Class I finance

Introduction to Financial Analytics
Fundamentals of Finance Class I
by Reuben Ray
reuben@pexitics.com

• Time value of money.
• Present value & future value of money.
• Applications of TVM (Time Value of Money)
• Annuity & perpetuity concepts.
• Introduction to financial statements.
What we are going to cover today!

• Time value associated with money.
• Determining future value at given interest rate.
• Present value based on current value of funds to be received.
• Determining Yield on an Investment.
• Compounding or discounting occurring on a less than annual basis.
The time value of money is used to determine whether future benefits
are sufficiently large to justify current financial spends.
Mathematical tools of the time value of money used to make capital
allocation decisions by organisations.
Time Value of Money (TVM)

Money is a perishable commodity.
True or False?
Products are paid for with products.
~ Jean Baptiste Say

• Expect consumers to have “positive time preference” :
• prefer consumption today rather than in the future
• Why?
• There is a chance that will not be able to consume in the future
• (in the long run we are all dead)
• Expectation that income will be higher in the future (economy will
grow)
• (Goods and services will be more abundant in the future as a
result of economic growth)

There are three reasons why a rupee tomorrow is worth less than a
rupee today:
• “Individuals prefer present consumption to future consumption. To
induce people to give up present consumption you have to offer
them more in the future.
• When there is monetary inflation, the value of currency decreases
over time. The greater the inflation, the greater the difference in
value between a dollar today and a dollar tomorrow.
• If there is any uncertainty (risk) associated with the cash flow in the
future, the less that cash flow will be valued.”
(Damodaran, 2010)

Measuring value of an amount that is allowed to grow at a given interest
over a period of time
– Assuming that the worth of ₹1,000 needs to be calculated after 4
years at a 10% interest per year, we have:
1st year……₹1,000 X 1.10 = ₹1,100
2nd year…...₹1,100 X 1.10 = ₹1,210
3rd year……₹1,210 X 1.10 = ₹1,331
4th year……₹1,331 X 1.10 = ₹1,464
Financial calculation for this equation:
PV (1+I)N = FVN
PV = Present Value
I = Rate of Interest
N = Period or Time (Years)
FV = Future Value

Value = + + +
FCF1 FCF2
FCF∞
(1 + WACC)1 (1 + WACC)∞(1 + WACC)2
Free cash flow
(FCF)
Market interest rates
Firm’s business riskMarket risk aversion
Firm’s debt/equity mixCost of debt
Cost of equity
Weighted average
cost of capital
(WACC)
Net operating
profit after taxes
Required investments
in operating capital
−
=
...
Determinants of Intrinsic Value: The Present Value Equation

• Present Value – earlier money on a timeline
• Future Value – later money on a timeline
• Interest rate – “exchange rate” between earlier money and later
money
• Discount rate
• Cost of capital
• Opportunity cost of capital
• Required return
Understanding Value: The Value Definition

• Suppose you invest ₹1000 for one year at 5% per year. What is the
future value in one year?
• Interest = ₹1000(.05) = ₹50
• Value in one year = principal + interest = ₹1000 + ₹50 = ₹1050
• Future Value (FV) = ₹1000(1 + .05) = ₹1050
• Suppose you leave the money in for another year. How much will
you have two years from now?
• FV = ₹1000(1.05)+.05 = ₹1000*1+(.05)2 = ₹1100.00
Future Value: The Straight Line calculation
Mathematically, the equation is ₹1000(1) + ₹1000(.05) = ₹1000(1+.05)2

The effect of compounding is small for a small number of periods, but
increases as the number of periods increases.
Future Value: Interest Rate
What is the difference between simple interest and compound interest?
Simple interest: Interest is earned only on the principal amount.
Compound interest: Interest is earned on both the principal and
accumulated interest of prior periods.
Simple interest is money paid only on the principal.
Principal is the amount of money borrowed or invested.
Rate of interest is the percent charged or earned.
Time that the money is borrowed or invested (in years).
I = P  r  t

Interest rate represents the cost of money
It is the opportunity cost of money:
It shows the return lost from not investing in a comparable risk investment.
It is expected to compensate the investor for the time, inflation, and risk.
Rate of Return: Interest Rate
Expected Return - the return that an investor expects to earn on an
asset, given its price, growth potential, etc.
Required Return - the return that an investor requires on an asset given
its risk and market interest rates.
Two Components of return
Periodic cash flows | Price Change (capital gains)

