Financial Decision Making-4
Sa1_Jyyy
Lesson3Understandingtheincomestatement.pptxppt/slideLayouts/slideLayout1.xml
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MN7029 – Financial Decision Making 1.2 Reviewing financial statements
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Week 1.2 – Learning Outcomes Explain the key statements within a company’s Financial Statements; Describe the main users of financial statements and why they would use them; Debate the limitations of financial statements
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Agency & Stakeholder Theory - Enron Who is responsible for the collapse of Enron? What steps could be, or have been, taken to prevent this sort of failure in the future?
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I asked the students to read the Enron article as part of pre course reading. This discussion is a general discussion on what went wrong and what mechanism should have, and have now been put in place to stop this happening again. Get thoughts from students before moving onto suggested answers
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Who is to blame? The business environment – rapid growth The CFO/CEO – set up the structure to enable fraudulent accounting (hiding debts/losses), failed to maintain control of operations Executives – exercised share options at inflated share prices The Board – pursued rapid growth and lost strategic focus Audit committee – did not understand or question the complexity of the business Auditors – close relationship, income from consultancy, failure to interrogate management Stock analysts – had conflict of interest with investment banking side of their firm
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What steps could be taken to prevent this happening? Accounting for the substance not the form of the transaction (changes to accounting standards) Stricter rules around audits Independence of audit firms and investment banks Independence of regulatory bodies – harsher penalties? Stricter rules on director duties More protection for whistleblowers Embedding a culture of ethics Independent audit committees and appointment of those with relevant skills
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Types of business Main types of business Sole trader Partnership Company/corporation In the UK we have Sole trader Partnership Limited Liability Partnership (LLP) Private company (Ltd) Public Company (Plc) We also have special designations e.g.: Charities Place of business B Corp Community Amateur Sports Club (CASC)
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Introduction to types of business structures in the UK
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Example Ownership Structure Nat’s International Company Ltd Investment Company Plc 70 shares = 70% 20 shares = 20% 10 shares = 10%
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This is to break down in simple terms how a company issues shares to owners. I set up Nat’s company with £20 and issue myself 20 shares of £1 each. At that stage I own 100% of the 20 shares in issue so I am the sole shareholder. A friend offers to invest £70 in exchange for 70 shares and a separate investment company invests £10 in exchange for 10 shares. Now the ownership structure consist of 100 shares, of which I own 70 so I own 70% of the company. I use the analogy of a pizza to describe this – the pizza is the whole company, but I can divide it up into as many slices as I like. People take a slice in exchange for putting money into the business. A pizza could have 4 slices (or shares) or 1 million slices and the amount of slices you hold indicates the level of influence you may have over the company.
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Public v Private Companies Company X Management Employees Banks Customers Suppliers General Public? Shareholders General Public
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Introducing the concept of private companies – companies where shares can be issued to and traded by members of the general public
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Public or Private Company A private company (in the UK a Ltd) is held privately, usually by founders or other private individual investors. The general public cannot buy or sell shares in Limited May invite specific people to invest (e.g. a Private Equity Fund or Business Angel) Does not appear on a Stock Exchange A public company (in the UK a Plc) has sold some or all of its shares to the general public by way of an Initial Public Offering (IPO). Listed on a stock exchange Public can buy and sell shares on investment platforms Has a higher level of scrutiny
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Public or Private Company Public companies tend to be larger and have more access to funding, but there are some very large private companies
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Examples of large private companies – private companies does not necessarily correlate to small company
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What is accounting? A process of identifying, recording summarizing and reporting economic information or transactions to decision makers and stakeholders in the form of financial statements There is a difference between financial accounting and management accounting The accounting system is the steps performed to analyze, record, quantify and report economic events and their effects on an organization. It must be designed to meet the needs of the users
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Reiterating the role of accounting as taking many economic transactions in a business and presenting them in a way that is understandable, allowing management to make decisions and allowing interested parties to compare different businesses in the understanding that the companies will have applied standard principles to organising their transactions into this format.
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What are Financial Statements? Record of the company’s performance (in the form of economic information or transactions); Key statements Statement of financial position (balance sheet); Profit or loss (income) statement; Statement of cash flows. A historical record of past events; Numerical data and explanatory notes; Publicly available in the UK Video – what are financial statements?
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Video is halfway down the linked page – you can show in class or the students can review later Financial Statements: List of Types and How to Read Them (investopedia.com)
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The Annual Report and Accounts All UK companies are required to prepare accounts and file with UK Companies House ( https://www.gov.uk/government/organisations/companies-house ); If a business is not a company they will still draw up financial statements; Companies must draw up accounts based on UK GAAP or IFRS; All UK companies require an audit unless subject to exemption (e.g. certain small co’s ); Additional publication requirements for public companies.
