1 chapter 5 financial statements analysis. 2 chapter goals recognize the importance of financial...
TRANSCRIPT
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Chapter 5
Financial Statements Analysis
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Chapter Goals
Recognize the importance of financial statements to PFP.
Produce and evaluate a balance sheet. Construct a cash flow statement. Compare finance and accounting based techniques.
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The Balance Sheet
Balance sheet: A statement of financial position at a given point in time.
The balance sheet consists of all assets, liabilities, and net worth.
Current assets: Assets that are expected to be or can be converted into cash in the current year.
Marketable investments: Assets that are traded publicly. Household assets: Assets used in day-to-day household
activities.
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The Balance Sheet, cont.
Human assets: The future income stream of household’s wage earners.
Because they cannot be sold, human assets are not usually placed on balance sheets.
Human-related assets: Other forms of resources in addition to human assets that are omitted from the balance sheet.
The term human-related is used because the value is derived from human- related work efforts or human relationships.
For example, human related assets include pension plans that pay out yearly income upon retirement.
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The Balance Sheet, cont.
Liabilities: Items that the household owes. Credit card debts, taxes outstanding, and mortgage
debt are liabilities. Liabilities can be split into current and long term,
based on whether they are due within one year or beyond that period.
The mortgage payment due within the year is expressed as a current liability.
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The Balance Sheet, cont.
Household equity (household net worth): The difference between its assets and liabilities.
Household equity can be relatively small or even negative when household members are young and college debt and other obligations are high.
Net worth generally increases as marketable investments increase.
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The Balance Sheet, cont.
Example: Tricia had a $20,000 savings account, owned a car
valued at $12,000, and owed $9,000 that she had borrowed to help finance the car.
Her net worth is:
Assets $32,000Liabilities $(9,000)Net Worth $23,000
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The Balance Sheet, cont.
Sample budget sheet:ASSETS LIABILITIES
Current Assets Current LiabilitiesChecking Accounts Credit Card DebtMoney Market Funds Other Current DebtRefund Due on Returned Clothing Current PortionTotal Current Assets Total Current Liabilities
Marketable Investments Long-Term LiabilitiesBonds and Bond funds MortgageStocks and Stock Funds Other Long-Term DebtTotal Marketable Investments Total Long-Term Liabilities
Pension Assets Total Liabilities401(k) PlansIRAsTotal Pension Assets
Real EstateHomeTotal Real Estate
Household AssetsAutosFurnitures and FixturesTotal Household Assets
Other Assets EQUITYJewelryStamp Collection Household EquityTotal Other Assets Total Equity
Total Assets Total Liabilities and Equity
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The Balance Sheet, cont.
Budget sheet items can be summarized as follows:
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The Cash Flow Statement
Cash flow statement: A statement that represents how much cash has been generated over a period of time.
The word “flow” indicates that it measures results between two periods, say between the end of last year and the end of this year.
The cash generated is simply the difference between the cash at the beginning and end of the period.
The cash flow is determined by totaling the sources of cash - cash inflows - and subtracting the uses of cash - cash outflows.
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The Cash Flow Statement, cont.
Functional cash flow statement: A cash flow statement that separates cash flows by type of household activity.
Use of a functional cash flow statement permits clear description of household results for the period and easy comparison with other periods.
The functional cash flow statement It is structured as a blend of the business income statement and its cash flow statements.
There are three basic types of activities: operating, financing, and investment activities. These are discussed next.
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The Cash Flow Statement, cont.
Example of a functional cash flow statement (continues on next slide):
2007 2008 2009 2010
Operating Activities
Income
Salary
BusinessInvestmentOther
Total Income
Expenses
Non DiscretionaryHousing UpkeepHealth Care
InsuranceInterestAlimonyFoodClothingTransportationPersonalTaxesTotal Non Discretionary Expenses
2006
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The Cash Flow Statement, cont.
(continued from previous slide):
Cash Flow Before Discretionary Activities
DiscretionaryRecreation-EntertainmentPersonalVacations Gifts and Charitable Cont.HobbiesInterestOtherTotal Discretionary Expenses
Cash Flow From Operating Activities
Capital Expenditures
DiscretionaryNon DiscretionaryTotal Capital Expenditures
Financing Activities
Total RepaymentsAdditional DebtTotal Financing Activities
CASH FLOW
Targeted for RetirementTargeted for Other
NET CASH FLOW
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Operating Activities
Operating activities: The day-to-day financial functions of the household.
Unlike a business income statement, the household statement is recorded on a strict cash basis.
The operations segment can be segregated into cash inflows and outflows that we will call income and expenses. – Income consists of salary, investment returns, and other
sources of operating cash. – Expenses can be divided into nondiscretionary and
discretionary items. The difference between income and expenses is cash flow
from operations.
