Chapter 5: Financial Position and Cash Flows Flashcards
Importance of the Statement of Financial Position
Statement of Financial Position (SFP) also known as the balance sheet under ASPE
SFP provides information:
- For evaluating the capital structure and
- For computing rates of return on invested assets
It is also useful for assessing a company’s:
- Liquidity (time until asset is realized or liability has to be paid)
- Solvency (ability to pay debts and related interest)
- Financial flexibility (ability to respond to unexpected needs and opportunities)
Statement of Financial Position: Limitations
- Many assets and liabilities are stated at historical cost
- Information presented is reliable, however
- Reporting at current fair value would result in more relevant information - Judgment and estimates are used in determining many of the items reported on the SFP
- SFP does not report items that cannot be recorded objectively (e.g. internally generated goodwill)
Statement of Financial Position: Classification
Similar items are classified (grouped together), with sub-totals
Considerations for reporting items separately:
1. Assets that differ in their type or expected function (e.g. inventory versus capital assets)
2. Liabilities with different implications for the entity’s financial flexibility (e.g. long term debt versus current debt)
3. Assets and liabilities with different general liquidity characteristics (e.g. cash versus receivables)
4. Assets, liabilities, and equities with characteristics that allow for easy measurement or valuation
Current Assets
- Current assets are cash and other assets expected to be realized:
- Within one year from the balance sheet date or
- Within the normal operating cycle, whichever is longer - Generally presented in order of liquidity (normally: cash, short-term investments, receivables, inventory, and prepaid expense)
Current Assets – Cash
Includes cash and cash equivalents
Defined as:
- Cash, demand deposits, short-term liquid investments convertible to a known cash amount, and not subject to material value changes
- Any known restrictions to availability of cash must be disclosed
Current Assets – Short-Term Investments
- Investments in debt and equity securities are presented separately from other assets
- Valued at cost/amortized cost or fair value
Current Assets – Receivables
- Amounts should be reported separately based on the nature of their origin:
1. Ordinary trade accounts
2. Amounts owing by related parties
3. Other (substantial) unusual items - Separate disclosure required for:
1. Amount and nature of nontrade receivables
2. Receivables pledged as collateral - Accounts receivable valued at net realizable value
Current Assets – Inventories
Assets that are:
- Held for sale in the ordinary course of business
- In the process of production for such sale, or
- In the form of materials or supplies to be consumed in the production process or in the rendering of service
Valued at lower of cost and net realizable value
- Cost is determined by a cost formula (e.g. FIFO, weighted average, specific item) and must be disclosed
Manufacturing enterprise should disclose completion stage of inventories:
- Raw materials
- Work in progress
- Finished goods
Current Assets – Prepaid Expenses
Defined as: expenditures already made for benefits to be received within one year or operating cycle (whichever is longer)
Current practice is to report some prepaid amounts as current assets even if the benefit extends beyond one year (or operating cycle)
Non-current Investments
Non-current investments normally consist of one of the following:
- Debt securities
- Equity securities
- Sinking funds (a fund established by setting aside revenue over a period of time to fund a future capital expense, or repayment of a long-term debt.)
