CHAPTER 2 FINANCIAL STATEMENTS

Chapter outline Introduction The objectives of financial statements Who are the users of financial statements? Requirements for financial statements The standardisation of financial statements Statement of financial position Statement of comprehensive income Statement of cash flows Conclusion

Learning outcomes By the end of this chapter, you should be able to: Discuss the objectives and requirements of financial statements Identify the users of financial statements Identify the components included in the main types of financial statements Distinguish between the three main types of financial statements Describe the formats of a statement of financial position, statement of comprehensive income and statement of cash flows.

Introduction Companies provide annual report at end of financial year Annual report provides analysts with information Includes a set of financial statements: Statement of financial position Statement of comprehensive income Statement of cash flows Indicates financial performance and position of company for analysis and comparison

The objectives of financial statements Main objective: Provide summary of financial position Financial performance Change in financial position Financial position Influenced by economic resources and the capital structure used to finance these resources Evaluated by focusing on assets, liabilities and shareholders’ equity included in the statement of financial position

The objectives of financial statements (cont.) Financial performance Company’s ability to generate income with its available assets Evaluated by focusing on the revenue and expenses provided in the statement of comprehensive income Change in financial position Depends on the investment, financing and operating activities during the year The statement of cash flows provides a summary of these activities

Users of financial statements Stakeholders: Shareholders – Evaluate existing and expected performance Management – Planning and control Providers of debt capital – Evaluate capital structure and ability to pay interest Government – SARS, economic statistics Other stakeholders – Employees, clients, customers, suppliers, competitors

Requirements for financial statements Understandable Relevant Significance Timeliness Accurate and objective Comparable

The standardisation of financial statements Financial statements need to be comparable Statements of companies may not be comparable as a result of different accounting guidelines SA companies converted to IFRS; comparison to previous years where other accounting guidelines were used may be problematic Solution Standardise published financial statements Facilitates comparison between companies & over time Simplifies the calculation of financial ratios

Statement of financial position Summary of a firm’s financial position at a specific point in time

Statement of financial position Current assets Ordinary shares Reserves Preference shares Non-controlling interest Non-current assets Current liabilities Non-current liabilities

Assets Capital investment - apply assets to generate revenue Two types of assets: Non-current Current Distinction based on how the assets are applied, as well as the period of time over which they will be applied

Non-current assets PPE at cost price Accumulated depreciation Usually indicated at original purchase price of items Accumulated depreciation Accumulate depreciation provided on PPE in the statement of comprehensive income PPE at carrying value Cost minus accumulated depreciation Assets under construction Asset not yet completed; no depreciation provided

Non-current assets Intangible assets Investment in associate Goodwill Other intangible assets (software, licences) Investment in associate Owns 20% - 50% of shares in another company Other long-term assets Loans granted Share investments < 20% Deferred tax assets Difference in accounting and tax treatment

Current assets Inventories Trade and other receivables Required for operations of a company Trade and other receivables Credit sales still outstanding Short-term outstanding amounts Short-term financial assets Financial assets with lifetime of less than a year Cash and cash equivalents Other short-term assets Assets for sale

Total equity Breakdown of different forms of equity capital to finance company’s assets Includes all capital provided by different shareholders Important to distinguish between contributions of different types of shareholders

Components of total equity Share capital Proceeds from sale of ordinary shares to shareholders Reserves Share-based payments Share repurchases Retained earnings Accumulation of retained profits reinvested Preference share capital Proceeds from the sale of preference shares

Components of total equity Shareholders’ equity Total capital invested by all shareholders Non-controlling interest Financial statements of subsidiary companies included

Liabilities Breakdown of the different forms of debt capital Two types of liabilities: Non-current liabilities Current liabilities Distinction based on the period over which the debt capital is obtained

Non-current liabilities Long-term debt capital Interest-bearing borrowings Long-term loans Mortgages Debentures Post-retirement obligations Deferred tax liabilities

Current liabilities Short-term debt capital Trade and other payables Outstanding amount on credit purchases Other short-term obligations Short-term debt Loans redeemed in the next financial year

Current liabilities Short-term financial liabilities Tax payable to SARS Bank overdraft Other current liabilities Liabilities in disposal groups, short-term provisions, short-term deferred income

Statement of comprehensive income Summary of financial performance for the financial year matching income and expenses Income: Turnover Operating income Investment income Non-recurring income Other

Statement of comprehensive income (cont.) Expenses: Cost of sales Operating expenses Non-recurring expenses Finance cost Taxation Non-controlling interest Preference dividends Ordinary dividends

Statement of comprehensive income (cont.) EXPENSES RETAINED PROFIT

Cost of sales and services rendered (88 508) (74 634) Gross profit 2009 2008 (R million) Turnover 137 836 129 943 Cost of sales and services rendered (88 508) (74 634) Gross profit 49 328 55 309 Other operating income 1 021 635 Operating expenses (25 681) (22 128) Operating profit 24 666 33 816 Investment income 2 060 989 Finance cost (1 917) (1 145) Profit before tax 24 809 33 660 Tax (10 480) (10 129) Profit after tax 14 329 23 531 Non-controlling interest (67) (1 111) Preference share dividends (614) (3) Attributable earnings 13 648 22 417 Ordinary dividends (7 193) (5 766) Retained earnings (for the year) 6455 16651

Statement of comprehensive income components Turnover Income received for products or services rendered by the company during the financial year Cost of sales and services rendered All costs directly incurred to generate turnover Purchases of inventory, transport costs, customs, etc. incurred to deliver products to customers Gross profit Turnover minus cost of sales Profit generated by sales activities of company