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Operating Activities, cont.
Nondiscretionary expenses: The household’s overhead items such as interest expense, rent, household, food, clothing, and taxes.
Nondiscretionary expenses are largely fixed costs that cannot be altered easily or quickly
Discretionary expenses: Expenses the household choose to incur to derive pleasure. Examples are entertainment, eating out, and vacation outlays.
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Capital Expenditures
Capital expenditures: Outlays on household related matters that provide benefit beyond the current year.
We display capital expenditures separately because these cash outflows don’t occur regularly.
Including capital expenditures with other costs can distort the operating figures.
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Financing Activities
Financing activities: The cash flows that come from changes in debt. – Borrowing money has a favorable impact on cash
flow because it increases the cash available. – Repaying debt has a negative effect on cash flow
because it reduces cash resources. People sometimes confuse lower debt with having
higher cash flow for that period.
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Savings
Savings: The cash left over after operating, capital expenditure, and debt activities.
Savings are also known, for financial statement purposes, as cash flow representing prior cash inflows minus cash outflows.
Investments that are not in the form of capital expenditures are treated as part of the savings section.
Savings can be intended for specific purposes such as retirement or a down payment on a home.
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Savings, cont.
Net cash flow: The amount of cash available after targeted savings.
When the net cash flow figure is negative it can be due to targeted investing. Alternatively, the figure may be positive only because of borrowing during the period.
Savings applied to investing are reported as marketable securities in the balance sheet.
Savings left in cash are reported as cash at period-end on the balance sheet.
Balance sheet cash at the end of the period less cash at the beginning of the period equals net cash flow on the cash flow statement for that time frame.
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Traditional Household Cash Flow Statement
In practice: – Many people use a cash flow statement that
groups all inflows and outflows together. – Paydown of debt and interest payments are
lumped together. – Income tax payments are often placed at the
bottom, just before the net cash flow figure. This approach is a traditional cash flow statement.
– Advantage: simplicity and custom. – Disadvantage: Less useful as an analytical
document for financial planners and individuals.
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Traditional Household Cash Flow Statement, cont.
Example of traditional household cash flow statement:
2007 2008 2009 2010
Income
SalaryBusinessInvestmentOther
Total Income
Expenses
Mortgages and Property TaxesHousing UpkeepFood ClothingHealth Care TransportationInsuranceRecreation and EntertainmentVacations HobbiesGifts and Charitable Contributions
Contributions to PensionsNet Additional Debty ProceedsCapital ExpendituresInterestOtherTaxes
Total Expenses
CASH FLOW
2006
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Traditional Household Cash Flow Statement, cont.
This tables summarizes the differences between a functional and traditional cash flow statement:
Traditional Functional Statement Statement
Calculates Net Cash Flows Properly Yes Yes Develops Separate Operational Income Statement No Yes Resembles Business Cash Flow Statement No Yes Segregates Capital Expenditures and Financing Activities No Yes Separates Nondiscretionary and Discretionary Costs Sometimes Yes Handles Revenues Properly Yes Yes Is More Simple Yes No Is More Informative No Yes
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Financial Statement Presentation
Financial statements are intended to make the household’s financial circumstances as clear as possible.
A number of situations call for either the separation of figures on the statement or, more frequently, footnotes to them.
We next discuss these situations.
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Balance Sheet: Retirement Assets
Retirement assets that are in pension accounts should be listed separately for two reasons: – Retirement assets often cannot be turned into
cash immediately, or at least not without penalty. – Normal withdrawals from pensions are taxable. It
can be useful to know what pensions would be worth on an after-withdrawal after-tax basis.
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Balance Sheet: Life Insurance
Much life insurance has no current value or a low cash value relative to its face amount.
If there is a significant cash value, it belongs on the balance sheet.
The face value should be given in a footnote. Face value: The amount to be paid in the event of
death during the period the policy is in effect.
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Balance Sheet: Taxation and Unrealized Appreciation
Investment assets are expressed on the balance sheet at their current value.
A footnote to the balance sheet should report their cost individually.
If there are many assets, a total cost figure should be reported.
Through the above reporting, the effect of taxation on the gain up on ultimate sale can be estimated.
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Balance Sheet: Liquidation Cost
One should footnote the amount of liquidation costs and net proceeds whenever we expect the proceeds from sale to be materially lower than the value placed on the balance sheet.
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Cash Flow Statement
The footnotes in the cash flow statement often provide further information on special charges for the year.
Where the “other” category is used for all miscellaneous expenses, a footnote could explain the substantial components of that category year by year.
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Pro Forma Statements
Pro forma statements: Statements that include projections.
