 Hello, and welcome to the session. This is Professor Farhad in which we would look at the major financial statements, which are the income statement, the balance sheet, and the statement of cash flows. The reason I'm going over those financial statements because in the next session, we would look at financial statement analysis. So when we prepare analysis, we rely on the income statement, on the balance sheet, on the statement of cash flows. Therefore, you have to understand what does the income statement represent? What does the balance sheet represent? What does the statement of cash flow represent? In this session, I will give you an overview about these statements. In other words, those financial statements are already completed. If you really want to learn how to prepare financial statements, please go to my accounting courses like financial accounting or intermediate accounting. This is a finance course. In a finance course, you are dealing with an already completed financial statement. And this is what I do today to help you explain the material. As always, I would like to remind you to connect with me on LinkedIn, subscribe to my website, where I have plenty of courses in finance, accounting, tax and audit, like my lectures and share them with others. And again, on my website, you will find additional information, especially if you are studying for your CPA exam, whether you are studying for your CPA or taking accounting or finance courses, you will find additional supplementary material. And if you are a CPA candidate, you want to check out how does your university stand vis-a-vis the CPA exam score, because this is going to give you an idea about the rigor of your accounting program. And this information is available on my website. So let's go ahead and start with the income statement. What is the income statement? So simply put, when you think of the income statement, think of the profitability of the company. It summarizes the profit of the firm over a period of time, such as a year or a quarter or a half a year. So the income statement shows you how well you did over a period in time. That's important. Simply put, the simplest way to explain the finance, the income statement, it's the difference between your revenues and your expenses, what you generated from your work and what expenditure you incurred cost to run the business. And the business incurred four types of expenses and we're gonna go over the expenses. Now bear in mind that the business could also have more than one type of revenues. They could have, for example, sales revenues, interest revenue, dividend revenue, rental revenue. The different businesses will have different type of revenues. But the expenses, definitely they will have many expenses and they are broken down into four categories. And for each financial statement, we would look at a sample and we're gonna look at the Home Depot Financial Statements because it's easier for students to relate to Home Depot because it's an easy business to understand its operation. So the expenses are broken into four categories. The first one and very important is cost of goods sold, which is the direct cost attributable to producing the product sold by the firm. For example, for Home Depot, cost of goods sold is what they purchase because Home Depot is technically a retailer. They purchase items, they turn around and they sell them for a profit. So the cost of goods sold is the purchase of those items, the cost of those items that they sold. Then they have general and administrative expenses correspond to overhead expenses like salaries, advertising and other costs to operate the business that are not directly attributable to production. You need to run the business, you need employees, you need to advertise, you need to pay heating, air conditioning, so on and so forth. Those are the general and administrative expenses. Then you have the third category, which is interest expense. And this is listed separately because of the importance of financing your business because you can finance your business through debt or through equity. So if you're relying on interest, we want to see this number separately stated on the income statement. And taxes is important, which is what is your taxes on earnings out to the federal and local government? How much taxes are you paying on your earning? So those are the four different categories of expenses. And let's take a look at Home Depot financial statement. Here we have net sales. And to arrive to net sales, simply put, this is net sales. What happened is you have sales and you deducted from sales returns, you deducted from sales allowances, you deducted from sales discounts. Those are all deducted until you come to net sales. So we have net sales. Then we have operating expenses and they're operating expenses cost of goods sold. And for a company like Home Depot, cost of goods sold is a large number because that's their largest expense because that's what they do, they sell stuff. Then we have selling general and administrative. This is to run the business. We have other expenses. And to know what the other expenses are, you'll have to read the notes in the financial statements. And we have depreciated depreciation listed separately. Now, this financial statement is prepared for finance majors, but in the real world, not in the real world in the accounting, will you all have net sales minus cost of goods sold, gives you gross profits, it will be designed a little bit differently. But this is designed for our use, which is our use is to analyze the company. Then we have a number called EBIT earnings before interest and taxes. This is an important number, EBIT. We're gonna see this later on when we do financial statement analysis. Then we have interest expense. Then we have taxable income. Then we have taxes. Now we arrived at just EB earnings, not before anything, right? So earnings after taxes and interest, net income, okay? And this is net income and this is in million. So you have to add 607.9 billion. This is how much dividend they paid. And this is what they kept, I guess, additions to retained earnings, what they kept. So this is basically a typical, I would