Expected Return
Expected return is based on expected cash flows (not accounting profits)
In uncertain world future cash flows are not known with certainty
To calculate expected return, compute the weighted average of possible returns
Calculating Expected Return:
k k P ki i
i
N
=
=
 ( )
1
where
ki = Return state i
P(ki) = Probability of ki occurring
N = Number of possible states

Rate of Return: Risk Calculation
Risk: the uncertainty of future outcomes.
Measuring Risk
Standard Deviation (s) measure the dispersion of returns.
 = −
=
(k ) (k )i i
i
N
k P2
1
State of Economy Probability Return
Economic Downturn .10 (–5%
Zero Growth .20 (5%
Moderate Growth .40 (10%
High Growth .30 (20%
– 10.5%)2 = 24.025%2
– 10.5%)2 = 6.05%2
– 10.5%)2 = 0.10%2
– 10.5%)2 = 27.075%2
2 = 57.25%2
 = √57.25%2
 = 7.57%

Simple Interest
Interest earned = 5% of ₹1000 = .05×1000 = ₹50 per year
Total interest earned = ₹50×2 = $100
Balance in your savings account:
= Principal + accumulated interest
= ₹500 + ₹50 = ₹1050
Compound interest (assuming compounding once a year)
Interest earned in Year 1 = 5% of ₹1000 = ₹50
Interest earned in Year 2 = 5% of (₹1000 + accumulated interest)
= 5% of (₹1000 + 50) = .05×1050 = ₹52.50
Balance in your savings account:
= Principal + interest earned = ₹1000 + ₹50 + ₹52.50 = ₹1052.50
Suppose that you deposit ₹1000 in your savings account that earns 5% annual interest. How
much will you have in your account after two years using (a) simple interest and (b) compound
interest?

What is value today of cash flow to be received in the future?
The answer to this question requires computing the present value, i.e.,
the value today of a future cash flow, and the process of discounting,
determining the present value of an expected future cash flow.
Since we know how to compound to get future value:
FVn=PV(1+i)n
We can get PV from FV:
PV=FVn/(1+i)n
Compound (multiply) to get future value; discount (divide) to get
present value.
Present value will be smaller than future value with positive rate.
Future Value to Present Value: Discounting

How much will ₹5,000 to be received in 10 years be worth today if the interest rate is 7%?
PV = FV /(1+i)n =5000 /(1.07)10= $2,541.75
To calculate present value, the interest rate is often referred to as the “discount rate.”
The textbook version of the PV formula (for annual compounding):

Rule of 72 is an approximate formula to determine the number of years
it will take to double the value of your investment.
Rule of 72: N = 72/interest rate in percentage
Using Rule of 72, determine how long it will take to double your
investment of ₹10,000 if you are able to generate an annual return of
9%.
Exact N=ln(2)/ln(1.09)=0.693/0.086=8.04
Approximate N=72/9=8.
Rule of 72

Time Value of Money is dependent not only on the time interval being
considered but also the rate of discount used in calculating current or
future values.
Based on this, we can use the time value of money concept to calculate
how much you need to invest or borrow now to meet a certain future
goal
What we learnt about Time Value of Money

• Let’s do an exercise:
• You need to sell your car and you receive offers from three different buyers.
• The first offer gives ₹400000 to be paid now
• The second offer gives ₹415000 to be paid one year from now
• The third offer gives ₹460000 to be paid after five years.
• Assume that the second and third offers have no credit risk.
• The risk free interest rate is 5%.
• Which offer would you accept?

• Time Value of Money, or TVM, is a concept that is used in all aspects
of finance including:
• Bond valuation
• Stock valuation
• Accept/reject decisions for project management
• Financial analysis of firms
• And many others!
Applications for Time Value of Money

• Future value is the value of an asset at a specific date in the future.
• It measures the nominal future sum of money that a given sum of
money is "worth" at a specified time in the future assuming a certain
interest rate, or more generally, rate of return.
• Actually, the future value does not include corrections for inflation or
other factors like Interest Rate Risk that affect the true value of
money in the future.
Future Value: Limitations

Applications of TVM Equation
Any time value problem involving lump sums -- i.e., a single outflow and
a single inflow--requires the use of a single equation consisting of 4
variables: PV, FV, r, and n
If 3 out of 4 variables are given, we can solve for the unknown one.
FV = PV x (1+r)n solve for future value
PV = FV x [1/(1+r)n] solve for present value
r = [FV/PV]1/n – 1 solve for unknown rate
n = [In(FV/PV)/In(1+r)] solve for unknown number of periods

Applications of TVM Equation: Interest Rate
Anil needs to borrow ₹50000 today for his personal needs. He agrees to
pay back the amount in a lumpsum five years from now. The lender says
that the amount to be returned is ₹70127.6. What is the interest rate
Anil is going to pay?
Solution:
r = (FV/PV)1/n - 1
= (70127.6/50000)1/5 – 1
= (1.40255….)1/5 – 1
= 7.01

Applications of Interest Rate: Growth Rate
You are head of Human Resources and need to plan for manpower
requirements of a large organisation. Today the staff strength is 940 but
is estimated to grow to 2500 in the next three years. What is the rate at
which the organization will be growing?

