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Chapter 2

Chapter 2 Lecture Notes

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University of Ottawa
Lamia Chourou

Chapter 2 ­ A Further Look at Financial Statements Statement of Changes in Equity • Share Capital o Common shares o Preferred shares • Retained earnings (Profit) • Other items Statement of Financial Position • Balance Sheet • What the company owns, and what the company owes • A = L + SE • Property, plant, equipment: recorded in order of permanency o Cost ­ Accumulated depreciation = Carrying amount o Depreciation: Allocating the cost over the useful life of the asset. • Intangible assets o Amortization rather than depreciation • No amortization for Goodwill Statement of Cash Flows • Operating activities • Investing activities • Financing activities Learning Objectives • Identify the sections of a classified statement of financial position. • Identify and calculate ratios for analyzing a company’s liquidity, solvency, and profitability. • Describe the framework for the preparation and presentation of financial statements. Statement of Financial Position • Presents a snapshot of the company’s financial position (Assets, Liabilities and Shareholders’  Equity) at a point in time • Similar types of assets and liabilities are grouped together • Order of presentation often used: o Liquidity order: From the most to the least liquid (North American companies) o Reverse liquidity order (international companies) Assets • An asset is: o A resource controlled by the company o As a result of past events o And from which future economic benefits are expected to flow to the company • Assets are usually classified into: o Current o Non­current Current Assets • Expected to be converted into cash, sold, or used up within one year of the company’s financial  statement date or its operating cycle, whichever is longer • Include: o Cash o Short­term investments o Receivables o Inventories o Supplies o Prepaid expenses Non­Current Assets • Assets that are not classified as current assets • Include: o Long­term investments o Property, plant, and equipment (also called tangible assets, capital assets, or fixed assets) o Intangible assets o Goodwill Liabilities • A liability is: o A present obligation of the company o Arising from past events o The settlement of which is expected to result in an outflow from the company of  resources embodying economic benefits • Usually classified as current / non­current Current Liabilities • Obligations that are to be paid or settled within one year of the company’s financial statement date  or its operating cycle, whichever is longer • Include: o Bank indebtedness o Accounts payable o Accrued liabilities (salaries payable, interest payable, income tax payable) o Notes payable o Current maturities of long­term debt Non­Current Liabilities • Obligations expected to be paid or settled after one year • Known as long­term debt • Include: o Notes payable (bank loan payable, bonds payable, mortgages payable) o Lease liabilities o Pension and benefit obligations o Deferred income tax Shareholders’ Equity • Is the residual interest in the assets of an entity after deducting all its liabilities • It is composed of: o Share capital  Includes all classes of shares issued o Retained earnings  Accumulated profit ­ Any losses ­ Dividends paid • Dividends: Distributions to shareholders. • Profit can be paid in dividends or remain in the company for  investment purposes o Other equity items  E.g. Accumulated other comprehensive income (loss) Presentation • Order of liquidity: o Current assets o Non­current assets o Current liabilities o Non­current liabilities o Shareholders’ equity • Order of reverse liquidity: o Non­current assets o Current assets o Shareholders’ equity o Non­current liabilities o Current liabilities Analyzing a Company’s Financial Statement Data • Three general types of ratios: o Liquidity ratios o Solvency ratios o Profitability ratios Liquidity • Measures the ability to pay obligations as they become due • Short­term creditors are interested in these ratios, e.g. suppliers • Two measures: o Working capital = Current assets ­ Current liabilities  Better to have a higher working capital o Current ratio = Current assets / Current liabilities  Better to have a higher ratio  For every dollar we have of current liabilities, we have … of current assets  Just because the ratio increases from year to year does not mean it is a good  thing, we must examine current assets to understand why our ratio increased ­ if  cash is higher this is good, if inventory is higher this may be bad Solvency • Measures the ability to survive over a long period of time through paying interest as it becomes  due and repaying the face value of debt at maturity • Investors and long­term creditors are interested in these ratios • Measured by the Debt to Total Assets Ratio: o Debt to total assets = Total liabilities / Total assets  Better to have a lower ratio  Gives you the percentage of assets financed by debt (lenders and creditors) Profitability • Measures a company’s operating success for a given period of time • Shareholders are interested in thes
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