2. financial statement cash flow

Chapter 3
Understanding
Financial
Statements and
Cash Flows

Copyright © 2011 Pearson Prentice Hall.
All rights reserved.

Learning Objectives

 Compute a company’s profits as reflected by its
income statement.

 Determine a firm’s financial position at a point in
time based on its balance sheet

 Measure a company’s cash flows.

 Compute taxable income and income taxes owed.

© 2011 Pearson Prentice Hall. All rights
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Slide Contents

Principles used in this Chapter
1. The Income Statement
2. The Balance Sheet
3. Measuring Cash Flows
4. Income Taxes and Finance

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Principles Applied
in this Chapter

 Principle 1:
Cash flow is what matters

 Principle 5:
Conflicts of interest cause agency problems

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1. The Income Statement

 It is also known as Profit/Loss Statement
 It measures the results of firm’s operation over a
specific period.
 The bottom line of the income statement shows the
firm’s profit or loss for a period.
 Sales – Expenses = Profits

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Income Statement Terms

 Revenue (Sales)
 Money derived from selling the company’s product or service
 Cost of Goods Sold (COGS)
 The cost of producing or acquiring the goods or services to be sold
 Operating Expenses
 Expenses related to marketing and distributing the product or
service and administering the business
 Financing Costs
 The interest paid to creditors
 Tax Expenses
 Amount of taxes owed, based upon taxable income

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Figure 3-1

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Figure 3-1 (cont.)

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Table 3-1

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Common-size
Income Statement

 Common-size income statement restates the
income statement items as a percentage of
sales.

 Common-size income statement makes it
easier to compare trends over time and
across firms in the industry.

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Table 3-2

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Profit-to-Sales analysis from
Common-size income statement

See Table 3-2
 Gross profit margin (or percentage of
sales going towards gross profit) is 23.3%
 Operating profit margin (or percentage
of sales going towards operating profit) is
12.5%
 Net profit margin (or percentage of sales
going towards net profit) is 7%
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2. The Balance Sheet

 The balance sheet provides a snapshot of a firm’s
financial position at a particular date.
 It includes three main items: assets, liabilities and
equity.
 Assets (A) are resources owned by the firm
 Liabilities (L) and owner’s equity (E) indicate how those
resources are financed
 A=L+E

 The transactions in balance sheet are recorded
historically at cost price, so the book value of a firm
may be very different from its current market value.

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Figure 3-3

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Balance Sheet Terms: Assets

 Current assets comprise assets that are relatively
liquid, or expected to be converted into cash within
12 months. Current assets typically include:
 Cash
 Accounts Receivable (payments due from customers who
buy on credit)
 Inventory (raw materials, work in process, and finished
goods held for eventual sale)
 Other assets (ex.: Prepaid expenses are items paid for in
advance)

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Balance Sheet Terms: Assets

 Fixed Assets – Include assets that will be used for
more than one year. Fixed assets typically include:
 Machinery and equipment
 Buildings
 Land

 Other Assets – Assets that are neither current
assets nor fixed assets. They may include long-term
investments and intangible assets such as patents,
copyrights, and goodwill.
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Balance Sheet Terms:
Liabilities

 Debt (Liabilities)
 Money that has been borrowed from a creditor
and must be repaid at some predetermined date.
 Debt could be current (must be repaid within
twelve months) or long-term (repayment time
exceeds one year).

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Liabilities
 Current Debt:
 Accounts payable (Credit extended by suppliers to a firm
when it purchases inventories)
 Accrued expenses (Short term liabilities incurred in the firm’s
operations but not yet paid for)
 Short-term notes (Borrowings from a bank or lending
institution due and payable within 12 months)

 Long-Term Debt
 Borrowings from banks and other sources for more than 1
year

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Equity

 Equity: Shareholder’s investment in the firm in the form of
preferred stock and common stock. Preferred stockholders
enjoy preference with regard to payment of dividend and
seniority at settlement of bankruptcy claims.
 Treasury Stock: Stock that have been re-purchased by the
company.
 Retained Earnings: Cumulative total of all the net income over
the life of the firm, less common stock dividends that have been
paid out over the years. Note retained earnings are not equal to
hard cash!

