Analysis of Financial Statements

Module 2

Dr. Gagandeep Sharma, SJIM

Analysis of Financial Statements 1

Classifying activities

Analysis of Financial Statements 2

Operating Activities

 Cash flows from core business operations (revenue-generating activities)

 Examples:
 - Cash received from sales of goods/services
 - Cash paid to suppliers/employees
 - Cash paid for taxes
 - Interest paid or received (as per company policy)

Analysis of Financial Statements 3

Investing Activities

 Cash flows from acquisition/disposal of long-term assets and investments

 Examples:
 - Purchase/sale of property, plant, and equipment
 - Purchase/sale of investments
 - Loans advanced to third parties
 - Interest/dividends received (if treated as investing)
 Note: Does NOT include cash equivalents.
 “Cash payments to acquire equity or debt instruments of other entities and interests in
joint ventures**, except those classified as cash equivalents or held for trading.”

Analysis of Financial Statements 4

Financing Activities

 Cash flows from transactions related to equity and borrowings

 Examples:
 - Proceeds from issue of shares/debentures
 - Borrowings and repayment of loans
 - Payment of dividends
 - Lease liabilities repayments (under Ind AS 116)

Analysis of Financial Statements 5

Cash Flows Between the Firm and Claimants in the Capital Market
 Cash received from debtholders and shareholders is
(temporarily) invested in financial assets. Cash payments to The firm Capital markets
debtholders and shareholders are made by liquidating financial
assets (that is, selling debt). Net financing assets are debt

ue bt rs
purchased from issuers, net of debt issued to debtholders.

iss de lde
Net financing assets can be negative (that is, debt sold to F

or t ho
debtholders is greater than debt purchased).

eb

rs
Net Financial
Assets (NFA)

rs
de
ol
d

eh
ar
Sh
Key:
F = net cash flow to debtholders and issuers
d = net cash flow to shareholders
NFA = net financial assets = financial assets – financial
Financing
liabilities Activities

Analysis of Financial Statements 6

Business Activities: All Cash Flows
 Cash generated from operations is invested in net
The firm Capital markets
financial assets (that is, it is used to buy financial assets
or to reduce financial liabilities). Cash investment in
operations is made by reducing net financial assets (that

ue bt rs
iss de l de
is, by liquidating financial assets or issuing financial
C F

or tho
obligations). Cash from operations and cash investment

Net Operating

eb

rs
Assets (NOA)

Net Financial
Assets (NFA)
may be negative (such that, for example, cash can be

D
generated by liquidating an operating asset and investing
the proceeds in a financial asset).
 Investing activities means investment in

rs
operating assets, not financial assets.

de
ol
d

eh
I

ar
Sh
Key:
F = net cash flow to debtholders and issuers
d = net cash flow to shareholders
C
I
=
=
cash flow from operations
cash investment Operating Financing
NFA
NOA
=
=
net financial assets
net operating assets = operating assets – operating Activities Activities
liabilities

Analysis of Financial Statements 7

The Cash Conservation Equation (sources and uses of cash equation)
A fundamental accounting identity: Free cash flow = net dividends + net payments to debtholders and issuers
C–I=d+F

C = Net cash from operations

I = Net cash outflow for investing
C-I = Free cash flow
d = Net dividends (common dividends + share repurchases – share issues)
F = Net cash outflow to debtholders and debt issuers
= Net borrowing principal payments + net interest paid
The treasurer’s rule:

If C-I-i>d: lend or buy down own debt

If C-I-i<d: borrow or reduce lending; where i net interest cash flow (interest paid – interest received)
 this is called an identity as cash generated must be disposed of, sources = uses

Analysis of Financial Statements 8

Reformulated Statement of Cash Flows

• This classification is essentially different Cash flows from operations C

from the GAAP statement of cash flows
• This is done from the viewpoint of a CFO Cash investment (I)
who’s deciding financing requirements Free cash flow C-I
Equity financing flows:
Dividends and share repurchases XX
Share issues (XX) d

Debt financing flows:

