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1. CHAPTER 2CHAPTER 2
FINANCIAL STATEMENTSFINANCIAL STATEMENTS
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2. A) Needs of financial statements
B) Financial statements
1. Income Statement
2. Balance Sheet
3. Statement of retained earnings
4. Statement of Cash Flows
Objectives :Objectives :
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3. Needs of Financial StatementsNeeds of Financial Statements
• Company Act 1965 required companies to expose
their annual report to Company Registrar.
• Among the content of the report is financial
statement, covers; income statement, balance sheet,
cash flow statement, and explanation notes about
those accounts.
• Financial statements can be classified into 2 types:
• External users
• Internal users
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4. THE IMPORTANCE OF FINANCIALTHE IMPORTANCE OF FINANCIAL
STATEMENTSTATEMENT
A firm’s financial statements can help
managers to carry out three important
duties:
a) supervise the current performance
b) establish that all works are accurate
c) check ,monitor and supervise
operations
d) list, plan, arrange and forecast future
performance and make sure the
things in a good position or order.
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5. 1)Income Statement1)Income Statement
 Also known as profit and loss account. Shows
the performance / achievement for a firm in
certain period (annually, semi annually, monthly
etc)
 Income statement supplied information on sales
or revenue that firm earned over a specified
period of time, usually a quarter of a year or a full
year.
 It contain expenses incurred such as cost of
good sold , depreciation , other operating
expenses ,taxes and interest paid to
bondholders.
 The answer for “how profitable is the business?”5

6. Income StatementIncome Statement
SALES
- EXPENSES
= PROFIT
•Cost of Goods Sold
•Operating Expenses
• Financing Costs
•Taxes
Revenue
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7. 5 activities related to business:
1. Sales – Income from sales of products or services
2. Cost of good sold – Cost of produce the product /
services
3. Operation expenses – expenses related to marketing
and distributing the products or services, and also
administration cost
4. Financing cost – Interest paid to debtors and
dividend paid to preferred stock holders (excluding
dividend paid to common stock holders)
5. Tax expenses – Amount of tax depends on
company’s taxable income.
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8. SALES
- Cost of Goods Sold
GROSS PROFIT
- Operating Expenses
OPERATING INCOME (EBIT)
- Interest Expense
EARNINGS BEFORE TAXES (EBT)
- Income Taxes
EARNINGS AFTER TAXES (EAT)
- Preferred Stock Dividends
- NET INCOME AVAILABLE TO COMMON STOCKHOLDERS
IncomeIncome
StatementStatement
Financing
Activities
Operating Activities
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9. Three additional important issues:Three additional important issues:
 Operating income is NOT affected by
how the firm is financed.
 Interest expense is subtracted from
income before computing the firm’s tax
liability. i.e Interest is not taxable
expenses
 Firm that has a +ve net income does
NOT necessarily mean it has any cash.
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10. 2)Balance Sheet2)Balance Sheet
 Balance sheet is a statement that shows the
financial position for a company at certain time.
 Give information about assets, liabilities
and equities of a company.
 Asset – Productive sources that give return
to the company.
 Liability – Creditor claim
 Equity – Owner claim.
 Total Asset = Total Liability + Total
Equity
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11. Balance SheetBalance Sheet
Assets Liabilities (Debt) & Equity
Current Assets
Cash
Marketable Securities
Accounts Receivable
Inventories
Prepaid Expenses
Fixed Assets
Machinery & Equipment
Buildings and Land
Other Assets
Investments & patents
Current Liabilities
Accounts Payable
Accrued Expenses
Short-term notes
Long-Term Liabilities
Long-term notes
Mortgages
Equity
Preferred Stock
Common Stock (Par value)
Paid in Capital
Retained Earnings
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12. Balance SheetBalance Sheet
 Types of assets :
 Current asset
 Fixed asset
 Other asset
 Types of financing :
 Liability (Debt)
 Long-term liability
 Owners’ equity
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13. Current AssetsCurrent Assets
It includes the assets with high liquidity (can be
converted within 1 year.)
Among the current assets are:
• Cash
• Marketable securities
• Account receivable
• Inventory
• prepaid expenses
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14.  Cash – currency or coins owned by company either in
bank account or hand.
 Marketable security – investment on short term
financial assets with high liquidity. Example: T-bill,
bankers acceptance, etc.
 Account receivable – the cash payment agreement
by customers whose bough by credit.
 Inventory – raw materials, working in process and
final products that will be sold.
 Prepaid expenses – it is reported in profit and loss
account and deducted as expenses income statements
after has been used. Example: rent expenses and
insurance.
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15. Fixed AssetsFixed Assets
 Cannot be converted into cash in short
period..
 Including plant and machinery, building and
land.
 Some businesses have more fixed assets than
the other. Example: factory
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16. Other AssetsOther Assets
 Besides current and fixed assets. Example the assets
that can’t be touched or saw physically such as
pattern, right and goodwill.
 Information exposed is different because it reported
based on cost in the time transaction occur. The value
appeared known as ‘accounting book value’ of the
company.
 Accounting book value – Value of assets as shown in
balance sheet of a firm. It represents historical cost
compare to present value of the asset.
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17. Debt CapitalDebt Capital
 Liability is money borrowed and must be pay
back at fixed date. It includes credit give by
suppliers and bank loans.
 Current debt/short-term liabilities-liability that must
be paid within 12 months.
 Sources of short term liability:
 Account payable
 Other payable
 Accrued expenses
 Short-term notes 17