Applications of TVM Equation: Period
You have been a good student of TVM and now decide to plan on
becoming rich. You have investments of ₹50000 and want it to grow at a
rate of 15% till it becomes 50 lakhs. How long will you have to wait?
Solution:
r = In(FV/PV)/In(1+r)
= In(5000000/50000)/In(1+0.15)
= 7.01
Mathematically solving it,
N = ----------------
In -------
FV
PV( )
In (1+r)

Think of the problem as a road trip. The present value is your starting point, and the future value
is your destination. The number of periods is the distance to be traveled, and the interest rate is
the average speed that you will be traveling.
Using this analogy, however imperfect it may be, we can identify several important relationships
between the variables:
•The future value is always bigger than the present value, ie., value of distance covered.
•From any given present value (starting point), the longer you drive (N) or the faster you go (i),
the bigger the future value will be.
•If you slow down (use a lower interest rate), it will take longer (larger N) to get from the present
value to the future value. If you speed up (higher interest rate), you will get there faster (lower
N).
•If you drive for less time (lower N), you will need higher speed (higher i) to reach the same
destination (FV).
TVM Solving tips

An annuity is a series of equal cash flows, equally distributed over time.
Examples of annuities abound: Mortgage payments, car loan payments,
leases, rent payments, insurance payouts, and so on. If you are paying
or receiving the same amount of money every month (or week, or year,
or whatever time frame), then you have an annuity.
Formula for calculation: FVA = A × FVIFA
FVIF
= Future Value Interest Factor
Annuity:
A series of consecutive payments or receipts of equal amount.
Future Value of an Annuity:
Calculated by compounding each individual payment into the future
and then adding up all of these payments.
Annuities

• Find the Future Value at the end of year 4 of the following cash flow
stream given that the interest rate is 10%.
0 1 2 3 4
100 200 200 300
Solution:
FV4 = 100(1+0.10)3 + 200(1+0.10)2 + 200(1+0.10) + 300
= 133.10 + 242.00 + 220.00 + 300
= 895.10
Applications of TVM Equation for Annuities

Annuities: Calculating Future Values
Assuming that at a 10% interest rate, after 4 years, an amount of
4,641 needs to accumulated:
For n = 4, and i = 10%, FVIFA is 4.641. Thus, A equals 1,000 as
below :
A= FVA / FVIFA = 4641/4.641 = 1000

Annuities: Calculation Formulas

Starting on her 30th birthday, a women invests x rupees every year on her birthday in an
account that grows at an annual effective interest rate of 7%. What should x be if she wants this
fund to grow to 300,000 just before her 65th birthday?
Mathematically solving,
300000 = xs-35|.07
= x(1+ .07)35
−1 /.07/(1+ .07)
= x(147.91346) or x = 2.02821.
So payments should be 2,028.21
Annuities: Mathematical Calculations

Annuities: Choosing an option plan
Time 0 1 2 3 . . . 36
Option A -2,000 -564.05 -564.05 -564.05 -564.05 -564.05
Option B -4,000 -500.14 -500.14 -500.14 -500.14 -500.14
To determine which deal to choose, we simply need to discount back each stream of flows to
find the present value of the cost of each option. We should choose the option with the lower
present value. The only problem is that we are not given a discount rate to use.
Discount
Rate
PV Option A PV Option B Best
Choice
6% 20,541 20,440 B
8% 20,000 19,960 B
10% 19,481 19,500 A
12% 18,982 19,058 A
With a given discount rate the present value can be computed, once again, with the PVA
formula. For a given rate r, we plug in 564.05 for C under option A, and 500.14 for C under
option B.
Once we have this present value we add to it the initial outflow (2,000 for A, 4,000 for B) to get
the total present value cost of the loan. The following table gives computed values for the two
options under various discount rates:

Annuities: Calculating Interest (Yield)
Determine the yield on an investment of 10000 producing 1490 per annum for 10 years.
Formula : PVA
= A * PVIFA
Hence, PVIFA
= PVA
/A
= 10000/1490
= 6.71
For calculating multiple yields from multiple and differential sources, we need to add up the
totals and divide and arrive at the yield in the same manner.

