable and phenomenal but because the
figures are based on book values, they do not tell the whole story. Using ROCE as
a proxy for ROA (=Net income /Assets) and reciprocal of equity/asset as a proxy
for equity multiplier, we can roughly estimate that ROE is 170 %.
The present majority owner (Tencent) bought 72 % of Supercell’s shares at 6450
M€ in 2016, which indicates that the total market value of equity was close to
9000 M€. The book value of equity was close to 500 M€
(http://www.largestcompanies.fi/yritys/Supercell-Oy-1323371/tilinpaatos-ja-
tunnusluvut). For Tencent, 9 billion is the value of equity, which they expect
return on.
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Financial ratios can be used in two main ways. First, one can compare the firm
with itself by analyzing how the firm has changed over time. Second, one can
compare the firm to other similar firms.
Analyzing the recent development of a single firm is a simpler case, because
annual reports (of listed companies) include key ratios from the current and
recent years.
Even though financial reporting standards direct how financial statements are to
be prepared, there are diverse options that firms may choose to apply. Therefore,
the financial statements of two companies are not fully comparable. The purpose
of the financial statement analysis is to adjust company-specific statements to
make them more comparable. It is the indicators calculated using the adjusted
figures that are used to compare firms.
Companies operate in diverse businesses and use different resources. It is not
reasonable to compare companies from different industries. There may even be
significant differences between firms in the same industry. Furthermore,
accounting standards do not recognize all intangible asset that contribute to the
actual market value of the firm. As a result, the book value of equity (the balance
sheet value) may be much smaller than the market value of equity (= number of
shares outstanding * current price of a share).
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