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CHAPTER

Accounting Statements
and Cash Flow

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Chapter Outline
2.1 The Balance Sheet
2.2 The Income Statement
2.3 Net Working Capital
2.4 Financial Cash Flow
2.5 The Statement of Cash Flows
2.6 Summary and Conclusions
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Sources of Information
Annual reports
Wall Street Journal
Internet
NYSE (www.nyse.com)
Nasdaq (www.nasdaq.com)
Text (www.mhhe.com)
SEC
EDGAR
10K & 10Q reports
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2.1 The Balance Sheet

An accountant’s snapshot of the firm’s

accounting value as of a particular date.
The Balance Sheet Identity is:
Assets ≡ Liabilities + Stockholder’s Equity
When analyzing a balance sheet, the
financial manager should be aware of three
concerns: accounting liquidity, debt versus
equity, and value versus cost.
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The Balance Sheet of the U.S. Composite Corporation

U.S. COMPOSITE CORPORATION
Balance Sheet
20X2 and 20X1
(in $ millions)
Liabilities (Debt)
Assets 20X2 20X1 The assets are listed in order
and Stockholder's Equity
20X2 20X1
Current assets: Current Liabilities:
Cash and equivalents $140 $107 by the length of time it $213 $197
Accounts payable
Accounts receivable
Inventories
294
269
270
280
normally would take a firm
Notes payable
Accrued expenses
50
223
53
205
Other
Total current assets
58
$761
50
$707
with ongoing operations$486 to $455
Total current liabilities
Long-term liabilities:
convert them into cash. $117 $104
Deferred taxes
Fixed assets: Long-term debt 471 458
Property, plant, and equipment $1,423 $1,274 Total long-term liabilities $588 $562
Less accumulated depreciation -550 -460
Net property, plant, and equipment 873 814 Stockholder's equity:
Intangible assets and other 245 221 Preferred stock $39 $39
Total fixed assets $1,118 $1,035 Clearly, cash is much more
Common stock ($1 per value) 55 32
Capital surplus 347 327
liquid than property, plant and
Accumulated retained earnings 390 347
equipment.
Less treasury stock
Total equity
-26
$805
-20
$725
Total assets $1,879 $1,742 Total liabilities and stockholder's equity $1,879 $1,742

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Balance Sheet Analysis

When analyzing a balance sheet, the financial
manager should be aware of three concerns:
1. Accounting liquidity
2. Debt versus equity
3. Value versus cost

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Accounting Liquidity
Refers to the ease and quickness with which
assets can be converted to cash.
Current assets are the most liquid.
Some fixed assets are intangible.
The more liquid a firm’s assets, the less likely
the firm is to experience problems meeting
short-term obligations.
Liquid assets frequently have lower rates of
return than fixed assets.
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Debt versus Equity

Generally, when a firm borrows it gives the
bondholders first claim on the firm’s cash flow.
Thus shareholder’s equity is the residual
difference between assets and liabilities.

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2.2 The Income Statement

The income statement measures performance
over a specific period of time.
The accounting definition of income is

Revenue – Expenses ≡ Income

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U.S.C.C. Income Statement

U.S. COMPOSITE CORPORATION
Income Statement
20X2
(in $ millions)

Total operating revenues $2,262

The operations Cost of goods sold - 1,655
section of the Selling, general, and administrative expenses - 327
Depreciation - 90
income
Operating income $190
statement reports Other income 29
the firm’s Earnings before interest and taxes $219
Interest expense - 49
revenues and Pretax income $170
expenses from Taxes - 84
principal Current: $71
Deferred: $13
operations Net income $86
Retained earnings: $43
Dividends: $43
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U.S.C.C. Income Statement

U.S. COMPOSITE CORPORATION
Income Statement
20X2
(in $ millions)

Total operating revenues $2,262

The non- Cost of goods sold - 1,655
operating Selling, general, and administrative expenses - 327
Depreciation - 90
section of
Operating income $190
the income Other income 29
statement Earnings before interest and taxes $219
Interest expense - 49
includes all Pretax income $170
financing Taxes - 84
costs, such Current: $71
Deferred: $13
as interest Net income $86
expense. Retained earnings: $43
Dividends: $43
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U.S.C.C. Income Statement

U.S. COMPOSITE CORPORATION
Income Statement
20X2
(in $ millions)

Total operating revenues $2,262

Usually a Cost of goods sold - 1,655
separate Selling, general, and administrative expenses - 327
Depreciation - 90
section Operating income $190
reports as a Other income 29
Earnings before interest and taxes $219
separate Interest expense - 49
item the Pretax income $170
amount of Taxes - 84
Current: $71
taxes Deferred: $13
levied on Net income $86
income. Retained earnings: $43
Dividends: $43

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U.S.C.C. Income Statement

U.S. COMPOSITE CORPORATION
Income Statement
20x2
(in $ millions)

Total operating revenues $2,262

Cost of goods sold - 1,655
Selling, general, and administrative expenses - 327
Depreciation - 90
Operating income $190
Other income 29
Earnings before interest and taxes $219
Interest expense - 49
Net income is the Pretax income $170
“bottom line”. Taxes - 84
Current: $71
Deferred: $13
Net income $86
Retained earnings: $43
Dividends: $43

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2.3 Net Working Capital

Net Working Capital ≡ Current Assets – Current Liabilities

NWC is usually growing with the firm.

