I am Rick Lambert. I am the Miller Shepard professor of accounting at the Wharton School. And I'm going to be following up what professor Oldhousen talked about with respect to decision making and scenarios. In particular, in this module, we are going to show how business activities, transactions and events, get translated into financial statements. We'll talk about balance sheets, income statements and cash flow statements. How these three statements are linked to each other, and in particular how balance sheets and income statements can help to forecast the future cash flow statements. Recall from the prior two modules that future cash flows are the things we want to put into our net present value calculations. In the next module, we're going to apply what we've been learning to the analysis of a new product venture. We're going to map out a plan of the business activities, transactions and events that need to happen to implement our new strategy including their timing. We'll show how to set up a spreadsheet to help us with our forecasts. And also to give us the ability to re-calculate things automatically as we rethink our plans. We'll forecast out the implied future cash flows and the financial statements, calculate the net present value. And then we'll use our spreadsheet to explore different risks our venture might face, and analyze the implications of these scenarios for the net present value. To apply present value techniques, we have to be able to express a project in terms of the time pattern of cash inflows and outflows that the project will generate. To forecast these future cash flows, we have to plan out the sequence, of business activities and transactions that give rise to the cash flows. Accounting systems that compile balance sheets, and income statements, in addition to cash flow statements, are helpful in keeping track of these activities, especially their timing and their coordination. Our objectives in this module are to explain how accounting systems translate business activities into financial terms, and how we can use this to better forecast the future cash flows. Now where do cash flows come from? Well they come from transactions with other parties. Like customers, suppliers, employees, government, investors, and creditors. These receipts and payments result from business activities like raising capital, debt, or equity, acquiring resources, buildings, equipment, technology, people, developing products and services, and selling to customers. For simple enough projects, putting together full blown financial statements is over kill. The rough magnitude of future cashflows, can be estimated and on back of the envelope type present value calculation, can often clearly reveal that the project is profitable or not. But for more complicated projects, the direct cash flow consequences and project are not readily apparent. They come from a combination of the activities we just mentioned. Here we need a plan for the timing of those activities. And also a prediction for the timing of their cash consequences. There's often a timing difference between when the activity occurs and when the cash payment is paid or received. For example, how big will sales be and when will the sales be collected? What combination of labor and materials will we need to deliver the product or the service at the forecasted time? What resources will we have to acquire and when? How will be coordinate all those activities? Putting together forecasted financial statements will help us do that. Constructing a forecasted balance sheet and an income statement that meshes, with the forecasted cash flow statements, it's going to force us to make sure we don't leave things out of the calculation. It's also going to force us to think more carefully about what needs to happen to implement your project idea. Articulating all the activities helps you spot problems and allows you to rethink your strategy for implementation so that you can improve it. This also helps later on after you've adopted the project in terms of evaluating the results as they come in, to be able to compare them to what you were expecting, and to spot deviations or take corrective actions to revise your strategy as new information becomes available. Having a more fully throughout plan is also going to enhance your credibility to get the project approved by other people or get the project funded. One more benefit, taxes. Taxes are likely to be on of the relevant cash flow associated with your project. Taxes are usually based on income not cash flow, so to calculate the taxes you need to calculate income. So, what are the three main financial statements? The balance sheet. That's the statement of financial position. A listing of the resources and the obligations on a specific date. The key equation for balance sheet is Assets = Liabilities + Owner's Equity. We'll come back and talk more about that. The income statement is the second one. This is the measure of the profitability of the operations over a period of time. The key equation here is Net Income = Revenues- Expenses. And then last but not least, the statement of cash flows. This is going to give us the sources and uses of cash during a period of time. A key feature of the cash flow statement is that it separates out cash flows into operating, investing and financing activities. Each of these statements conveys something different, but they're all linked