Net purchases of financial assets XX
Interest on financial assets (XX)
Net issue of debt (XX)
Interest on debt XX F

Total financing flows d+F

Analysis of Financial Statements 9
The Reformulated Balance Sheet
 Classification of accounts that represents the stock
of flows into and out from net assets.
 Keeps track of net indebtedness of a business Assets
 Published accounts are useful for credit analysis Operating assets OA
 Financing items can be assets or liabilities Financial assets FA
 Operating items can also be positive (asset – Total Assets OA + FA
accounts receivable) or negative for the business
(liability – accounts payable). Liabilities and Equity
Operating liabilities OL
Financial obligations FO
Common stockholders’ equity CSE
Total OL + FO + CSE

Analysis of Financial Statements 10

Balance Sheet Restated (reformulated)
 Regrouping is required Operating Assets
 Net operating assets (NOA) = OA – OL
Operating assets OA
 Net financial assets (NFA) = FA – FO
Operating liabilities (OL)
 Common shareholder’s equity (CSE) = NOA + NFO
 Usually NFA are negative so CSE = NOA – NFO Net operating assets NOA
 So we’re restating the normal balance sheet identity in
terms of net stocks of operating and financial
Financial Obligations & Owners’ Equity
activities Financial liabilities FO
 So instead of owners’ equity = assets – liabilities we
have Financial assets (FA)
CSE = NOA + NFO Net financial obligations NFO
Common equity CSE
 Now where does the income statement fit in? Total NFO & Equity NFO + CSE

Analysis of Financial Statements 11

Business Activities: All the Stocks & Flows
• Net operating assets are employed in Product and
The firm Capital markets
input markets
operations to generate operating revenue
(by selling goods and services to

ue bt r s
customers) and incur operating expenses

iss de l de
s
C F

er
OR

or tho
m
(by buying inputs from suppliers).

Net Operating

eb

rs
to

Net Financial
Assets (NOA)

Assets (NFA)
us

D
∆ indicates changes.

C
• Commonly operating activities and
investing activities are not depicted

rs
separately because purpose of investments

de
rs

ol
li e
is to buy assets for operations

eh
OE d

pp

ar
I

Sh
Su
Key:
F = net cash flow to debtholders and issuers
d = net cash flow to shareholders OR-OE=OI
C = cash flow from operations OI -NOA=C-I
I = cash investment
NFA = net financial assets C-I -NFA+NFI=d
NOA = net operating assets
OR = operating revenue
OE = operating expense Operating Financing
OI = operating income Activities Activities
NFI = net financial income

Analysis of Financial Statements 12

Reformulated Income Statement
 The difference between operating revenue and operating
expense is called operating income: Income Statement

Operating income
OI  OR  OE Operating revenue OR
Operating expense (OE) OI

Net financial expense

Financial expense FE
 Financial expense and revenue is in the form of interest Financial revenue (FI) NFE
paid and received respectively Earnings Earn
 Net financial expense can be negative (net financial
income)
 Should be valued using accruals e.g. cash interest on
discount bond

Analysis of Financial Statements 13

Analysis of Balance Sheet and Income Statement: the Steps
1. Reformulate to distinguish between operating and financing activities
2. Carry out common size and trend analysis
3. Calculate balance sheet and income statement ratios

Analysis of Financial Statements 14

The Standard Assets Liabilities and Stockholders’ Equity
Balance Sheet Current assets: Current liabilities:

Cash Accounts payable

Cash equivalents Accrued expenses
Short-term investments Deferred (unearned) revenues
Deposits and advances Advances from customers
Accounts receivable (less allowances) Short-term notes payable
Short-term notes receivable Short-term borrowings
Other receivables Deferred taxes (current portion)
Inventories Current maturities of long-term debt
Prepaid expenses
Deferred income taxes (current portion)

Long-term assets: Long-term liabilities:

Long-term debt securities Bank loans

Equity investment at cost Bonds payable
Equity investments at market Long-term notes payable
Equity investments - equity method Lease obligations
Property plant and equipment Commitments and contingencies
(less accumulated depreciation) Deferred taxes
Land Pension liabilities
Buildings Post employment liabilities
Equipment
Leased assets
Leasehold improvements
Construction in progress Redeemable preferred stock

