Foundations of Financial Management

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Foundations of Finance

Tenth Edition

Chapter 3

Understanding Financial Statements and Cash Flows

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Learning Objectives

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

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

3.3 Measure a company’s cash flows.

3.4 Describe the limitations of financial statements.

3.5 Calculate a firm’s free cash flows and financing cash flows.

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.

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

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

Five Guy’s Burger and Fries (Dec 2019)

$45,000 – 39,000 =

Figure 3.1 The Income Statement: An Overview

Income Statement Terms (1 of 2)

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, general administrative expenses and depreciation expense

Income Statement Terms (2 of 2)

Financing Costs

The interest paid to creditors

Tax Expenses

Amount of taxes owed, based upon taxable income

Figure 3.1 The Income Statement: An Overview

Common-Sized Income Statement

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

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

See Table 3.1.

Table 3.1 Walmart: Income Statement for the year ending January 31, 2018 (expressed in millions, except per share data, and as a percentage of sales) (1 of 4)

Blank	Dollars	Percentage of Sales	Blank
Sales	$500,343	100%	Blank
Cost of goods sold	(373,396)	–74.6	Blank
Gross profits	126,947	25.4	Gross profit margin

Table 3.1 Walmart: Income Statement for the year ending January 31, 2018 (expressed in millions, except per share data, and as a percentage of sales) (1 of 4)

Blank	Dollars	Percentage of Sales	Blank
Sales	$500,343	100%	Blank
Cost of goods sold	(373,396)	–74.6	Blank
Gross profits	126,947	25.4	Gross profit margin

Table 3.1 Walmart: Income Statement for the year ending January 31, 2018 (expressed in millions, except per share data, and as a percentage of sales) (2 of 4)

Blank	Dollars	Percentage of Sales	Blank
Operating expenses	Blank	Blank	Blank
Selling, and administrative expenses	(95,981)	–19.2	Blank
Depreciation expense	(10,529)	–2.1	Blank
Total operating expenses	(106,510)	–21.3	Blank
Operating income (earnings before interest and taxes)	20,437	4.1	Operating profit margin

Table 3.1 Walmart: Income Statement for the year ending January 31, 2018 (expressed in millions, except per share data, and as a percentage of sales) (2 of 4)

Blank	Dollars	Percentage of Sales	Blank
Operating expenses	Blank	Blank	Blank
Selling, and administrative expenses	(95,981)	–19.2	Blank
Depreciation expense	(10,529)	–2.1	Blank
Total operating expenses	(106,510)	–21.3	Blank
Operating income (earnings before interest and taxes)	20,437	4.1	Operating profit margin

Table 3.1 Walmart: Income Statement for the year ending January 31, 2018 (expressed in millions, except per share data, and as a percentage of sales) (3 of 4)

Blank	Dollars	Percentage of Sales	Blank
Interest expense	(2,178)	–0.4	Blank
Non-operating losses	(3,136)	–0.6	Blank
Earnings before taxes (taxable income)	(15,123)	3.0	Blank
Income taxes	(5,261)	–1.1	Blank
Net income (earnings available to common shareholders)	$9,862	2.0%	Net profit margin

Table 3.1 Walmart: Income Statement for the year ending January 31, 2018 (expressed in millions, except per share data, and as a percentage of sales) (3 of 4)

Blank	Dollars	Percentage of Sales	Blank
Interest expense	(2,178)	–0.4	Blank
Non-operating losses	(3,136)	–0.6	Blank
Earnings before taxes (taxable income)	(15,123)	3.0	Blank
Income taxes	(5,261)	–1.1	Blank
Net income (earnings available to common shareholders)	$9,862	2.0%	Net profit margin

Table 3.1 Walmart: Income Statement for the year ending January 31, 2018 (expressed in millions, except per share data, and as a percentage of sales) (3 of 4)

Blank	Dollars	Percentage of Sales	Blank
Interest expense	(2,178)	–0.4	Blank
Non-operating losses	(3,136)	–0.6	Blank
Earnings before taxes (taxable income)	(15,123)	3.0	Blank
Income taxes	(5,261)	–1.1	Blank
Net income (earnings available to common shareholders)	$9,862	2.0%	Net profit margin