not say this is a typical, this is an income statement that is prepared for a finance student to understand the income statement. Now, in addition to the raw numbers, the dollar amount, when you're analyzing a company, it's very important to see the weight of each number compared to a certain figure on the financial statement. For income statement, we use sales. We compare everything to sales. For example, here, we know that percent of revenue cost of goods sold represent 65%, more than half, almost two-third, not two-third, but almost two-third of the cost to operate the business is cost of goods sold. This is called common size income statement. Why do we call this a common size income statement? Because I don't know how large is home depot. If I want to compare home depot to lows, well, I need to know what is the percentage of the cost of goods sold vis-a-vis sales. It doesn't matter whether home depot sells in million or billions or cold sells in millions or hundreds of thousands. Once I compute the percentage, I can compare the two company based on the percentage. So home depot, they incur 65.8% for that particular period of their sales and cost of goods sold. Selling general and administrative 16 other 1.9, really not material, the appreciation 2.9, total operating expenses is 85. They're earning before interest and taxes is 14.2. Now I can compare this 14.2 to lows earnings before interest and taxes, only using percentages to know which company is making more profit per dollar amount. Then their interest expense is approximately 1%. Again, I can compare this to lows. Their taxes represent for 8% of their cost. I can compare this to lows. This is what we called common size, basically putting everything in percentages so we can compare. Now also what we have to understand is cash versus net income. The income statement gives us net income. Net income is an accrual figure. Accrual means it's not cash, it's based on accounting figures. This means net income is accounting earning. It's affected by conventions that we use in accounting. So the way we account for inventories, for example, Home Depot could account for the inventory different than lows. One could be using what we called FIFO first and first out. The other could be using LIFO. That's one example of a difference. Also the way they book depreciation expense, the way they book this figure. For example, one company could be using the straight line. The other company could be using what's called the sums of years digit. It makes a difference in the numbers. But if you're a financial analyst, you have to understand those differences. You have to understand accounting and make appropriate adjustment. Also the way they account for sales could differ how they account for contracts. A lot of things could differ. So what's important about the income statement is to understand if the earning is sustainable. What does it mean sustainable? If the earning is repeating. And for a company like Home Depot, it's easy to understand this because Home Depot don't have, let's call this complicated operations. They don't buy other companies that's not in their business. They don't discontinue large divisions. Basically they're in the business of selling home improvement products. So their earnings is sustainable. But also we want to look at their earning to find out if they're selling more in terms of number of units or are they increasing prices because of inflation. So also we have to look at the numbers and analyze the numbers themselves. Versus transitory figures. Transitory means sales that they make one time and they no longer have that sale. For example, let's assume Home Depot, a local government or state government contracted Home Depot to supply them for a large project. And as a result, the revenue went up by 10%. Well, this was a one year event. It's not every year that a state government is gonna agree to buy from Home Depot supplies. Therefore, we have to understand if they have any large clients and those large clients, are they repetitive or are they transitory? Because that's important to understand the growth. How is the company growing? Because if I account that there's a 10% increase in sales and I say, well, this 10%, if this is the growth, you remember the G in the formula when we compute the different discount model or the cash flow model? Well, if we say G is 10% and G does not repeat, then that's not really true. Then we are computing the wrong value for the company. So the financial statement clearly convey considerable information and proof of that is the stock prices respond to when company reports earnings. So if you are watching earnings and today is Wednesday, October the, October what? October the 27th? Yes, tomorrow, for example, Apple and Amazon are reporting. And I can assure you when Amazon and Apple reports their figures, when they report their earnings, the stock price will move. Therefore financial statements are important. So what's gonna, what they're gonna be reporting is their net income and their earnings per share EPS, basically net income, earnings per share derives from earnings, earnings per share derives from net income, which we'll talk about in the next session. So this is basically an overview of the income statement. So what we look for is how much profit they made versus what is the profit that they kept, not kept the profit that they, how much sales minus all these, how much did they keep in profit then from the profit, they're gonna pay some of it in dividend. For example, they pay some of it in dividend a little bit less than less and they keep the other part. The balance sheet again, but before I proceed, please don't think this is the only thing about the income statement. This is what you need is a finance students. Now, if you're an accounting major, if you go to my intermediate accounting course, just go to farhatlectures.com to my website, you will find more, we have discontinued operation, we have unusual gains and losses, but we don't get into those items, which are called transitory items. Transitory items here, you just need to understand the basic financial statements. The second financial statement is the balance