University of Arkansas System
Type of paper: Thesis/Dissertation Chapter
Financial Statements: A Step-by-Step Guide to Understanding and Creating Financial Reports
An investment appraisal is a planning process that is utilized in determining the preparedness of a business to undertake a long term investments such as expansion, developing a new project, acquiring new machinery among others (Les Dlabay, 2007). This is a complex process that requires the analysis of sources of finance, their implications, budgeting and financial statements.
Sources of finance
Coca-cola which is the world leading non-alcoholic beverage company marketing their products in over 200 countries worldwide have the god foundation of assets, shares, short term liabilities, long-term loans and goodwill as its source of finance.
The assets of the company form the major source of its finances accounting for $ 57,751 million in 2013 and $ 55,849 million in 2012 (The Coca-Cola Company, 2013). These include tangible and non-tangible assets such as property, plants, equipment, equity method investments and goodwill. This can be summarized as shown in the table below.
(In millions) 2013
Equity method investments 10,393 9,216
Investment in bottling companies 1,119 1,232
Other Assets 4,661 3,585
Property, Plant and Equipment 14,967 14,476
Trademarks with indefinite lives 6,744 6,527
Bottles franchise rights with indefinite life 6,415 7,408
Goodwill 12,312 12,255
Other intangible assets 1,140 1,150
TOTAL ASSETS 57,751 55,849
Long term and short term liabilities are another source of finance for the company. The company’s total long term liabilities in the year 2013 were $ 90,055 million and $ 86,174 million in 2012 (The Coca-Cola Company, 2013). Their long term external sources of finance include debts, deferred income taxes and the company’s share owners as contained in the table below.
LONG TERM LIABILITIES
(In millions) 2013
Long term debts 19,154 14,736
Other liabilities 3,498 5,468
Deferred income taxes 6,152 4,981
TOTAL ASSETS LONG TERM LIABILITIES 90,055 86,174
Important company activities that generate profits that are ploughed back to the business as a source of finance include investments and new ventures. These are proceeds from the investments, acquisition of other businesses, equity method investments, non-marketable securities, purchase and sale of property, plants and equipment and their associated proceeds. In 2013, the company realized a total of $ 10, 414 from the investment and operating activities as per their 2013 annual report.
Internal short term sources of finance for the company are the current assets of cash and cash-equivalents such as marketable securities, inventories, current assets held for sale and the proceeds from the short term investment. Their balance sheet as at December 31, 2013 shows a total of $ 17, 121 million current assets.
Implications of the sources
However much the company had good financial sources in its assets, liabilities and shares, each of the sources may impact negatively or positively to the business. The straight forward implication of liabilities especially loans is the interest rates and the obligation to repay them in good time. Failure to settle the debts and loans may lead to imposition of fines and penalization. The creditors may go to the extent of stopping to supply the company with goods and services on credit and demand for cash on delivery.
Use of shareholding as a source of finance for the company may also have its own positive and negative implications. Shareholders are like investors in the business and therefore they must be paid their returns as dividends (Fardon, 2003). This might be very difficult in cases where the company makes losses. Sometimes, especially in a scenario where there are no strict policies on the maximum percentage share that a shareholder can buy, the ownership of the company may be transferred to a shareholder that buys majority of the Company shares.
Importance of financial planning
Finance is the driving force for a company like Coca-cola. After its financial sources have been identified, accurate financial planning is necessary for its success. Financial planning is the foundation from which all successful businesses are built. Running on a clear financial plan ensures that a company is well prepared to meet its anticipated expenses in terms of payroll, transport, communication any other day to day business operation expenses.
The plan is important when the company is at the extremes of either profit making or suffering losses. It provides a stepping stone in which the company can forge a way forward and plan for the future while at the same time handle the present. A good financial plan finds it usefulness when a company is preparing to deal with rising costs and increasing current and long term liabilities. It allows for these conditions to be anticipated early enough so as deal with them when they arise.
Additionally, a financial plan is a critical tool in the organization of the various departments within the company. A well prepared and revised financial plan that considers every quarter of the company is of valuable contribution to the smooth running of the company as a whole. Lastly, an estimate of earnings can be done through a financial plan. Lack of these estimates sets a trap that the company might fall in due embezzlement of funds and misappropriations. A financial plan is very effective in making investments and profits into diversified portfolios within the company.
The process of making decisions requires the company directors to be provided with the necessary information. These include financial reports that contain details of business transactions, profits, losses, expenses, revenues, assets and liabilities. This allows for comparison of business performance in the previous financial year. The departmental estimates of expenditures and their estimated sources of revenue are also part of this information.