Table 3.1 Walmart: Income Statement for the year ending January 31, 2018 (expressed in millions, except per share data, and as a percentage of sales) (4 of 4)

Additional information:	Blank
Number of shares outstanding (millions)	3,007
Earnings per share (net income/number of shares)	$3.28
Dividends paid to shareholders	$6,124
Dividends per share	$2.04

Profit-to-Sales Analysis from Common-Sized Income Statement

See Table 3.1

Gross profit margin (or percentage of sales going toward gross profit) is 25.4%.

Operating profit margin (or percentage of sales going toward operating profit) is 4.1%.

Net profit margin (or percentage of sales going toward net profit) is 2.0%.

Figure 3.1 The Income Statement: An Overview

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 owner-supplied capital (shareholders’ 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 at cost price, so the book value of a firm may be very different from its current market value.

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Figure 3.2 The Balance Sheet: An Overview

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Balance Sheet Terms: Assets (1 of 2)

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 (e.g., prepaid expenses are items paid for in advance)

Balance Sheet Terms: Assets (2 of 2)

Long-Term Asset

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.

Balance Sheet Terms: Liabilities (1 of 2)

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 12 months) or long-term (repayment time exceeds one year).

Balance Sheet Terms: Liabilities (2 of 2)

Short-Term Debt (Current Liabilities)

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 one year

Balance Sheet Terms: 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 repurchased 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 that retained earnings are not equal to hard cash!

Figure 3.2 The Balance Sheet: An Overview

Balance Sheet: A = L + E

Assets (A)

Current Assets

Fixed Assets

Total Assets

Liabilities (L)

Current Liabilities

Long-Term Liabilities

Total Liabilities

Owner’s Equity (E)

Preferred Stock

Common Stock

Retained Earnings

Total Owner’s Equity

Total Liabilities + Equity

Table 3.2 Walmart Balance Sheet for Years Ending January 31, 2017 and January 31, 2018 (expressed in millions) (1 of 4)

Assets	Dollars January 31, 2017	Percentage of Assets January 31, 2017	Dollars January 31, 2018	Percentage of Assets January 31, 2018
Cash and cash equivalents	$6,867	3.5%	$6,756	3.3%
Accounts receivable	5,835	2.9%	5,614	2.7%
Inventories	43,046	21.7%	43,783	21.4%
Prepaid expenses and other current assets	1,941	1.0%	3,511	1.7%
Total current assets	$57,689	29.0%	$59,664	29.2%
Gross plant and equipment	$191,129	96.1%	$202,298	98.9%
Less accumulated depreciation	(76,951)	–38.7%	(87,480)	–42.8%
Net plant and equipment	$114,178	57.4%	$114,818	56.1%

Table 3.2 Walmart Balance Sheet for Years Ending January 31, 2017 and January 31, 2018 (expressed in millions) (2 of 4)

Blank	Dollars January 31, 2017	Percentage of Assets January 31, 2017	Dollars January 31, 2018	Percentage of Assets January 31, 2018
Goodwill and other intangible assets	26,958	13.6%	30,040	14.7%
Total assets	$198,825	100.0%	$204,522	100.0%
Liabilities and Equity	Blank	Blank	Blank	Blank
Current liabilities	Blank	Blank	Blank	Blank
Accounts payable	$41,433	20.8%	$46,510	22.7%
Accrued liabilities	21,575	10.9%	24,031	11.7%
Short-term notes	9,320	4.7%	9,662	4.7%
Total current liabilities	$72,328	36.4%	$80,203	39.2%

Table 3.2 Walmart Balance Sheet for Years Ending January 31, 2017 and January 31, 2018 (expressed in millions) (3 of 4)

