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Chapter 3
Understanding
Financial
Statements
and Cash Flows
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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Figure 3-1
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Figure 3-1 (cont.)
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Table 3.1
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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 34.3%
• Operating profit margin (or percentage
of sales going towards operating profit) is
8.5%
• Net profit margin (or percentage of sales
going towards net profit) is 4.9%
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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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Figure 3-2
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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
• 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
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Table 3-2
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Table 3-2
• Total assets decreased by $752 million due
to reduction in current assets and in net
fixed assets.
• Total debt and equity decreased by $752
million due to paying of $263 owed on
accounts payable, repurchasing stock of
$2.608 billion, receipt of $335 million from
issue of new stock, and increase in retained
earnings of $1.769 billion.
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Table 3-2
(columns 4 & 5)
Common-sized balance sheet reveals:
– Inventories account for 25% of total assets and
most of current assets
– The total assets consist of about one-third
current assets and two-third fixed assets
– Approximately 50% of the company’s assets are
financed by debt and 50% by equity
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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
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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Sources and Uses of Cash
Sources of Cash
 Decrease in an Asset
 Example: Selling
inventories or collecting
receivables provides cash
 Increase in Liability or
Equity
 Example: Borrowing
funds or selling stocks
provides cash
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Uses of Cash
 Increase in an Asset
 Example: Investing in
fixed assets or buying
more inventories uses
cash
 Decrease in Liability or
Equity
 Example: Paying off a
loan or buying back stock
uses cash
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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
Cash Flow from Operations: Five Steps
1. Add back depreciation.
2. Subtract (add) any increase (decrease) in
accounts receivable.
3. Subtract (add) any increase (decrease) in
inventory.
4. Subtract (add) any increase (decrease) in other
current assets.
5. Add (subtract) any increase (decrease) in
accounts payable and other accrued expenses.
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Figure 3-5
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Home Depot (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.
• Home Depot’s spent $1.126 billion on fixed
assets (as observed by the change in gross
fixed assets) and $159 million on other
assets.
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Cash Flows from
Financing the Business
Cash Inflows
Cash Outflows
 Borrowings (as
 Repayment of debt (as
reflected by increase in
shown by decrease in
short-term and longshort-term and/or longterm debt)
term debt)
 Owner(s) invest in
business (as reflected
by an increase in
stockholders’ equity)
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 Payment of dividend
 Repurchase of stock
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Financing the Business
Illustrated: Home Depot
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Table 3-4
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Tips for Statement of 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 and allows more room for
discretion. U.S. may switch to IFRS by
2014.
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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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Computing Taxable Income
Table 3-5
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Table 3-6
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ACCOUNTING MALPRACTICE
AND LIMITATIONS
OF FINANCIAL STATEMENTS
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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
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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
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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.)
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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
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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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Figure 3-3
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Table 3-3
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