together. Understanding how they're linked is going to help us a lot in terms of making sure we understand how our business strategy is actually going to play out in terms of its financial consequences. Now often when we think about financial statements, especially balance sheets, we think about a financial statement as being for the firm as a whole. But we can also do this for projects as well. For example, you can think about a project's balance sheet as how its adoption will impact or change the balance sheet for the company as a whole. So, balance sheets. What's a balance sheet? It's a list in dollars or monetary terms at a point in time of the assets. These are the resources that we've acquired that are going to help generate the future cash flows. Liabilities. These are obligations that we have to pay or back back money to people in the future. So again, a future cash flow, but this time, an outflow. And then the Owner's Equity. This is the capital that the owners have put into the firm or perhaps re-invested into the firm. You can think of a balance sheet as a snapshot, okay. It's at a particular point in time. Balance sheet equation, this is the key thing for the balance sheet. Virtually everything in accounting is driven by this seemingly simple relationship. Assets = Liabilities + Owners' Equity. Assets are the resources. Owner's equity and liabilities are the claims on the resources. Liability is claims by other people. Owner's equity, well, obviously by the owners. Another way to express the balance sheet equation is by just flipping it around. Owner's Equity = Assets- Liabilities. Sometimes you hear you the term net worth as a synonym for owner's equity, or net assets. The net of Assets- Liabilities. Everything that's not claimed by somebody else, is implicitly belonging to the owners. A simple example, suppose you have a house that's worth a $1 million, but you've got a mortgage on it for $400,000. The house is the asset that's a $1 million, the mortgage is a liability, $400,000. So your owner's equity in the house is the difference, $600,000. As the liability goes down, your ownership claim goes up. Or if the value of the house goes up, your ownership claim goes up. So again, assets equals liabilities plus owner's equity. Now, some common assets that show up on balance sheets. Cash, obviously is one, and in fact this is what the cash flow statement is going to be about, how the cash account on the balance sheet goes up or down. Accounts Receivable is another common asset. These are sales that you've made to other people but you haven't collected yet. It's an asset because those future collections will be cash flows. Inventory's another one. These are products that you have bought or produced, but haven't sold yet. The benefit is going to be when you sell them. Property plant and equipment, often it's going to benefit for many periods in terms of providing production capacity and all those kinds of things. Intangible assets. Some types of intangible assets show up on balance sheets. And also investments in financial assets. Financial securities, debt, equity, and those kinds of things that you own and somebody else. Balance sheets are perfect to complete though. Not all resources that are important are going to show up on balance sheet. Many companies will say something like our most important asset is our people, but people don't show up on balance sheets of companies. Many softer investments, like research and development or advertising or marketing, don't show up as assets either. Amounts that we spend on those things are expensed, not put on the balance sheet. Also, balance sheet assets are generally not measured at the present value of the future cash flows they're going to generate. Instead, they're usually measured at the cost that we paid to acquire them. This is sometimes referred to as the historical cost. So despite these limitations, keeping track of the balance sheet and how it will evolve over time is extremely helpful in forecasting out the amounts and the the timing of future cash flows. Liabilities. What are some examples of liabilities on balance sheets? Accounts payable. These are amounts you still owe to suppliers for things you've ordered but not paid yet. Other kinds of payables, perhaps for wages or interest or income taxes. If somebody pays you in advance for a product or a service, you have a liability to provide that service. Short term, long term debt are other examples of liabilities, also product warranties or employee pensions. Last but not least, owner's equity, or sometimes refered to as shareholder's equity. This is the residual claim on the assets after settling the claims of the creditors. Again, it's the net of assets and liabilities. There are two important types of owners equity accounts. One is called contributed capital. These are amounts that the company gets as a result of investments made by the owners, perhaps by issuing shares. The other important type of owner's equity account is called retained earnings these are the profits earned by the firm that been reinvested back into the firm as suppose to paid out as a dividend. This is where the link between balance sheets and income statements is going to exist. Income, feeds into the retained earnings account on a balance sheet. Forecasting out how the balance sheet is going to change over time, is going to be very important, in terms of helping us keep