ChungyiaTFIN7015-1

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1 VALUING THE THREE MAJOR FINANCIAL STATEMENTS Valuing the three Major Financial Statements Chungyia Thao FIN7015 Week 1 January 2, 2022 Dr. John Halstead

2 VALUING THE THREE MAJOR FINANCIAL STATEMENTS The preparation of financial statements is to provide transparency of the firm's performance, which is critical for strategic decision making. Using financial statements can help the management make optimal data-driven decisions that increase the competitiveness of their firms. Apart from having timely and reliable financial statements, managers need to understand the different components that comprise the financial statements even to interpret them. Effective interpretation is essential in making financial and operational decisions, which are strategic to the organization (Ganin & Khrystofor, 2018). Thus, the financial statements need to support needs linked to a company's strategic goals. Decisions that are not considerate of the financial impact of a firm's strategic goals can lead to financial distress and disarray in the company focus (Ganin & Khrystofor, 2018). Managers must have a good understanding of and the ability to correctly interpret the three basic financial statements: balance sheet, income statement, and cash flow statements. This paper will describe each of these financial statements, their functionality, and how they help in sound decision-making. Balance Sheet The standard company balance sheet consists of three main components: assets, liabilities, and owner's equity. The balance sheet starts with assets, with the main ones listed first and in the order of the most to the least liquid. Assets on the left side of the balance sheet are listed in two sub-categories: current and non-current (Ganin & Khrystofor, 2018). Assets (Current and Non-current) Current assets are those assets that the organization can quickly liquidate to pay for the current liabilities in less than one year. Typically, assets in this category will include accounts receivable, cash and cash equivalents, prepaid expenses, inventories, and short-term investments (Ganin & Khrystofor, 2018). Accounts receivable includes services and products unpaid by other entities to the company, that is, goods and services sold on credit. Executing

3 VALUING THE THREE MAJOR FINANCIAL STATEMENTS and account receivable involves mailing an invoice to the customer that establishes credit terms (Ganin & Khrystofor, 2018). Cash and cash equivalents represent the most liquid assets in a company's balance sheet. These assets can be easily converted into cash and may include commercial papers, short-term treasury bills or government bonds, money market holdings, and marketable securities (Kimmel et al., 2020). All these represent investments that mature in 3 months or less, distinguishing characteristics from other investments. Short-term investments mature in one year or less, while long-term investments mature in one year or more. Inventories for manufacturing firms such as Canadian Solar Inc. (CSI) may include raw materials, work in progress, finished goods, and goods for resale. Prepaid or deferred expenses represent cash paid instead of services the company will get in a future accounting period. For example, the current assets in Canadian Solar Inc. (CSI) balance sheet (Appendix A1) include cash and cash equivalents, restricted cash, accounts receivables, inventories, advances to suppliers, derivative assets, and project and prepaid expenses and other current assets. The second sub-category in the assets side of the balance sheet is the non-current assets. These represent property and assets that cannot be liquidated easily and include investment property retained for investment purposes such as real estate, long-term financial assets, property, plant, and equipment (PPE), and intangible assets (Ganin & Khrystofor, 2018). It also includes investments that can be accounted for by utilizing the equity method and includes stakes (20-50%) in other firms (Ganin & Khrystofor, 2018; Kimmel et al., 2020). For example, in the CSI balance sheet, the non-current assets listed in the balance sheet include PPE, solar power systems, deferred tax assets, advances to

