[PBL] Trigger 7

  1. Components of balance sheet and income statement
  2. Caculate figures within financial statement
  3. How to assess a company’s current financial situation and overall profitability?

 

Preamble: The first and second question are part of accounting and finance, and the last question is more likely to be part of finance (analysis). Those questions are very basic questions in accounting and finance analysis; all the basics knowledge related to those questions are provided in basics finance/accounting books. That’s why in this research, only a few sources are used, to be more extreme there is only ONE source needed (as the books from Chartered Financial Analyst). Increasing the number of sources will reduce the quality, increase the time of researching by finding unnecessary sources with equal or lower quality with the books.

 

 

1+2:

  1. Income statement

Basis of preparation

Income statement is prepared on the accruals basis of accounting.

This means that income (including revenue) is recognized when it is earned rather than when receipts are realized (although in many instances income may be earned and received in the same accounting period).

Conversely, expenses are recognized in the income statement when they are incurred even if they are paid for in the previous or subsequent accounting periods.

Income statement does not report transactions with the owners of an entity.

Hence, dividends paid to ordinary shareholders are not presented as an expense in the income statement and proceeds from the issuance of shares is not recognized as an income. Transactions between the entity and its owners are accounted for separately in the statement of changes in equity.

Components

Income statement comprises of the following main elements:

Revenue

Revenue includes income earned from the principal activities of an entity. So for example, in case of a manufacturer of electronic appliances, revenue will comprise of the sales from electronic appliance business. Conversely, if the same manufacturer earns interest on its bank account, it shall not be classified as revenue but as other income.

Cost of Sales

Cost of sales represents the cost of goods sold or services rendered during an accounting period.

Hence, for a retailer, cost of sales will be the sum of inventory at the start of the period and purchases during the period minus any closing inventory.

In case of a manufacturer however, cost of sales will also include production costs incurred in the manufacture of goods during a period such as the cost of direct labor, direct material consumption, depreciation of plant and machinery and factory overheads, etc.

You may refer to the article on cost of sales for an explanation of its calculation.

Other Income

Other income consists of income earned from activities that are not related to the entity’s main business. For example, other income of an entity that manufactures electronic appliances may include:

  • Gain on disposal of fixed assets
  • Interest income on bank deposits
  • Exchange gain on translation of a foreign currency bank account

Distribution Cost

Distribution cost includes expenses incurred in delivering goods from the business premises to customers.

Administrative Expenses

Administrative expenses generally comprise of costs relating to the management and support functions within an organization that are not directly involved in the production and supply of goods and services offered by the entity.

Examples of administrative expenses include:

  • Salary cost of executive management
  • Legal and professional charges
  • Depreciation of head office building
  • Rent expense of offices used for administration and management purposes
  • Cost of functions / departments not directly involved in production such as finance department, HR department and administration department

Other Expenses

This is essentially a residual category in which any expenses that are not suitably classifiable elsewhere are included.

Finance Charges

Finance charges usually comprise of interest expense on loans and debentures.

The effect of present value adjustments of discounted provisions are also included in finance charges (e.g. unwinding of discount on provision for decommissioning cost).

Income tax

Income tax expense recognized during a period is generally comprised of the following three elements:

  • Current period’s estimated tax charge
  • Prior period tax adjustments
  • Deferred tax expense

Prior Period Comparatives

Prior period financial information is presented along side current period’s financial results to facilitate comparison of performance over a period.

It is therefore important that prior period comparative figures presented in the income statement relate to a similar period.

For example, if an organization is preparing income statement for the six months ending 31 December 2013, comparative figures of prior period should relate to the six months ending 31 December 2012.

  1. Finance Statement

Classification of Components

Statement of financial position consists of the following key elements:

Assets

An asset is something that an entity owns or controls in order to derive economic benefits from its use. Assets must be classified in the balance sheet as current or non-current depending on the duration over which the reporting entity expects to derive economic benefit from its use. An asset which will deliver economic benefits to the entity over the long term is classified as non-current whereas those assets that are expected to be realized within one year from the reporting date are classified as current assets.

Assets are also classified in the statement of financial position on the basis of their nature:

  • Tangible & intangible: Non-current assets with physical substance are classified asproperty, plant and equipment whereas assets without any physical substance are classified as intangible assets. Goodwill is a type of an intangible asset.
  • Inventories balance includes goods that are held for sale in the ordinary course of the business. Inventories may include raw materials, finished goods and works in progress.
  • Trade receivables include the amounts that are recoverable from customers upon credit sales. Trade receivables are presented in the statement of financial position after the deduction ofallowance for bad debts.
  • Cash and cash equivalents include cash in hand along with any short term investments that are readily convertible into known amounts of cash.

