CFA topics - financial reporting and analysis (ii)

Having discussed income statement in the previous post, this post will discuss the key concept behind balance sheet and cashflow statement. 

Balance sheet: while an income statement shows how much a company makes in profit over a period of time, a balance sheet shows the balance between the assets vs. liabilities and equities of a company at a particular point in time (typically at the end of a relevant financial period.) The balance sheet of a company is driven by the following equation

Assets = liabilities + equities

The above equation is not that difficult to understand; in fact the above equation illustrates a simple fact about all companies – assets are financed by liabilities and equities. The liabilities and equities side tells us where a company gets it sources of funds, while the assets side tells us how these funds are being used.

Typical items on the asset side include (from more liquid assets to more illiquid asset) cash & cash equivalent, marketable securities, inventories, trade receivables, prepayments, equipment, properties & plants, goodwill, etc. Typical items on the liabilities side include trade payables, tax payables, bank borrowings, bond borrowings, etc. Last but not least, equities represents the claims of shareholders in a company’s business. Equities is increased by additional contribution from shareholders and retained earnings; on the other hand, equities is reduced by net loss.

Cashflow statement: while an income statement shows how much profit is made over a period of time, cashflow statement shows how much cash is generated over a period of time. It is important to note that profit generation and cash generation are two different concepts: profit generated can be in form of cash, receivables, etc; cashflow statement tells us how much of the net income is actually converted into cash.

Three main categories of cashflow include operating cashflow, investing cashflow, and financing cashflow.

Operating cashflow includes the cash inflow / outflow involved in the core operation of a company’s business. Company’s operating profit and working capital changes, for example, are part of operating cashflow. Investing cashflow concerns the capital expenditure and financial investments of a company. Financing cashflow includes loan drawdown, loan repayment, equity contribution, dividend payments, etc.