Chapter 4: Preparing Financial Statements Flashcards
Interrelation of Financial Statements
Financial Statements Interconnected: Numbers in one statement flow into the next; errors or changes in one statement affect others.
Fundamental Accounting Equation: Exhibits the interconnections, emphasizing the flow of numbers among statements.
Reporting Shareholders’ Equity: Elements like contributed capital and retained earnings are reported, with detailed discussion of changes in future chapters.
Statement Preparation Order
Statement Sequence: Net earnings computed first (Statement of Earnings), followed by Statement of Changes in Equity, connecting to Statement of Financial Position.
Statement of Earnings (1): Computes net earnings, a component of retained earnings on the Statement of Financial Position.
Statement of Changes in Equity (2): Reports changes and ending balances in contributed capital and retained earnings.
Statement of Financial Position (3): Reflects adjusted ending balances from the trial balance after applying adjustments.
Adjusted Trial Balance and Statement Preparation
Adjusted Trial Balance Update: Adjusted balances for statements obtained from the T-accounts following each adjustment.
Highlighted Changes: Accounts impacted by adjustments are highlighted in the adjusted trial balance (Exhibit 4.5).
Balanced Columns: Total debits equal total credits in each column, ensuring accuracy in the adjusted trial balance for statement preparation.
Earnings per Share Calculation
Regulatory Requirements
Statement of Comprehensive Income: Canadian publicly accountable enterprises, including Gildan, are required to prepare a statement of comprehensive income. Its preparation is beyond the scope of this textbook.
EPS Disclosure: Earnings per share (EPS) is the only ratio mandated to be disclosed on the statement or in the notes to financial statements, providing insight into the company’s financial performance.
Supplemental Measures of Earnings
Non-GAAP Financial Measures: Some companies report non-GAAP financial measures, like EBITDA (earnings before interest, taxes, depreciation, and amortization), alongside IFRS-required net earnings.
Gildan’s Example: Gildan’s 2020 annual report mentions “Adjusted EBITDA,” calculated by excluding financial expenses, income taxes, depreciation, and amortization, also excluding restructuring, acquisition-related costs, impairment of goodwill, and certain insurance gains related to specific events.
Purpose: These alternative measures provide additional insights into a company’s operating performance, often resulting in figures significantly different from net earnings.
Usage Caution: Investors are warned about relying solely on non-GAAP measures as they are not mandatory under IFRS and might lack comparability across companies due to varying calculation methods.
Statement of Changes in Equity
Net Earnings Transition: Net earnings from the statement of earnings are carried forward as the starting point for retained earnings in the statement of changes in equity.
Dividends Deduction: Dividends declared during the period are subtracted from retained earnings to compute the ending balance.
Additional Shares Issued: If new shares were issued (as discussed in Chapter 2), their value is added to the beginning balance of contributed capital.
Other Equity Components: For this illustration, other components of equity remain unchanged.
Statement of Financial Position
Ending Balances: Includes the ending balances of contributed capital, retained earnings, and other components from the statement of changes in equity.
Contra-Asset Adjustment: Accumulated depreciation is subtracted from property, plant, and equipment to show the carrying amount (or net book value) for financial reporting.
Listing Order: Assets are arranged in order of liquidity, while liabilities are listed in order of time to maturity.
Current Assets: Assets converted to cash or used within one year.
Current Liabilities: Obligations to be settled within one year.
Comparative Balances: Balances from the beginning of the period (January 3, 2021, in this case) are presented for comparison.
Note Disclosures: Additional information in notes provides detailed context for the reported numbers, aiding analysis of the company’s performance and financial condition. Detailed exploration of note disclosures is covered in subsequent chapters.
Cash Flow from Operations, Net Earnings, and Quality of Earnings
Statement of Cash Flows: Lists categorized transactions that affected the cash account, including operating, investing, and financing activities.
Cash Flow Categories: Categories identified in the cash T-account at the end of Chapter 3 remain the same after adjustments, as adjustments didn’t impact cash.
Financial Analysis Warning: Analysts often warn against unusual deferrals and accruals when predicting future earnings, highlighting disparities between net earnings and cash flow from operations.
Quality of Earnings Ratio: Measures the quality of earnings by relating cash flows from operations to net income. A higher ratio suggests higher-quality earnings, indicating that revenue recognition or expense accrual criteria yielding high net income also result in high cash flows.
Net Profit Margin Ratio and Return on Equity
Objective: Evaluating company performance is the primary goal of financial statement analysis. Various stakeholders, including managers, competitors, analysts, investors, and creditors, use financial statements to assess a company’s business strategy and performance.
Return on Assets: Introduced in Chapter 3, it assesses how effectively managers use assets to generate earnings.
Net Profit Margin Ratio: Analytical tool to evaluate management’s efficiency in controlling revenues and expenses to generate more earnings. Calculated as net earnings divided by net sales (or operating income), it indicates the proportion of earnings generated from each dollar of revenue.
Return on Equity (ROE): Evaluates the relationship between net earnings and shareholders’ investment in the business. Indicates how efficiently a company uses shareholders’ equity to generate profits.
Purpose: These measures provide insights into a company’s profitability, efficiency, and effectiveness in utilizing resources to generate earnings, helping stakeholders make informed decisions about investments and credit evaluations.
Interpreting Net Profit Margin Ratio
Definition: Net profit margin ratio measures the percentage of profit earned concerning the revenues generated during a specific period.
Indicator of Efficiency: A rising net profit margin ratio indicates efficient management of sales and expenses.
Industry Variances: Differences in ratios among industries stem from the nature of products/services and competition intensity.
Competitive Differences: Variances among competitors in the same industry reflect responses to changes in competition, demand, sales volume, prices, and costs.
Expectations: Analysts anticipate well-run businesses to maintain or enhance their net profit margin ratio over time.
Cautions for Analysts
Long-term Implications: Decisions to maintain the net profit margin ratio in the current period might have negative long-term consequences.
Detailed Analysis: Analysts should delve deeper, analyzing each component of revenues and expenses by dividing them by net sales, creating common-sized statements of earnings. Changes in these percentages offer insights into shifts in management strategies.
Return on Investment (ROI) Formula:
ROI is a financial metric used to evaluate the profitability of an investment. It measures the return on an investment as a percentage of the initial investment cost. A higher ROI indicates a more profitable investment.
Positive ROI: Indicates a profitable investment.
Negative ROI: Indicates a loss on the investment.
Interpreting Return on Equity (ROE)
Definition: ROE measures how much profit the firm earned for every dollar invested by shareholders.
Long-term Implications: Firms with higher ROE are expected to have higher share prices in the long run, assuming other factors remain constant.
Evaluation Tool: Managers, analysts, and creditors use ROE to assess the effectiveness of the company’s overall business strategy, including operating, investing, and financing strategies.
ROI Cautions for Analysts
Short-term Focus: A rising ROE might suggest a company is not investing in research, development, or modernization, leading to future declines in ROE as assets reach the end of their life cycles.
Holistic Evaluation: Experienced decision-makers consider ROE within the context of a company’s business strategy, evaluating both short-term gains and long-term sustainability.
Return on Investment (ROI) Formula:
ROI is a financial metric used to evaluate the profitability of an investment. It measures the return on an investment as a percentage of the initial investment cost. A higher ROI indicates a more profitable investment.
How to Calculate:
Net Profit: Subtract the initial investment cost from the total revenue generated or the final value of the investment.
Investment Cost: The total amount of money invested in the project or asset.
Multiply the ratio by 100 to express ROI as a percentage.
Interpretation:
Positive ROI: Indicates a profitable investment.
Negative ROI: Indicates a loss on the investment.