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Emphasise just how much information is publicly available in the UK – all UK company must prepare accounts and submit to Companies House and anyone can view – different in other jurisdictions – the US does not require private companies to make these publicly available.
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Financial Statements Statement of Financial Position A summary at a fixed point in time; Assets, liabilities and equity. Statement of Profit or Loss Data for a period of time (accounting period); Shows income and expenditure for that period. Cash Flow Data for a period of time (accounting period); Shows cash in and outflows for that period. Not profit
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Financial Statements Cycle 12 month period 12 month period 12 month period Income Statement Cash Flow Income Statement Cash Flow Income Statement Cash Flow Statement of Financial Position Statement of Financial Position Statement of Financial Position Statement of Financial Position
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Emphasising that the Statement of financial position bookends the period
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Who might use financial statements?
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Question for the class – get their ideas on who might use them
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Users of financial statements
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This page can be used if you want to write up the students ideas on who the users might be or you can do it as a discussion
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Pick a user – what might they use the financial statements for?
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Class input – why might people use the statements – this might have been discussed in the previous slide
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Who uses financial statements and why? Current/potential investors Employees Lenders Suppliers Customers Government and regulators The public Will I get paid? Is the company meeting its company law and regulatory requirements? What is the environmental and social impact of the company? What level of profit did the company make? Will the company be able to repay borrowings? How much tax should the company pay? Is the company in danger of insolvency? Can the company continue to supply my goods? Should I invest more/sell shares? Is the company managed effectively? Is the company growing?
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Some ideas of users and what they use them for
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Some key terms… Revenue: Sales made to customers Cost of goods sold: the cost of making the sales Operating expenses: the cost of marketing the product or administering the business Profit: Excess of revenue (sales, turnover) over expenditure (costs of good sold and operating expenses) Assets: Business resources that the company owns or has use of Equity: the investment or “stake” of the owner, the owner’s value in the business (initial investment in shares, retailed profits) Inventory: Stock, goods for resale, raw materials Receivables: money owed to the business Payables: money the business owes to others
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Statement of Financial Position (Balance Sheet)
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Purpose of the balance sheet The purpose of the balance sheet is to set out the financial position of a business at a particular point in time, the economic resources ( assets ) it controls and where its finance comes from ( liabilities and equity ). It sets out the assets of the business and the claims against it (liabilities and owners’ equity) at a particular point in time.
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What types of assets might you find in a business?
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Ask the class to see if they can guess the assets that the pictures are clues to: Cash Property Machinery Inventory/stock/raw materials Brand names or intangible assets
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Merlin Entertainments Ltd – statement of financial position
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An example of a statement of financial position – Merlin owns and operates theme parks around the world – I usually highlight the property, intangible assets, inventories etc
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Types of assets Current Held for sale or consumption Lifespan of a year of less Held principally for trading Cash or liquid short term investments Non Current Held for longer term Business may be done in or with them (i.e. not consumed) Tangible and intangible
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Figure 2.3 The circulating nature of current assets Cash Trade receivables Inventories
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Circular nature of current assets – business uses cash to buy stock which it then sells for cash immediately (or cash to be received in the future – trade receivable)
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Intangible assets Goodwill: Represents for example brand name, strong management team, business contacts, staff relations Not possible to identify created goodwill separately from the business – subjective so cannot be recorded. Purchased goodwill = price paid – (fair value of the assets – liabilities) – objective so can be recorded. Subject to annual impairment review Other intangibles: For example, trademarks, patents. Stated at cost and amortised over useful economic life
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Typical assets
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What is depreciation?
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Depreciation Depreciation is the allowance for wear and tear on some fixed assets like, plant and machinery. It is an allowance for: Wearing out, Consumption or other reductions in the useful economic life of a fixed asset, NOT A CASH FLOW!!!! Accumulated depreciation shows amount that the asset has lost in value since its purchase You can depreciate on a straight line or a reducing balance (%) method.
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Claims Equity The owner’s claim against the business. Ordinary shares plus reserves Capital. Separate legal identity Liabilities Other parties For example, money owed for raw materials, upfront customer prepayments
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Types of claim Current Settled in a year or less Arise from trading Non Current Held for longer term May not arise from trading (e.g. long term bank loan)
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Typical claims
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The accounting equation Liabilities Assets Equity = +
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The beauty of double entry accounting! The statement of financial position will always balance = assets must equal equity + liabilitirs
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The effect of trading transactions on the accounting equation The accounting equation can be extended as follows: Profit (Loss) Assets Equity Liabilities = + + ( − )
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The income statement (profit & loss account)
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Profit (or loss) for the period = Total revenue for the period – Total expenses incurred in generating that revenue
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What types of income might we have in a business?