Liabilities

liability is an obligation that a business owes to someone and its settlement involves the transfer of cash or other resources. Liabilities must be classified in the statement of financial position as current or non-current depending on the duration over which the entity intends to settle the liability. A liability which will be settled over the long term is classified as non-current whereas those liabilities that are expected to be settled within one year from the reporting date are classified as current liabilities.

Liabilities are also classified in the statement of financial position on the basis of their nature:

  • Trade and other payables primarily include liabilities due to suppliers and contractors for credit purchases. Sundry payables which are too insignificant to be presented separately on the face of the balance sheet are also classified in this category.
  • Short term borrowings typically include bank overdrafts and short term bank loans with a repayment schedule of less than 12 months.
  • Long-term borrowings comprise of loans which are to be repaid over a period that exceeds one year. Current portion of long-term borrowings include the installments of long term borrowings that are due within one year of the reporting date.
  • Current Tax Payable is usually presented as a separate line item in the statement of financial position due to themateriality of the amount.

Equity

Equity is what the business owes to its owners. Equity is derived by deducting total liabilities from the total assets. It therefore represents the residual interest in the business that belongs to the owners.

Equity is usually presented in the statement of financial position under the following categories:

  • Share capital represents the amount invested by the owners in the entity
  • Retained Earningscomprises the total net profit or loss retained in the business after distribution to the owners in the form of dividends.
  • Revaluation Reservecontains the net surplus of any upward revaluation of property, plant and equipment recognized directly in equity.

 

Rationale – Why the balance sheet always balances?

The balance sheet is structured in a manner that the total assets of an entity equal to the sum of liabilities and equity. This may lead you to wonder as to why the balance sheet must always be in equilibrium.

Assets of an entity may be financed from internal sources (i.e. share capital and profits) or from external credit (e.g. bank loan, trade creditors, etc.). Since the total assets of a business must be equal to the amount of capital invested by the owners (i.e. in the form of share capital and profits not withdrawn) and any borrowings, the total assets of a business must equal to the sum of equity and liabilities.

This leads us to the Accounting Equation: Assets = Liabilities + Equity

 

http://accounting-simplified.com/financial/statements/statement-of-financial-position.html

http://accounting-simplified.com/financial/statements/income-statement-profit-and-loss.html

 

  1. How to assess a company’s current financial situation and overall profitability?

(Statement of financial position helps users of financial statements to assess the financial health of an entity. When analyzed over several accounting periods, balance sheets may assist in identifying underlying trends in the financial position of the entity. It is particularly helpful in determining the state of the entity’s liquidity risk, financial risk, credit risk and business risk. When used in conjunction with other financial statements of the entity and the financial statements of its competitors, balance sheet may help to identify relationships and trends which are indicative of potential problems or areas for further improvement. Analysis of the statement of financial position could therefore assist the users of financial statements to predict the amount, timing and volatility of entity’s future earnings.

Income Statement provides the basis for measuring performance of an entity over the course of an accounting period.

Performance can be assessed from the income statement in terms of the following:

Change in sales revenue over the period and in comparison to industry growth
Change in gross profit margin, operating profit margin and net profit margin over the period
Increase or decrease in net profit, operating profit and gross profit over the period
Comparison of the entity’s profitability with other organizations operating in similar industries or sectors
Income statement also forms the basis of important financial evaluation of an entity when it is analyzed in conjunction with information contained in other financial statements such as:

Change in earnings per share over the period
Analysis of working capital in comparison to similar income statement elements (e.g. the ratio of receivables reported in the balance sheet to the credit sales reported in the income statement, i.e. debtor turnover ratio)
Analysis ofinterest cover and dividend cover ratios)

Sources for the part below: CFA Programme Curriculum, Level 1 Volume 3 Financial Reporting and Analysis

To assess company’s current financial situation, financial data is converted into financial metrics. A primary source of data is a company’s annual report, including the financial statements and notes, and management commentary

Analysis on data presented in financial reports:

  1. Common size analysis

Create ratio between financial item and the base item.

The term vertical analysis is used to denote a common-size

Normally:
Common size analysis for balance sheet: compare with total asset (base item)

For income statement: Same with Balance Sheet but base is Total revenue

2. Cross-sectional analysis

Compare with other companies in the same industry

 

3.Categories of Financial Ratios:

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ANALYSIS FROM THE TRIGGER

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INTERPRETATION

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