Deferred Annuities:
• Situations involving a combination of single amounts and an annuity.
• When annuity is paid sometime in the future
Assuming a contract involving payments of different amounts each year for a three year period :
– An annuity of 1,000 is paid at the end of each year from the fourth through the eighth
year
– To determine the present value of the cash flows at 8% discount rate
Year 1 1000
Year 2 2000
Year 3 3000
Year 4 1000
Year 5 1000
Year 6 1000
Year 7 1000
Year 8 1000
Year 1 2 3 4 5 6 7 8
Pmt 1000 2000 3000 1000 1000 1000 1000 1000
PV = 5022 PV = 3993
PV = 5022 + 3170
PV = 5022 + 3170 = 8192

Multiple Annuities
X Corporation has 75,000 invested in securities that earn a return of 16% compounded
quarterly. The company is developing a new product that it plans to launch in two years at a
cost of 500,000. Management would like to bank money from now until the launch to be
sure of having the 500,000 in hand at that time. The money currently invested in securities
can be used to provide part of the launch fund. XC’s bank account will pay 12% compounded
monthly.
How much should XC deposit with the bank each month ?
A: Two things are happening in this problem
• XC is saving money every month (an annuity) and
• The money invested in securities (an amount) is growing independently at interest
We have three steps
• First, we need to find the future value of 75,000
• Then, we subtract that future value from 500,000 to determine how much extra XC
needs to save via the annuity
• Then, we solve a future value of an annuity problem for the payment

XC Solution
XCSOlution
To find the future value of 75,000
PV
N
PMT
I/Y
102,645
8
0
4
75000FV
Answer
To find the savings annuity value
PMT
N
PV
I/Y
14,731
24
0
1
397355FV
Answer
500,000 - 102,645
= 397,355

• When the amount of an annuity remains on deposit for a number of
periods beyond the final payment, the arrangement is known as a
deferred annuity.
• When the amount of an ordinary annuity continues to earn
interest for an additional one year period we have an annuity due
situation.
• When the amount of an ordinary annuity continues to earn
interest for more than one additional periods, we have a deferred
annuity situation.
• A Perpetuity is an Annuity where the payments continue
indefinitely.
• Can you name an example of a Perpetuity?
Annuity to Perpetuity

Perpetuity principles
A perpetuity is a stream of regular payments that goes on forever;
An infinite annuity
Future value of a perpetuity;
Makes no sense because there is no end point
Present value of a perpetuity;
A diminishing series of numbers
Each payment’s present value will be smaller than the one before

A financial statement is a quantitative way of showing how a company is
doing.
Three different ways of representing the financial state of a company:
• Cash Management (can the company meet its obligations?)
• Profitability (Is it making money?) - the income statement
• Assets versus Liabilities (what is the value of the company? Who
owns what?) - the balance sheet
Each one of these questions is answered by Financial Statements.
Financial Statements

• Cash Flow Statements
– These answer the important managerial question “do I have
enough cash to run my business”
• Income Statements
– This is the financial sheet that tells you if your company is
profitable or not.
• Balance Sheets
– How much debt do I have? How large are my assets? This sheet
tells you the answer to these questions.
Financial Statements: Three are the key

It answers questions like;
Do we have enough money to pay salaries?
Can we buy the new machine this month?
Are clients paying in time?
Will the entity be able to serve its loan books?
Does not answer questions like;
Is the organization profitable?
What is the value of this entity?
Financial Statements: Cash Flow statements
• A report of all a firm’s transactions that involve cash
• The key elements are revenues (money flowing in) and expenses
(money flowing out).
• Cash flow statements compare the sum of the revenues to the sum of
the expenses on a regular time basis – usually monthly.

REVENUES
• Cash Flow from sales & services
• Interest from firm’s investments (e.g., a company savings account)
• Royalty and Licensing payments for appropriate use of firm’s intellectual property.
Another source of cash inflow, but not a revenue is the cash the firm receives from borrowing
money.
Cash Flow statements: Components of CFS
EXPENSES
Fixed Costs and Variable Costs
Any cost not dependent on the number of units produced or customers served are fixed costs
• Rent, salaries etc are fixed Cost components.
• Capital Investments like cost of buying land, machines are fixed costs.
• Utilities like electricity, water, taxes etc are also part of fixed costs in standard CFS.
Costs which are dependent on number of units produced or consumed are variable in Nature
• Raw Material, packaging costs, production wages, commissions are variable costs.
• Equipment maintenance, advertising, supplies of commodities are variable costs.

