Reading Financial Statement by CFI

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Module 1
Understanding financial statements
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Introduction to understanding financial statements
The related noted to the We are going to use Microsoft's

The balance sheet
financial statements 2010 financial statements
The three key financial statements
Balance sheet
• Statement of financial position
Income statement
• Statement of operation / profit and loss
Statement of cash flows
Balance sheet
Liabilities
Assets
Equity
Income statement
0$ 6,825$ 13,650$
Fiscal year
+ 1,000
- 13,750
+ 1,500
+ 25,500
- 600
Revenues Expenses Profit or loss
Statement of cash flows
Cash flow statement

The opening cash balance
Operating
All cash transactions Investing
Financing
The closing cash balance
The transactions are sorted by activity type
Simplified balance sheet
Assets Liabilities
Current assets Current liabilities
Cash 20,000 Accounts payable 2,000
Accounts receivable 3,000 Accrued expenses 1,000
Inventory 60,000 Total current liabilities 3,000
Prepaid expenses 11,000
Non current liabilities 11,000
Total current assets 94,000
Bank loan 100,000
Non current assets
Shareholder equity
Property Plant & Equipment 110,000
Common shares 100,000
Intangible assets 10,000
Retained Earnings 11,000
Total non current assets 120,000
Total liabilities and
Total assets 214,000 shareholders equity 214,000
Current vs non-current
Assets
Current Non-current
Assets that are expected to be converted Any asset that is expected to be held for
into cash in less than one year more than one year
Liabilities
Current Non-current
Any amount due to be paid to a creditor in Any obligation that is not due to be repaid
less than one year within one year
Pop quiz – current vs non-current
Match the following items as either current or non-current:
A. Inventory (current asset) C. Long-term debt (non-current liability)
D. Property, plant & equipment

B. Accrued expenses (current liability)
(non-current asset)
Microsoft balance sheet demonstration
Investments
A company will hold external investments for two reasons:

• Excess cash
• Accumulating cash to make a large purchase
External investments
Investments in equity or debt instruments to be held
for capital gain and/or income
Short term (less than year)
Long term (more than year)
Investments
A company can also make internal investments
Internal investments
Investment in subsidiaries, associates
and joint ventures
Short term (less than year)
Long term (more than year)
Deferred income tax
Deferred income tax
Deferred income tax
What is deferred tax?
Causes of difference between

accounting profits & taxable profits
Permanent
Timing differences
differences
Deferred tax
(tax attributable to
timing differences)
Deferred income tax
What is deferred tax?
Timing differences may lead to:
Deferred Tax Liabilities Deferred Tax Assets

e.g. depreciation versus e.g. tax losses,
accelerated tax allowances retirement benefits
on assets (including pensions)
Deferred income tax
What is goodwill?
Goodwill only arises on acquisition. It is not possible to generate it internally
Consideration paid/payable X
Fair value of net assets acquired (X)
Goodwill X
Intangible assets
Intangible assets are without physical substance but are held to generate revenue.
Common intangible assets include:
Trademarks
Patents
Copyrights
Intangible assets
What are commitments?
Future obligations that a company has agreed to
Unearned revenue
Revenue that is collected before it is earned
Eg. 12 month subscription sold for $1,200 in January
Earned: $100 $300 $600 $900 $1,200
Jan Mar Jun Sep Dec
Unearned: $1,100 $900 $600 $300 $0
Contingencies
Companies are required to record any contingent

liabilities when both of the following criteria are met:
It is likely that a future event will confirm impairment of an asset

or that a liability existed as at balance sheet date
The loss amount can be reasonably estimated
Contingent gains are never recorded

in financial statements
Equity types - common shares
Equity consists largely of common shares.

However, companies may also issue preferred shares.
Common shares Preferred shares

Common shares offer an equal Preferred shares offer investors a fixed
share in earnings after annual dividend
obligations to debt holders and
preferred shareholders are met Most preferred shares are cumulative
(if not paid, it accumulates and must
Common shares give the right to
be paid in full before common
vote on appointments to the
dividends can be paid)
board of directors (and a number
of other matters) Preferred shares are not a widely used
Common shares hold a residual form of financing. Most businesses
claim on the business and view preferred shares as debt with a
therefore have the ultimate tax disadvantage (dividends do not
control of the company’s affairs reduce taxable income)
Common vs preferred shares
Common vs preferred shares
Common shares
allow for participation in the profits of the company

• Comes in the form of a dividend
allow for voting rights in a company

• One vote for every share held
if dissolved, any residual amount after everyone else

is paid would go to the common shareholders
Deferred income tax
What is the difference between authorized and outstanding shares?
Authorized shares Outstanding shares

