Securitization Process (2 of 2)
Balance sheet: Balance sheet contains
4. These MBSs are sold to investors who can
hold them as investments or resell them to
other investors.
Since the original lender gets the money back
quickly and does not have to worry about
repayment, it may not adequately screen the loan
applicants. Financial crisis began with poor
screening and spread worldwide through sale of
MBSs.
Dodd—Frank Wall Street Reform and
Consumer Act
In the wake of 2008 financial crisis, the financial
industry was again transformed. The major standalone
investment banks failed or were converted to
commercial banks.
In 2010 the Dodd-Frank Wall Street Reform and
Consumer Protection Act was passed, which
subjects banks and non-bank financial institutions to
more oversight and greater transparency. One of the
rules, “Volker” rule, prohibits banks from
proprietary trading.
Chapter 3: Understanding Financial Statements, Taxes,
and Cash Flows
Learning Objectives (1 of 2)
1. Describe the content of the four basic financial
statements and discuss the importance of
financial statement analysis to the financial
manager.
2. Evaluate firm profitability using the income
statement.
3. Estimate a firm’s tax liability using the corporate
tax schedule and distinguish between the
average and marginal tax rate.
4. Use the balance sheet to describe a firm’s
investments in assets and the way it has
financed them.
5. Identify the sources and uses of cash for a firm
using the firm’s cash flow statement.
Principles Used in This Chapter
• Principle 1: Money Has a Time Value.
• Principle 3: Cash Flows Are the Source of Value.
• Principle 4: Market Prices Reflect Information.
• Principle 5: Individuals Respond to Incentives.
3.1 AN OVERVIEW OF THE FIRM’S FINANCIAL
STATEMENTS
Basic Financial Statements (1 of 4)
The accounting and financial regulatory authorities
mandate that firms provide the following four types
of financial statements:
1. Income statement
2. Balance sheet
3. Cash flow statement
4. Statement of shareholders’ equity
Basic Financial Statements (2 of 4)
1. Income Statement: An income statement
provides the following information for the firm
over a specific period of time (usually a quarter
of a year or a full year):
§ Revenue earned,
§ Expenses incurred, and
§ Profit earned
2.
information as of the date of its preparation of
the following:
§ Assets (everything of value the company owns),
§ Liabilities (the company’s debts), and
§ Stockholders’ equity (the money invested by the
company owners)
3. Cash flow statement: It reports cash received
and cash spent by the firm over a specific period
of time, usually a quarter of a year or a full year.
4. Statement of shareholder’s equity: It provides a
detailed account of activities in the firm’s
common and preferred stock accounts and its
retained earnings account and of changes to
shareholders’ equity.
Why Study Financial Statements?
Analyzing a firm’s financial statement can help
managers carry out three important tasks:
1. assess the financial condition of the firm
2. monitor and control operations, and
3. financial forecasting and planning.
What are the Accounting Principles
Used to Prepare Financial Statements?
• Accountants use the following three fundamental
principles when preparing financial statements:
1. The revenue recognition principle,
2. The matching principle, and
3. The historical cost principle.
3.2 THE INCOME STATEMENT
An Income Statement (1 of 2)
An income statement (also called a profit and loss
statement) measures the amount of profits
generated by a firm over a given time period
(usually a year or a quarter). It can be expressed as
follows:
Revenues (or Sales) – Expenses = Profits
An income statement will contain the following:
1. Revenues
2. Cost of Good Sold
3. Gross Profit
4. Operating Expenses
5. Net Operating Income
6. Interest Expense
7. Earnings Before Taxes
8. Income Taxes
9. Net Income
Table 3.1 H. J. Boswell, Inc. (1 of 2)
Income Statement ($ millions, except per share data) for
the Year Ended
December 31, 2016
Evaluating a Firm’s per Share Earnings
and Dividends
• Per Share earnings = company’s net income
divided by the number of common shares
outstanding.
• Dividends per share = total dividends paid div
by the number of common shares outstanding.
Evaluating a Firm’s EPS and Dividends
(for Boswell, Table 3.1)
• Earnings per share = $204.75m ÷ 90m
= $2.28 per share
• Dividends per share = $45m ÷ 90m
= $0.50 per share
Connecting the Income Statement and the
Balance Sheet
• What can the firm do with the net income?: P
dividends to shareholders, and/or Reinvest in
firm
– Boswell, Inc. earned net income of $204
million, of which $45 million was distrib
in dividends and $159.75 million was
retained and reinvested in the firm.