In a typical CFS, the revenues at placed at the “top” and the expenses below to arrive at a three
month Cash Flow Statement for an entity:
Jan-00 Feb-00 Mar-00
REVENUES (inflow)
SALES $0.00 $0.00 $1,000.00
INTEREST $239.27 $167.04
RECEIPTS $0.00 $239.27 $1,167.04
EXPENDITURES (outflow)
MATERIALS COST AND MFG. LABOR $0.00 $0.00 $50.00
SALES COMMISSIONS $0.00 $0.00 $100.00
COST OF GOODS SOLD (COGS) $0.00 $0.00 $150.00
GROSS MARGIN $0.00 $239.27 $1,017.04
SALARY AND BENEFITS OF CEO $3,000.00 $3,000.00 $3,000.00
SALARY AND BENEFITS OF ASSISTANT $2,000.00 $2,000.00 $2,000.00
RENT $500.00 $500.00 $500.00
TELEPHONE AND OTHER $75.00 $75.00 $75.00
ADVERTISING $2,000.00 $2,000.00 $2,000.00
EQUIPMENT $20,000.00 $10,000.00 $10,000.00
TOTAL FIXED COSTS $27,575.00 $17,575.00 $17,575.00
MONTHLY CASH FLOW ($27,575.00) ($17,335.73) ($16,557.96)
“Receipts” is the sum of all the
firm’s sales and interest it collected
that month
Gross Margin is the Receipts minus
the COGS
Total Fixed Costs is the sum of all the
fixed costs
Monthly Cash flow is the Gross Margin minus
the Total Fixed Costs

Just like the average person keeps their checking account balance – a
firm also needs to know their cumulative cash flow or cash balance.
It is an easy calculation – simply take the cumulative cash flow from this
month and add it to the previous month’s cash balance.
Your very first month’s cumulative cash balance is your first month’s
monthly cash flow added to your start-up capital (probably an initial
loan or first round financing).
Cash Flow statements: Cumulative CFS

Cash Flow statements: Calculating EBIDTA
Earnings
Before
Interest
Depreciation
Taxes
Amortisation
THE CHAIN OF EARNINGS
EBIDT (Earnings Before Interest, Depreciation and Tax)
EBIT (Earnings Before Interest and Tax)
EBI
TOTAL EARNINGS
( - accrued depreciation)
( - taxes paid once a year)
( - interest payments on your debt)

• Continue depreciation on items purchased in earlier years, using
previously established methods
• Sum up all of that fiscal year’s capital expenses
• Decide which method of Depreciation your firm wants to use
(Straight Line or Accelerated)
• Determine the useful lifetime for the assets
• Determine the salvage value
• Use the formulas to calculate depreciation on new equipment
• Add up all depreciation contributions
NOTE: while EBIDT may be a monthly figure – since taxes and depreciation are only calculated
once a year – EBIT, EBI, and net earnings MUST be Year-End numbers.
Cash Flow statements: Calculating Depreciation

Take the EBIDT and subtract the depreciation – this yields Earnings
Before Interest and Tax
Then calculate profit (or earnings) before taxes by subtracting interest
expenses.
Then multiply the profit before taxes by your effective tax rate – that
will give the corporate income taxes the firm owes.
Cash Flow statements: Interest after Depreciation

Sep-00 Oct-00 Nov-00 Dec-00
REVENUES (inflow)
SALES $22,000.00 $28,000.00 $35,000.00 $46,000.00
INTEREST $39.14 $85.66 $153.62 $246.65
RECEIPTS $22,039.14 $28,085.66 $35,153.62 $46,246.65
MATERIALS COST AND MFG. LABOR $1,100.00 $1,400.00 $1,750.00 $2,300.00
SALES COMMISSIONS $2,200.00 $2,800.00 $3,500.00 $4,600.00
COST OF GOODS SOLD (COGS) $3,300.00 $4,200.00 $5,250.00 $6,900.00
GROSS MARGIN $18,739.14 $23,885.66 $29,903.62 $39,346.65
SALARY AND BENEFITS OF CEO $3,000.00 $3,000.00 $3,000.00 $3,000.00
SALARY AND BENEFITS OF ASSISTANT $2,000.00 $2,000.00 $2,000.00 $2,000.00
RENT $500.00 $500.00 $500.00 $500.00
TELEPHONE AND OTHER $75.00 $75.00 $75.00 $75.00
ADVERTISING $2,000.00 $2,000.00 $2,000.00 $2,000.00
EQUIPMENT $0.00 $0.00 $0.00 $0.00
TOTAL FIXED COSTS $7,575.00 $7,575.00 $7,575.00 $7,575.00
MONTHLY CASH FLOW $11,164.14 $16,310.66 $22,328.62 $31,771.65
ENDING CASH BALANCE $20,557.84 $36,868.50 $59,197.12 $90,968.77
EBIDT* PROFITS $11,164.14 $16,310.66 $22,328.62 $31,771.65
CUMULATIVE EBIDT* PROFITS ($14,442.16) $1,868.50 $24,197.12 $55,968.77
Depreciation Expense for Tax Purposes $4,500.00
EBIT Profits $51,468.77
Taxes $23,160.95
EBI Profits $28,307.82
NET EARNINGS FOR YEAR (PROFIT AFTER TAX) $21,507.82
Cash Flow statements: CFS to Income Statement

