Chapter 5
Financial Statements
Analysis
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Chapter Goals
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Recognize the importance of financial statements to
PFP.
Produce and evaluate a balance sheet.
Construct a cash flow statement.
Compare finance and accounting based techniques.
The Balance Sheet
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Balance sheet: A statement of financial position at a
given point in time.
The balance sheet consists of all assets, liabilities,
and net worth.
Current assets: Assets that are expected to be or
can be converted into cash in the current year.
Marketable investments: Assets that are traded
publicly.
Household assets: Assets used in day-to-day
household activities.
The Balance Sheet, cont.
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Human assets: The future income stream of
household’s wage earners.
Because they cannot be sold, human assets are not
usually placed on balance sheets.
Human-related assets: Other forms of resources in
addition to human assets that are omitted from the
balance sheet.
The term human-related is used because the value
is derived from human- related work efforts or human
relationships.
For example, human related assets include pension
plans that pay out yearly income upon retirement.
The Balance Sheet, cont.
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Liabilities: Items that the household owes.
Credit card debts, taxes outstanding, and mortgage
debt are liabilities.
Liabilities can be split into current and long term,
based on whether they are due within one year or
beyond that period.
The mortgage payment due within the year is
expressed as a current liability.
The Balance Sheet, cont.
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Household equity (household net worth): The
difference between its assets and liabilities.
Household equity can be relatively small or even
negative when household members are young and
college debt and other obligations are high.
Net worth generally increases as marketable
investments increase.
The Balance Sheet, cont.
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Example:
Tricia had a $20,000 savings account, owned a car
valued at $12,000, and owed $9,000 that she had
borrowed to help finance the car.
Her net worth is:
Assets
Liabilities
Net Worth
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$32,000
$(9,000)
$23,000
The Balance Sheet, cont.
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Sample budget sheet:
ASSETS
LIABILITIES
Current Assets
Checking Accounts
Money Market Funds
Refund Due on Returned Clothing
Total Current Assets
Current Liabilities
Credit Card Debt
Other Current Debt
Current Portion
Total Current Liabilities
Marketable Investments
Bonds and Bond funds
Stocks and Stock Funds
Total Marketable Investments
Long-Term Liabilities
Mortgage
Other Long-Term Debt
Total Long-Term Liabilities
Pension Assets
401(k) Plans
IRAs
Total Pension Assets
Total Liabilities
Real Estate
Home
Total Real Estate
Household Assets
Autos
Furnitures and Fixtures
Total Household Assets
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Other Assets
Jewelry
Stamp Collection
Total Other Assets
EQUITY
Total Assets
Total Liabilities and Equity
Household Equity
Total Equity
The Balance Sheet, cont.
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Budget sheet items can be summarized as follows:
The Cash Flow Statement
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Cash flow statement: A statement that represents
how much cash has been generated over a period of
time.
The word “flow” indicates that it measures results
between two periods, say between the end of last
year and the end of this year.
The cash generated is simply the difference between
the cash at the beginning and end of the period.
The cash flow is determined by totaling the sources
of cash - cash inflows - and subtracting the uses of
cash - cash outflows.
The Cash Flow Statement, cont.
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Functional cash flow statement: A cash flow
statement that separates cash flows by type of
household activity.
Use of a functional cash flow statement permits clear
description of household results for the period and
easy comparison with other periods.
The functional cash flow statement It is structured as
a blend of the business income statement and its
cash flow statements.
There are three basic types of activities: operating,
financing, and investment activities. These are
discussed next.
The Cash Flow Statement, cont.
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Example of a functional
cash flow statement
(continues on next slide):
2006
Operating Activities
Income
Salary
Business
Investment
Other
Total Income
Expenses
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Non Discretionary
Housing Upkeep
Health Care
Insurance
Interest
Alimony
Food
Clothing
Transportation
Personal
Taxes
Total Non Discretionary Expenses
2007
2008
2009
2010
The Cash Flow Statement, cont.
(continued
from
previous
slide):
Cash Flow Before Discretionary Activities
Discretionary
Recreation-Entertainment
Personal
Vacations
Gifts and Charitable Cont.
Hobbies
Interest
Other
Total Discretionary Expenses
Cash Flow From Operating Activities
Capital Expenditures
Discretionary
Non Discretionary
Total Capital Expenditures
Financing Activities
Total Repayments
Additional Debt
Total Financing Activities
CASH FLOW
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Targeted for Retirement
Targeted for Other
NET CASH FLOW
Operating Activities
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Operating activities: The day-to-day financial
functions of the household.
Unlike a business income statement, the household
statement is recorded on a strict cash basis.
The operations segment can be segregated into
cash inflows and outflows that we will call income
and expenses.
– Income consists of salary, investment returns, and
other sources of operating cash.
– Expenses can be divided into nondiscretionary
and discretionary items.
The difference between income and expenses is
cash flow from operations.
