Chapter 5: Balance Sheet and Statement of Cash Flows Flashcards
Current Ratio
Company’s ability to pay current liabilities from current assets
= Total current assets / total current liabilities
1.5 is strong, 1 is low/ risky
(Current = short term)
Liquidity Ratios
Measure the ability of the company to pay current liabilities with current assets
Current ratio: CA/ CL (2+ preferred)
Shows amount of current assets available for every $1.00 of current liabilities
Working Capital = CA- CL
shows assets left after paying all current liabilities
Liquidity
Ability to pay obligations expected due in the next year
“the amount of time that is expected to elapse until an asset is realized or otherwise converted into cash or until a liability is paid.”
Long-Term Liabilities
Obligations the company expects to pay after a year (or operating cycle)
- does not include currently maturing portions of long-term liabilities, those are current.
- obligations from financing
- obligations from extraordinary operations
- obligations contingent of future events
Requires much supplementary disclosures - inclusion of terms of agreements in notes
Current Liabilties
Obligations whose liquidation is reasonably expected to require use of existing resources properly classified as current assets or the creation of other current liabilities
(generally in one year/ one operating cycle)
includes portion of long term liabilities currently coming due
- notes payable
- accounts payable
- other current liabilities in order of magnitude
Long term assets
Holding over one year/ operating cycle
Order on balance sheet
2) Long-term investments
3) Property, plant and equipment
4) Intangible assets
5) Other assets
Current Assets
Assets the company expects to convert to cash or use up within one year or one operating cycle (whichever is longer)
Generally listed in order expected to change to cash
Cash (at fair value) Short term investments (at fair value) Accounts Receivable (at estimated amount collectable) Inventory (lower of cost or market) Prepaid expenses (cost
Operating Cycle
Average time from purchase of inventory to collection of cash from customers
Lower-of-cost-or-Market Rule
If value of ending inventory is lower than its cost:
- companies must “write down” (recognize loss on income statement) the inventory to market value (replacement cost, not selling price) in the period where a decline below cost occurs
Conservatism in action
Cash Ratio
Measures company’s ability to pay current liabilities from cash and cash equivalent
= (cash + cash equivalents)/ total current liabilities
Cash equivalent = can be converted to cash in three months or less
Cash Equivalent
Cash equivalents: short term highly liquid investments that mature within THREE MONTHS (90 days) or less
company must disclose any restrictions or commitments in availability
- current assets if current assets
- other assets if NOT current obligations
Current assets NRV on balance sheet
Net Realizable Value of current assets on balance sheet
Current Assets:
Accounts Receivable
Less: Allowance for bad debts
Receivables on the Balance Sheet
- identify each major type of receivable in the balance sheet or in the notes
- report short term receivables as current assets
- report both gross amount of A/R and allowance for doubtful accounts
- identify any receivables used as collatoeral
Valuing Accounts Receivable
- Always a current asset
- reported at the amount the company thinks they will be able to collect (Net realizable cash value = NRV)
- difficulty is that an unknown amount of receivables will become uncollectable
Types of Receivables
Amounts due to economic entity that are expected to be received in cash
Accounts Receivable: owed by customers for goods/ services sold
Notes Receivable: Claims for formal instruments of credit issued as proof of debt
Other receivables: “nontrade”, interest, loans to officers, advances in pay, income tax refundable
Intangible assets on financial statements
Usually shown as a separate category from PP&E
(Natural resources listed under PP&E)
Shown only at net book value (accumulated amortization not shown on balance sheet)
Intangible Assets
Characteristics
1) Lack physical existence
2) Not financial instruments
Categorized as having a limited life or an indefinite life
- rights, privileges, competitive advantages that do not possess physical substance
Trademarks, patents, goodwill, copyrights, franchises/ licenses
categorized as internally created vs purchased
Current Liabilities on Balance Sheet
Notes Payable
Accounts Payable
Then in order of magnitude (largest to smallest)
When long term debt matures
On the balance sheet shows under current liabilities as “long term debt due within one year”