Blank	Dollars January 31, 2017	Percentage of Assets January 31, 2017	Dollars January 31, 2018	Percentage of Assets January 31, 2018
Long-term debt	51,362	25.8%	45,179	22.1%
Total debt	$123,690	62.2%	$125,382	61.3%
Stockholders’ equity:	Blank	Blank	Blank	Blank
Common stock (par value)	$305	0.2%	$295	0.1%
Paid-in capital	2,371	1.2%	2,648	1.3%
Retained earnings	72,459	36.4%	76,197	37.3%
Total equity	$75,135	37.8%	$79,140	38.7%
Total liabilities and equity	$198,825	100.0%	$204,522	100.0%

Total Assets

Total Liability

Total Equity

Total Assets = Total Liabilities + Total Equity

Table 3.2 Walmart Balance Sheet for Years Ending January 31, 2017 and January 31, 2018 (expressed in millions)

Total Assets

Total Liability

Total Equity

Total Assets = Total Liabilities + Total Equity

Table 3.2 Walmart Balance Sheet for Years Ending January 31, 2017 and January 31, 2018 (expressed in $ millions) (4 of 4)

Total assets exceeded $200 billion, consisting of about one-third current assets and two-thirds of long-term assets

Holding over $6 billion in cash, or about 3% of all the company’s assets.

Held 21 percent of its assets as inventory and 3% as accounts receivable.

Property, plant and equipment accounted for about 56% of its assets.

Intangible assets made up 15% of the assets.

Debt Ratio

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

Debt ratio is an indication of “financial risk.” Generally, the 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.

Net Working Capital

Net Working Capital = Current assets − current liabilities

The larger the net working capital, the 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.

Measuring Cash Flows

Why isn’t Profit = Cash?

Measuring Cash Flows

Profits in the financial statements are calculated on “accrual basis” rather than “cash basis.”

Thus, profits are not equal to cash.

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. Similarly, inventory purchases may not be entirely paid for in cash because suppliers may extend credit for some of the purchases.

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.

The Beginning Point: Changes in the Balance Sheet and Cash Flows

Sources of Cash	Use of Cash
Decrease in an Asset	Increase in an Asset
Example: Selling inventories or collecting receivables provides cash.	Example: Investing in fixed assets or buying more inventories uses cash.
Increase in a Liability or Equity	Decrease in a Liability or Equity
Example: Borrowing funds or selling stock provides the firm with cash.	Example: Paying off a loan or buying back stock uses cash.

Table 3.3 Walmart’s Changes in Balance Sheets Between 2017 and 2018 Create Sources and Uses of Cash ($ millions) (1 of 2)

Changes in Assets	January 31, 2017	January 31, 2018	Changes	Sources	Uses
Accounts receivable	$5,835	$5,614	($221)	($221)	Blank
Inventories	$43,046	$43,783	$737	Blank	$737
Prepaid expenses and other current assets	$1,941	$3,511	$1,570	Blank	$1,570
Gross plant and equipment	$191,129	$202,298	$11,169	Blank	$11,169
Goodwill and other intangible assets	$26,958	$30,040	$3,082	Blank	$3,082

Table 3.3 Walmart’s Changes in Balance Sheets Between 2017 and 2018 Create Sources and Uses of Cash ($ millions) (2 of 2)

Changes in debt and equity	January 31, 2018	January 31, 2017	Changes	Sources	Uses
Accounts payable	$41,433	$46,510	$5,077	$5,077	Blank
Accrued liabilities	$21,575	$24,031	$2,456	$2,456	Blank
Short-term notes	$9,320	$9,662	$342	$342	Blank
Long-term debt	$51,362	$45,179	($6,183)	Blank	($6,138)
Par value	$305	$295	($10)	Blank	($10)
Paid-in capital	$2,371	$2,648	$277	$277	Blank

Figure 3.3 Statement of Cash Flows: An Overview

Three Sources of Cash Flows (1 of 2)

Cash flows from Operations (e.g., sales revenue, labor expenses)

Cash flows from Investments (e.g., purchase of new equipment)

Cash flows from Financing (e.g., borrowing funds, payment of dividends)

Three Sources of Cash Flows (2 of 2)

Why do we care?

Three Sources of Cash Flows (2 of 2)

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.

Income Statement Conversion: From Accrual to Cash Basis

Cash Flow from Operations: Five Steps

Add back depreciation.