Operating Activities, cont.
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Nondiscretionary expenses: The household’s
overhead items such as interest expense, rent,
household, food, clothing, and taxes.
Nondiscretionary expenses are largely fixed costs
that cannot be altered easily or quickly
Discretionary expenses: Expenses the household
choose to incur to derive pleasure. Examples are
entertainment, eating out, and vacation outlays.
Capital Expenditures
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Capital expenditures: Outlays on household related
matters that provide benefit beyond the current year.
We display capital expenditures separately because
these cash outflows don’t occur regularly.
Including capital expenditures with other costs can
distort the operating figures.
Financing Activities
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Financing activities: The cash flows that come from
changes in debt.
– Borrowing money has a favorable impact on cash
flow because it increases the cash available.
– Repaying debt has a negative effect on cash flow
because it reduces cash resources.
People sometimes confuse lower debt with having
higher cash flow for that period.
Savings
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Savings: The cash left over after operating, capital
expenditure, and debt activities.
Savings are also known, for financial statement
purposes, as cash flow representing prior cash
inflows minus cash outflows.
Investments that are not in the form of capital
expenditures are treated as part of the savings
section.
Savings can be intended for specific purposes such
as retirement or a down payment on a home.
Savings, cont.
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Net cash flow: The amount of cash available after
targeted savings.
When the net cash flow figure is negative it can be
due to targeted investing. Alternatively, the figure
may be positive only because of borrowing during
the period.
Savings applied to investing are reported as
marketable securities in the balance sheet.
Savings left in cash are reported as cash at periodend on the balance sheet.
Balance sheet cash at the end of the period less
cash at the beginning of the period equals net cash
flow on the cash flow statement for that time frame.
Traditional Household Cash Flow
Statement
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In practice:
– Many people use a cash flow statement that
groups all inflows and outflows together.
– Paydown of debt and interest payments are
lumped together.
– Income tax payments are often placed at the
bottom, just before the net cash flow figure.
This approach is a traditional cash flow statement.
– Advantage: simplicity and custom.
– Disadvantage: Less useful as an analytical
document for financial planners and individuals.
Traditional Household Cash Flow
Statement, cont.
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Example of
Income
traditional Salary
household Business
Investment
cash flow Other
Total Income
statement: Expenses
Mortgages and Property Taxes
Housing Upkeep
Food
Clothing
Health Care
Transportation
Insurance
Recreation and Entertainment
Vacations
Hobbies
Gifts and Charitable Contributions
Contributions to Pensions
Net Additional Debty Proceeds
Capital Expenditures
Interest
Other
Taxes
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Total Expenses
CASH FLOW
2006
2007
2008
2009
2010
Traditional Household Cash Flow
Statement, cont.
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This tables summarizes the differences between a
functional and traditional cash flow statement:
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Calculates Net Cash Flows Properly
Develops Separate Operational Income Statement
Resembles Business Cash Flow Statement
Segregates Capital Expenditures and Financing Activities
Separates Nondiscretionary and Discretionary Costs
Handles Revenues Properly
Is More Simple
Is More Informative
Traditional
Statement
Yes
No
No
No
Sometimes
Yes
Yes
No
Functional
Statement
Yes
Yes
Yes
Yes
Yes
Yes
No
Yes
Financial Statement Presentation
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Financial statements are intended to make the
household’s financial circumstances as clear as
possible.
A number of situations call for either the separation
of figures on the statement or, more frequently,
footnotes to them.
We next discuss these situations.
Balance Sheet: Retirement Assets
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Retirement assets that are in pension accounts
should be listed separately for two reasons:
– Retirement assets often cannot be turned into
cash immediately, or at least not without penalty.
– Normal withdrawals from pensions are taxable. It
can be useful to know what pensions would be
worth on an after-withdrawal after-tax basis.
Balance Sheet: Life Insurance
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Much life insurance has no current value or a low
cash value relative to its face amount.
If there is a significant cash value, it belongs on the
balance sheet.
The face value should be given in a footnote.
Face value: The amount to be paid in the event of
death during the period the policy is in effect.
Balance Sheet: Taxation and
Unrealized Appreciation
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Investment assets are expressed on the balance
sheet at their current value.
A footnote to the balance sheet should report their
cost individually.
If there are many assets, a total cost figure should be
reported.
Through the above reporting, the effect of taxation
on the gain up on ultimate sale can be estimated.
Balance Sheet: Liquidation Cost
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One should footnote the amount of liquidation costs
and net proceeds whenever we expect the proceeds
from sale to be materially lower than the value
placed on the balance sheet.
Cash Flow Statement
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The footnotes in the cash flow statement often
provide further information on special charges for the
year.
Where the “other” category is used for all
miscellaneous expenses, a footnote could explain
the substantial components of that category year by
year.
Pro Forma Statements
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Pro forma statements: Statements that include
projections.