Some notes may have portions report as current and portions reported as long term
Stock on balance sheet (common only)
Stockholders' Equity
Paid-In Capital
Common Stock
Paid-In-Capital in excess of par value
Total Paid-in-capital
Retained Earnings
Total Stockholder's EquityTreasury Stock on Balance Sheet
Stockholder's Equity
Paid-in- Capital
Common Stock
APIC
Retained Earnings
Total P-I-Capital & Retained Earnings
Less Treasury stock (qty at cost)
Total Stockholder's Equity
Treasury Stock= reduction in total stockholder’s equity
APIC
Paid in capital in excess of stated or par value of stock
aka: additional paid-in-capital, premium on stock
usually on balance sheet as one amount though there may be subtotals
Stock on balance sheets
Stockholder’s Equity
Paid in Capital
% preferred Stock, $ par value
X shares authorized, x issued and outstanding
Common Stock, $ value (par or stated)
X shares authorized, x issued and outstanding
Total capital stock
Additional paid in capital also separated into preferred and common stock
Par Value stock
Value per share assigned by charter
while it used to be the legal capital per share a company was required to retain to protect creditors this is no longer required in most states
Treasury Stock
Debit Natural Balance
Corporations own stock that it was required from shareholders but not retired
- a contra-stockholder’s equity account
- not an asset
- reduces the value of stockholder’s equity
- holds no voting or dividend rights
Buy back of outstanding stock = creation of treasury stock
Retained Earnings
Net income a corporation retains for future use
Earned but not property of/ distributable to the owners
Effect of stock dividend on balance sheet
Total shareholders equity is unchanged (moves from retained earnings to common/ preferred stock or APIC)
Number of shares outstanding and book value do change
Cash dividends decrease stockholder’s equity
Dividends on Financial Statements
Dividends not deducted as expense on income statement
Stock dividends distributable is shown as an addition to capital stock
Discount on Bonds Payable on Balance sheet
Long term liabilities
Bonds payable
Less: Discount on bonds payable
Total = carrying value/ book value
Bond discount = increase on cost of borrowing
Leases on Balance Sheet
portion to paid in next year = current liability
remainder outstanding = long term liability
Premium on Bonds Payable on Balance sheet
Long Term Liabilities
Bonds Payable (face value)
Add Premium on Bonds Payable
Total = carrying balue
Bond premium = reduction of the cost of borrowing, lowers interest amount paid
Realized/ Unrealized Gain or loss on balance sheet
Other revenues and gains
- Interest revenue
- Dividend revenue
- Gain on sale of investments
- unrealized gain - income
Other expenses and issues
- loss on sale of investments
- unrealized loss - income
Unrealized gain or loss on available for sale securities
Goes on balance sheet
- separate component of stockholder’s equity: other comprehensive income or loss
Stockholder’s Equity
Common Stock
Retained Earnings
Total Paid in capital and retained earnings
Less unrealized loss on AFS securities (or plus unrealized gain)
= total stockholder’s equity
Available For Sale Securities
As of 2016 okay for debit, but not for equity investments
- securities held with the intent of selling sometime in the future
- classified as current assets or long term assets depending on intent
- reported at fair value (FMV) and report changes from cost as part of equity section)
Trading Securities
Trading debt investments
- securities held with the intention of selling them in a short period
(trading = frequent buying + selling_
Trading securities reported at fair market value and report changes in value from cost as part of net income
Always short term/ current assets
Free Cash Flow
Measure of financial flexibility
= net cash provided by operating activities
Less: capital expenditures (planned)
Less: cash dividends
Describes cash remaining from operations after adjustment for capital expenditures (on PP&E) and dividends. aka discretionary cash
Financing Activities
A section of the statement of cash flows
Activities that increase or decrease long term term liabilities or equity
- issuing stock and paying dividends
- buying and selling treasury stock
- borrowing and paying off long term liabilities/ bonds, notes, mortgages
- obtaining resources and providing a return
(long term liabilities and equity)
Operating Activities
A section of the statement of cash flows
Activities that create revenue or expense in the entity’s business (net income)
Day to day operation
PLUS interest revenue
