CHAPTER 4. FINANCIAL STATEMENTS

CHAPTER 4. FINANCIAL STATEMENTS

Accounting standards require statements that show the financial position, earnings, cash flows, and investment (distribution) by (to) owners. These measurements are reported, respectively, by the following statements: balance sheet, income statement, statement of cash flows, and statement of changes in equity. These statements can be constructed in a variety of different ways and levels of detail. An important consideration is that the financial framework of the firm should compliment the physical performance measures of the firm.

A typical indicator used as a measure of the firm's financial health is its cash position. Cash flows are an important, but often misleading, indicators of the financial health of a firm. Two necessary conditions for long-term survival in any firm are profitability and feasibility. Profitability is defined as the difference between a firm's revenues and its expenses. Feasibility is the solvency or short-term ability of the firm to meet its obligations when they become due. If a firm is not both profitable and feasible over time, it cannot survive. In the short run, a firm can be feasible but not profitable. For a limited time, the firm can generate cash flows to remain solvent by borrowing, refinancing existing debt, selling inventory, liquidating capital assets, increasing accounts payable, or depleting its capital base. Unfortunately, these techniques are only temporary solutions and don't substitute for long-run profitability. Focusing on only the firm's "cash position" can, and has, led to devastating results for firms. An appropriately constructed set of financial statements will allow a firm to monitor both profitability and solvency and diagnose any difficulties the firm has in these areas.

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Balance Sheet A balance sheet is a listing of a firm's assets, debt claims, and equity claims at a particular

point in time. People are usually taught to think of it as a "snap shot" of the firm on a given date. As a result, it is important to know the date for which the balance sheet was constructed. Table 2.4 presents 1995-97 year-end balance sheets for the hypothetical HiQuality Nursery company, which might be organized as sole proprietorship, partnership, or corporation.

The underlying principal for any balance sheet is the fundamental accounting equation:

Assets / Liabilities + Equity.

In other words, every dollar of the firm's assets must be financed either by a liability (debt borrowed by the firm) or equity claim (capital supplied by the firm's owners), or some combination of the two. This principal results in the separation of assets from liabilities and equity on the balance sheet. We can check the above equality by noting that the total value of assets at the bottom of the balance sheet is equal to the total value of liabilities and equity for each year.

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Table 4.1 Year-End Balance Sheets for HiQuality Nursery

ASSETS

HiQuality Nursery Balance Sheets ($000)

1997

Year 1996

Cash and Mkt Securities Accounts Receivable Inventory

$ 600 1,200 5,200

$ 930 1,640 3,750

CURRENT ASSETS

7,000

6,320

Prop, Plant, and Equip Other Assets

2,800 600

2,990 690

LONG TERM ASSETS

3,400

3,680

TOTAL ASSETS

10,400

10,000

1995

$1,200 1,560 3,150

5,910

3,270 710

3,980

9,890

LIABILITIES

Notes Payable Current Portion LTD Accounts Payable Accrued Liabilities

CURRENT LIABILITIES

TOTAL LONG TERM DEBT

TOTAL EQUITY

TOTAL DEBT AND EQUITY

1,270 450

4,000 800

6,600

1,985

1,815

10,400

1,500 500

3,000 958

5,958

2,042

2,000

10,000

1,400 700

2,400 870

5,370

2,560

1,960

9,890

The firm's assets and liabilities are typically listed in order of liquidity or payment. For example, current assets are expected to be liquidated within the next year and are listed above long-

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term assets, which are not expected to be liquidated during the upcoming year. Likewise, current liabilities are debts due within the upcoming year and are listed above long-term liabilities, which are debts that will not come due during the next year. Equity, which represents residual ownership of the firm's assets, has no fixed due date and is consequently listed last. Items within each category on the balance sheet are also listed in order of liquidity or payment.

Assets Assets represent the resources available to the firm to be used to generate earnings and

includes everything owned that has value. Current assets are represented by cash and near-cash assets that are expected to be liquidated during the next year. Current assets are typically assets whose liquidation will not significantly disrupt the operation of the firm. Besides cash, current assets often include marketable securities, accounts receivable, notes receivable, and inventories. Marketable securities are interest bearing deposits which are low risk in terms of principal balance and can easily be converted to cash if needed. Accounts receivable are sales that have been made but not collected from customers. Notes receivable are debt payments due to the firm during the upcoming year. Finally, inventories represent the value of inputs used in production or manufacturing of goods that have not been sold. Inventories are often the least liquid of the current assets and their value is often not known until the assets are sold.

Noncurrent long-term assets are assets that yield service over a period of time and are expected to remain in the firm beyond the upcoming year. Liquidation of fixed assets typically would

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disrupt the operations of the firm. Fixed assets include such items as machinery, equipment, automobiles, breeding stock, contracts, long-term notes receivable, and real estate.

Book Value versus Market Value Assets are recorded at a value equal to their acquisition costs. Many fixed assets wear out

or lose value over time. This loss in value is accounted for by depreciating, or lowering the acquisition cost, of the assets over time. The value of each asset on the balance sheet (acquisition cost - accumulated depreciation) is called the asset's book value. A difficulty with financial statement analysis is that an asset's book value almost always differs significantly from the asset's market value which is what the firm can actual get if it sells the asset.

In order to understand why book value is not equal to market value, let's think about what determines market value. We'll show this more formally later, but it turns out that the value of an asset generally depends on the following three characteristics of the future cash flows the asset is expected to generate:

1. the size and/or number of expected future cash flows; 2. the timing of expected future cash flows; and 3. the risk and variability of future cash flow. In general, the larger the size and/or number of expected future cash flows, the larger the assets market value will be. Likewise, the sooner you expect to get the cash flows, the higher the market value of the asset (think about the time value of money concept). Finally, everything else held constant, the greater the risk or variability of an asset's future cash flows, the lower the market value

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