track of the amounts, and the timing of the resources we're going to be adding, new assets, and the resources we'll be using up. New obligations that we'll be adding, and old obligations we'll be paying off. And new investments made by owners and distributions made back to the owners. Now what makes a balance sheet change over time? These are the business activities and the economic events that take place during the period. Two important summaries of these activities are the income statement, revenues minus expenses, and the cash flow statement, cash inflows minus cash outflows. We can think about the relationship between the three financial statements, okay, via this graph. We've got a balance sheet at a particular time. The balance sheet has to be in balance. Assets = Liabilities + Owners' Equity. So let's expand the assets into cash and non-cash, and expand the owner's equity into contributed capital and retained earnings. We also have a balance sheet at the end of the period. How do these two balance sheets relate to each other? Well the income statement explains how the cash account on the assets side of the balance sheet change overtime. The income statement on the other hand, explains how the retained earning account in the owners equity section change overtime. So they're talking about two different parts of the balance sheet, but again balance sheets parts have to all balance. So to say that again, the Balance Sheet shows the resources and the claims on the resources at a point in time. The Income Statement and the Cash Flow statement provide information about how the balance sheet changes over a period of time. The Cash Flow Statement is about the cash account. The retained earnings change is what the income statement is about. Now let's go more into the income statement. Income or profits is a measure of the performance of a company during a period of time. Income is not the same as cash flow though. On the income statement, we recognize revenues and expenses as business activities occur, not necessarily when the associated cash flow occurs. Income measures the increase in economic value from a transaction or event, whereas cash flow measures the timing of the receipt of that value in the form of cash. The difference between these two is a timing difference. So as an example, how are they different? Income will match the cost of products that you sell to the price you sell them at, to calculate the profit on the sale. Whereas the cash flow statement will match the cost of the product, to the period in which you paid for it. And the receipt of cash from the customer, to the period in which it was received, even if those are in different periods. This is where the balance sheet is going to come in, to provide a linkbetween these two statements. So on a balance sheet inventory represents products that we have made or bought but have not sold yet. Receivables on the balance sheet are sales we have made but don't collect yet, have not collected yet in the form of cash. Revenue is an increase in shareholders' equity, again, not necessarily in the form of cash from providing goods and services. We recognize revenue in financial statements when it's earned so that the goods and services have actually been delivered or provided, and it's realized. You can figure out how much you're actually going to collect. Revenue could be recognized before we get the cash. A credit sale is an example of that. Or it could be recognized after we get the cash. So if a customer pays a deposit, or pays in advance, we'd have the cash actually before we've delivered the service. Which is when we recognize the revenue. Expenses are the other side, the decreases in shareholders equity that arise int he process of generating the revenues. We recognize expenses ideally as a match to the underlying revenues that they're related to. Product costs is an example where we do that, the cost of goods sold. But not all expenses are easily matched, and so for many expenses we just expense them in the period in which they're incurred. Selling costs, administrative costs, marketing costs, things like that are often just expensed as incurred. Often we can think of expenses as the using up of the assets, depreciation on long term asset cost the good sold with respect to inventory or good examples of that. The cash flow statement format tries to organized the expenses into groups. So the typical format with start with the sales, or the revenue, and then match to that the cost associated with the products that we sold, the costs to make or buy the products that we ultimately sold. This difference is called the gross profit. We then subtract other types of costs. Selling, administrative, marketing costs, and those kinds of things. And that's referred to as the operating income or operating profits of the company. Then interest expense, other types of gains or losses to get our pre-tax income, the tax expense. And then finally, the bottom line is net income. That's what feeds into the retained earnings account then on the balance sheet. We've got an idea for what balance sheet and income statements are. What a cash flow statement is. Our next objective is going to be to try to see how we record transactions and compile them into balance sheets, income statements and cash flow statements and then to show how we can construct the cash flow statement from the balance sheet and the income statement.