dividend income
interest expense
income tax expense
current assets and laibilties
Investing activities
A section of the statement of cash flows
Activities that increase or decrease long term assets
- PP&E
- notes receivable
- investments (acquiring and disposal)
- sale and purchase of long term assets
- lending and collection of long term notes receivables
- making and collecting loans
long term assets
Steps in preparing a statement of cash flows
1) Determine change in cash
2) Determine net cash flows from operating activities
3) Determine net cash flows from investing and financing activities
4) Ensure net change in cash from statement of cash flows matches the change from one balance sheet to the next
Classifications of cash flows
Operating activities
- transactions from income statement
Investment Activities
- changes in investments and long term assets
Financing Activities
- changes in long term liabilties and stockholder’s equity
Indirect method of statement of cash flows
- shows more detail than direct method
- GAAP requires indirect method to be shown if direct method is used
- easier, less costly to prepare
- focus on difference between net income and net cash flow from operating activities
- starts from net income and adjusts it to cash provided
Indirect method of Statement of cash flows: items subtracted from net income
Anything that increased net income without changing available cash
- gains on disposal of long-term assets
- increase on non-cash and current assets
- decrease in current liabilities
(long term assets gains & loss –> investing section)
Common Statement of Cash Flows adjustments to net income (loss)
Liabilities: Deduct decrease, add increase
Assets: Add decrease, Deduct increase
Anything that changes net income without affecting cash
- add back non-cash expense (depreciation, amortization, depletion)
- deduct gains, add losses
- adjust for changes in non-cash current assets and current liabilities
- accounts receivable (add any decrease between years)
- inventory (deduct any increase between years)
- prepaid accounts (deduct any increase)
- payables (add increase, deduct decrease)
Determining Net Cash Flow from investing and financing activities
- analysis of comparative balance sheet data and selected additional info to determine affect on cash
(remember to disclose non-cash transactions)
Significant noncash activities on cash flow statement
Full disclosure principle
- direct issuance of common stock to purchase assets
- conversion of bonds to common stock
- issuance of debt to purchase assets
- Exchange of plant assets (long lived assets)
Reported in a separate schedule at the bottom of statement of cash flows or in a note to the financial statements
Sources of information for statement of cash flows
- comparative balance sheets (including analysis of statement of retained earnings
- current income statements
- selected transaction data
- write downs
- amortization charge- book entries such as depreciation that have no affect on cash
Form indirect method statement of cash flows
Cash Flows from Operating Activities
Net Income
Adjustments to reconcile net income to cash provided by operating activities
- list of items that caused changes to income but not cash
Net Cash provided by operations
Cash Flows from investment activities
Net cash used / provided by investment activities
Cash flows from financing activities
Net cash used/ provided by financing activities
Net increase (decrease) in cash
Uses of statement of cash flows
Provides information to asses
- entity’s ability to generate future cash flows
- entity’s ability to pay dividends and obligations
- reasons for differences between net income and net cash provided (used) by operating activities
- cash investing and financing transactions during the period
Statement of cash flows format
Cash flows from operating activities
Net cash provided/ used by operating activities
Cash Flows from investing activities
Net cash provided/ used by investing activities
Cash Flows from Financing activities
Net cash provided/ used by financing activities
Net increase/ decrease in cash
Cash at the beginning of the period
cash at the end of the period
non-cash investing and financing activities
Cash flows: investing activities
Changes in investments and long term assets
Inflow
- sale of PP&E
- sale of investments (debit or equity of other corporations)
- collection on principle of loans made
Outflow
- purchase of PP&E
- Purchase of investments
- loans made to other entities
Cash Flows from financing activities
Changes to long term liabilities and stockholders equity
Inflows
- sales of common stock
- Issuance of debt (bonds/ notes)