The total number of The total number of
shares a company can sell shares a company has sold
Authorized vs outstanding share capital
Authorized shares
• The total number of shares that a
company has to sell
Outstanding shares
• The total number of shares that a
company has sold
Equity types - common shares
If share have a par value, and they are issued for more than the par value,
the share premium is credited to the contributed surplus account
If a company issues 180,000 shares for 40 cents each

and shares have a par value of 25 cents, how would
this be recorded in their financial statements?
Balance sheet (extract)

$000
Paid-up share capital (180,000 x 25c) 45
Contributed surplus (180,000 x 15c) 27
Other comprehensive income
Other comprehensive income

represents certain gains and losses that
a company may have that are not
otherwise recorded through the income
statement. Instead, they go directly to
retained earnings
Examples of typical items within OCI

include unrealized gains
and losses on investments and hedging
instruments
Balance sheet component matching exercise
• You can find these links on the attachment tab
1. Open the Balance sheet component matching

exercise with instructions
2. Open the Balance sheet component matching

solution for results
Statement of shareholders' equity
Statement of shareholders' equity
The full disclosure principle
One of the basic accounting principles is full disclosure:
Financial statements must report any information that could reasonably

be seen to affect the judgment or decision of an informed user
Disclosure may be made:

• Within the main body of the financial statements
• Within the notes to the financial statements
• As supplementary information (including disclosure within
the “management discussion and analysis” (MD&A))
Three key financial statements notes
Examples
• Future financial commitments
• Accounting standards
• Valuation of inventory
I
• Types of financial instruments
• Depreciation and amortization methodology
• Stock-based compensation plans
• Detailed breakdown of long-term debt

II
• Detailed explanation of each type of financial instrument
• Future financial commitments

III • Outstanding litigation
• Stock-based compensation plans
Price
Significant accounting policies
Company accounting standards
How inventory & investments are valued
Financial instruments
Significant accounting policies
Revenue is recognized
Property, plant & equipment is amortized
Any other policies
Direct information
A breakdown of the types of investments
Debt and financial instruments
Direct information
What is included in:
Inventory
PP&E
Intagible assets
Income taxes
Indirect information
Commitments
Contingencies
Stock based compensation plans
Noteworthy exercise
1. Open the Noteworthy exercise with instructions
2. Open the Noteworthy solution for results
Conclusion
Module 2
Understanding the income statement and cash flow
Reading financial statements overview
We are going to use Microsoft's 2010 annual

The income statement
report and financial statements
Statement of cash flows The key contents of an annual report
The three key financial statements
Balance sheet Income statement Statement of cash flows
Liabilities Operating
Revenues
Assets Investing
Equity Expenses
Financing
Profit
Single step vs multi-step income statements
Single step Multiple step

•All income items and expense items are grouped •Income and expense items are separated out intocomponents
•Profitability is only at final stage of net income/loss •Profitability is shown at four key stages
Example: Example:
Revenues Revenue
Gains Cost of Goods Sold
Total Revenue Gross Profit
Expenses Selling, General & Administrative
Losses Operating income
Total Expenses Gains
Net Income Losses
Other Expenses
Pre-tax income
Income taxes
Net income
Cost of sales
Cost of good sold / sales are made up expense items such as:
Direct materials (eg, materials used in manufacturing)
Direct labour (eg, professional services delivered)
Direct overhead (eg, other costs related to

the production of the goods or services)
Selling, general and administrative expenses
S,G&A is made up expense items such as:
Advertising and Business Legal, insurance and Office supplies Rent, repairs and
promotion costs development costs accounting expenses maintenance costs
Gains and losses
Some activities that a business conducts give rise to gains and

losses that are incidental to operating activities.
Sale of investments
Other financial instrument transactions
Sale of property, plant and equipment
Foreign exchange translations
Microsoft income statement exercise
1. Open the Microsoft income statement exercise

with instructions
2. Open the Microsoft income statement exercise

for results
Income statement
$
Revenue x Cash Flow Statement
Expenses (x) $
Operating income x Operating
Interest (x) Operating income x
x Depreciation x
Tax (x) Changes in working capital (x)
Net income x
Dividends (x)
Operating cash flows x
Investing
Retained earnings x
PP&E acquisitions (x)
PP&E disposals x
Balance Sheet
Business acquisitions (x)
$ $
Business disposals x
Fixed assets x
x
Working capital:
Net cash before financing x
Inventory x
Receivables x Financing
Payables (x) Shares x
x Loans x
Financed by: Movement in cash x
Equity x
Debt x
x
The cash flow statement
Cash flows are organized based on:
Cash flows from

OPERATING ACTIVITIES
(e.g. revenues, operating expenses)
Operating cash flows
Cash flows relating to

INVESTING ACTIVITIES
(e.g. sale/purchase of assets)
Cash before financing
Cash flows relating to