Income Statement
Income Statement compares the profitability of the firm to prior years
Total (yearly) revenues minus total (yearly) expenditures.
Operating Information
Net Earnings 172,593.77$
Expenses
Cost of Goods Sold 25,725.00$
Total Salary/Benefits 60,000.00$
Advertising 24,000.00$
Rent 6,000.00$
Other 900.00$
EBIDT Profits 55,968.77$
Depreciation 4,500.00$
Taxes 23,160.95$
AFTER TAX PROFIT 28,307.82$
Accumulated Interest Expenses 6,800.00$
Earnings After Accumulated Interest 21,507.82$
• The income statement is more like
a picture of the firm’s operations
for a specified period of time.
• You generally report revenues first
and then deduct any expenses for
the period
• Matching principle – GAAP say to
show revenue when it accrues and
match the expenses required to
generate the revenue

Income Statement
Expenses
Rent 6,000.00$
Other 900.00$
Taxes 23,160.95$
The income statement can be split into two
different sections:
Operating result (or ‘profit before interest and
tax’): result from the company’s operating
activities, irrespective of the financial
structure of the company
Returns to interested parties others than the
owners:
Income taxes due to government
Interest on loan finance
‘Profit available for shareholders’ is the residual
return to equity providers
It is the wealth generated by the company
during the period
To pay dividend to shareholders or to finance
future growth (auto-financing)

Note that the final Net Earnings number for both the final month of the
cash flow statement is exactly the same as the year-end Net Earnings
total for the Income Statement, reflecting the same time period.
Expenses
Rent 6,000.00$
Other 900.00$
Taxes 23,160.95$
Sep-00 Oct-00 Nov-00 Dec-00
REVENUES (inflow)
SALES $22,000.00 $28,000.00 $35,000.00 $46,000.00
INTEREST $39.14 $85.66 $153.62 $246.65
RECEIPTS $22,039.14 $28,085.66 $35,153.62 $46,246.65
MATERIALS COST AND MFG. LABOR $1,100.00 $1,400.00 $1,750.00 $2,300.00
SALES COMMISSIONS $2,200.00 $2,800.00 $3,500.00 $4,600.00
COST OF GOODS SOLD (COGS) $3,300.00 $4,200.00 $5,250.00 $6,900.00
GROSS MARGIN $18,739.14 $23,885.66 $29,903.62 $39,346.65
SALARY AND BENEFITS OF CEO $3,000.00 $3,000.00 $3,000.00 $3,000.00
SALARY AND BENEFITS OF ASSISTANT $2,000.00 $2,000.00 $2,000.00 $2,000.00
RENT $500.00 $500.00 $500.00 $500.00
TELEPHONE AND OTHER $75.00 $75.00 $75.00 $75.00
ADVERTISING $2,000.00 $2,000.00 $2,000.00 $2,000.00
EQUIPMENT $0.00 $0.00 $0.00 $0.00
TOTAL FIXED COSTS $7,575.00 $7,575.00 $7,575.00 $7,575.00
MONTHLY CASH FLOW $11,164.14 $16,310.66 $22,328.62 $31,771.65
ENDING CASH BALANCE $20,557.84 $36,868.50 $59,197.12 $90,968.77
EBIDT* PROFITS $11,164.14 $16,310.66 $22,328.62 $31,771.65
CUMULATIVE EBIDT* PROFITS ($14,442.16) $1,868.50 $24,197.12 $55,968.77
Depreciation Expense for Tax Purposes $4,500.00
EBIT Profits $51,468.77
Taxes $23,160.95
EBI Profits $28,307.82
NET EARNINGS FOR YEAR (PROFIT AFTER TAX) $21,507.82
Income Statement & CFS
Further the Income Statement’s year-end figures for COGS (Cost Of Goods Sold), Salary, Rent,
Advertising, and sales should be the 12 month totals of the cash-flows corresponding to the
respective line item. Likewise, depreciation and taxes should be equal for that fiscal year.