18. Long-term DebtLong-term Debt
 Covers loan from bank or other sources
that provide capital for liability term more
than 1 year.
 Example; loan from bank where the period
of payment is 5 years or loan of buying
machinery, building, equipment or land for
period 25 to 30 years.
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19. EquityEquity
 Equity investment by shareholders in the company and the profit which
is not distributed to them will be pooled in company.
 Equity shows the company’s financing structure , it means how many
percent of the assets finance by debt and how many contribute by owners.
 Relationship between debt and equity is important to the debtors and
investors in certain situation. We will discuss about it in others topic later.
 Preferred stockholders
 Received dividend in fixed amount.
 Priority after creditor pay the liability.
 Common stockholders
 Receive whatever left over-good or bad.
 The firm common stock value as reported in balance sheet
includes sales value of the stocks and the firm’s retain earning.
 Retain earning-earning assembled and retained and will be reinvest in
the firm. 19

20. Debt vs Equity :
- DEBT: If the firm borrows money, its usually give first claim to
the firm’s cash flow to creditors. The bondholders are the first
creditor who can claims for their income.
- EQUITY: refers to stockholder’s investment in the firm and the
cumulative profits of retained earnings.
Market vs Book Value
- Market Value? is the current price at which the assets,
liabilities or equity can actually be bought or sold.
- Book Value ? which is stated in the balance sheet. Refer to
the assets, liabilities and equity.
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22. Liquidity & Net working capitalLiquidity & Net working capital
 Liquidity refers to how fast the assets can be converted to
cash. Illiquid assets are refer to assets that are not easily
convertible to cash.
 Net working capital: Differentiate between current assets and
current liabilities.
 Working Capital = Current assets – Current liabilities
 It is important for lenders because it give a picture of
company’s liability to determine the ability to pay back.
 Liquidity means how fast & how easy an asset can be
converted into cash without losing its value.
 More current assets than current liabilities in a company means
higher liquidity.
 Positive when the cash that will be received over the next 12
months exceeds the cash that will be paid out. If your net
working capital is positive, it shows that that company is in a
good condition and seem to be a healthy firm. 22

23. 3)Statement of retained earnings
 A statement or retained earnings
express how much of the firm’s earning
were retained in the business rather
than paid out in dividends.
 The amount or value for retained
earnings that available here is the sum
of the annual retained earnings for each
year of the firm’s history.
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24. Example: Falah Junior Statement of RetainedExample: Falah Junior Statement of Retained
Earning for year ending Dec. 31,2011 (RM)Earning for year ending Dec. 31,2011 (RM)
Balance of retained earnings Dec. 31, 2010 709
Add: Net income 2011 113.5
Dividend to common stockholders (57.5)
Balance retained earnings 2011 765.0
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25. 4)Statement of cash flows
 Statement of cash flows is a firm’s financial
statement that states all sources and uses of
cash over a specified period.
 Cash Flow Identity:
1) Cash Flow From Assets = Cash Flow to Creditors + cash
Flow to Owners (shareholders)
Sources of cash or supply cash: Sources ( a firm’s
activities that produce cash). Cash inflow- occurs
when we offer or sell something.
 Uses or spent of cash: Uses ( a firm ‘s activities in
which cash is spent).Cash Outflow – occurs when
we buy something.
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26. Three categories of sources
and uses of fund
– Operating activities – includes net
income and changes in most current
account
– Investment activities– includes
changes in fixed assets
– Financing activities– includes changes
in notes payable, long term debt and
equity accounts as well as dividends.
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27. Cash flow identity
• Cash Flow From Assets (CFFA) =
Cash Flow to Creditors + Cash
Flow to Stockholders
• Cash Flow from Assets =
Operating Cash Flow – Net Capital
Spending – Changes in Net
Working Capital (NWC)
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28. Operating Cash Flow
• OCF = EBIT + DEP – TAXES
• Net Capital spending = Ending net –
beginning net fixed asset +
Depreciation
• Change in net working capital =
Ending net working – beginning net
working
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29. Cash Flows to creditors and
stockholders
• Cash flows to creditors = Interest
paid – Net new borrowing
• Cash Flows to stockholders =
Dividend paid – Net new equity
raised
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30. TAXATION AND DEPRECIATION FROMTAXATION AND DEPRECIATION FROM
FINANCIAL PERSPECTIVEFINANCIAL PERSPECTIVE
 Taxation - % of tax is set by the government
Tax expenses – Amount of tax depends on
company’s taxable income.
 Depreciation
Depreciation expenses : a non-cash expense to
allocate the cost of depreciable assets, such as
plant & equipment, over the life of the assets.
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