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The Balance Sheet of the U.S.C.C.

U.S. COMPOSITE CORPORATION
Balance Sheet
$252m = $707- $455 20X2 and 20X1
(in $ millions)
Liabilities (Debt)
Assets 20X2 20X1 and Stockholder's Equity 20X2 20X1
Current assets: Current Liabilities:
Cash and equivalents $140 $107 Accounts payable $213 $197
Accounts receivable 294 270 Notes payable 50 53
Inventories 269 280 Accrued expenses 223 205
Other 58 50 Total current liabilities $486 $455
Total current assets $761 $707
Long-term liabilities:
Fixed assets: Here we see NWC grow
Deferred taxes $117 to $104
Property, plant, and equipment
Less accumulated depreciation
$1,423 $1,274
-550 -460 $275 million in 20X2 from
Long-term debt
Total long-term liabilities
471
$588
458
$562
Net property, plant, and equipment
Intangible assets and other
873
245
814
221
$252 million in 20X1.
Stockholder's equity:
Total fixed assets $1,118 $1,035
$23 million
Preferred stock
Common stock ($1 par value)
$39
55
$39
32
Capital surplus 347 327
$275m = $761m- $486m This increase of $23 million is
Accumulated retained earnings 390 347
Less treasury stock -26 -20
an investment of the firm.
Total equity $805 $725
Total assets $1,879 $1,742 Total liabilities and stockholder's equity $1,879 $1,742
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2.4 Financial Cash Flow

In finance, the most important item that can be
extracted from financial statements is the actual
cash flow of the firm.
Since there is no magic in finance, it must be the
case that the cash from received from the firm’s
assets must equal the cash flows to the firm’s
creditors and stockholders.
CF(A)≡ CF(B) + CF(S)
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Financial Cash Flow of the U.S.C.C.

U.S. COMPOSITE CORPORATION
Financial Cash Flow
20X2
(in $ millions)

Cash Flow of the Firm

Operating cash flow $238 Operating Cash Flow:
(Earnings before interest and taxes
plus depreciation minus taxes) EBIT $219
Capital spending (173)
(Acquisitions of fixed assets Depreciation $90
minus sales of fixed assets)
Additions to net working capital (23) Current Taxes ($71)
Total $42
OCF $238
Cash Flow of Investors in the Firm
Debt $36
(Interest plus retirement of debt
minus long-term debt financing)
Equity 6
(Dividends plus repurchase of
equity minus new equity financing)
Total $42

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Financial Cash Flow of the U.S.C.C.

U.S. COMPOSITE CORPORATION
Financial Cash Flow
20X2
(in $ millions)
Cash Flow of the Firm
Operating cash flow $238
(Earnings before interest and taxes
plus depreciation minus taxes)
Capital Spending
Capital spending (173) Purchase of fixed assets
(Acquisitions of fixed assets
minus sales of fixed assets)
$198
Additions to net working capital (23) Sales of fixed assets (25)
Total $42
Cash Flow of Investors in the Firm
Capital Spending $173
Debt $36
(Interest plus retirement of debt
minus long-term debt financing)
Equity 6
(Dividends plus repurchase of
equity minus new equity financing)
Total $42

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Financial Cash Flow of the U.S.C.C.

U.S. COMPOSITE CORPORATION
Financial Cash Flow
20X2
(in $ millions)

Cash Flow of the Firm

Operating cash flow $238 NWC grew
(Earnings before interest and taxes
plus depreciation minus taxes) from $275
Capital spending (173) million in
(Acquisitions of fixed assets
minus sales of fixed assets) 20X2 from
Additions to net working capital (23) $252 million
Total $42
Cash Flow of Investors in the Firm
in 20X1.
Debt $36
(Interest plus retirement of debt This increase
minus long-term debt financing)
Equity 6
of $23 million
(Dividends plus repurchase of is the addition
equity minus new equity financing)
Total $42
to NWC.
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Financial Cash Flow of the U.S.C.C.

U.S. COMPOSITE CORPORATION
Financial Cash Flow
20X2
(in $ millions)
Cash Flow of the Firm
Operating cash flow $238
(Earnings before interest and taxes
plus depreciation minus taxes)
Capital spending (173)
(Acquisitions of fixed assets
minus sales of fixed assets)
Additions to net working capital (23)
Total $42
Cash Flow of Investors in the Firm
Debt $36
(Interest plus retirement of debt
minus long-term debt financing)
Equity 6
(Dividends plus repurchase of
equity minus new equity financing)
Total $42

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Financial Cash Flow of the U.S.C.C.

