Financial Tools and the Legal Environment

M155LON

Financial Tools and the Legal Environment

Week 1 Financial Statements

Learning Objectives

• Understand the nature, purpose and characteristics of the income statement, the balance sheet, and the statement of cash flows 

• Evaluate a company’s financial performance, financial position, and changes in cash flows using the three key financial statements 

• Apply cash flow projections to monitor a venture’s cash position 

• Understand how pro forma financial statements are developed

Basic Accounting Concepts

• Generally Accepted Accounting Principles (GAAP): 

• Guidelines that set out the manner and form for presenting accounting information 

• International Financial Reporting Standards (IFRS) & International Accounting Standards (IAS) 

• Accounting Methods

Accrual Accounting: All revenues generated by the business and all expenses incurred are included, regardless of whether actual cash has been received or disbursed.

Cash Accounting: 

All revenues and expenses are recognized when actual cash is received and paid.

Accounting Methods

An end-of-the-year income statement using both methods. The company has sold and invoiced $1 million worth of merchandise and has received payment for $600,000. The merchandise cost was $500,000, an amount for which the company has been billed. The company has paid its suppliers $400,000.

Accounting Methods 

Publicly owned companies prefer to use the accrual method.

• It gives the reader of financial statements a richer and more complete depiction of the business’s financial condition. 

• It helps them achieve increases in revenue and profit. Some owners could get too aggressive and sometimes even act unethically with regard to growth.

Case: Premiere Laser Systems, Inc

Accounting Methods

Some privately owned entities, which seek to minimize taxes by reducing their reported earnings before tax (EBT), prefer to use the cash accounting method.

• The cash accounting method gives the reader a more limited picture of the company’s financial condition.

•  Private-practice physicians, whose revenues come from slow third-party payers, e.g. insurance companies and the government.

•  The cash method helps delay revenue recognition until the cash is actually received, reducing the company’s profit before taxes and consequently the taxes.

• Using the cash method does not result in tax avoidance/elimination. It simply delays tax payments into future years.

The Income Statement

The income statement (I/S), also known as the profit and loss (P&L) statement.

• It records the flow of resources over time by stating the financial condition of a business over the course of a period, usually a month, quarter, or year. 

• It shows the revenues (i.e., sales) achieved by a company during a particular period and the expenses (i.e., costs) associated with generating these revenues. 

The Income Statement

Net Income

Revenues – Expenses = Net Income

EBITDA

Earnings before interest expense, taxes, depreciation, and amortization. 

• Earnings – net income or profit 

• Interest expense – the cost of debt 

•  Taxes – the payments to the government based on a company’s profit 

• Depreciation – noncash expenditures for the decline in value of tangible assets 

• Amortization – noncash expenditures for the decline in value of intangible assets such as patents or goodwill

The Income Statement

The Income Statement

The Balance Sheet

The balance sheet (B/S), also known as the statement of financial position.

• It is a financial snapshot of a company’s assets, liabilities and shareholder’s equity at a particular time.

• Bankers rely on the analysis of ratios of various assets and liabilities on the balance sheet to determine a company’s creditworthiness and solvency position.

The Balance Sheet

The Balance Sheet

Net Working Capital

Net Working Capital = Current Assets – Current Liabilities

• A measure of the company’s ability to pay its bills, i.e. the company’s short-term financial strength.

• Two companies have the exact same level of working capital does not mean that they have equal short-term financial strength. A company with greater working capital than another is not necessarily financially stronger. 

•  A banker would prefer to lend to a company that has greater financial strength. 

• How can we tell which company has greater financial strength?

The Balance Sheet

Net Working Capital 

Net Working Capital = Current Assets – Current Liabilities

The Balance Sheet

Net Working Capital 

Net Working Capital = Current Assets – Current Liabilities

The Statement of Cash Flows

The statement of cash flows

• Uses information from the two other financial statements 

• Develops a statement that explains changes in cash flows resulting from operating and financing activities.

The Statement of Cash Flows

The Statement of Cash Flows

The Statement of Cash Flows

Pro Forma Financial Statements

• Entrepreneurs should develop pro forma financial statements for all new entrepreneurial opportunities, including either start-ups or existing companies that are being purchased.

• Any pro forma should have figures for at least 3 years and 3 scenarios—a bestcase, a worst-case, and a most-likely-case scenario.

• A company’s historical performance drives the financial projections for that company’s future unless other information indicates that past performance is not a good indicator.
• 
  

Pro Forma Financial Statements

How can a start-up company develop its financial projections when historical data are absent? 

• Conduct an industry analysis and select a company within the same industry that can be used as a comparable. 

• Use secured sales commitments to calculate the worst-case scenario. Use larger amounts to calculate the best-case and most-likely-case scenarios. 

• Market research can be undertaken to determine the overall market demand for this new product or service. 

•  Use specific figures for projections, based on your own assumptions or expectations.

Questions?