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© 1999 by Robert F. Halsey In this chapter, we will cover the four financial statements that are provided by companies to shareholders and other interested parties: The Balance Sheet - a snapshot of what we own and what we owe at one point in time, The Income Statement - revenues, expenses and profit earned over a period of time, The Statement of Stockholder’s Equity - this shows changes in equity during the period such as new contributions from the sale of stock by the company, dividends paid to its shareholders, and profit earned for the period, And the Statement of Cash Flows - cash inflows and outflows realized by the company during the period
© 1999 by Robert F. Halsey Balance Sheet Balance Sheet The Balance sheet is divided into 2 sections: The first of these is a listing of the company’s Assets - Assets are things that the company owns as of the date of the balance sheet. Another characteristic of an asset is that it is expected to provide the company with future benefits in the form of inflows of other assets (like cash) or decreases in the company’s indebtedness to others.
© 1999 by Robert F. Halsey The second section of the balance sheet is a listing of the company’s liabilities and stockholder’s equity - Liabilities are what the company owes to outsiders as of the date of the balance sheet. Another characteristic of liabilities is that they are expected to require a future sacrifice by the company, like the payment of cash or the giving up of assets.
© 1999 by Robert F. Halsey Stockholder’s equity represents the investment that has been made into the company by its shareholders, less the amount of investment that has been returned to the shareholders in the form of dividends. This investment is comprised of 2 components: Contributed capital - these are the funds that have been invested into the company through purchases of stock Earned capital - these are the net profits of the company that have not been paid out as dividends. Shareholders have made an additional investment in the company through their decision to retain the profits in the company rather than to pay them out in the form of dividends.
© 1999 by Robert F. Halsey Another way to think about the balance sheet is that liabilities and equity represent sources of funds. Companies generate cash by borrowing from creditors as well as from selling their shares to investors. Likewise, assets represent uses of funds by the company. The company has invested its cash in assets that are expected to provide future benefits. Since sources of funds must equal the uses of those funds, assets must equal liabilities plus equity. This is the basic accounting equation: ASSETS = LIABILITIES + STOCKHOLDER’S EQUITY
© 1999 by Robert F. Halsey This is a summary of the Balance Sheet ASSETS 3What we own 3Provides future benefits (i.e., cash inflows) Uses of Cash Liabilities and Stockholder’s Equity 3What we owe 3Requires future sacrifices (i.e., cash outflows) Sources of cash = =
© 1999 by Robert F. Halsey This is the balance sheet from Colgate-Palmolive’s annual report Total assets equal $7.6 billion As do Total Liabilities and Shareholder’s Equity Now … take a moment to look at the format of this statement
© 1999 by Robert F. Halsey Income Statement Income Statement The second of the 4 financial statements in the Income statement. It reports the revenues that have been earned and the expenses that have been incurred during the period. Revenues are increases in assets or reductions of liabilities resulting from business transactions. Expenses are outflows of assets or increases in liabilities resulting from business transactions Net Profit is equal to Revenues - Expenses Notice that revenues, expenses, and net income refer to assets and liabilities and, therefore, do not necessarily relate to the receipt and payment of cash. Companies can, therefore, report profits without receiving net cash inflows.
© 1999 by Robert F. Halsey Here is Colgate’s income statement: Colgate reported revenues of $8.9 billion And net profit of $848 million Now … take a moment to look at the format of this statement
© 1999 by Robert F. Halsey Statement of Stockholder’s Equity Statement of Stockholder’s Equity The Statement of Stockholder’s Equity reconciles changes in stockholder’s equity from beginning of period to end of period. Basically, these changes result from sales and repurchases of stock and net profits less dividends paid to shareholders.
© 1999 by Robert F. Halsey Notice that Colgate sold 3.3 million shares and repurchased 7.1 million shares during the year This is Colgate’s statement of Stockholder’s Equity: Notice, also, that Colgate’s retained earnings increased by the amount of profit earned during the year And decreased by the amount of dividends paid to shareholders Now … take a moment to look at the format of this statement
© 1999 by Robert F. Halsey Here is the connection between the Balance Sheet and the Income Statement: Stockholder’s equity changes each period by the amount of net profit via changes in Retained Earnings which increase with profit and decrease with losses The Income Statement provides the detail of the changes in Retained Earnings (other than from dividends)
© 1999 by Robert F. Halsey Statement of Cash Flows Statement of Cash Flows Revenues are recorded when “earned” and expenses are recorded when “incurred” whether or not cash is received or paid Income Statement provides detail of revenues and expenses, but not of cash inflows and outflows The Statement of Cash Flows is needed to provide users with information about cash inflows and outflows
© 1999 by Robert F. Halsey Net cash flows from Operating Activities + Net cash flows from Investing Activities + Net cash flows from Financing Activities = Net change in CASH cash flows The statement of cash flows is organized into 3 sections as follows: Operating activities refer to the normal business activities of the company, that is, the sale of its products. Investing activities refer to purchases and sales of long- term assets Financing activities refer to cash inflows and outflows from sales or repurchases of stock, borrowing and repayment of debt and dividends.
