FINANCIAL STATEMENTS ANALYSIS Reclassified financial statements: the Balance Sheet

FINANCIAL STATEMENTS ANALYSIS Reclassified financial statements: the Balance Sheet TEACHING MATERIAL FOR THE ADVANCED ACCOUNTING COURSE PROF. G.MODU...
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FINANCIAL STATEMENTS ANALYSIS Reclassified financial statements: the Balance Sheet

TEACHING MATERIAL FOR THE ADVANCED ACCOUNTING COURSE

PROF. G.MODUGNO

Why do Financial Statements need to be reclassified? 2

The reclassification of financial statements:  

improves their capability to provide information to investors; some choices taken by the Italian legislator are not consistent with the purpose of the analysis;

 

allows to reduce the number of items in the financial statements: this improves the understandability of the whole picture;

 

allows to highlight some important margins in the Income Statement, that are important to assess company’s profitability.

RECLASSIFIED BALANCE SHEETS 3

THE FINANCIAL APPROACH AND THE FUNCTIONAL APPROACH

Reclassified Balance Sheets 4

Two alternative approaches can be used in order to reclassify the Balance Sheet: 1. 

The “financial” approach, where assets and liabilities are classified into two main categories, i.e. current and non current. This approach aims at answering the question: “Is the financial position balanced? Will the company be able to meet its obligations?”

2. 

The “functional” approach: assets are classified depending on their destination (operating, financial) and sources of capital depending on the subjects that provided the funds (shareowners or other institutional investors). In this approach, trade payables and other operating payables are subtracted from the assets, in order to calculate the Net Invested Capital.

The Financial Approach for the reclassification of the Balance Sheet 5

Purpose 6

—  The purpose is to verify that the date of maturity of

liabilities is consistent with the duration of the assets —  Considering that: ¡ 

Non Current Assets are expected to be transformed into cash in more than one year (or the operating cycle of the company)

¡ 

Current Assets are expected to be transformed into cash within one year (or the operating cycle of the company)

the reclassified Balanced Sheet emphasizes the comparison between non current assets and long term sources of capital, as well as between current assets and current liabilities.

The reclassified Balance Sheet 7

Non Current Assets: Intangible Tangible Equity investments and l.t. receivables

Current Assets:

Equity

Shareowners’ capital Capital Surplus Realized reserves Non realized reserves - Treasury shares

Liabilities:

1.  Non current liabilities:

Inventory (materials, wip,f.p.)

a)  Financial liabilities b)  Provisions for risks c)  Employee termination benefits

Advanced payments & prep.expenses

2.  Current liabilities:

Acc. Receivables Other receivables Cash & cash equivalents

a)  Trade payables b)  Other operating liabilities c)  Borrowings 3.  Unearned incomes and advanced payments from customers

Items That Need To Be Reclassified 8

The distinction between “current” and “non current” assets is not precise in the Italian structure of the Balance Sheet. To improve the understanding of the company’s financial position, it is necessary to reclassify some accounts: 1. 

Short term receivables corresponding to the share of long term receivables (mainly loans to other entities) due within one year, are included in the fixed assets;

2.  Similarly, current assets include some long term receivables, i.e.

operating receivables that are not supposed to be transformed into cash within one year. Both elements must be reclassified depending on their duration.

Items That Need To Be Reclassified 9

3.  Treasury shares must be deducted from equity 4.  Accrued incomes can be assimilated to other operating

receivables. 5.  All trade receivables from affiliated or subsidiaries and

also from holding company should be reclassified as trade receivables

Some guidelines to reclassification 10

—  All categories of the reclassified statements (either the

Balance Sheet or the Income Statement) should be capable of being used in the calculation of relevant ratios. —  It makes no sense to classify into different categories

accounts having similar meanings. —  If different choices are reasonable for the reclassification of

an item, choose the most conservative one. —  The peculiarities of different sectors may suggest different

structures of the reclassified statements.

The Assets’ Section 11

1. NON CURRENT ASSETS: a) TANGIBLE b) INTANGIBLE c) EQUITY INVESTMENTS & other financial invest. 2. CURRENT ASSETS: a)  INVENTORY: Materials

EQUITY

WIP Fin. Products

b) RECEIVABLES: Trade receivables Other Receivables Prepaid exp. and adv. payments

c) CASH AND CASH EQUIVAL.

LIABILITIES

Current Assets 12

—  If possible, separate different elements of the inventory: by

doing this, one can separately calculate the Days of Storage for materials and for products and assess the company’s efficiency in the management of inventory. —  Prepaid expenses on services and advanced payments for

materials are both non monetary assets: they can be reclassified in the same class because of this similarity.