We include projections in a statement to better
anticipate needs, to forecast resources to meet
those needs, and to adjust our plans accordingly.
Pro Forma Cash Flow Statement, cont.
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Two principal approaches to making projections for a
cash flow statement are as follows:
Common Rate: The rate of annual increase that
many household expenses share. The increase is
often based on an assumed future inflation rate.
Separate Rate: Certain inflows and outflows that
cannot be estimated by using a projected rise in
inflation.
Pro Forma Cash Flow Statement, cont.
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The following list details operating activities and
projections (continues next slide).
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Salary: As separately estimated or rate of inflation
Business: As separately estimated or rate of inflation
Investment: Assumed rate of return
Housing Upkeep: Rate of Inflation
Health Care: Rate of Inflation
Insurance: Per contract where fixed; otherwise, rate of inflation
Interest: Per debt outstanding
Alimony: As stated
Food: Rate of inflation
Clothing: Rate of inflation
Transportation: Rate of inflation
Personal: Rate of inflation
Pro Forma Cash Flow Statement, cont.
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(continued from previous slide).
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Taxes: Based on separate tax calculation
Recreation-Entertainment: Rate of inflation
Personal: Rate of inflation
Vacations: Rate of inflation
Gifts/Charitable Contributions: Rate of inflation
Hobbies: Rate of inflation
Interest: At stated rate
Other: Rate of inflation
Non Discretionary: As separately estimated or rate of inflation
Discretionary: As separately estimated or rate of inflation
Total Repayments: Per contract
Additional Debt: As separately estimated
Targeted for Retirement: As stated
Pro Forma Balance Sheet
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The balance sheet can be a more difficult to forecast
than the statement of cash flows as some of its
figures include the impact of cash flows and
outflows.
For example:
– The investment account will not only include the
growth rate on existing assets but the deposit of
new savings.
– Liabilities will include the impact of cash inflows to
reduce the amount outstanding or the absence of
cash flow, which results in a larger debt figure.
For this reason projected balance sheets are used
less frequently than those for cash statements.
Finance versus Accounting
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Accounting employs GAAP, or generally accepted
accounting principles.
Most large businesses use GAAP accounting.
Under GAAP the business attempts a proper
matching of revenues and expenses.
Household accounting generally determine results
for a period using changes in cash.
Finance versus Accounting, cont.
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Household results for a period are provided on a
cash flow statement.
Business results are given on an income statement.
Capital expenditures are outlays that have benefit for
more than the current period.
Businesses capitalize them as assets on the balance
sheet instead of expensing them on the income
statement.
Finance versus Accounting, cont.
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Depreciation: The projected reduction in asset value
due to wear and tear or obsolescence.
Depreciation is a tax deductible expense on the
business income statement.
Since the decline in asset value associated with
depreciation does not involve a cash transaction, it is
not recorded on the household’s cash flow
statement.
GAAP generally requires that businesses record
transactions on the balance sheet at original cost
less accumulated depreciation.
Households generally record assets at their fair
market value.
Finance versus Accounting, cont.
Item
Explanation
GAAP Business
Finance
Balance Sheet
Assets and liabilities at
a given point in time
Cash flow statement giving
operating performance for the
period
Based on original cost
Revenues
Sale transactions
Expenses Paid
Cost transactions
Recorded when fairly
represents a transaction
Recorded as necessary for
proper matching with
revenues
Based on current fair
market value of assets
Cash inflows and
outflows only in a cash
flow statement without
regard to proper
matching
Recorded when cash is
received
Recorded when cash is
disbursed
Performance for
Period
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(Continued next slide.)
A proper matching of
revenues and costs for the
period in an income
Statement
Finance versus Accounting, cont.
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(Continued from previous slide.)
Item
Explanation
GAAP Business
Finance
Profits
Earnings for period
A “fair” presentation of results
for the period
Capital
Expenditures
Outlays providing
extended-period
benefits
Capitalized as asset on balance
sheet, not as an expense on
income statement
Depreciation
Amount an asset has
declined in value for
the period
Asset Value on
Balance Sheet
The assigned worth of
an item at a point in
time
Recorded as an expense on
income statement based on
original cost. Deducted from
asset on balance sheet
Recorded at original cost less
depreciation
No exact equivalent.
Replaced by cash inflows
minus cash outflows
Recorded as outflow on
flow statement. Recorded
at fair market value on
balance sheet
Not recorded
Recorded at fair market
value
Chapter Summary
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Financial statements can provide an objective way to
assess your financial condition.
The balance sheet reports assets, liabilities, and
equity at a given point in time.
The cash flow statement indicates how well the
household it is operating.
The cash flow statement is divided into operating,
capital expenditures, debt, and net cash flow figures.
Finance focuses on actual cash generated while
accounting attempts to match income and expenses
even when cash is not received or paid.
In forming a balance sheet, finance uses fair market
value; accounting uses original cost.