Outflows
- dividends to stockholders
- redemption of long-term debt
- re-acquisition of capital stock (treasury stock)
Determining net cash flow from operating activities
Cash provided/ used by operating activities
to find have to net income from accrual bases
- current year’s income statement
- comparative year balance statement
Cash flows from operating activities
Inflows:
- sales of goods or services
- interest and dividends received
Outflows:
Operating expenses:
- to suppliers
- to employees (payroll)
- to governments (taxes)
- to lenders (interest)
Net increase/ decrease in cash
= net cash provided by operating activities
- net cash used for investing activities
+ net cash provided by investing activities
Times Interest Earned
A solvency ratio
AKA interest coverage
Indicates the company’s ability to meet interest payments as they come due
= (net income + interest expense + income tax expense) / interest expense
net income before interest expense and income tax expense
Payout Ratio
A profitability ratio
measures the percentage of earnings distributed in the form of cash deductions
= cash dividends declared on common stock / net income
Price Earnings Ratio
A profitability ratio (AKA P-E ratio)
reflects investors assessment of a company’s future earnings
= market price per share of common stock / earnings per share
Earnings per share
A profitability ratio (aka EPS)
Measures net income earned on each share of stock
= (Net income less preferred dividends) / weighted-average shares of common stock outstanding
(weighted average = beg + end / 2)
Per FASB must be shown on income statement
Return on COMMON stockholder’s Equity
A profitability ratio (aka Return on Equity)
Shows how many dollars of net income the company earned for each dollar invested by the owners
= Net income less any preferred dividends / average common stockholder’s equity
(average = beg + end / 2)
profitability of owner’s investment
Return on Assets
A profitability ratio
an overall measure of profitability of assets
= net income + interest expense / average total assets
net income + interest expense determines real return on income regardless of financing choices
average = beg + end / 2
AKA return on total assets
Profit Margin
A profitability ratio
Measures the percentage of each dollar of sales that results in net income
= net income / net sales
profit margin on sales
Profitability Ratios
Measure the income or operating success of a company for a given period of time.
Income level affects companies ability to obtain debt and equity financing shows company’s ability to grow
Ratios: Profit margin, asset turnover, return on assets, return on common stockholder’s equity, earnings-per-share, price-earnings, payout
Asset Turnover
A profitability Ratio
Measures how efficiently a company uses its assets to generate sales
= net sales / average total assets
Inventory Turnover
A liquidity ratio
measures the average number of times the inventory is sold during a period
= cost of goods sold / average inventory
average = beg + end / 2
liquidity of inventory
Accounts Receivable Turnover
A liquidity Ratio
Measures the average number of times a company collects receivables during a period
= net credit sales / average net accounts receivable
(net accounts receivable = net w/ allowance for doubtful accounts)
liquidity of receivables
Acid Test Ratio
A liquidity ration (aka Quick Ratio)
Measures immediate liquidity
= (cash + short term investments + net accounts receivable) / current liabilities
ignores inventory and prepaid accounts as not liquid enough
Current Ratio
A liquidity ratio
measures amount of current assets for every dollar of current liabilities
= current assets / current liabilities
measures short term debt paying abilities
Liquidity Ratios
Measure the short term ability of a company to pay its maturing obligations and to meet unexpected needs for cash
Of interest to short term creditors: bankers and suppliers
current ratio, acid-test ratio, receivables turnover, inventory turnover
Working Capital
A measure of a businesses ability to meet its short-term obligations with its current assets
= current assets - current liabilities
Ratio Analysis
Requires comparison for meaning: intra-company, inter-company or inventory average
Expresses the relationship among selected items of financial data
Liquidity: measures short term ability of a company to pay maturing obligations and meet unexpected needs for cash
Profitability: measures income or operating success of a company for a period of time
Solvency: Measures ability of a company to survive over a long period of time
Liquidity
The measure of the ability of a firm to meet its immediate current financial obligations
