R.HARIHARAN
AP/EEE
Balance sheet structure

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A balance sheet presents a picture of the
company’s finances at the end of the
financial year, and the assets which it has
acquired and which have not yet been
consumed within the business
A balance sheet can be presented
according to two basic formats:
◦ Horizontal balance sheet
◦ Vertical balance sheet
Company X – Balance sheet
at 31 December 20X2
Resources
=
Assets
=
Sources of finance
“Equities”
Owners’equity
(interests of owners)
of
creditors)
Liabilities
(interests
Horizontal balance sheet
Fourth EC Accounting Directive
Liabilities and equity
Assets
Intangible assets
Tangible assets
Investments
Fixed Assets
Stocks
Debtors
Cash at bank
Deferred charges
Total
943
1,988
213
3,144
Ordinary shares
Reserves
Retained profit
1,589
973
881
176
Provisions
Financial liabilities
Trade liabilities
6,763
Shareholders’ equity
Total
2,455
982
947
4,384
520
1,500
359
6,763
Horizontal balance sheet
US format
Assets
Liabilities and equity
Cash at bank
Deferred charges
Receivables
Inventory
881
176
973
1,589
Trade payables
Debt
Provisions
Investments
Tangible assets
Intangible assets
213
1,988
943
Ordinary stock
Reserves
Retained profit
Fixed assets:
Total
6,763
Equity
Total
359
1,500
520
2,455
982
947
6,763
Horizontal balance sheet

Left-hand side - the assets:
◦ Fixed assets: used over a period of more than
one year
 Tangible assets (e.g. physical plant and machinery)
 Intangible assets (patents, brand names, licences)
 Investments (shares of and loans to other companies)
◦ Other (current) assets: constantly changing
during accounting period
 Inventories
 Receivables (amount due from customers)
 Cash
Horizontal balance sheet
(cont.)

Right-hand side - the financing:
◦ Share capital: put into the company by the
owners
◦ Provisions: a liability to pay in the future, but
amount or timing is uncertain
◦ Financial Liabilities: loans made by banks and
financial markets
◦ Trade liabilities: debts due to suppliers
Balance sheet – vertical
format
Intangibles
Tangible assets
Investments
Fixed assets
Stocks
Debtors and prepaid1
Cash at bank
Current assets
Creditors due in less than one year
Net current assets
Creditors due in more than one year
Provisions
Capital
Ordinary shares
Reserves
Retained profits
€ ’000
€ ’000
943
1,988
213
3,144
1,589
1,149
881
3,619
(359)
3,260
(1,500)
(520)
4,384
2,455
982
947
4,384
Vertical balance sheet
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
Same content but different presentation
Liabilities are shown as a deduction from assets
Liabilities are split according to when they are
due for payment, with current liabilities
deducted from current assets
Capital (or equity) is shown as the residual: it is
more a proprietary approach (focusing on the
interests of the owners) while the horizontal
presentation follows an entity approach
(company presented as an economic whole)
The basics of accounting
measurement

Accounting measurement is based on a
set of assumptions and conventions
which automatically limit the information
content
◦ Generally accepted accounting principles
◦ Conventional measurement bases

Accounting measurement necessitates
extensive use of estimates, which make it
a subjective process
Generally accepted accounting
principles