Subtract (add) any increase (decrease) in accounts receivable.

Subtract (add) any increase (decrease) in inventory.

Subtract (add) any increase (decrease) in other current assets.

Add (subtract) any increase (decrease) in accounts payable

Add (subtract) any increase (decrease) in other accrued expenses.

Figure 3.4 Cash Flow from Operations

Walmart’s Cash Flow from Operations

Net income	Blank	$9,862
Depreciation expense (Source of cash)	$10,529	Blank
Decrease in accounts receivable (Source of cash)	221	Blank
Increase in inventories (Use of cash)	(737)	Blank
Increase in other current assets (Use of cash)	(1,570)	Blank
Increase in accounts payable (Source of cash)	5,077	Blank
Increase in accrued liabilities (Source of cash)	2,456	Blank
Total adjustments to net income	Blank	$15,976
Cash flows from operating activities	Blank	$25,838

Cash Flow from Investing in Long-Term Assets

Long-term assets include fixed assets and other long-term assets. A firm may be engaged in acquisition and sale of such assets leading to cash flows.

Walmart example:

Changes in Long-Term Assets	January 31, 2017	January 31, 2018	Changes	Inflow	Outflow
Gross plant and equipment	$191,129	$202,298	$11,169	Blank	($11,169)
Goodwill and other intangible assets	$26,958	$30,040	$3,082	Blank	$3,082

Cash Flows from Financing the Business

Cash Inflow	Cash Outflow
The firm borrows more money (an increase in short-term or long-term debt).	The firm repays debt (a decrease in short-term or long-term debt).
Owner(s) invest in the business (an increase in stockholders’ equity).	The firm pays dividends to the owner(s) or repurchases the owners’ stocks (a decrease in equity).

Financing the Business Illustrated: Walmart

Dividends paid to shareholders	($6,124)
Increase in short-term notes payable	342
Decrease in long-term debt	($6,183)
Issued new common stock (increase in par value and paid-in capital)	$267
Net cash outflows from financing activities	($11,698)

Table 3.4 The Walmart Company Statement of Cash Flows ($ millions) Year Ended January 31, 2018

Suggestions for Computing Cash Flows

Consider one section at a time.

You need only two items from the income statement: net income and depreciation expense.

Consider change for all items in the balance sheet, except ignore accumulated depreciation and net fixed assets; ignore change in retained earnings.

The Limitations of Financial Statements and Accounting Malpractice

Accounting Malpractice and Limitations of Financial Statements

Financial statements are prepared following the Financial Accounting Standards Board’s generally accepted accounting principles (GAAP).

Because accounting rules give managers discretionary powers, it is possible that two firms with similar financial performance may report different results.

There have been several cases of accounting malpractice where rules have been broken.

Key Terms (1 of 7)

Accounts payable (trade credit)

Accounts receivable

Accrual basis accounting

Accrued expenses

Accumulated depreciation

Balance sheet

Book value

Cash

Key Terms (2 of 7)

Cash basis accounting

Common-size balance sheet

Common-size income statement

Common stock

Common stockholders

Cost of goods sold

Current assets (gross working capital)

Debt

Key Terms (3 of 7)

Debt ratio

Depreciation expense

Dividends per share

Earnings before taxes (taxable income)

Earnings per share

Equity

Financing cash flows

Fixed assets

Key Terms (4 of 7)

Fixed costs

Free cash flows

Gross fixed assets

Gross profit

Gross profit margin

Income statement (profit and loss statement)

Inventories

Liquidity

Key Terms (5 of 7)

Long-term debt

Mortgage

Net fixed assets

Net income (net profit, or earnings available to common stockholders)

Net profit margin

Net working capital

Operating expenses

Key Terms (6 of 7)

Operating income (earnings before interest and taxes)

Operating profit margin

Other current assets

Paid-in capital

Par value

Preferred stockholders

Profit margins

Retained earnings

Key Terms (7 of 7)

Semi-variable costs

Short-term debt (current liabilities)

Short-term notes (debt)

Statement of cash flows

Treasury stock

Variable costs

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