sheet. The income statement provide measure of profitability if we are profitable or not. A balance sheet is basically a list of information about a company's assets, liabilities and equity, which is basically a snapshot, basically a list of things. And it's for a particular time. Particular time means one point in time. It's on a particular date. This is what we mean by that. So the balance sheet lists the firm's assets, liabilities at a particular moment. Assets is what they have. What resources they have to run the company. Liabilities is that, how much that do they have? The difference between those two, difference between assets and liabilities. So the company have $10 an asset, $7 in liabilities. We say equity is $3. Equity is how much is the company worth. So if you take all your assets, pay off your liabilities. You have $10 of assets, pay off your liabilities, $7. What's left is the stockholders' equity or shareholders' equity. This is what the owners of the company is worth. Like the income statement, the presentation of the balance sheet is pretty standardized. I would say more standardized than the income statement because on the income statement, you always have some transitory items, items that don't repeat that you have to report separately. But let's take a look at the balance sheet. The balance sheet is, so we're gonna have an asset, here are all the assets. This is the liability section and this is the equity section. So I'm gonna cover each topic separately. So when I cover a topic, I'm gonna focus on that. First, starting with the balance sheet specifically, we're gonna look at current assets and these are the current assets. What are the current assets? Current assets are assets that you're gonna be used or convert to cash or consume within one year. For example, cash is obviously and marketable securities which is short-term investments, they're gonna be converted into cash, receivable. If you sell on account, you're gonna have receivable which are considered current assets because you convert to cash within one year. Inventories, obviously, it's gonna be converted within one year or that's your intent and you might have other current assets like prepaid supplies. So those are your current assets. It's what you have in assets to run the company in the near future. Those are listed first according to the U.S. gap. They are listed first. After current assets, we have fixed asset or long-term assets, sometimes we call them long-term assets. And under long-term assets, we have assets that serve the company for many years, mainly tangible assets, fixed asset, asset that you can touch like property, plant and equipment, other long-term assets as well. As well in the total tangible asset, we have the total tangible asset is 23 billion for Home Depot. So this is what comes next. Then what comes after the tangible assets are the intangible assets like contract value, customer list, copyright, so on and so forth, including something that we call Goodwill. So Goodwill is listed on the balance sheet and Home Depot has approximately 2 billion of Goodwill. Goodwill is when Home Depot buys another company and they pay more than its fair value. When you pay more than what something is worth, well, you paid for everything that's worth, but you paid extra. The extra that you paid is maybe for its location, for its management, for its research. Therefore, you are paying some extra amount. It's called Goodwill. So you record this as Goodwill. So this occur when you purchase another company and you pay extra for it, okay? Also, also for assets, what we can do, we can show them as a common size as a relationship to total assets. So here what we have is we have cash in relationship to total asset, receivable in relationship to total assets. So notice for a company like Home Depot, inventories and their tangible assets, their property, plant and equipment and building, represent if we take 53 plus approximately 30, so 30 plus 53 is approximately 83 to 84% of Home Depot assets are tied up in inventory and property, plant and equipment. And this should make sense because that's the business that Home Depot is in. They sell product, they have inventory and to sell the product, they need warehouses, they need parking lot, they need place to store their inventory, therefore they have a lot of property, plant and equipment. Now we're done with assets and these are Home Depot resources, assets, they go on the balance sheet. On the other side, we have liabilities and liabilities are divided into current liabilities, current liabilities and long-term liabilities, long-term liabilities. What current liabilities are listed first? Current liabilities are liabilities, that we have to pay within one year. They usually include accounts payable when Home Depot buys stuff on account and they do buy a lot of stuff on account, obviously, because they buy inventory from manufacturers and suppliers, therefore they give them some time to pay. For example, if they owe any taxes, if they owe any payroll liabilities, if they owe any small accrued expenses, that are not yet paid, those are considered current liabilities. And current liabilities represent 32% of their liabilities and equity, which is the same thing as assets, represent 30% of their liabilities are due within one year, current liabilities. Now, long-term liabilities, they represent here, they represent 52%. Long-term liabilities, they have other loans that are long-term. So together liabilities represent 89 or almost 90% of their assets between current and long-term. Now, eventually we're gonna be running some ratios that compare those that ratios means x over y, one number divided by the other to give us more sense, but we'll talk about that later on. This is just an overview of the financial statement. The third category of the balance sheet is the stockholders' equity. And frankly, I don't like this balance sheet because it doesn't show really what we need to show. Stockholders' equity is divided into the two main component of stockholders' equity. The two main components is one is called retained earnings and one is called capital contribution. Those are the two main sections in the