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4 VALUING THE THREE MAJOR FINANCIAL STATEMENTS suppliers, prepaid land use rights, intangible assets, investment in affiliates etc. other non- current assets (Appendix A1). Liabilities and Owner's Equity Liabilities represent obligations of an organization that arise from prior events or transactions and whose settlement of such obligations in the future may result in the use or transfer of assets, services, or other economic benefits. Liabilities, just like assets, are categorized into current and non-current liabilities. Current liabilities are due to the debtor in 12 months (Palepu et al., 2020). For CSI, these include short-term borrowings, accounts payable, notes payable, other payables, derivative liabilities, operating lease liabilities, and other current liabilities (Appendix A2). Non-current liabilities are long-term (LT) obligations and include LT borrowings, convertible notes, derivative liabilities, financing liabilities, and deferred tax liabilities (Appendix A2). Owner's equity represents what is left for the shareholders of the business after accounting for liabilities (Kimmel et al., 2020). To satisfy the accounting equation, owners' equity = assets – liabilities. Therefore, if the company's liabilities exceed the assets, negative equity will be. Equity is thus equivalent to the business's net assets and may include capital surplus, common stock, preferred stock, reserves, retained earnings, stock options, and treasury stock (Kimmel et al., 2020). For CSI, equity is reflected on the balance sheet by common shares, treasury stock, additional paid-in capital, and retained earnings (Appendix A2). Using the Balance Sheet for Decision-Making The balance sheet is a crucial financial statement from which managers can deduce the working capital (WC) available to their organizations. Working capital is a metric that

5 VALUING THE THREE MAJOR FINANCIAL STATEMENTS represents a firm's operating liquidity, that is, the ability to quickly convert assets into liquid cash for financing operating expenses (Kimmel et al., 2020). The management can calculate the net working capital by simply deducting the current liabilities from the existing assets. The net WC is crucial for valuation methods like discounted cash flows (DCFs). When there is an increase in Net WC, the rationale is that the business has either decreased its current liabilities or has increased its existing assets such as account receivables. Managers have the most impact on three accounts under current assets (CA) and current liabilities (CL). These include accounts receivables (CA), inventories (CA), and accounts payable (CL). Decisions regarding the balancing of current assets and liabilities are critical to the management are essential because it helps the management ensure the company continues with uninterrupted operations (Kimmel et al., 2020). There are sufficient cash flows to meet operational expenses (upcoming) and maturing short-term debt. Using the information on the balance sheet (current assets and current liabilities) (including note disclosures), managers can make decisions on inventory management, debt management (Fischer, 2019). Short-term financing, cash management, and liquidity. Income Statement An income statement, also called the profit and loss statement, is a financial statement used to report a company's revenues, expenses, and income (net), in a specified time period (Palepu et al., 2020). The management can use the information from an income statement to ascertain an enterprise's past performance, predict its future performance, and determine the firm's capability to generate cash flows in the future (Shadiqiawan & Mulyani, 2020). A typical income statement consists of three main sections: revenues, expenses, and resulting income (Lin et al., 2018). Revenues consist of inflows of money from the sale of services and products before deducting the expenses and are considered the "top line." The "bottom line"

6 VALUING THE THREE MAJOR FINANCIAL STATEMENTS is the net income calculated by revenues fewer expenses. The income statement can be segmented into operating and non-operating revenues and expenses. The operating revenues and expenses section includes the gross or sales revenues (cash inflows or assets enhancements of the company) and expenses (cash outflows) that entail incurring liabilities or using-up assets (Palepu et al., 2020). Some of the elements that comprise the expenses include the cost of goods sold (COGS), selling, general and administrative expenses (SG&A), depreciation and amortization, and research & development (R&D). The non-operating category comprises revenues from business activities non-primary to the enterprise, such as patent income and rents (Palepu et al., 2020). It may also comprise of gains (unusual or infrequent. The section also includes irregular expenses (such as borrowing costs), losses from non-primary business activities (such as foreign exchange fees), and income tax expenses. Using Income Statement for Decision-Making The main components of the CSI income statement include the revenues, cost of revenue, gross profit, operating and non-operating expenses, net profit, and net income (Appendix B1 and B2). By examining the income statement, the management can determine how much sales were made over a certain period, such as quarterly (Kimmel et al., 2020). They show profits and losses over an extended period of time than the balance sheet. The gross profit for CSI, for example, indicates how the company's products are after subtracting the COGS from the net revenues. The net profits are also significant in decision making. For example, the company can make substantial gross profits but have a lot of expenses. These components, along with notes to the income statement, provide both quantitative and qualitative information critical for decision making (Bjorklund, 2019). Statement of Cash Flows