A set of assumptions, conventions and rules
underlying financial accounting, necessary to
make financial statements comparable and
useful, but introducing significant constraints
on their content
Different Generally Accepted Accounting
Principles (GAAP)-sets exist, such as European
GAAP and related national GAAP, US GAAP, IFRS
GAAP,...
The ‘true and fair view principle’ (or fair
presentation) of financial statements is
pragmatically linked to the proper application of
‘generally accepted accounting principles’
Financial Ratios
FOUR BASIC TYPES - most commonly used for each - can
be used for some financial companies.
LIQUIDITY
• Current ratio = Current Assets / Current Liabilities
Not so relevant for financial firms - most assets liquid.
MANAGEMENT SKILL
• Total Asset Turnover = Sales / Total Assets
Again, not so relevant because traditional sales are typically not very large.
Interest and investment income is more relevant.
PROFITABILITY
• Operating profit margin = Operating Profit/Sales
• Return on Revenues = Net Income (or EBIT)/Tot. Assets
• Return on Assets = Net Income (or EBIT)/Total Assets
• Return on Equity = Net Income/Equity
These are measures of top-line profitability and bottom-line profitability,
respectively. Similar for financial firms.
FINANCIAL RISK
• Debt Ratio = Debt / Assets
• Times Interest Earned = Net Operating Income /
Interest Expense
Leverage and interest-paying ability - used for financials.
Financial Statements
• National-charter banks must submit uniform accounting statements to the
Comptroller of the Currency.
• State charter banks submit accounting statements to their state regulator.
LIQUIDITY RISK - different than typical liquidity ratios
• Liquidity ratio = (Cash+short-term securities)/Assets
• Loans to Deposits = Loans/Deposits
• Deposits Times Capital = Deposits/Equity
A mixture of profit potential and risk measures.
MANAGEMENT EFFICIENCY
• Earning Assets to Total Assets = Assets-(Cash+Fixed
earning Deposits) / Total Assets
Assets+Non-
• Burden = (Noninterest Exp.-Nonint. Inc.)/Tot. Assets
• Efficiency = Nonint. Exp./(Nonint. Inc. + Net Int. Inc.)
• Asset Utilization = Total Operating Income / Total Assets
PROFITABILITY
Interest Margin to Earning Assets =
Income-Interest Expense)/Earning Assets
• Profit Margin = Net Income/Total Operating Income
• Return on Earning Assets = Net Income/Earning Assets
• Return on Equity = Net Income/Equity
(Interest
Cash Flow Analysis
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
Each cash flow activity will increase or
decease over time depending upon the lifecycle of the company’s products.
Here is the most common pattern for
revenues, net income, and cash flows.
Cash flow analysis can be used to address a variety of
questions regarding a firm's cash flow dynamics:
 How strong is the firm's internal cash flow generation?
◦ Is the cash flow from operations positive or negative?
◦ If it is negative, why?
◦ Is it because the company is growing?
◦ Is it because its operations are unprofitable?
◦ Or is it having difficulty managing its working capital
properly?
 Does the company have the ability to meet its shortterm financial obligations, such as interest payments,
from its operating cash flow?
◦ Can it continue to meet these obligations without
reducing its operating flexibility?
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
How much cash did the company invest in growth?
◦ Are these investments consistent with its business strategy?
◦ Did the company use internal cash flow to finance growth,
or did it rely on external financing?
Did the company pay dividends from internal free
cash flow, or did it have to rely on external
financing?
◦ If the company had to fund its dividends from external
sources, is the company's dividend policy sustainable?

What type of external financing does the company
rely on?
◦ Equity, short-term debt, or long-term debt?
◦ Is the financing consistent with the company's overall
business risk?

