MODULE 9
INTERPRETING FINANCIALS
AT BOARD LEVEL
ADB Private Sector Development Initiative
Corporate Governance Training
Solomon Islands, 2014-2015
Originally by
Dr Judy Taylor
Acknowledgement
These materials were produced by Dr Judy Taylor from La Trobe University, through the Asian Development Bank’s
Pacific Private Sector Development Initiative (PSDI). PSDI is a regional technical assistance facility co-financed by the
Asian Development Bank, Australian Aid and the New Zealand Aid Programme.
Module 9:
Interpreting financials at board level
• What are the main financial statements
• How to read the financial statements
Introduction to key financial
statements
1. balance sheet
2. changes in equity
3. income statement
4. comprehensive income
5. cash flow statement.
Overview of financial governance
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The board is responsible for the true and fair
financial reporting of their company (entity)
While the board delegates some of the oversight
tasks to committees, they retain ultimate
responsibility and authority
Board’s role is not to manage, but to ensure the
organisation is being managed (governed)
When something goes wrong the board is
collectively accountable.
Financial statements
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All companies must complete a Balance Sheet as well as
an Income Statement
IFRS compliant companies must complete all 5
statements
The Cash Flow Statement is required under IFRS and for
companies that have to be audited
Unfortunately the Cash Flow Statement is not required
to be completed by all companies, but directors who do
not compare their budgeted cash flow with their actual
cash flow are missing vital information on the health of
their company
Underlying principle
Accrual system underlies
balance sheet
income statement
Accrual system
“determines profit by recognising revenues as earned
when the goods/services are provided, and expenses
as incurred when the benefit is consumed”.1
eg. sale or purchase on credit
1. Anthony Simmons and Richard Hardy, Cambridge VCE Accounting Units 1 &2, (2012, Cambridge University Press), p.277
Performance V Position
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The income statement shows the performance of the
company over a period of time, whereas
the balance sheet shows the position of the company
on a set date
Cash Flow
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The cash flow statement is drawn up on the basis of
cash received and paid,
classified as
 operating,
 investing
and
 financing activities.
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Together these three accounts provide useful and
valuable insight into the financial health and
performance of the company
How to read a balance sheet
Balance sheet consists of three main categories
Assets - things the company owns
Liabilities - things the company owes
Equity - the owners portion and retained
earnings of the company
A=L+E
Owners Equity
Alternatively we can see the balance sheet from the
owner’s perspective
E= A-L
Balance Sheet format
There are many acceptable formats for the
presentation of the balance sheet. The industry type,
such as manufacturing, retail or medical, usually
determines the format.
A variety of balance sheet formats can be found
online by googling “format balance sheet”.
Balance sheet
What is an asset, what is a liability? IASB framework defines them as:
Assets: “Resources controlled by the enterprise as a result of past
events and from which future economic benefits are expected to
flow to the enterprise. Assets are what a company owns.
Liabilities: present obligations of an enterprise arising from past
events, the settlement of which is expected to result in an outflow
of resources embodying economic benefits. Liabilities are what
the company owes.
Equity: in public companies, also known as shareholders equity or
stockholders equity. Assets less liabilities. “Equity is the residual
interest in the assets after subtracting liabilities.” 2
2. IASB, Framework for the Preparation and Presentation of Financial Statements, Para 4.4(a), 4.44-57
Classification of Assets and Liabilities
Assets are divided between
current assets (CA), those that will be used up within a year
non-current assets (NCA) that will live beyond a year.
Liabilities are also divided into two categories
current liabilities (CL), those that need to be paid within a year
non-current liabilities (NCL), those that will be paid after a
year
Equity is the owner’s contribution (stock/shares) into the company as
well as the retained earnings (undistributed profits) of the company
and any capital reserves.
Balance sheet - overview
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At a glance the balance of each of these categories
should be
CA>CL
You should have more assets that will mature within one
year than liabilities. Otherwise you will not be able to
meet all short-term liquidity commitments.
NCA>NCL
The NCA should be greater than NCL,
Finally assets should be able to generate a return
sufficient to cover the liabilities (interest, lease and rent
payments) and pay a reward to the owners of the
capital (dividends)
How to read an income statement
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The income statement is a statement of revenue and expenses earned and
incurred using accrual accounting. It shows how the company has performed
over the period, usually 12 months.
INCOME: “Increases in economic benefits in the form of inflows or
enhancements of assets, or decreases in liabilities that result in an increase
in equity. Income includes both revenues and gains. Revenues represent
income from ordinary activities of the enterprise. Gains may result from
ordinary activities or other activities.”3
Expenses: “decreases in economic benefits in the form of outflows or
depletion of assets or increases in liabilities that result in decreases in
equity.”4
Income is recognised if it is probable to occur and when it can be measured
reliably
3. IASB, Framework for the Preparation and Presentation of Financial Statements, (2010)Para 4.38
4. IASB, Framework for the Preparation and Presentation of Financial Statements, (2010)Para 4.25 (a-b)
How to read an income statement
The expenses listed on the income statement can be grouped either by
function or by nature.
Example - by nature
including all depreciation relating to machinery used in production as well
as depreciation of office furniture together– they are all depreciation.
grouping by function
grouping all costs that are incurred in manufacturing such as only
depreciation on machinery plus production inputs.5 (Depreciation of office
furniture would appear under operating costs.)