The factors that may affect the choices of decisions makers during financial planning are the number and wages of employees, available cash at hand and cash required to pay suppliers on time and to buy current assets such as equipment and stationeries. The possibility of expanding the business is also considered when such decisions are made (M. P. Narayanan, 2004).
Appropriateness of the sources of finance for a business project
In order to manage the financial sources and make appropriate decisions, it is important that the directors analyze the costs of the sources, for example, the cost to be incurred to obtain the finance such as fees payable to the financial institutions, commissions and interests, stock brokers among others. In the Coca-Cola Company where the major sources are the fixed assets, liabilities, ploughed back profits, profits from investments and current assets, the appropriateness of the sources depend on the ability of the finances to run a business investment. Bank loans are the major long term source of finance for many companies. This source is very appropriate for Coca-Cola Company. The repayment is spread over a long period of time. The company is financially stable and can easily afford the required securities to acquire a loan. Although the interest rates may be higher making the process expensive, the merits outweigh the demerits and the risk is worth taking.
Coca-cola is a limited company and therefore the use of stock shares as a source of finance is appropriate. The finances are not repaid although the profit is shared among the shareholders as dividends. The capacity of this company to make profit is unquestionable. The risk of change in company ownership due to sale of major shares can be regulated by business policies that restrict such sales. Moreover, sale of assets such as the current assets to raise capital is appropriate for this company. The surplus assets can be sold off and the proceeds retained to run the business. There is little, if any, risk associated with sale of surplus assets.
Impact of finance and financial statements
Finance and financial statements have positive and negative effects to the business depending on the financial position of the company. Financial statements form the basis from which shareholders and potential investors evaluate the performance of the business. The statements also regulate accountability in the running of the business.
The financial position of the business is portrayed in the financial statements. It used by the company to acquire loans from banks. Financial statements that directly indicate instability of a business have a negative impact to the business by blocking potential investors, creditors and banks. Finance and financial statements have a direct effect on business transactions. It gives detailed information about the lag phases and peaks of a business. Such details include fluctuations in prices in comparison to competitors in the market (Ittelson, 2009). If, for example, Coca-Cola Company increased the prices of their beverages by 1%, their immediate competitor Pepsi may have an upper hand in the market.
A balance sheet gives information on the resources that the business has against its liabilities and the capacity of the business to settle its debts. Cash flow statements are important in informing the public about the money entering and leaving the business. All of these can negatively or positively influence the customers, suppliers, creditors and potential investors. Financial statements have a direct impact on the stock price. The information in the statements can be used by business managers to either increase or decrease the price of products.
Main financial statements
In designing investment options and identifying their appropriateness, it is important to prepare financial statements. These statements have different formats depending on the size and type of the business. The statements are; balance sheets, cash flow statements and income statements. A balance sheet is a financial statement that reports a company’s assets, liabilities and stock holders’ equity in a given financial period. Current assets, fixed assets and investments are balanced against liabilities and stock holders’ equity. A balance sheet for Coca-Cola Company as at 31st December, 2013 is as follows (The Coca-Cola Company, 2013).
THE COCA-COLA COMPANY
CONSOLIDATED BALANCE SHEET
AS AT 31ST DECEMBER, 2013.
Cash and cash equivalents10,414
Short term investments 6,707
Total cash, cash equivalents and short term investment17,121
Trade accounts receivable less allowances of $ 614,873
Prepaid expenses and other assets2,886
Total current assets31,304
Equity method investments10,393
Other investments principally bottling companies1,119
Property, plant and equipment –net14,927
Trademarks with indefinite lives6,744
Other intangible assets1,140
LIABILITIES AND EQUITY(In Millions)
Current liabilities $
Accounts payable and accrued expenses9,577
Loans and notes payable16,901
Current maturities of long term debt1,024
Accrued income taxes 309
Total current liabilities27,811
Long term debts19,154
Other long term liabilities 3,498
Shareholders’ equity –total33,440
TOTAL LIABILITIES AND EQUITY90.055
The balance sheet is similar regardless of the size and type of the business. Its format does not change. Cash flow statements are prepared to assess the company’s earnings and expenses. The quality of the earnings is determined by comparing the cash flow from operating activities with the company’s net income (R, 2003).
Income statements are financial documents that show the sources of income in a business organization. Coca-cola Company had the following statement of comprehensive income as at December 31, 2013.
THE COCA-COLA COMPANY
CONSOLIDATEDSTATEMENT OF COMPREHENSIVE INCOME
AS AT 31ST DECEMBER, 2013.