- Tangible assets held as investments
Investments are intended to be held for an extended period of time
Valuation options are:
- Fair value
- Amortized cost
- Equity Method
Property, Plant, and Equipment
- Physical (tangible) assets used in on-going business operations of the business to generate income
- Generally reported at cost or amortized cost
- IFRS allows for valuation at fair value
- Most assets are depreciable, except for land
- Written down when impaired
Intangible Assets
Intangible Assets are capital assets without physical substance, held to generate revenue
- Higher degree of uncertainty regarding future benefits
- Include (most common): Patents, copyrights, franchises, trademarks, and trade names
- Intangibles are grouped into two categories:
- Those with finite life – amortized over useful life
- Those with indefinite life – not amortized- Both are tested for impairment
Goodwill
Goodwill may be acquired in a business combination
- Not amortized
- Tested for impairment
Other Assets
- Assets in special funds
- Non-current receivables
- Deferred income tax assets
- Property held for sale
- Advances to subsidiaries
Current Liabilities
Obligations due within one year (from the date of the SFP) or within the operating cycle, whichever is longer
Accounts payable normally listed first; however, current liabilities not reported in any specific order
Working Capital
Working Capital = Current Assets - Current Liabilities
- A key indicator of the company’s short-term liquidity
- Not usually disclosed on the SFP
- Often calculated by bankers and other creditors
Long-Term Liabilities
- Long-term obligations are those not expected to be paid within the normal operating cycle
- Three types:
- Obligations arising from specific financing situations (e.g. bonds)
- Obligations from ordinary operations of the business (e.g. pension obligations)
- Obligations arising from ordinary business operations that are contingent on future events (e.g. product warranty) - SFP presentation requires reporting the portion due within the next year as a current liability
Shareholders’ Equity
- Capital Shares
- Contributed Surplus
- Retained Earnings (Deficit)
- Accumulated Other Comprehensive Income
Shareholders’ Equity - Capital Shares
Exchange value of issued shares
Disclose authorized, issued, and outstanding amounts
Shareholders’ Equity - Contributed Surplus
Term used whenever shares are sold at a price above their stated par value
Usually reported as one amount
Includes issued share premiums
Shareholders’ Equity - Retained Earnings (Deficit)
The amount of undistributed accumulated earnings/losses
Presented as one item
Shareholders’ Equity - Accumulated Other Comprehensive Income
Includes unrealized gains and losses on FV-OCI investments, certain types of donations, etc.
SFP - Other Required Disclosures
- Contingencies (ASPE) and provisions (IFRS)
- Material events that have an uncertain outcome
- Contingent gains not recognized under IFRS or ASPE; note disclosure - Accounting policies
- Pprinciples and methods chosen
- Use of estimates - Contractual situations
- Contractual obligations (terms and conditions)
- Commitments that require specific actions (e.g. maintain working capital at a certain level) if material - Subsequent events
- Further evidence of conditions that existed
- Conditions that occurred after the statement date - Additional detail
Techniques of Disclosure
- Parenthetical explanations (following the items in the SFP)—brings the information into the body of the statement
- Notes (to the SFP)—reduces amount of detail on statements
- Cross references, and contra and adjunct items (such as Accumulated Depreciation and Bond Premiums)
- Supporting schedules to provide detail for single line items
- Terminology
Statement of Cash Flows
- To assess the firm’s ability to generate cash and cash equivalents and
- To allow comparison of the operating performance and cash flows of different entities
Statement of Cash Flows shows:
- Where the cash came from
- What the cash was used for
- The change in the cash balance
Categories of cash activities
Operating Activities: Main revenue-producing activities
Investing Activities: Changes in long-term assets and investments
Financing Activities: Changes in equity and borrowings
Statement of Cash Flows - Preparation Methods
Direct method: restates operations on a cash basis; includes specific cash inflows/outflows (e.g. cash received from customers, cash paid to suppliers and employees, interest paid/received, taxes paid, etc.)
Indirect method: reconciles accrual net income to cash-based net income (e.g. adds back non-cash charges deducted from net income, such as depreciation)
Only the operating activities section differs between the two methods
Usefulness of the Statement of Cash Flows
Provides creditors with useful information:
- Company’s ability to generate net cash from operating activities
- Net cash flow trends or patterns from operating activities
- Major reasons for positive or negative net cash from operating activities
- Whether the cash flows are renewable or sustainable
Financial Liquidity
Cash debt coverage ratio: indicates a company’s ability to repay its liabilities from net cash provided by operating activities without having to liquidate the assets it uses in its operations
Current cash debt coverage Ratio = Net cash provided by operating Activities ÷ Average current liabilities
Financial Flexibility
Cash debt coverage ratio: indicates a company’s ability to repay its liabilities from net cash provided by operating activities without having to liquidate the assets it uses in its operations
Cash debt coverage Ratio = Net cash provided by Operating Activities ÷ Average Total Liabilities
Perspectives
Cash Flow Patterns
- There may be useful patterns from operating, investing and financing activities
- Predictive value
Free Cash Flow
- Calculated as net cash from operations less capital expenditures and dividends
- Indicates discretionary cash flow (cash left to invest or expand) to make additional investments, to retire its debt, or to add to its liquidity
- Free cash flow analysis answers questions:
- Can the company pay dividends without external financing?
- If operations decline, will the company be able to maintain its required capital investment.
