Framework for Analysis and Valuation
Organizations undertake planning activities that shape three major activities: financing, investing, and operating. Financing is the means a company uses to pay for resources. Investing refers to the buying and selling of resources necessary to carry out the organization’s plans. Operating activities are the actual carrying out of these plans. Planning is the glue that connects these activities, including the organization’s ideas, goals and strategies. Financial accounting information provides valuable input into the planning process, and, subsequently, reports on the results of plans so that corrective action can be taken, if necessary.
An organization’s financing activities (liabilities and equity = sources of funds) pay for investing activities (assets = uses of funds). An organization’s assets cannot be more or less than its liabilities and equity combined. This means: assets = liabilities + equity. This relation is called the accounting equation (sometimes called the balance sheet equation), and it applies to all organizations at all times.
The four main financial statements are: income statement, balance sheet, statement of stockholders’ equity, and statement of cash flows. The income statement provides information about the company’s revenues, expenses and profitability over a period of time. The balance sheet lists the company’s assets (what it owns), liabilities (what it owes), and stockholders’ equity (the residual claims of its owners) as of a point in time. The statement of stockholders’ equity reports on the changes to each stockholders’ equity account during the year. The statement of cash flows identifies the sources (inflows) and uses (outflows) of cash, that is, where the company got its cash from and what it did with it. Together, the four statements provide a complete picture of the financial condition of the company.
The balance sheet provides information that helps users understand a company’s resources (assets) and claims to those resources (liabilities and stockholders’ equity) as of a given point in time.
The income statement covers a period of time. An income statement reports whether the business has earned a net income (also called profit or earnings) or incurred a net loss. Importantly, the income statement lists the types and amounts of revenues and expenses making up net income or net loss.
The statement of cash flows reports on the cash inflows and outflows relating to a company’s operating, investing, and financing activities over a period of time. The sum of these three activities yields the net change in cash for the period. This statement is a useful complement to the income statement, which reports on revenues and expenses, but which conveys relatively little information about cash flows.
Retained earnings (reported on the balance sheet) is increased each period by any net income earned during the period (as reported in the income statement) and decreased each period by the payment of dividends (as reported in the statement of cash flows and the statement of stockholders’ equity). Transactions reflected on the statement of cash flows link the previous period’s balance sheet to the current period’s balance sheet. The ending cash balance appears on both the balance sheet and the statement of cash flows.
External users and their uses of accounting information include: (a) lenders for measuring the risk and return of loans; (b) shareholders for assessing the return and risk in acquiring shares; and (c) analysts for assessing investment potential. Other users are auditors, consultants, officers, directors for overseeing management, employees for judging employment opportunities, regulators, unions, suppliers, and appraisers.
Managers deal with a variety of information about their employers and customers that is not generally available to the...
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