$ (In Millions)
CONSOLIDATED NET INCOME8,626
OTHER COMPREHENSIVE INCOME
Net foreign currency translation adjustment(1,187)
Net gain (loss) available for sale of securities (80)
Net gain (loss) on derivatives 151
Net change in pension and other benefit liabilities1,066
TOTAL COMPREHENSIVE INCOME8,576
Less comprehensive income loss attributed to interests 39
TOTAL COMPREHENSIVE INCOME ATTRIBUTED TO
SHAREHOLDERS OF THE COMPANY8,537
Note: Figures in brackets indicate losses or reductions
Interpretation of the financial statements
Financial statements are usually prepared and interpreted towards the end of a financial year to give information about the business financial stability. The above financial statements can be interpreted by using appropriate financial ratios to help compare them with the performance during the previous financial year or with another company. These ratios derived from a balance sheet are working capital, current ratio, Quick ratio (Pamela Peterson Drake, 2012).
Financial statements provide rich information to investors and suppliers. This information are used to evaluate the performance of the company. The statements are also used as a communication tool by managers to interested parties about their achievement in the management of the company. There are different financial statements as discussed above that give unique business information on the company.
Financial conditions of a company are the major detail and a point of concern for several potential investors. Investors are the major capital providers. They rely on the information contained in the balance sheet, income statements and cash flow statements for their safety and certainty regarding a potential investment into a company. It enables the investors to understand their position in the company’s capital regimen.
The balance sheet is considered the snap shot of a company’s assets in comparison to liabilities and shareholders’ equity. This is considered the operating result of the company. These results are also an area of concern to investors. Income statement gives a report of operating results. This includes the sales, expenses and profit or losses in a given financial year. This information is critical in the evaluation of the company’s past performances and to predict the future of the business. Profits or losses are usually provided by the income statement but this may contain non cash-equivalent or non-cash parameters. The information is not direct as to the company’s cash transaction during the financial year. This leaves room for cash flow statements to give the details. It contains information about the cash that get into the business and those that leave the business thereby showing an exchange of cash. Shareholders’ equity shows the variations in the various equity components. This is usually calculated by deducting total liabilities from the total assets of the company. A company with a good performance like Coca-Cola has a steady increase in its shareholders’ equity. This is associated with either a decreasing or constant shareholders base.
Working capital is calculated by deducting current liabilities from the current assets. The working capital for Coca-Cola Company for the year ended December 31, 2013 can be calculated as follows.
Working Capital (in millions) =Current assets – Current liabilities.
= $ 31,304- $ 27,811
The working capital for Coca-Cola Company is a positive figure of $ 3,493 million indicating that the company is at a better position to meet its current obligations such as paying workers, paying brokers, servicing short term loans among others.
Current ratio is calculated by dividing the current assets by the current liabilities. It is related to the working capital. Another ratio is Quick ratio. It is also known as acid test ratio and is calculated as follows;
Quick ratio = Cash + Temporary investment + Accounts receivable
The Quick ratio is similar to the current ratio only that inventories, supplies and prepaid expenses are excluded. It is used to determine the amount of assets that can be turned quickly into cash.
Free or Discounted cash flow is a financial ratio that is derived from the cash flow statement. Free cash flow is calculated by deducting capital expenditures from total cash flow provided by operating activities (Fardon, 2003). Free cash flow for Coca-cola as at December 31, 2013 is calculated as shown.
Free cash flow = Cash flow provided by the operating business – Capital expenditures.
=10,542 – (14,782+2,550+303)
This statistically indicates that the company is at a deficit of $ 7, 093 million after paying its capital expenditures.
The income statement can be analyzed to give gross margin, profit margin, Return on Stoke holders’ equity and earnings per share. Return on Stoke holders’ equity is important in revealing the percentage profit after taxation and therefore the dividends payable to shareholders. Return on stock holders’ equity for Coca-Cola Company as at December 31, 2013 is calculated as shown.
Return on Stockholders’ equity = Net income after taxes
Average shareholders’ equity
This reveals that the company earned 1.01% of profit after taxation on an average shareholders balance during the year.
Suitable budget and appropriate decisions
The most significant form of planning a capital investment budget is to make appropriate decisions and market well. Budgeting is the foundation of financial economics. Making decisions that have importance long term effects is the basis of budgeting. In budgeting, policies are maximized so as to achieve the most positive net profit and returns. Making decisions should be principally governed by benefit analysis. The budgeting process is also governed by the future consequences and impact to the business
Every financial source has an implication to the business. Financial statements help provide such implications and can be used in selecting a suitable budget. A company may decide to sell its shares after analyzing its effectiveness in raising capital for a new business venture (Pamela P. Peterson, 2004). The process of deciding on a proper capital investment for the expansion of Coca-Cola Company involves calculating the cost of investment, protection of cash flow from the investment, consideration of the inflation rates and the time value of the expansion. For example, if the investment will cost $ 10 million and generates $ 4 million annually, the investment is feasible because it provides a pay back within 2.5 years. A budget can therefore be prepared from this basis.