© 1999 by Robert F. Halsey Colgate realized $1.1 billion net cash inflow from operating activities A net cash outflow of $351 million related to investing activities And, a net cash outflow of $830 million relating to financing activities This is Colgate’s statement of cash flows Now … take a moment to look at the format of this statement
© 1999 by Robert F. Halsey Let’s run through an example to give you a feel for how transactions are reflected in the balance sheet and the income statement. Assume that an individual starts up a retail company, selling dresses, with an initial investment of $250. The funds are used to purchase 5 dresses for $200 that will be resold for $75 each. The company issues stock to reflect the investment. How would this be reflected on the company’s opening balance sheet?
© 1999 by Robert F. Halsey First, cash (an asset) is increased by $250 when the stock is sold, then decreased by $200 for the purchase of the dresses. The net increase in cash is, therefore, $50. Second, the company records the dresses on its books as inventory (another asset) at its cost of $200. Inventories are goods that a company holds for resale. Finally, shareholder’s equity is increased by $250 to reflect the initial investment. The company’s balance sheet at this point in time is as follows:
© 1999 by Robert F. Halsey Dress Company, Inc. Balance Sheet Assets Cash 50 Inventories200 Total Assets250 Liabilities and Stockholder’s Equity Liabilities 0 SH Equity250 Total L & SH E250 ASSETS = LIABILITIES + STOCKHOLDER’S EQUITY
© 1999 by Robert F. Halsey Now, assume that the business sells 2 dresses for $75 each and that the business incurs $50 in expenses for the period which is paid in cash. Cash increased by $150 as payment is received for the dresses, then decreased by $50 for expenses incurred during the period. The net increase is, therefore, $100. When we add this to the balance in the account at the end of the previous period ($50), the new balance in cash is $150. Two somewhat difficult questions are, How do we account for the cost of the dresses that were sold? How do we account for the profit earned during the period?
© 1999 by Robert F. Halsey The dresses are initially accounted for as inventory, an asset. When purchased, they are recorded on the balance sheet at their cost ($200 in this case). When the dresses are sold, the cost of the dresses sold is removed from the balance sheet and transferred to the income statement as an expense, called cost of goods sold (2 * $40 per dress = $80 in this case). The remaining cost in inventory for the 3 unsold dresses is $200 - 2 * 40 = $120 The company’s income statement for the period would look like this:
© 1999 by Robert F. Halsey Dress Company, Inc. Income Statement Sales (2 * $75)150 Cost of Goods Sold 80 Gross Profit 70 Expenses 50 Net Profit 20 And the company’s balance sheet at the end of the period would look like this:
© 1999 by Robert F. Halsey Dress Company, Inc. Balance Sheet Assets Cash 150 Inventories120 Total Assets270 Liabilities and Stockholder’s Equity Liabilities 0 SH Equity270 Tot L & SH E270 Why is Stockholder’s equity reported as $270?
© 1999 by Robert F. Halsey Remember that stockholder’s equity is comprised of 2 components: contributed capital and earned capital. Contributed capital increased by $250 when stock was sold to the owner to raise funds to start the business. Now, earned capital increases by $20 to reflect the profit that has been earned by the company that has not been paid out to the stockholder as dividends. These accumulated profits are reported in a stockholder’s equity account called Retained Earnings. The balance in stockholder’s equity of $270, then, is comprised of $250 in contributed capital and $20 of retained earnings (look back at the Colgate-Palmolive Balance Sheet and the Statement of Stockholder’s Equity to see how this is reported in practice).
© 1999 by Robert F. Halsey Let’s finish by reviewing, once again, the balance sheet and income statements to provide you with a definition of the most commonly used accounts...
© 1999 by Robert F. Halsey Accounts receivable represent amounts owed to the company. They are reported at the net amount the company expects to collect, after deducting expected uncollectable accounts Accounts payable are amounts owed to other companies for goods or serviced purchased Accruals represent other short-term obligations, such as amounts due for taxes, wages, or interest Long-term debt represent bonds and other obligations with maturities in excess of 1 year Stockholder’s equity is divided into paid in capital (preferred, common stock and additional paid in capital) and earned capital (retained earnings) Goodwill is the excess of the purchase price for another company less the fair market value of the net assets purchased. It is reported at cost less accumulated amortization Cash refers to currency on hand as well as short-term investments expected to mature within 3 months Marketable securities consist of stocks, bonds, commercial paper, etc. that the company holds as short-term investments. Inventories are goods that the company holds for sale. They are reported at the cost the company paid for them (if purchased) or their manufacturing cost (e.g., raw materials, labor and overhead). Property, plant and equipment represent long-term assets. They are reported at their original cost less accumulated depreciation Notes payable refer to short-term debt and may also include current payments on long-term debt Here is Colgate-Palmolive’s balance sheet that we reviewed earlier:
© 1999 by Robert F. Halsey The End
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