Trade Receivables and DSO 13

—  The calculation of DSO (Days of Sales Outstanding, i.e a ratio that aims

at estimating the average time needed by the company to collect cash from clients) considers at numerator all trade receivables. —  In the Balance Sheet, trade receivables are classified in two different

classes: ¡ 

Account receivables

¡ 

Receivables from Subsidiaries and Affiliated companies: this item contains trade as well as financial receivables.

In the reclassified balance Sheet, all account receivables should considered in the same category

Trade Receivables and DSO 14

BALANCE SHEET according to civil law

RECLASSIFIED BALANCE SHEET

ACCOUNTS RECEIVABLE CII 1

ACCOUNTS RECEIVABLE TRADE RECEIVABLE CII 2,3,4

RECEIVABLES FROM SUBSIDIARIES , AFFILIATED & PARENT CO. C II 2,3,4

FINANCIAL RECEIVABLE CII 2,3,4

OTHER RECEIVABLES

Transactions with related parties: an example (Graniti Fiandre: Trade Payables) 15

As well as for Trade Receivables, also Trade Payables are divided in different classes: •  Accounts Payables •  Liabilities with Related Parties: include financial an trade payables In the reclassified Balance Sheet, trade payables should be grouped in the same class. Hereinafter there is an example of this:

Reclassifying Equity: Contributed Capital vs. Retained Earnings 16

Items of the Equity can be: ¢ 

Contributions from shareowners: i.e. shareowners’ capital and capital surplus

¢ 

Retained earnings: i.e. legal reserve, revaluation reserve, statutory reserve…

¢ 

Income of the period

For the addressees of the Financial Statements, it might be relevant to quantify and separate the contributed capital and the retained incomes. Nevertheless, it is not uncommon that shareholders’ capital include also earnings: this happens, for instance, when bonus shares were issued by the company. Therefore, it is often difficult to separate contributions and earnings.

Reclassifying Equity: an alternative 17

—  Accumulated earnings can be classified as —  “realized”: earnings produced in market transactions —  “not realized”: earnings arising from the change in the fair value of

an asset or liability this distinction can be used in order to understand the quality of earnings and assess the financial health of the company. In Italy, non realized earnings are usually excluded from the Income Statement: with the only exception of revaluations of financial assets that are shown in the class D of the Income Statement, all other non realized incomes are recorded as increases of the Equity.

EQUITY RECLASSIFICATION 18

ASSETS

EQUITY: Capital Capital surplus Realized Incomes Non Realized Incomes Income of the period - Treasury Shares

LIABILITIES

Reclassifying the Equity 19

RECLASSIFIED SHAREH.’S EQUITY Share capital Share premium reserve Non realized earnings

Realized retained earnings

Net profit (loss) - Treasury Shares

Non Realized Incomes: the Italian case 20

According to the Italian civil law, non realized incomes should not be recorded because of conservatism. Nevertheless, there are some exceptions: a) 

Write-up of equity investments and other fin. investments (account D18, Income St.)

b) 

Foreign exchange gains (account C17 bis, Income St.)

c) 

Revaluation reserves (Equity)

Only the first two elements influence the Net Income, while the third one is a direct movement of the Equity. If any write up or foreign exchange gain occurred, they have to be allocated to a non distributable reserve.

Non Realized Incomes in the IFRS: main concepts 21

—  IFRS 1 has introduced the concept of Comprehensive

Income: “Comprehensive income is the change in equity of a business enterprise during a period from transactions and other events from non-owner sources.” —  It includes all non-owner changes in equity, in contrast to net income, which doesn’t include many non realized incomes.

The Statement of Comprehensive Income 22

—  According to IFRS, all non realized gains and losses are

therefore recorded as components of the comprehensive income. —  The traditional structure of the Income Statement has been integrated, in order to complete the Statement also with non realized components. —  Two approaches can be adopted by companies, according to IFRS: One statement approach: realized and non realized components are confused in the same statement ¡  Two statements approach: most of the non realized components are shown in a separate section called Statement of Comprehensive Income ¡ 

An example: Heineken Comprehensive Income Statement, 2010 23

Reclassifying equity: some conclusions 24

—  In the Italian context, it is difficult to separate

realized and non realized reserves in the equity: the nature of the reserve is often undetermined. —  In the international context, more and more

emphasis was given to this distinction; non realized components are now allocated to a non distributable reserve