Solvency
The firm’s ability to have sufficient assets to meet its debts in the long term
Solvency Ratios
Measure the ability of a company to survive over a long period of time
Debt to total assets ratio
Times interest Earned ratio
both show debt-paying ability
Indirect method of statement of cash flow items added to net income
Anything that decreased net income without changing cash available:
- depreciation, depletion and amortization expense
- loss on disposal of long term assets
- decreases in non-cash current assets
- increases in current liabilities
any long-term asset loss/gain goes to the inventory section
Purpose of statement of cash flows
- Predict future cash flows
- evaluate management decisions
- predict ability to pay debts and dividends
Usefulness of Balance Sheet
- computing rates of return
- evaluating capital structure
- company risk
- future cash flows
- liquidity
- solvency
- financial flexibility
Financial Instruments
Cash, an ownership interest or a contractual right to receive or obligation to deliver cash or another financial instrument
Asset or liability
includes: investments, payables and receivables
Financial Flexibility
Ability of an enterprise to take actions and alter the amounts and timing of cash flows so it can respond to unexpected needs and opportunities
Types of Stockholders’ equity
- Capital Stock (par or stated value)
- APIC: capital received over par/stated value)
- Retained earnings
- Accumulated other comprehensive income
- Treasury Stock
- Noncontrolling interest
Property Plant and Equipment
Tangible assets used in regular operation of the business
all depreciate (except land) or deplete
Short term investments
Recorded at fair value with changes reported in net income
unless equity method was used or measurement is not practical
Use of free cash flow measurement
- can a company pay dividends without external financing
- if operations decline will company be able to maintain needed capital investment
- what discretionary cash is available for additional investment, retirement of debt, purchase of treasury stock, added liquidity
Purpose of statement of cash flows
Summary of cash inflows and outflows (sources and uses) of cash in a period
- financial flexibility
- assess timing and uncertainty of future cash flows
Assesses:
- liquidity (availability of cash)
- Solvency (ability to pay debts)
- Financial flexibility (ability to respond and adapt)
Limitations of balance sheet
- Assets/ liabilities often reported at historical cost, not fair value
- Judgements and estimates are made on many items
- Omits items of financial value that cannot be measured objectively
Held-to-maturity securities
Debt investments
Investments intended to be held / have the ability to be held until they mature
current or long term assets depending on a maturity date
reported at amortized cost
When is a liability payable in the next year NOT a current liability
- Debt will be refinanced via another long term issue
- debt will be retired with non-current assets
(So not resulting from use of current assets/ creation of new liabilities)
Long Term investments
A non-current asset
- securities (bonds, stock, long term notes)
- assets (like land) that are not used in operations
- Funds (pension plans)
- investments in nonconsolidated subsidiaries or affiliated companies
A/R, A/P, and the statement of cash flows
Increase in A/R = income increased but cash is not received. SUBTRACT the difference from net income
Increase in A/P = income decreased but cash not paid out. ADD the difference to net income
Reporting stock on the balance sheet
Preferred always listed before common
Report: par value, shares authorized, shares issued and shares outstanding for each class of stock
additional paid-in capital is in its own section
Potential structure of statement of financial position
AKA balance sheet
Framework:
Business:
Operating assets and liabilities NET (total short term assets/ liabilities)
Investing Assets and Liabilities NET (long term assets/ liabilities)
Financing:
Financing Assets
Financing Liabilities
NET
Income Taxes
Discontinued Operations
Equity
Net Assets = Equity
“Netting” on financial statements
Currently in flux
IFRS more restrictive than GAAP
GAAP does not permit reporting of summary accounts alone
“offsetting” = netting
Wording on balance sheet
- Understandable account titles
- “reserve” recommended only used in regarding appropriation of retained earnings (“appropriated” also works)
- discontinue use of “surplus”
Techniques of note disclosures
Focus on understandability
- parenthetical explanations: in the body of the financial statement. Short.