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Ask the class if they can guess the types of revenue a business might have: Sales of goods (e.g. a supermarket) Sales of subscriptions (Netflix, a gym) Financial income (e.g. bank interest, or income from share investments) Income from licencing (e.g. Disney might allow someone to use the image of Mickey Mouse on a pencil case and they pay to use that right) Sales of services (e.g. an accountant or lawyers) Rent (e.g. hotels renting rooms, or a landlord renting a property) I like to compare how businesses have evolved their sales models e.g. Blockbuster video (sale/rental or physical product and late fees) v Netflix (subscriptions to view licecnced content)
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Expenses
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Ask the class if they can guess the types of revenue a business might have: People, wages, salaries Light and heat Phone Computing or cloud services (AWS) Delivery costs Rent of property or office Raw materials
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Figure 3.2 The layout of the income statement
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How does Twitter make money?
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This made me laugh – when Elon Musk bought Twitter he had to figure out how to make money from it and introduced the idea of paying for the blue tick. Lots of people complained, including the esteemed author Stephen King and Elon replied to that seemingly negotiating the price. I’m not sure how much product pricing is determined live online with Stephen King, but clearly some is!
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How does Twitter make money?
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How does Twitter make money though? It is free to users, so they are not asking for payment from users. Most of its money is made through advertising. Other companies pay Twitter to promote ads. Some money is also made by selling or licencing the data it collects to other companies who are interested in that data
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How does Twitter make money?
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In 2021 Twitter received revenue or sales of $4.5bn from advertising and $0.5bn from licencing data. Ask students to consider how business they use actually generate cash from sales? Will Twitter need to find a new model e.g. payment for users? Even though it made that money in sales in 2020 and 2021 it made a loss – revenue is not profit. Can a business survive if it continually makes a loss? Yes provided that people are willing to invest money, but when they are not and the cash runs out the business will fail. Lack of profits is not the ultimate killer of businesses it is lack of cash.
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The cash flow statement
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Figure 5.3 Standard presentation for the statement of cash flows
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Cash is not profit!!!
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Operating examples {073A0DAA-6AF3-43AB-8588-CEC1D06C72B9} Profit Cash Receiving a loan from the bank Profitable sale for cash Profitable sale on credit Buying a machine for cash Depreciation of the machine Buying inventory (stock) for cash Issuing shares to investors for cash
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Operating examples {073A0DAA-6AF3-43AB-8588-CEC1D06C72B9} Profit Cash Receiving a loan from the bank None Increase Profitable sale for cash Increase Increase Profitable sale on credit Increase None Buying a machine for cash None Increase Depreciation of the machine Decrease None Buying inventory (stock) for cash None Decrease Issuing shares to investors for cash None Increase
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Financial Management Also called cost and management accounting; Using financial data to help make business decisions; Fundamental qualities of financial information: Relevant Timely Understandable Comparable Verifiable
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We’ve so far looked at financial accounting – how do businesses present their annual economic transactions. Financial management or management accounting is using financial data to help the management team make decisions
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Differences between financial management and financial accounting
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Financial accounting and management accounting can differ in lots of ways – the crucial element is that the financial accounting tends to be historic and summarised and subject to rules about accounting standards and disclosure. Management need timely and often detailed and forward looking information to aid the decision making process. This may mean they want it to be presented in different ways.
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Financial planning and analysis Treasury manager Risk management Corporate strategy Who might form part of a finance function? Financial Controller Financial accountant General ledger accountants Cash book REPORTING/HISTORICAL FORECASTING/FUTURE CFO FD
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CFO is known as Csuite – part of the Board of Directors, Financial controller – oversees the accounts reporting team, responsible for budgets, analysis Ginance /accounts manager – day to day running of the finance requirements May also have general ledger accounts responsible for specific areas e.g. cash book Strategic finance function: FP&A:
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Click to edit Master text styles Second level Third level Fourth level Fifth level
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Land and buildings, Machinery and equipment, Fixtures and fittings, Debtors (receivables), Investments Cash Inventory
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Land and buildings, Machinery and equipment, Fixtures and fittings, Debtors (receivables), Investments Cash Inventory
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Long term loans Wages payable Deposits received Trade creditors Loans and debentures Bank overdraft
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Long term loans Wages payable Deposits received Trade creditors Loans and debentures Bank overdraft
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Financial Statements Users? Rules? Features? Type? Frequency? Uses? Whole company? Timing? Detail?
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Financial Statements Users? Rules? Features? Type? Frequency? Uses? Whole company? Timing? Detail?
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