Unlike Cash-Flow and Income Statements, Balance Sheets lists
ASSETS and LIABILITIES
Examples of Assets include:
Land and Capital Equipment less accrued dep
Intellectual Property (if purchased)
Cash on Hand (which the year end Cumulative
Cash Balance)
Accounts Receivable
Inventory
Retained Earnings from Previous Years
Balance Sheet
Examples of Liabilities include:
Short Term Debt (loans)
Long Term Debt (bond issues, etc)
Accounts Payable
Interest Payable
Taxes Payable
The difference between Assets and Liabilities is your EQUITY
ASSETS FYE 2001 FYE 2000
Current Assets
Cash on Hand 90,968.77$ 85,000.00$
Accounts Receivable -$ -$
Inventory -$ -$
Prepaid Expenses -$ -$
90,968.77$ 85,000.00$
$50,000.00 $0.00
less depreciation $4,500.00
Other Assets -$ -$
TOTAL ASSETS 136,468.77$ 85,000.00$
LIABILITIES FYE 2001 FYE 2000
Current Liabilities
Interest Payable 6,800.00$
Short-term loans -$ -$
Accounts Payable -$ -$
Income Taxes Payable $23,160.95 -$
Total Current Liabilities 29,960.95$ -$
Long Term Debt 85,000.00$ 85,000.00$
TOTAL LIABILITIES 114,960.95$ 85,000.00$
TOTAL EQUITY 21,507.82$ -$
LIABILITES PLUS EQUITY 136,468.77$
Total Current Assets
Property / Plant / Equipment

Illustration – Constitution of share capital
Assets 1 2 3 4 Situation
Cash +20000
+15000
+15000
Receivables
Inventory
Property
Total +50000
Liab./Equity
Long-term debt
Shares +20000
+15000
+15000
Profit
Total +50000

Illustration – Bank loan
Cash +20000
+15000
+15000
+30000
Receivables
Inventory
Property
Total +50000 +30000
Liab./Equity
Long-term debt +30000
Shares +20000
+15000
+15000
Profit
Total +50000 +30000

Illustration – Buying office furniture
Cash +20000
+15000
+15000
+30000 -55000
Receivables
Inventory
Property +55000
Total +50000 +30000 0
Liab./Equity
Shares +20000
+15000
+15000
Profit
Total +50000 +30000 0

Illustration – Buying office equipments
Cash +20000
+15000
+15000
+30000 -55000 -18000
Receivables
Inventory +18000
Property +55000
Total +50000 +30000 0 0
Liab./Equity
Shares +20000
+15000
+15000
Profit
Total +50000 +30000 0 0

Illustration – Intermediate position tracking
Cash +20000
+15000
+15000
+30000 -55000 -18000 7000
Receivables
Inventory +18000 18000
Property +55000 55000
Total +50000 +30000 0 0 80000
Liab./Equity
Long-term debt +30000 30000
Shares +20000
+15000
+15000
50000
Profit
Total +50000 +30000 0 0 80000

Illustration – Intermediate balance sheet
Assets Equity and Liabilities
Tangible assets
(Property)
55.000 Share capital 50000
Fixed assets 55.000 Shareholders’equity 50000
Inventory (Furniture &
Eqpt)
18000 Financial liabilities
(LT debt)
30000
Cash at bank 7000
Current assets 25000 Liabilities 30000
Total 80000 Total 80000

Illustration – Sale of equipment and repairs
Assets Situation A 5 6 7 Situation B
Cash 7000 (a) +5000
(c) -250
Receivables
Inventory 18000 (b) -4000
Property 55000
Total 80000 +750
Liab./Equity
Long-term debt 30000
Trade creditor
Shares 50000
Profit (a) +5000
(b) -4000
(c) -250
Total 80000 +750

Illustration – Sale of equipment on credit
Cash 7000 +5000
-250
Receivables (a)+7000
Inventory 18000 -4000 (b) -5500
Property 55000
Total 80000 +750 +1500
Liab./Equity
Long-term debt 30000
Trade creditor
Shares 50000
Profit +5000
-4000
-250
(a)+7000
(b) -5500
Total 80000 +750 +1500

Illustration – Buying equipments on credit
Cash 7000 +5000
-250
11750
Receivables +7000 7000
Inventory 18000 -4000 -5500 +12000 20500
Property 55000 55000
Total 80000 +750 +1500 +12000 94250
Liab./Equity
Long-term debt 30000 30000
Trade creditor +12000 12000
Shares 50000 50000
Profit +5000
-4000
-250
+7000
-5500
2250
Total 80000 +750 +1500 +12000 94250