Intangible assets
Patents Minority interest
Copyrights
Goodwill
Shareholders’ equity
Deferred taxes (non-current) Preferred equity
Deferred charges Common equity

Analysis of Financial Statements 15

Reformulating the Balance Sheet:
The Governing Accounting Relations
Net Operating Assets (NOA) = Operating Assets (OA) – Operating Liabilities (OL)

Net Financial Obligations (NFO) = Financial Obligations (FO) – Financial Assets (FA)

Common Shareholders’ Equity (CSE) = NOA – NFO

____Reformulated Balance Sheet___

OA FO
(OL) (FA)
NFO
CSE
NOA NFO + CSE
________________________________

Analysis of Financial Statements 16

The Typical Reformulated Balance Sheet

Assets Liabilities and Stockholders’ Equity

Financial assets: Financial liabilities:

- Cash equivalents - Short-term borrowings

- Short-term investments - Current maturities of long-term debt

- Short-term notes receivable (?) - Short-term notes payable (?)

- Long-term non-marketable - Long-term borrowing (bank loans,

debt investments bonds, payable, notes payable)

- Long-term marketable - Lease obligations

debt securities
- Preferred stock

Operating assets: Operating liabilities:

all other assets all other liabilities

Minority interest

Common equity

Analysis of Financial Statements 17

Issues in Reformulating Balance Sheets
 Cash: working cash and excess cash
 Short term notes receivable: trade receivables or investment of cash?
 Finance receivables: an operating asset
 Debt investments: financial assets
 Short-term equity investments: excess cash or trading securities?
 Short-term notes payable: trade notes or borrowing?
 Lease assets: operating assets
 Lease liabilities: financial obligation
 Deferred tax assets and liabilities: operating
 Deferred revenues and accrued expenses: operating
 Minority interest: not a financial obligation
 For financial firms, many “financial items” are operating assets and liabilities

Analysis of Financial Statements 18

GAAP Balance Sheet: Nike Inc.

Analysis of Financial Statements 19

Reformulated Balance Sheet: Nike Inc.

Analysis of Financial Statements 20

Nike Inc.: Notes on the Reformulation
1. Cash and cash equivalents have been split between operating cash and interest-bearing cash
investments
2. Interest-bearing accounts receivable are classified as financing items
3. Accrued liabilities exclude dividends payable (now added to shareholders’ equity) and include
stock-based compensation liability (transferred from shareholders’ equity)
4. Notes payable are interest bearing and classified as financing liabilities

Analysis of Financial Statements 21

Strategic Balance Sheets
Reformulated balance sheets inform about the firm’s strategy for running the business:
 How the firm invests in operations
 How the firm relies on operating liabilities
 How the firm conducts its financing of the operations

Analysis of Financial Statements 22

Strategic Balance Sheet: Microsoft Corporation
Year ending June 30 2002 2001

Net Operating Assets

Operating assets:
Working cash1 $ 50 $ 50
Account receivable, net 5,129 3,671
Inventories 673 83
Deferred income taxes 2,112 1,522
Property and equipment, net 2,268 2,309
Equity investments 9,151 8,780
Convertible preferred debt2 3,036 3,925
Goodwill 1,426 1,511
Intangible assets, net 243 401
Other assets 2,952 3,372
27,040 25,624
Operating liabilities
Accounts payable 1,208 $ 1,188
Accrued compensation 1,145 742
Income taxes payable 2,022 1,468
Unearned revenue 7,743 5,614
Preferred income taxes 398 409
Other liabilities 2,950 15,466 2,120 11,541
11,574 14,083
Net financial assets
Cash equivalents 2,966 3,872
Short-term investments 35,636 27,678
Long-term debt investments 2,004 40,606 1,656 33,206

Common Stockholders’ Equity 52,180 47,289

1
Cash and cash equivalents split between working cash and financial assets.
2
Convertible debt of AT&T Corp. in connection with investment in broadband.
Analysis of Financial Statements 23