- Cross-reference and contra items:
- relationship between asset and liability
- contra account decreases account
- adjunct account increases account
- Supporting schedule: detailed information
Notes to the financial statements
To meet Full Disclosure principle
- explanatory, supplemental
- accounting polities used that involve selection or are industry specific
- nature of operations
- contractual situations (balance sheet note)
- contingencies (balance sheet)
- fair values (especially for financial instruments: balance sheet)
Fair value measurement disclosures in notes to financial statements
- fair value hierarchy level
- fair value measurement
- additional disclosure for any level 3 measurements must identify assumptions made and related income effects
Summary of significant accounting policies
- generally 1st note in financial statements
- GAAP recommends disclosing all significant accounting principles and methods that:
- involve selection from alternatives
- are particular to industry
- disclosure of use of estimates & basis of estimates
- risk and uncertainties
Contractual obligations to disclose in notes to financial statements
Must disclose if material
- commitments / obligations to maintain a level of working capital
- limits on payments of dividends
- restrictions on assets
- requirements to maintain certain financial ratios
- in tabular summary in management discussion of annual report
“When in doubt, disclose”
Basic statement of cash flow components
- Cash effects of operating, investing and financing = net increase or decrease of cash during a period
Balance sheet account form
Lists assets (by sections) on the left side and liabilities and stockholders equity on the right side
generally requires two facing pages
Balance sheet report form
Assets, liabilities and assets listed in sections down the same page.
Assets
- current
- long term
- PPE, intangible, other
Liabilities and Stockholders’ Equity
- current
- long term
- stockholder’s equity
Non-controlling interests
shown as a separate item as part of quity
Retained Earnings on balance sheet
May be divided between: unappropriated (available for dividend distribution) and restricted
Non-current assets on balance sheet
Long term investments: just below current assets
- usually listed as "investments"
- equity investments at fair value or equity method
- may be adjusted for Available for Sale securities - PP&E shown with accumulated depreciation
- discloses basis of value along with any liens in notes - intangible assets - other assets (vary)
- prepaid expenses/ costs
- special funds, restricted assets
Inventory on balance sheet
- must disclose basis of valuation (lower of cost or net realizable vs lower of cost or market)
- must disclose cash flow assumption
- manufacturers must also include state of completion (raw materials, work-in-progress, finished goods, inventories, and in-transit
- may separate into product lines
Receivables from unusual transactions on balance sheet
Receivables arising from unusual transactions classified separately as long-term unless collection is expected with the year
Usefulness of statement of cash flows
- how successful is the company in generating net cash from operating activities
- trends in cash flow from operations over time
- major reasons for positive or negative cash flow from operating activities
Major classification categories
Assets:
- current assets
- long-term investments
- PP&E
- intangible assets
- other assets
Liabilities:
- current liabilities
- long-term debt
- Owner’s (stockholders’) equity
Classified balance sheet
Items grouped together to arrive at significant subtotals and show important relationships
FASB discourages use of summary accounts
- items that differ in type/ expected function
- different implications to financial flexibility
- different general liquidity characteristics
Coverage Ratios
Measures the degree of protection for long term creditors and investors
- debt to assets ratio
- times interest earned
- book value per share
- free cash flow
Book Value per share
The amount each share would receive if the company were liquidated at the amounts shown on the balance sheet
= common stockholders’ equity / outstanding shares
Cash Debt coverage
Measure of financial flexibility
= net cash provided by operating activities / average total liabilities
ability to pay liabilities from net cash from operating activities
higher = less difficulty meeting obligations
Activities Ratios
Measures of how effectively a company uses its assets
- accounts receivable turnover
- inventory turnover
- asset turnover
Current cash debt coverage
Liquidity assessment
= net cash provided by operating activities / average current liabilities
higher = less likely to have liquidity problems
Z scores
Bankruptcy prediction module (used in loan evaluation)
= (working capital/ total assets) x 1.2 + (retained earnings / total assets) x 1.4 + (EBIT / total assets) x 3.3 + (sales / total assets) x .99 + (MV equity x total liabilities) x 0.6
Working Capital
Net working capital
Sometimes on the balance sheet
Current assets less current liabilities