An example of a suitable budget proposed for The Southeastern Pennsylvania Transportation Authority (SEPTA) for the Fiscal year 2012 is as follows (SEPTA, 2011) .
FISCAL YEAR 2012 CAPITAL BUDGET
Project FY 2012 Funding
Bus Purchase Program $59,209,593
Capital Asset Lease Program 28,720,862
Congestion Relief 2,233,000
Debt Service 52,654,545
Infrastructure Safety Renewal Program 34,400,000
Paratransit Vehicle Acquisition 5,000,000
Regional Rail Signal System Modernization 35,800,000
Safety and Security Improvements 5,000,000
State of Good Repair Initiatives 15,200,000
Station Accessibility 4,800,000
Station and Parking Improvements Program 10,400,000
System Improvements Program 5,000,000
Vehicle Overhaul Program 53,100,000
TOTAL FY 2012 Capital Budge$311,518,000
Marketing decisions are dependent on capital budgeting. The decisions to be made on long term investments are dependent on the income that will be generated from the project. It is important to know the duration that the project will take to mature. That is, the time it will take to generate income equivalent to the amount invested in the business. Modern finance theories equate the value of the assets to the discounted future income generation. The net profit value rule is therefore used by companies that contemplate venturing unto capital project if they adopt this theory.
Assessing project viability
The financial viability of a project is assessed using the investment appraisal techniques. This involves the use of tools such as Return on Investment (ROI), Debts Service Coverage Ratio (DSCR), Break Even Point (BEP) and Debt Equity Ratio (DER).
In Return on Investment, the collections of the company are used to create assets and in the running of the business. The business must generate surplus on the collected capital for it to be considered viable. Borrowed and own capital is considered the cost of the project while the profits are the surplus generated. ROI should be greater than the cost of the investment for the business to be considered viable.
Debt Service Coverage Ratio (DSCR) measures the ability of the project to meet its repayment obligations on loans acquired financial institutions (Pamela P. Peterson, 2004). It is calculated as follows.
DSCR= Net profit + Interest on long term loans + Depreciation
Interest on long term loan + Principal loan
The cumulative DSCR during the repayment period should be at least 2:1 for the project to be considered viable. Break Even Point (BEP) measures the level of total contribution to the total fixed assets. Contribution is usually the excess of sales over the variable cost. That is;
Contribution = Sales – Variable Costs.
PEP is the point where both fixed and variable costs are recovered from the resources. It is calculated using the formula;
Total fixed cost× selling price per unit
Contribution per unit cost
It indicates the risks involved in the business. If the PEP is achieved at a lower level of capacity utilization, it is considered safer. In this case, the investment is viable.
Debt Equity Ratio measures the level at which the investment project is leveraged to acquire loans from financial institutions. It is calculated by the formula;
Total long term debts
Total funds in the investment
The factors to be considered when assessing the viability of a project are the nature of the goods and services to be offered. Their level of complexity should be determined and the risks involved as well. The value of the procurement is another factor of concern. It involves the determination of the amount of capital that the procurement can cost. The financial viability assessment matrix group risks speculated into several levels. The low risk level contains low levels of complexity, low value and short term supplies. The moderate risk level contains moderate value, sensitivity and medium term supply. The high risk level contains high strategic importance to agency, high complexity levels and sensitivity. When assessing the risks, the likelihood of a financial feasibility should not be ruled out while making budgeting decisions.
Fardon, C. D. (2003). Management of Finance. New york: Osborne Books.
Ittelson, T. R. (2009). Financial Statements: A Step-by-Step Guide to Understanding and Creating Financial Reports. New York: Career Press, Incorporated.
Les Dlabay, J. B. (2007). Business Finance. Stamford: Cengage Learning.
M. P. Narayanan, V. K. (2004). Finance for Strategic Decision-Making: What Non-Financial Managers Need to Know. New Jersy: John Wiley & Sons.
Pamela P. Peterson, F. J. (2004). Capital Budgeting: Theory and Practice. New Jersey: John Wiley & Sons.
Pamela Peterson Drake, F. J. (2012). Analysis of Financial Statements. New Jersey: John Wiley & Sons.
R, D. J. (2003). Accounting for Non-Accounting Learners. New York: Pitman.
SEPTA. (2011, Aril). The Southeastern Pennsylvania Transportation Authority. Retrieved April 2014, from Finance: http://www.septa.org/reports/pdf/budget-proposal-cb12.pdf
The Coca-Cola Company. (2013, December). The Coca-Cola Journey. Retrieved April 2014, from Annual Financial Report: http://www.coca-colacompany.com/our-company/company-reports