U.S. COMPOSITE CORPORATION
Financial Cash Flow
20X2
(in $ millions)
Cash Flow of the Firm
Operating cash flow $238 Cash Flow to
(Earnings before interest and taxes Creditors
plus depreciation minus taxes)
Interest $49
Capital spending (173)
(Acquisitions of fixed assets Retirement
minus sales of fixed assets) of debt 73
Additions to net working capital (23)
Total $42 Debt service 122

Cash Flow of Investors in the Firm Proceeds from new

Debt $36 debt sales (86)
(Interest plus retirement of debt Total 36
minus long-term debt financing)
Equity 6
(Dividends plus repurchase of
equity minus new equity financing)
Total $42

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Financial Cash Flow of the U.S.C.C.

U.S. COMPOSITE CORPORATION
Financial Cash Flow
20X2
(in $ millions)
Cash Flow of the Firm
Operating cash flow $238 Cash Flow to
(Earnings before interest and taxes Stockholders
plus depreciation minus taxes) Dividends $43
Capital spending (173)
(Acquisitions of fixed assets Repurchase of
minus sales of fixed assets) stock 6
Additions to net working capital (23)
Cash to Stockholders 49
Total $42
Proceeds from new
Cash Flow of Investors in the Firm
Debt $36 stock issue (43)
(Interest plus retirement of debt Total $6
minus long-term debt financing)
Equity 6
(Dividends plus repurchase of
equity minus new equity financing)
Total $42

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Financial Cash Flow of the U.S.C.C.

U.S. COMPOSITE CORPORATION
Financial Cash Flow
20X2
(in $ millions)
Cash Flow of the Firm
Operating cash flow $238 The cash from
(Earnings before interest and taxes received from the
plus depreciation minus taxes) firm’s assets must
Capital spending (173)
(Acquisitions of fixed assets equal the cash flows
minus sales of fixed assets) to the firm’s
Additions to net working capital (23) creditors and
Total $42
stockholders:
Cash Flow of Investors in the Firm
Debt $36 CF ( A) 
(Interest plus retirement of debt
minus long-term debt financing) CF ( B )  CF ( S )
Equity 6
(Dividends plus repurchase of
equity minus new equity financing)
Total $42

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2.5 The Statement of Cash Flows

There is an official accounting statement called the
statement of cash flows.
This helps explain the change in accounting cash, which
for U.S. Composite is $33 million in 20X2.
The three components of the statement of cash flows are
Cash flow from operating activities
Cash flow from investing activities
Cash flow from financing activities

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U.S.C.C. Cash Flow
from Operating Activities
U.S. COMPOSITE CORPORATION
Cash Flow from Operating Activities
20X2
(in $ millions)

To calculate cash
Operations
flow from
Net Income $86
operations, start Depreciation 90
with net income, Deferred Taxes 13
add back Changes in Assets and Liabilities
noncash items Accounts Receivable (24)
like depreciation Inventories 11
and adjust for Accounts Payable 16
Accrued Expenses 18
changes in
Notes Payable (3)
current assets Other (8)
and liabilities
(other than Total Cash Flow from Operations $199
cash).

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U.S.C.C. Cash Flow

from Investing Activities
U.S. COMPOSITE CORPORATION
Cash Flow from Investing Activities
20X2
(in $ millions)

Cash flow from

Acquisition of fixed assets $(198)
investing activities Sales of fixed assets 25
involves changes Total Cash Flow from Investing Activities $(173)
in capital assets:
acquisition of fixed
assets and sales of
fixed assets
(i.e. net capital
expenditures).

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U.S.C.C. Cash Flow
from Financing Activities
U.S. COMPOSITE CORPORATION
Cash Flow from Financing Activities
20X2
(in $ millions)

Cash flows to Retirement of debt (includes notes) $(73)

and from Proceeds from long-term debt sales 86
Dividends (43)
creditors and
Repurchase of stock (6)
owners include Proceeds from new stock issue 43
changes in
Total Cash Flow from Financing $7
equity and debt.

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U.S.C.C. Statement of Cash Flows

Operations
Net Income $86
The statement of Depreciation 90
Deferred Taxes 13
cash flows is the Changes in Assets and Liabilities
addition of cash Accounts Receivable (24)
Inventories 11
flows from Accounts Payable 16
operations, Accrued Expenses
Notes Payable
18
(3)
cash flows Other (8)
Total Cash Flow from Operations $199
from investing Investing Activities
Acquisition of fixed assets $(198)
activities, and Sales of fixed assets 25
cash flows from Total Cash Flow from Investing Activities $(173)
Financing Activities
financing Retirement of debt (includes notes) $(73)
activities. Proceeds from long-term debt sales
Dividends
86
(43)
Repurchase of stock (6)
Proceeds from new stock issue 43
Total Cash Flow from Financing $7
Change in Cash (on the balance sheet) $33

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Statement of Cash Flows versus Cash Flow

from the Firm
Since interest paid is deducted as an expense
when net income is calculated (and not deducted
under financing activities) there is a difference
between cash flow from operations and total cash
flow to the firm—the difference is interest
expense.

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2.5 Summary and Conclusions

Financial statements provide important
information regarding the value of the firm.
You should keep in mind:
Measures of profitability do not take risk or timing of
cash flows into account.
Financial ratios are linked to one another.

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