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Balance Sheet: A = L + E

 ASSETS (A)  LIABILITIES (L)
 Current Assets  Current Liabilities
 Fixed Assets  Long-Term Liabilities

 Total Assets  Total Liabilities

 OWNER’S EQUITY (E)
 Preferred Stock
 Common Stock
 Retained earnings
 Total Owner’s Equity
 Total liabilities + Equity
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Table 3-3

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Net Working Capital

 Net Working Capital
 = Current assets – current liabilities

 Larger the net working capital, better the firm’s ability to
repay its debt

 Net working capital can be positive or zero or negative. It is
generally positive.

 An increase in net working capital may not always be good
news. For example, if the level of inventory goes up, current
assets will increase and thus net working capital will also
increase. However, increasing inventory level may well be a
sign of inability to sell.
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Debt Ratio

 Debt ratio is the percentage of assets that
are financed by debt.

 Debt ratio is an indication of “financial risk.”
Generally, higher the ratio, the more risky
the firm is, as firms have to pay interest on
debt regardless of the earnings or cash
flow situation.

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3. Measuring Cash Flows

 Profits in the financial statements are
calculated on “accrual basis” rather
than “cash basis” (see next slide for
accrual basis accounting).

 Thus profits are not equal to cash.

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Accrual Basis Accounting

 Accrual basis is the principle of recording revenues
when earned and expenses when incurred, rather
than when cash is received or paid.
 Thus sales revenue recorded in the income statement
includes both cash and credit sales.

 Treatment of long-term assets: Asset acquisitions
(that will last more than one year, such as equipment)
are not recorded as an expense but are written off
every year as depreciation expense.

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Figure 3-6
How to measure a firm’s cash flows

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Three sources of cash flows

 Cash flows from Operations
(ex. Sales revenue, labor expenses)

 Cash flows from Investments
(ex. Purchase of new equipment)

 Cash flows from Financing
(ex. Borrowing funds, payment of dividends)

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Three sources of
cash flows (cont.)

 If we know the cash flows from
operations, investments and financing,
we can understand the firm’s cash flow
position better, that is, how cash was
generated and how it was used.

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Income Statement Conversion:
From Accrual to Cash Basis

 Two steps:
 Add back depreciation (as it is a non-cash
expense) to net income
 Subtract any uncollected sales (i.e.
increase in accounts receivable) and cash
payment for inventories (i.e. increase in
inventories less increase in accounts
payables)
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Figure 3-7

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Table 3-5

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4. Income Taxes and Finance

Computing Taxable Income for Corporation
 Gross Income
 Dollar sales from a product or service less cost of production
or acquisition
 Taxable Income
 Gross income less tax deductible expenses, plus interest
income received and dividend income received
 Tax Deductible Expenses
 Include Operating expenses (marketing, depreciation,
administrative expenses) and interest expense
 Dividends paid are not deductible

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Table 3-6
Computing Taxable Income ($000’s)

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Table 3-7

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Figure 3-2

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Figure 3-2 (cont.)

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Figure 3-4

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Table 3-4

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Key terms

Accounts Payable  Debt
Accounts Receivable  Debt ratio
Accrual basis accounting  Depreciation expenses
Accrued expenses  EBIT
Accumulated depreciation  Earnings before taxes
Additional paid-in-capital  Earnings per share
Balance sheet  Equity
Cash  Financing cash flows
Common size financial  Financing cost
statements  Fixed assets
 Common stock  Free cash flows
 Cost of goods sold  Gross fixed assets
 Current assets
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Key terms (cont.)

 Gross Profit  Operating income
 Gross profit margin  Operating profit margin
 Income statement  Operating working capital
 Inventories  Par value
 Long-term debt  Preferred stockholders
 Mortgage  Profit margins
 Net fixed assets  Retained earnings
 Net income  Short-term liabilities
 Net profit margin  Short-term notes (debt)
 Net working capital  Taxable income
 Operating expenses  Trade credit
 Treasury stock

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2. financial statement cash flow

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