Statement of comprehensive income components Other operating income Income items not part of the sales activities of the company, but which are generated as part of the operating activities Operating expenses Expenses incurred to support primary activities Includes depreciation, employee costs, research and development, operating lease charges, etc Operating profit Profit resulting from primary activities of business Excludes income items not part of the business’s normal activities

Statement of comprehensive income components Investment income Income generated by financial investments Dividends & interest received Finance cost Interest paid on debt financing Profit before tax Tax Tax calculated on the profit before tax Profit after tax

Statement of comprehensive income components Non-controlling interest Portion of profit that belongs to non-controlling interest shareholders Preference share dividends Dividends paid to preference shareholders Preference above ordinary dividends Attributable earnings Portion of profit left after all expenses have been allocated Important to the ordinary shareholders: amount available for ordinary dividend payments

Statement of comprehensive income components Ordinary share dividends Total amount paid to ordinary shareholders in the form of dividends Retained earnings Portion of profit not paid out as dividends to shareholders but reinvested Transferred to reserves of business and used to finance business’s activities Earnings still belongs to shareholders – included as part of shareholders’ equity

Statement of cash flows Summary of a firm’s cash flows for the financial year Three major categories: Cash from operating activities Cash from investing activities Cash from financing activities

Statement of cash flows CASH FROM OPERATING ACTIVITIES CASH FROM INVESTING ACTIVITIES CASH FROM FINANCING ACTIVITIES CASH AT BEGINNING OF YEAR MOVEMENT IN CASH DURING THE YEAR CASH AT END OF YEAR + = + / -

Statement of cash flows 2009 2008 (R million) Cash received from customers 144 963 123 452 Cash paid to suppliers and employees (96 776) (88 712) Cash generated by operating activities 48 187 34 740 Finance income received 2 264 957 Finance expenses paid (2 168) (2 405) Tax paid (10 252) (9 572) Cash available from operating activities 38 031 23 720 Dividends paid (7 193) (5 766) Cash retained from operating activities 30 838 17 954

Statement of cash flows 2009 2008 (R million) Additions to assets under construction (13 047) (8 671) Additions to other intangible assets (126) (17) Non-current assets sold 697 184 Acquisitions of businesses (30) (431) Disposal of businesses 3 486 693 Purchases of investments (89) (42) Proceeds from sale of investments 7 Other cash flows from investing activities (917) (393) Cash flow from investing activities (12 518) (10 844)

Statement of cash flows 2009 2008 (R million) Share capital issued 1 189 475 Share capital repurchased (1 114) (7 300) Proceeds from long-term debt 5 575 3 806 Repayments of long-term debt (4 820) (4 588) Proceeds from short-term debt 280 1 942 Repayments of short-term debt (2 091) (2 292) Other (212) (458) Cash flow from financing activities (1 193) (8 415) Translation effect of foreign operations (870) (448) Increase/(decrease) in cash and cash equivalents 16 257 (981) Cash and cash equivalents at the beginning of the year 4 335 6 088 Cash and cash equivalents at the end of the year 20 592 4 335

Cash flow from operating activities Cash generated from normal operating activities of the company Cash received from customers Cash amount that customers paid for products sold and services rendered Cash generated by operating activities Cash received from customers minus cash paid to suppliers and employees

Cash flow from operating activities (cont.) Finance income received on investments Finance expenses paid on interest-bearing debt capital Tax paid in cash Cash available from operating activities Indicates if sufficient cash flow was generated to afford a dividend payment Negative value: indicates that cash dividend can only be afforded if cash is obtained elsewhere

Cash flow from operating activities (cont.) Dividends paid Cash payment of preference and ordinary dividends Cash retained from operating activities Negative operating cash flow – no surplus cash flow available to invest in replacement and expansion of assets Additional cash has to be generated from financing activities or company may have to sell assets to finance cash deficit Consistent failure to generate positive cash flow can be seen as indicator of serious financial problems

Cash flow from investing activities Additions to PPE, to assets under construction & to other intangible assets Cash incurred to purchase additional assets Non-current assets sold Cash proceeds from sale of non-current assets Acquisitions of businesses & disposal of businesses Cash effect of acquiring & selling business units Proceeds from sale of investments and purchases of investments Cash result of increases & decreases in investment

Cash flow from financing activities New share capital issued Cash inflow Share capital repurchased Cash outflow New long-term debt obtained Repayments of long-term debt Proceeds from short-term debt and repayments of short-term debt Cash inflows and outflows respectively

Conclusion The main objectives of financial statements are to provide information about the financial position, financial performance and changes in the financial performance of a company. The users of financial statements include the existing and potential shareholders; providers of debt capital; the management of the company; government; and other stakeholders. The requirements for financial statements are that they should be understandable, relevant, accurate, objective and comparable.

Conclusion (cont.) It is sometimes necessary to standardise the published financial statements of a company to ensure that they are comparable with other companies, and over time. The statement of financial position provides a summary of a company’s financial position on a specific date. The statement consists of two parts: the asset side, and the equity and liabilities side. The asset part provides an indication of the specific assets that the company owns. The equity and liability part contains the different sources of capital used to finance these assets.

Conclusion (cont.) The statement of comprehensive income provides a summary of a company’s financial performance over a period of time. Within a statement of comprehensive income the turnover generated during the financial year is allocated to the different stakeholders up to a point where only retained earnings are left. The statement of cash flows provides a summary of a business’s ability to generate cash and the application of cash (i.e. how the cash is used). A distinction is made between the cash results of operating, investing and financing activities.