We include projections in a statement to better anticipate needs, to forecast resources to meet those needs, and to adjust our plans accordingly.
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Pro Forma Cash Flow Statement, cont.
Two principal approaches to making projections for a cash flow statement are as follows:
Common Rate: The rate of annual increase that many household expenses share. The increase is often based on an assumed future inflation rate.
Separate Rate: Certain inflows and outflows that cannot be estimated by using a projected rise in inflation.
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Pro Forma Cash Flow Statement, cont.
The following list details operating activities and projections (continues next slide).
– Salary: As separately estimated or rate of inflation– Business: As separately estimated or rate of inflation– Investment: Assumed rate of return– Housing Upkeep: Rate of Inflation– Health Care: Rate of Inflation– Insurance: Per contract where fixed; otherwise, rate of inflation– Interest: Per debt outstanding– Alimony: As stated– Food: Rate of inflation– Clothing: Rate of inflation– Transportation: Rate of inflation– Personal: Rate of inflation
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Pro Forma Cash Flow Statement, cont.
(continued from previous slide).– Taxes: Based on separate tax calculation– Recreation-Entertainment: Rate of inflation– Personal: Rate of inflation– Vacations: Rate of inflation– Gifts/Charitable Contributions: Rate of inflation– Hobbies: Rate of inflation– Interest: At stated rate– Other: Rate of inflation– Non Discretionary: As separately estimated or rate of inflation– Discretionary: As separately estimated or rate of inflation– Total Repayments: Per contract– Additional Debt: As separately estimated– Targeted for Retirement: As stated
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Pro Forma Balance Sheet
The balance sheet can be a more difficult to forecast than the statement of cash flows as some of its figures include the impact of cash flows and outflows.
For example: – The investment account will not only include the
growth rate on existing assets but the deposit of new savings.
– Liabilities will include the impact of cash inflows to reduce the amount outstanding or the absence of cash flow, which results in a larger debt figure.
For this reason projected balance sheets are used less frequently than those for cash statements.
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Finance versus Accounting
Accounting employs GAAP, or generally accepted accounting principles.
Most large businesses use GAAP accounting. Under GAAP the business attempts a proper
matching of revenues and expenses. Household accounting generally determine results
for a period using changes in cash.
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Finance versus Accounting, cont.
Household results for a period are provided on a cash flow statement.
Business results are given on an income statement. Capital expenditures are outlays that have benefit for
more than the current period. Businesses capitalize them as assets on the balance
sheet instead of expensing them on the income statement.
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Finance versus Accounting, cont.
Depreciation: The projected reduction in asset value due to wear and tear or obsolescence.
Depreciation is a tax deductible expense on the business income statement.
Since the decline in asset value associated with depreciation does not involve a cash transaction, it is not recorded on the household’s cash flow statement.
GAAP generally requires that businesses record transactions on the balance sheet at original cost less accumulated depreciation.
Households generally record assets at their fair market value.
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Finance versus Accounting, cont.
(Continued next slide.)
Item Explanation GAAP Business Finance Balance Sheet Assets and liabilities at
a given point in time Based on original cost Based on current fair
market value of assets Performance for Period
Cash flow statement giving operating performance for the period
A proper matching of revenues and costs for the period in an income Statement
Cash inflows and outflows only in a cash flow statement without regard to proper matching
Revenues Sale transactions Recorded when fairly represents a transaction
Recorded when cash is received
Expenses Paid Cost transactions Recorded as necessary for proper matching with revenues
Recorded when cash is disbursed
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Finance versus Accounting, cont.
(Continued from previous slide.)
Item Explanation GAAP Business Finance Profits Earnings for period A “fair” presentation of results
for the period No exact equivalent. Replaced by cash inflows minus cash outflows
Capital Expenditures
Outlays providing extended-period benefits
Capitalized as asset on balance sheet, not as an expense on income statement
Recorded as outflow on flow statement. Recorded at fair market value on balance sheet
Depreciation Amount an asset has declined in value for the period
Recorded as an expense on income statement based on original cost. Deducted from asset on balance sheet
Not recorded
Asset Value on Balance Sheet
The assigned worth of an item at a point in time
Recorded at original cost less depreciation
Recorded at fair market value
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Chapter Summary
Financial statements can provide an objective way to assess your financial condition.
The balance sheet reports assets, liabilities, and equity at a given point in time.
The cash flow statement indicates how well the household it is operating.
The cash flow statement is divided into operating, capital expenditures, debt, and net cash flow figures.
Finance focuses on actual cash generated while accounting attempts to match income and expenses even when cash is not received or paid.
In forming a balance sheet, finance uses fair market value; accounting uses original cost.