Liabilities 25

The aim of the reclassification is to summarize liabilities into two groups: a)  Current liabilities b)  Non current liabilities When non monetary liabilities (current and non current) are relevant, they might be grouped in an adjunctive class. While the Italian Balance Sheet has 4 categories: a.  Contingent liabilities b.  Employee benefits c.  Liabilities d.  Accrued expenses and unearned revenues

Contingent Liabilities 26

—  Contingent liabilities are often long term liabilities,

but their expiring dates are not specified, neither in the statement nor in the notes. The company itself often doesn’t know when the liability have to be paid —  A conservative approach would suggest to classify them as current liabilities

Pension benefits & Employee Severance Indemnity 27

ITALIAN  LAW   B)  CONTINGENT  LIABILITIES  

RECLASSIFIED  BALANCE  SHEET   LONG  TERM  LIABILITIES  

1  for  pension  benefits  &  similar  

Financial  liabili)es  (non  curr.  debts)  

2  taxes  

Employee  severance  indemnity  &   similar  provisions  

3  other  

Other  long  term  liabili)es   SHORT  TERM  LIABILITIES  

C)  EMPLOYEE  SEVERANCE   INDEMNITY   If  it  is  not  specified  which  part  of  provisions  for  pension  benefits  and  Employee  Severance   Indemnity  are  current  liabili)es,  one  can  consider  the  whole  amount  as  a  long  term  liability.  

Current Liabilities 28

—  It is necessary, first, to separate interest bearing liabilities

(i.e. financial) and operating liabilities, that do not produce explicit interests —  In the operating liabilities, the class of trade payables is the

most relevant for the analysis: it allows the calculation of Days of Payables, a ratio that gives the average time needed to pay suppliers. —  All other operating liabilities, including accrued expenses,

can be grouped in another class

Liabilities: the classes 29

Assets

Equity LIABILITIES: 1.  Non current liabilities: a)  Financial liabilities b)  Provisions for risks c)  Employee termination benefits

2.  Current liabilities: a)  Trade payables b)  Other operating liabilities c)  Borrowings 3.  Accrued expenses and advanced payments from customers

Working Capital And Operating Working Capital 30

NON CURRENT ASSETS

EQUITY NON CURRENT LIABILITIES WC (working capital)

CURRENT ASSETS

CURRENT LIABILITIES

In finance, the WC often is mentioned with reference only to the sum of the operating items of current assets and liabilities (inventory, operating receivables and payables). This measure is used to calculate the operating cash flow.

The Functional Approach to the reclassification of the Balance Sheet 31

Functional Balance Sheet (1) 32 TANGIBLE AND INTANGIBLE FIXED ASSETS + WORKING CAPITAL - CONTINGENT LIABILITIES - EMPLOYEE SEVERANCE INDEMNITY & SIMILAR LIABILITIES a) NET OPERATING INVESTED CAPITAL (NOIC) + EQUITY INVESTMENTS & LONG TERM FIN. INVESTMENTS + MARKETABLE SECURITIES, CASH & CASH EQUIVALENTS b) CAPITAL INVESTED IN FINANCIAL ASSETS NET INVESTED CAPITAL: a) + b) EQUITY LONG TERM FINANCIAL LIABILITIES SHORT TERM FINANCIAL LIABILITIES TOTAL COLLECTED CAPITAL

Functional Balance Sheet (2) 33

TANGIBLE AND INTANGIBLE FIXED ASSETS + EQUITY INVESTMENTS + WORKING CAPITAL (OPERATING) - CONTINGENT LIABILITIES - EMPLOYEE SEVERANCE INDEMNITY & SIMILAR LIABILITIES NET INVESTED CAPITAL: a) + b) EQUITY LONG TERM FINANCIAL LIABILITIES SHORT TERM FINANCIAL LIABILITIES - MARKETABLE SECURITIES, CASH & CASH EQUIVALENTS TOTAL COLLECTED CAPITAL

Functional Balance Sheet (3) 34

TANGIBLE AND INTANGIBLE FIXED ASSETS + EQUITY INVESTMENTS + WORKING CAPITAL (OPERATING) - CONTINGENT LIABILITIES - EMPLOYEE SEVERANCE INDEMNITY & SIMILAR LIABILITIES NET INVESTED CAPITAL: a) + b) EQUITY NET FINANCIAL POSITION TOTAL COLLECTED CAPITAL

Reclassified Balance Sheet: Mediaset Group 35

Net Financial Position: Mediaset Group 36

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