Does the company have excess cash flow after
making capital investments?
◦ Is it a long-term trend?
◦ What plans does management have to deploy the free cash
flow?
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Although it is possible to answer these
questions using the GAAP SCF format,
recasting the SCF makes answering these
questions easier.
In addition, using a standard format makes
comparison between companies easier.
Here is the model that we will use in this
class.
Traditional SCF Format
Net Income
+ Depreciation and Amortization
± Deferred Taxes
± Gains/Losses
± Changes in Working Capital
= Cash Flow from Operating Activities
- Purchases of Long Term Assets
+ Sales of Long Term Assets
= Cash Flow from Investing Activities
+ Sale of Stock
+ New Borrowing
- Debt Payments
- Dividends
- Stock Repurchases
= Cash Flow from Financing Activities
Cash Flow from Operating Activities
+ Cash Flow from Investing Activities
+ Cash Flow from Financing Activities
= Net Change in Cash
Recast SCF Format
Net Income
+ Interest Expense (Net of Tax)
+ Depreciation and Amortization
± Deferred Taxes
± Gains/Losses
= OCF before Working Capital Investments
± Changes in Working Capital
= OCF before Investment in Long Term Assets
- Purchases of Long Term Assets
+ Sales of Long Term Assets
= FCF Available to Debt and Equity
- Interest Expense (Net of Tax)
- Debt Payments
+ New Borrowing
= FCF Available to Equity
+ Sale of Stock
- Dividends
- Stock Repurchases
= Net Change in Cash
OCF = Operating Cash Flow
FCF = Free Cash Flow
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Operating Cash Flow is broken up into two
components, OCF before working capital
investments and OCF before investments in
long term assets.
Over the long run OCF must be positive, but
firms in the early stages of development,
growing rapidly, or investing heavily in
research and development, marketing and
advertising, and other future growth
opportunities will have negative OCF.
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If cash flow after investing in long term assets
is not positive then the firm did not generate
enough cash from operations to pursue longterm growth opportunities and must rely on
external financing.
These firms have less flexibility than firms
that can generate the necessary funds
internally.
Cash flow after long term investments is cash
flow available to both debt and equity
holders.
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Payments to debt holders include interest and
principal payments.
Firms with negative free cash flow after
investments in long term assets must borrow
additional funds to meet their interest and
principal payments.
They can also reduce their investments in
working capital, long term investments, or
issue additional equity.
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Cash flow after payments to creditors is free
cash flow available to owners.
Payments to equity holders include dividends
and stock repurchases.
If firms pay dividends despite negative cash
flows available to equity holders then they are
borrowing to pay dividends. This is not
sustainable in the long term.
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
Examine cash flow from operations before
investment in working capital to verify the
company is able to generate a cash surplus
from its operations.
Examine cash flow from operations before
investment in long term assets to how the
firms working capital is being managed and
to see if the company can invest in long-term
assets for future growth.
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Examine free cash flow to debt and equity
holders to asses a firm’s ability to meet its
principal and interest payments.
Examine free cash flow to equity holders to
asses a firm’s ability to sustain its dividend
policy.
All cash flow analysis must be done taking
into consideration the company’s business,
its growth strategy, and its financial policies.
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
The Quality of Income Ratio is calculated as
Cash Flow from Operations
Net Income
OR
Cash Flow from Operations
Net Income + Depreciation
This ratio should be > 1 for a healthy firm.

If there are significant differences between
net income and operating cash flow ask the
following questions:
◦ What are the sources of the difference?
◦ Is it due to accounting policy?
◦ Is it due to one-time events or on-going activities?

Is the relationship changing over time?
◦ If so, why? (see above for possible reasons).
◦ Is it because of changes in business conditions or
accounting policies and estimates?

What is the time lag between recognition of
revenues and expenses and the receipt or
payment of cash?
◦ What uncertainties are there regarding cash
collection or cash payments (e.g. bad debts,
contingent liabilities, etc.)

Are the changes in working capital accounts
normal?
◦ If not, is there an adequate explanation for the
changes?
MEANING OF FUNDS FLOW STATEMENT
The Funds flow statement (FFS) is a financial
statement which reveals the methods by which
the business has been financed and how it has
used its funds between the opening and closing
Balance-Sheet dates. It studies – from where the
funds have been received and where the funds
have been used.
IMPORTANCE OF FUNDS FLOW
STATEMENT
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Financial Analysis and Control
Financial Planning and Budget preparation
Useful to Bankers and Money Lenders
Helpful in Comparative Study
Knowledge of Managerial Policies
Knowledge of Business Problems
Dividend Policy
Financial Statement Analysis

Non-accounting majors, especially, should
relate well to this chapter
It looks at accounting information from users’
perspective

Relates very closely to topics you will
study in your finance course
Therefore, we will use a somewhat broader
brush on this chapter

What is financial statement analysis?
”Tearing apart” the financial statements
and looking at the relationships
Methods of
Financial Statement Analysis
 Horizontal
 Vertical
Analysis
Analysis
 Common-Size
 Trend
 Ratio
Statements
Percentages
Analysis
Horizontal Analysis
Using comparative financial
statements to calculate dollar
or percentage changes in a
financial statement item from
one period to the next
Vertical Analysis
For a single financial
statement, each item
is expressed as a
percentage of a
significant total,
e.g., all income
statement items are
expressed as a
percentage of sales
Common-Size Statements
Financial statements that
show only percentages and no
absolute dollar amounts
Trend Percentages
Show changes over time in
given financial statement items
(can help evaluate financial
information of several years)