retain, the two main, it doesn't mean that the only one, there could be many. Capital contribution is what the investors invested in the company. Here it's represented by common stock, common stock, which is in its negative, that doesn't make any sense. Well, the reason it's negative is because Home Depot, they're taking cash and they're buying back their stock. When you buy back more stock than what you issued, they're buying back their own stock, then you have a negative, what we call common stock, negative common stock, that's very unusual. Matter of fact, in accounting what we do is we have common stock and we have another account called treasury stock. We don't net them out. Here they're netting them out. It's a little bit unusual. So this is not a typical presentation. Then the other section is retained earnings is what the company made and profit and kept over the years. This is retained earnings. So notice here are the figures. We have negative 72.6 of capital contribution and positive 82.7 of retained earnings. A little bit unusual presentation, but okay, that's fine. Overall, it represents 10.1% of assets. So we have retained earnings and capital contribution. We have treasury stock, which is not showing here. Treasury stock will be listed separately and it will be a negative number. Treasury stock will be a negative number, but we don't net it against common stock. That's fine. So the shared health by investors are said to be issued and outstanding. And here they're not giving us the number. Home people, par value is negative, which is, again, it doesn't, you know, don't worry about this. It's a little bit an unusual presentation. The third financial statement is the statement of cash flows. And from a financial analytical perspective, it's the most important financial statement because remember when we value a company, what we care about is cash flows. How much cash are they bringing in? So the income statement and the balance sheet are based on a cruel method of accounting, which is, you know, you know, recognize revenue when earned, incurred expenses when, record expenses when incurred, okay? Revenue recognized at the time of the sale. And if no cash has yet, has not yet been exchanged, there is no revenue. And if no cash has paid, there is no expense. The income statement, we're looking at like a small business, a small business, look at everything from a cash transaction. So we're going to take the business and turn it into cash transaction. We got paid, it's revenue. We paid the expense, it's an expense. Otherwise it's not revenue and it's not an expense. Okay, so we forget about the cruel method when we prepare the statement of cash flows. It's by its name, cash flows. It means you are not using the cruel. You're using cash method. For example, if goods are sold now with payment due in 60 days, the income statement will treat revenue. For example, if goods are sold now and we don't get paid until 60 days later, well, for a cruel, we made the sale. For the cash flow, there's no sale until we get the cash. Okay, same thing with expenses. When we incur an expense, it's not really an expense until we actually pay it. That's when it's an expense. And this is the most important of the three financial statements for financial statement analysis and it's derived. I mean, for a finance students, this will be given to you, you need to understand it. But for an accounting students and on my website, forhatlectures.com, I show you how to prepare, how to build because the accounting job is to build an actual cash flow statement. The cash flow statement is composed of three sections. The first one is operating. The second one is investing. And the third one is financing. And I'm gonna go over each one of them as much as possible that help you give you the big picture of this. Because again, if I wanna teach you this from an accounting perspective, it will be much, much longer to teach because you'll have to build it from zero. So for the operating section, the operating section basically, think of the income statement. The income statement gives you net income. Net income is an accrual figure. It's based on accounting number. It's based on gap, generally accepted accounting principle. What we do on the cash flow statement, we're gonna take this accrual figure and turn it into net income cash basis. I made this word up just kind of to make the point. So now you're gonna convert net income accrual to net income cash basis. So basically convert your income statement into a cash income statement. So how do you do that? You will start with the income statement and this is the indirect methods. There are two methods. Again, you don't have to worry about this. One of the biggest adjustment that you make is you add depreciation because depreciation is a non-cash. When you deduct the depreciation, you did not really pay any cash. Therefore, when you convert your net income to cash, you add back depreciation. Notice here you had a decrease. You had actually an increase in account receivable. Your account receivable went up. When your account receivable went up, it means you are selling and you are not receiving money. You'll be receiving the money later. Therefore, you deduct that difference. You have a increase in inventory. When your inventory went up, it means you are buying and not selling. It's a negative. Remember, if this was a decrease, it would have been the opposite. It will be positive cash flow. Again, if you really want to learn about the cash flow, please go to my website because this is just a shortcut of things because as a finance major, you just need to understand how to read it. Increase in or decrease in liabilities. If you have an increase in liabilities, it's positive. If you have any increase in liabilities, it's a positive cash flow. You might be asking why? Think about it. When your liabilities go up, you are not using your cash. You are using other people's money. Therefore, you are preserving your cash. Therefore, your cash flow will go up. That's why it's positive. There are other adjustments. We don't have to worry about this. All in all, notice here, notice here that from a cruel perspective, you