FINANCING ACTIVITIES
(e.g. issuing shares, raising debt)
Net cash movement
Direct method vs indirect method
Direct method Indirect method

• Uses net income as the starting point
• Starting point is based on cash transactions
• Reconciles net income to cash through changes in
• Groups classes of cash receipts and disbursements
working capital and non-cash balances
Example: Example:
Operating activities Operating activities
Cash collected from customers Net income
Cash paid to suppliers Add back depreciation and amortization
Cash paid to employees Adjust change in working capital balances
Cash flow from operating activities Cash flow from operating activities
Investing activities Investing activities

Purchase of equipment Purchase of equipment
Purchase of securities Purchase of securities
Disposal of property Disposal of property
Cash flow from investing activities Cash flow from investing activities
Net movement in cash Net movement in cash
Key elements in a cash flow statement
Net cash provided by Represents operating 'lifeblood' of business after paying necessary
operating activities outgoings for financing and tax
Shows whether business is absorbing funds for working capital or releasing

Changes in working capital them. Trend may indicate either financial stress or loose control over
working capital
Companies must invest in PPE to maintain their productive capacity.

PPE investment A downward trend may indicate a declining company. Identify the
necessary sustainable level of expenditure
Shows whether internally generated funds are sufficient to cover

Financing requirement/
investments made in fixed assets and businesses. Continuous deficits
surplus
indicate that growth depends on regular injections of external finance
Microsoft cash flow statement exercise
You can find these links on the attachment tab
1. Open the Microsoft cash flow statement exercise

with instructions
2. Open the Microsoft cash flow statement solution

for results
The annual report
The annual report contains a significant amount of information:
Financial
• Management discussion & analysis (MD&A)
• Financial statements
• Notes to financial statements
Non-financial
• Messages from the Chair, CEO
• Corporate profile
• MD&A
• Risk and control processes and analysis
What are the benefits of an annual report?
The annual report communicates:
All of which can be used to analyze present

and future performance
Contents of an annual report
Letter to the shareholders Business description
Audit report (or in rare

Management’s Discussion
circumstances other forms
and Analysis (MD&A)
of an accountant’s report)
Balance sheet, Income

Notes to the financial
Statement, and Statement
statements
of Cash Flows
Listing of all directors

Earnings per share
of the company
Management discussion and analysis
The MD&A is meant to be read in conjunction with financial statements:
MD&A
Highlights financial information
Provides an analysis of results
Contains risk statements including

how risks are being
mitigated or managed
Microsoft reporting challenge exercise
1. Open the Microsoft reporting challenge exercise

with instructions
2. Open the Microsoft reporting challenge solution
for results
Conclusion

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Advance

The related noted to the We are going to use Microsoft's

Statement of cash flows

Revenues Expenses Profit or loss

Cash flow statement

All cash transactions Investing

The transactions are sorted by activity type

A. Inventory (current asset) C. Long-term debt (non-current liability)

D. Property, plant & equipment

A company will hold external investments for two reasons:

Short term (less than year)

Long term (more than year)

A company can also make internal investments

Short term (less than year)

Long term (more than year)

What is deferred tax?

Causes of difference between

What is deferred tax?

Timing differences may lead to:

Deferred Tax Liabilities Deferred Tax Assets

Goodwill only arises on acquisition. It is not possible to generate it internally

Fair value of net assets acquired (X)

What are commitments?

Future obligations that a company has agreed to

Revenue that is collected before it is earned

Eg. 12 month subscription sold for $1,200 in January

Earned: $100 $300 $600 $900 $1,200

Jan Mar Jun Sep Dec

Unearned: $1,100 $900 $600 $300 $0

Companies are required to record any contingent

It is likely that a future event will confirm impairment of an asset

The loss amount can be reasonably estimated

Contingent gains are never recorded

Equity consists largely of common shares.

Common shares Preferred shares

allow for participation in the profits of the company

allow for voting rights in a company

if dissolved, any residual amount after everyone else

What is the difference between authorized and outstanding shares?

Authorized shares Outstanding shares

If a company issues 180,000 shares for 40 cents each

Balance sheet (extract)

Other comprehensive income

Examples of typical items within OCI

• You can find these links on the attachment tab

1. Open the Balance sheet component matching

2. Open the Balance sheet component matching

One of the basic accounting principles is full disclosure:

Financial statements must report any information that could reasonably

Disclosure may be made:

• Detailed breakdown of long-term debt

• Future financial commitments

Company accounting standards

How inventory & investments are valued

Property, plant & equipment is amortized

Any other policies

A breakdown of the types of investments

Debt and financial instruments

What is included in:

Stock based compensation plans

• You can find these links on the attachment tab

1. Open the Noteworthy exercise with instructions

2. Open the Noteworthy solution for results

We are going to use Microsoft's 2010 annual