Both are permitted under IFRS
5. Thomas R. Robinson, International Financial Statement Analysis, (2012, Wiley) p 138
Income statement
An income statement is tiered giving at least five
subtotals of profit,6
 gross
profit
 profit for year before tax
 profit for year from continuing operations
 profit for the year
 total comprehensive income for the year
When the income Statement is analysed more tiers
are added. See next Module.
Gross profit
1. Gross profit
This profit is generated by revenue (usually net after an
allowance for bad debts has been estimated) from the sale of
goods and or services of a firm’s continuing operations (the
main purpose) less the cost of manufacturing or purchasing the
inputs.
The gross profit is independent of the firm’s capital structure.
Net revenue less cost of goods sold = gross profit
Profit for year before tax
2. Profit for year before tax
Gross profit
Plus - other income such as interest income or other gains and losses,
less - the indirect cost of selling and administrative activities as well as
other expenses such as research and development, -but not interest
and taxation expenses.
Gross profit less operating expenses = EBIT profit for the year before
interest and tax
EBIT less interest = EBT profit for year before tax
Profit for year from continuing operations
3. Profit for year from continuing operations,
profit for the year before tax, EBT, less tax expense
=profit for the year from continuing operations.
4. Profit for the year
=profit for the year from continuing operations
less discontinued operations
Comprehensive income
5. Total comprehensive income for the year
This includes a list of amounts that are included in the
calculation of the income statement as well as amounts that are
not.
 Listed but not included - gains such as revaluation of
property, share of gain or loss on property revaluation of
associate, or re-measurement of defined benefit obligations
must be recorded but not included in income.
 Listed and Included - other gains such as exchange
differences on translating foreign operations, net fair values
gain available from sale of financial assets and net fair
value gain on hedging instruments entered into for cash flow
hedges are included
 Profit for year plus other comprehensive income = total
comprehensive income for the year.
Financial Reporting
Sales
Cost of sales
Gross profit
Operating expenses
Depreciation &
amortisation
EBIT
Interest
EBT
Tax
Income continuing operation
Less discontinued operation
Net Income/Profit for year
Revaluation of property
Translation gain (loss)
Comprehensive income
2013
50000
25000
25000
12000
2014
60000
32000
28000
14000
2000
11000
1000
10000
500
9500
2000
4000
10000
2000
8000
600
7400
1500
7500
1500
2000
9500
6100
1500
(1200)
4900
Tiered income helps directors
These levels are helpful for directors who need to
understand where their profit is coming from.
1.
Core function
2.
Core function less operational costs and debt
3.
Profit less impact of taxation
4.
Profit impacted for activities closed down or sold
5.
Income after effect of non core activities
How to read the Cash flow statement
The cash flow statement has 4 components,
 Cash
flow from operations (CFO)
 Cash flow from investing (CFI)
 Cash flow from financing. (CFF)
 Reconciliation of cash balance with previous year.
Cash flow statement shows what cash has been
received and paid. It does not show the profitability
of the company.
How to read the Cash flow statement
CFO
 Records activities that create revenues and expenditures from ‘core’
manufacturing or production or servicing operations
 Can include interest receipts and interest payments but NOT net
interest
CFI
 Cash flow from investing represents the purchase or sale of
productive assets for cash, e.g. property plant and equipment,
shares in another company (not held for trading).
 Cash flow from investments in joint ventures and affiliates and cash
flow from long term investment in securities are included as investing
cash flows.
 Cash flow consequences of acquisitions and divestments are also
included as investing cash flows.
 Interest on investment activities can be classified as either CFI or
CFO
How to read the Cash flow statement
CFF
 Cash inflows include additional borrowings and
equity capital raisings
 Cash outflows include debt repayments and equity
capital buy backs
 Dividend payments are included as financing cash
outflows,
 Interest expenses can be either CFF or CFO
Presentation of Cash flow
2 Methods
direct method or
indirect method.
 Both methods give different information, but should
give the same result.
 only CFO is done on an indirect basis both CFI and
CFF are always constructed using the direct method.
 IFRS prefer direct but allow indirect
Direct versus indirect method
direct method
gives the gross amounts of revenues and expenses received
and paid.
indirect method
begins with the net income and makes adjustments to the net
income for amounts that were
not received or paid, for
noncash amounts and for
changes in working capital accounts.
The indirect method tells you why there is a difference between net
income and Cash flow from operations whereas the direct method gives
you information regarding gross sales received and gross expenses
paid.
What do you expect to see on a cash
flow statement?
Cash flow from operations should be positive.
A young company may not have a positive CFO, but a
mature company will not survive if its CFO is not positive.
Directors must review the CFO:
Is the company generating enough cash from their
operations to be able to
meet the obligations above AND
to grow the company?
What you do not see on the cash
flow statement
Noncash transactions
Companies settling a debt by issuing equity capital.
This transaction would not be reported within the cash
flow statement as no cash flow occurred.
However because the transaction may affect future
cash flows through increased dividend payments, they
should be disclosed in a separate schedule
What do you not see in the financial
statements?
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The three financial statements usually aggregate
the activity of the business so that the financial
statements appear very superficial.
Detail can found in the footnotes to the accounts
that often run over 40 or 50 pages. The financial
statements cannot be understood properly unless
the footnotes are all read thoroughly.
Statement of Changes in Equity
activity.
Equity is made up of shareholders’ contribution (share
capital), reserves and retained earnings.
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Complete columns B and D for each year.
Calculate the retained earnings for each year in
column E.
Check: Does total profits less total dividends over
the 4 years = retained earnings at the end of year
4?