made 7.9 billion. From a cash perspective, you made 7.9 from a cash, 9.7 billion. So from a cash perspective, Home Depot is doing pretty well and this is what you want. You want to be generating revenue and you want to be collecting that revenue in cash because at the end of the day, what matters is cash. So this is the first component of the cash flow statement which is cash provided. It happens to be provided. It means it's positive. Cash provided plus by operation. The second section is the cash flow from investing. Okay, I'm gonna give you the overall idea here. What's the overall idea of investing? What do you do? When you have a company, you're gonna make investments. You're gonna buy other bonds and stocks of other companies. That's one form of investments. Or you're gonna buy property, plant and equipment and vehicles and warehouses to invest in yourself. This is what goes here. For example, Home Depot gross investment intangible fixed asset is negative 1.6 billion. What does that mean? It means Home Depot purchased property, plant and equipment, usually warehouses and stores to expand. Okay, it's negative. Investment and other assets, it seems positive. Now I don't know what this investment and other assets, maybe they had stocks and bonds of other companies and they sold them and as a result, they received cash. So this is what goes in here. But notice from investment, it's used. It's not provided. So they have a negative 1.5 billion. It means they used up some of their cash to expand the company. You want this number to be negative. You want the operating to be positive. You want this to be negative. It means you are expanding because you wanna keep on expanding the company. Assuming you have projects that will earn you more than your required rate of return. Okay, now the third category is cash either used or provided by financing. So the third section is financing activities. How do you finance yourself? Well, you finance yourself through that, through your own borrowing or you finance yourself through stocks, selling your own stocks or paying dividend or paying interest, so on and so forth. So here what we have is let's look at the overall. Overall, we have cash used. Notice it's a negative. It means they paid 7.8 billion. They consumed of cash 7.8 billion. Now, how did they consume this cash? Well, addition to long-term debt. It seems they borrowed 2.2 billion in debt. Net issue or repurchase of shares. Here's a big one. Home Depot is buying backdoor shares. Home Depot is taking their cash and they're buying back their shares. Now, why would they buy back their shares? Because they have confidence in the company. They want to reward the shareholders. They buy back the shares. Because when they buy back the shares, the price usually go up. Therefore, notice 6.6 billion of their cash is spent on buying back their own shares, which is a huge commitment, a huge commitment. Now, also they paid dividend. They paid dividend of 3.4 billion. So notice between paying dividend, between paying dividend and buying back their own stocks, they consumed all the cash that they generated from their stores. Actually, they have more. Here they have almost 10 billion, 10 billion, okay? And the cash that they generated from the stores is 9.7. Hold on a second. And how did they also consume or they spent 1.5 billion on expanding? They borrowed money. They borrowed 2.2 billion. Then there's other, don't worry about other. It's a small amount. So what's happening to Home Depot is this? Home Depot is considered what we called a mature company. What do you mean by mature company? Mature company makes money from operating their business and they're mature. They can no longer expand that much. So they are still expanding, but not that much. But what they do, the money that they generate from the business, they either buy back their stock or they pay dividend. Notice what's happening here. This is considered a mature company. In other words, they're in good shape. Now, a startup company, what would the startup company would look like? A startup company, they might have a startup company, they might have a negative operating. They may not be making money from operating the business because they're still like early Amazon, early Netflix, they don't make money. Then they have a large negative here for investing, but they will have a big positive under financing. So what they do startup companies, they borrow money, they issue stocks to finance to invest in the company and to make up for the losses. After a while, what happened is this, once the company, it's in its midlife, they will start to make money from operation. They would still be expanding the company and they will start to have a small negative financing. Once they mature, they would still be making money. Now they will make more money. The investing will slow down because they can no longer have enough project and the financing will be a big minus because now they're gonna take the money and reward the investors, pay back their debt because they have enough money. But here's what's happening with Home Depot, they're borrowing money because interest rate is very low. They feel it's better to borrow money, okay, to pay back the shareholders, to buy back the stock and pay off, pay the shareholders. They believe it's worth it for them because obviously interest rate is low. So this is an overview of the three major financial statements. At the end of this recording, I'm gonna invite you to visit my website forhatlectures.com, whether you are a CPA candidate or an accounting student. If you are a CPA candidate, this is an investment in your career and the CPA is a one, it's a once in a lifetime. It will serve you 20 to 30 years. Do not under, don't under change yourself and say, well, I'm not gonna pay a small amount of money to pass the exam. This is a small amount of an investment in your overall career. Study hard, it's a great value for your money. Stay safe, most importantly, because COVID numbers are keep on going higher. You know, October 27th, 2020, I don't know when you're gonna be watching this recording, hopefully it will, you know, slow down and stay safe, most importantly.