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Chapter 3

Understanding Financial

Statements and Cash Flows

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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.

Explain the difference between GAAP and IRFS.

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Learning Objectives

Compute taxable income and income taxes owed.

Describe the limitations of financial statements.

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

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THE INCOME STATEMENT

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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, general administrative expenses and depreciation expense

Financing Costs

The interest paid to creditors

Tax Expenses

Amount of taxes owed, based upon taxable income

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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

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

See Table 3.1

Gross profit margin (or percentage of sales going towards gross profit) is 61.1%

Operating profit margin (or percentage of sales going towards operating profit) is 21.1%

Net profit margin (or percentage of sales going towards net profit) is 15.4%

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THE BALANCE SHEET

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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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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

Long-Term Assets: Fixed Assets and Other 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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Balance Sheet Terms: Liabilities

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

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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!

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Balance Sheet: A = L + E

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

ASSETS (A)

Current Assets

Fixed Assets

Total Assets

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Table 3-2

Total assets exceeded $90 billion (1/3 current assets, 2/3 long-term assets)

1/4 of assets were held in cash

Small accounts receivable and inventory

1/3 of assets are intangible

Nearly 2/3 of financing came from debt (debt ratio = 67%)

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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, 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.

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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.

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MEASURING CASH FLOWS

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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. Similarly, inventory purchases may not be entirely paid for in cash as 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.

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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

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.

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Coca-Cola(cash flow from operations)

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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.

Coca-Cola example:

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Cash Flows from Financing the Business

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Financing the Business Illustrated: Coca-Cola

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Suggestions for Computing Cash Flows

Consider one section at a time.

You need only 2 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.

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GAAP AND IFRS

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GAAP and IFRS

U.S. follows GAAP (Generally Accepted Accounting Principles) – a set of standards, conventions and rules established by FASB.

Most other countries follow IFRS (International Financial Reporting Standards) – a set of broad and general principles established by IASB.

IFRS is simpler but allows more leeway for accounting malpractice.

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INCOME TAXES AND FINANCE

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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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THE LIMITATIONS OF FINANCIAL STATEMENTS AND ACCOUNTING MALPRACTICE

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Accounting Malpractice and Limitations of Financial Statements

Since 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!

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Key Terms

Accounts payable

Accounts receivable

Accrual basis accounting

Accounting book value

Accrued expenses

Accumulated depreciation

Additional paid-in-capital

Average tax rate

Balance sheet

Capital gains

Cash

Cash basis accounting

Common size financial statements

Common stock

Common stock holders

Cost of goods sold

Current assets

Current debt

Debt

Debt ratio

Depreciation expense

Dividends per share

Earnings before taxes

Earnings per share

Equity

Financing cash flows

Fixed costs

Fixed assets

Free cash flows

GAAP

Gross fixed assets

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Key Terms (cont.)

Gross profit

Gross profit margin

IFRS

Income statement

Inventories

Liquidity

Long-term debt

Marginal tax rate

Mortgage

Net fixed assets

Net income

Net profit margin

Net working capital

Operating expenses

Operating income

Paid-in capital

Par value

Preferred stockholders

Profit margins

Retained earnings

Semi-variable costs

Short-term notes (debt)

Statement of cash flows

Taxable income

Trade credit

Treasury stock

Variable costs

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