Illustration – Income statement
Sales 12000
Cost of sales
- Equipments 9500
- Repairs 250
9750
Net Profit 2250

Illustration – Balance sheet
Assets Equity and Liabilities
Tangible assets
(Property)
55.000 Share capital
Profit
50000
2250
Fixed assets 55.000 Shareholders’equity 52250
Inventory (Eqpts)
Receivables
20500
7000
Financial liabilities
(LT debt)
30000
Cash at bank 11750 Trade creditor 12000
Current assets 39250 Liabilities 42000
Total 94250 Total 94250

Illustration -
Reconciliation of profit and net cash flow
Net Profit (Income statement) 2250
Value of inventory sold (paid previously) 9500
Amount due by customer (still to be received) -7000
Change in cash during period +4750

Understanding Financial Statements
A firm’s cashflows can be quite different from its net income.
The income statement does not recognize capital expenditures as expenses in the year that the
capital goods are paid for. Those expenses are spread over time as a deduction for depreciation.
The income statement recognizes revenues and expenses when sales are made, even though
the money may not have been collected (revenues) or paid out (expenses).
Since increases in working capital are increases in investments, they are not relevant for the
determination of cashflows pertaining to recurring returns from the use of assets.
A definition of Operating Cashflow for project evaluation purposes becomes:
Operating Cashflow = EBIT + Depreciation – Taxes
The other items that appear in the Cashflows from Operations category in the Statement of
Cashflows, e.g. change in accounts receivable are, really, short-term investments. We define
these separately as Change in Working Capital.
Finally, we have Net Capital Spending or long-term investments.
Cashflows from Assets = Operating Cashflow – Change in Working Capital – Net Capital
Spending.

Interest
Dividends
Operating
Cashflow
Assets Liabilities
Current Assets –
Current Liabilities
Fixed Assets
Equity
Paid-in capital
Debt
Retained Earnings
CF to
Stockholders
CF to
Debtholders
Net Capital
Spending
Change in WC
Income Statement
How Cash flows in Financial Statements
Operating Cashflows– recurring cashflows generated by the use of assets.
Net Working Capital and Net Capital Spending are investment outlays to build up the assets that
generate cashflows.
Cashflows to Stockholders and Cashflow to Bondholders are how the investments are funded.
The division of cashflows into operating cashflows and new investments in assets is important in
forecasting future cashflows.
Investments in assets are the drivers and operating cashflows are the result of this investment.
New investment and forecasted growth in operating cashflows need to be consistent with each
other.

What influences Financial Statements
• Financial reporting is deeply embedded in a country’s culture and
traditions =>national accounting rules tend to vary significantly
• Additionally, company characteristics will impact its reporting
behaviour, e.g.
❖ Nature of ownership
❖ Managerial objectives
❖ Nature of activity
❖ Legal form
❖ Company size

Financial Statements on accrual basis
Financial accounting aims to measure business transactions at the time they take place, rather
than when cash changes hands.
This approach distinguishes financial accounting from a simple record of cash transactions
‘Matching’: all costs and revenues associated with a particular sale should be recognized
together in the income statement when the sale takes place.
“In order to meet their objectives, financial statements are prepared on the accrual basis of accounting.
Under this basis, the effects of transactions and other events are recognised when they occur (and not as cash
or its equivalent is received or paid) and they are recorded in the accounting records and reported in the
financial statements of the periods to which they relate. Financial statements prepared on the accrual basis
inform users not only of past transactions involving the payment and receipt of cash but also of obligations to
pay cash in the future and of resources that represent cash to be received in the future. Hence, they provide
the type of information about past transactions and other events that is most useful to users in making
economic decisions.”
Source: IASB, Framework, par.22

Principles
Revenues should only be recognised when they are certain.
Expenses are recognised when they become probable.
Unrecoverable expenses should be recognized even if not yet realized.
In preparing financial statements it is assumed that the company will continue in business
for the foreseeable future
This assumption is necessary to apply accrual principle
If nothing has been paid, no recognition of values in the balance sheet, e.g.
• Trade mark loyalty
• Human capital
Any accounting transaction must preserve the equilibrium between sources and uses of
funds, and will involve either a change in both, or a reallocation within one side of the balance
sheet equation.
Accounting transactions with impact on revenues and expenses fit into this fundamental
equation approach.
• If profit is generated, it adds to the ‘equity’ part of the equation.
• Revenues have a positive impact on profit and, thus, on equity.
• Expenses have a negative impact on profit and, thus, on equity.
Financial Statements principles

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