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7 VALUING THE THREE MAJOR FINANCIAL STATEMENTS The cash flow statement is another important financial statement that details a business's cash during an accounting period (Kimmel et al., 2020). The information from the cash flow statement can help a manager determine an enterprise's ability to sustain operations both in the short- and long-term depending on the cash inflow and outflows. A cash flow statement has three components: operating activities, investing activities, and financing activities (Kimmel et al., 2020). The operating activities section includes revenues and expenses; that is, the business generates cash flows from the sale of services and products. Investing activities section consists of the cash flows generated from the sale or purchase of assets and using cash rather than debt (Kimmel et al., 2020). The financing activities category includes cash flows arising from equity and debt financing. By analyzing the cash flow statements for CSI, cash flows from operating activities were positive during years 2018-19 but negative during the end of financial period 2020 (Appendix C1 and C2). Cash flows from investing activities emanated purchase/sale of PPEs, sale of a business, sale of investments, and other investing changes. Cash flows from financing activities included issuing/payments of debts, common stock, paid cash dividends, and other financing changes. Using Cash Flow Statement for Decision-Making Managers can make critical business decisions by analyzing cash flow statements and seeing the cash that different activities generate. The cash generated from operating income needs to exceed a company's net income to reflect a positive cash flow. Routine positive cash flows reflect that the business can grow its operations and remain solvent (Kimmel et al., 2020). Based on the cash flow statement, the management can understand how various activities and departments contribute to the financial wellbeing of the company and make

8 VALUING THE THREE MAJOR FINANCIAL STATEMENTS adjustments based on the insights gained (Palepu et al., 2020). Some of the critical internal decisions influenced by cash flow statements include budgeting and recruiting decisions. Conclusion Overall, there are three most important financial statements that managers rely on for making strategic (financial and operational) decisions. These financial statements include the balance sheet, income statement, and cash flow statement. Collectively, these financial statements provide critical information that can help managers make decisions that help focus on the company's short- and long-term goals. Financial statements provide quantitative information that provides the basis for calculating financial ratios that help examine the company's health. They also provide qualitative information in the form of notes in each of these financial statements that help give more information critical for making decisions. Most notably, managers must understand and know how to interpret financial statements because it is only then that they can make impactful business decisions.

9 VALUING THE THREE MAJOR FINANCIAL STATEMENTS References Bjorklund, P. R. (2019). The financial statements of a property & casualty company. Journal of Legal Economics, 25 (1/2), 101–111. Fischer, M. (2019). Governmental financial statement note disclosures and analysis of Texas public two-year colleges' reporting. Journal of Accounting & Finance (2158-3625), 19 (6), 47–60. Ganin, V., & Khrystofor, A. (2018). Financial statements of the company – information source for managerial decision-making. Economy and Society , (18). https://doi.org/10.32782/2524-0072/2018-18-122 Kimmel, P. D., Weygandt, J. J., & Kieso, D. E. (2020). Financial accounting: tools for business decision-making . John Wiley & Sons. Lin, S., Martinez, D., Changjiang Wang, & Ya-wen Yang. (2018). Is other comprehensive income reported in the income statement more value-relevant? The role of financial statement presentation. Journal of Accounting, Auditing & Finance, 33 (4), 624–646. Palepu, K. G., Healy, P. M., Wright, S., Bradbury, M., & Coulton, J. (2020). Business analysis and valuation: Using financial statements . Cengage AU. Shadiqiawan, R. M., & Mulyani, S. (2020). The quality of local government financial statements and the use of financial information in decision making. Journal of Accounting Auditing and Business , 3 (1), 73. https://doi.org/10.24198/jaab.v3i1.25605

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