Interpreting Firm Profitability using the
Income Statement (1 of 5)
From H.J. Boswell Inc.’s income statement (Ta
we observe that firm has been profitable. We ca
identify three different measures of profit or in
1. The gross Profit margin is 25% ($675 mil
2. The operating profit margin is only 14.2%
($382.5 million)
3. The net profit margin is only 7.6% ($204.
million)
Interpreting Firm Profitability using the
Income Statement (2 of 5)
1. The gross profit margin (GPM)
= gross profits ÷ sales
= $675 million ÷ $2,700 million
= 25%
– GPM indicates the firm’s “mark-up” on its co
goods sold per dollar of sales. The markup
percentage equals gross profit divided by cos
goods sold (= $675m ÷ $2.025m = 33.3%)
Interpreting Firm Profitability using the
Income Statement (3 of 5)
2. The operating profit margin
= net operating income ÷ sales
= $382.5 million ÷ $2,700 million
= 14.2%
– The operating profit margin is equal to the ra
net operating income or EBIT divided by fir
sales.
Interpreting Firm Profitability using the
Income Statement (4 of 5)
3. The net profit margin
= net profits ÷ sales
= $204.75 million ÷ $2,700 million = 7.6%
– Net profit margin indicates the percentage of revenues left ov
after all expenses (including interest and taxes) have been
considered.
Interpreting Firm Profitability using the
Income Statement (5 of 5)
By comparing these margins to those of similar
businesses, we can dissect a firm’s performance
and identify expenses that are out of line.
GAAP and Earnings Management
• In the United States, while the firms must adhere to
GAAP, there is considerable room for company’s
managers to actively influence the firm’s reported
earnings.
• Managers have an incentive to tamper with earnings
as their pay depends upon it and because investors pay
close attention to earnings announcements.
• An audit by an independent accounting firm serves as
a check and balance to control management’s incentive
to disguise the firm’s financial condition.
CHECKPOINT 3.1: CHECK YOURSELF
Constructing an Income Statement
Reconstruct the firm’s income statement assuming the
firm is able to cut its cost of
goods sold by 10% and that the firm pays taxes at a
40% rate. What is the firm’s net income and earnings
per share?
Step 1: Picture the Problem (1 of 2)
• The income statement can be expressed as
follows:
Revenues – Expenses = Net Income
• We are given information on revenues and
expenses (cost of goods sold, operating
expenses, interest expense and income taxes)
to fill the template given on next slide.
Step 1: Picture the Problem (2 of 2)
Step 2: Decide on a Solution Strategy
• Given the account balances, constructing the
income statement will entail substituting the
appropriate balances into the template of step 1.
Step 3: Solve (1 of 2)
Step 3: Solve (2 of 2)
Earnings per share:
= net income÷number of shares
= $1,374,900,000 ÷ 716,296,296 = $1.92
Step 4: Analyze
The firm is profitable since it earned net income of
$1,374,900,000. The shareholders were able be
earn $1.96 per share.
3.3 CORPORATE TAXES
Corporate Taxes
A firm’s income tax liability is calculated using its
taxable income and the tax rates on corporate
income.
Computing Taxable Income
The table reveals the following:
– Tax rates range from 15% to 39%
– Tax rates are progressive i.e. corporations with
higher profits tend to pay more taxes.
Marginal and Average Tax Rates (1 of 3)
• Marginal tax rate is the tax rate that the company
will pay on its next dollar of taxable income.
• Average tax rate is total taxes paid divided by the
taxable income.
Example: What is the average and marginal tax
liability for a firm reporting $100,000 as taxable
income.
• Average tax rate
– = Total tax liability 􀃗 Total taxable income
– = $22,250 􀃗 $100,000
– = 22.25%
• Marginal tax rate
– = 39% as the firm will have to pay 39% on its
next dollar of taxable income i.e. if its taxable
income increases from $100,000 to $100,001.
Dividend Exclusion for Corporate
Shareholders (1 of 2)
For corporate stockholders, the dividend received
are at least partially exempt from taxation. The
rationale behind the exclusion is to avoid double
taxation. The percentage of exempt taxes is based
on the degree of ownership of the firm.
Example What will be the taxable income if firm A
receives $100,000 in dividends from firm B
3.4 THE BALANCE SHEET
The Balance Sheet (1 of 4)
The balance sheet is a snapshot of the firm’s
financial position on a specific date. It is defined by
the following equation:
Total Assets = Total Liabilities + Total Shareholders
Equity
• Total liabilities represent the total amount of
money the firm owes its creditors
• Total shareholders’ equity refers to the
difference in the value of the firm’s total assets
and the firm’s total liabilities.
• Total assets, sum of total shareholders’ equity
and total liabilities, represents the resources
owned by the firm.
The Balance Sheet (3 of 4)
• In general, GAAP requires that the firm report
assets using the historical costs.
• Cash and assets held for sale (such as
marketable securities) are an exception to the
rule. These assets are reported using the lower
of their cost or current market value.
The Balance Sheet (4 of 4)
• Assets whose value is expected to decline over
time (such as equipment) are adjusted downward
periodically by depreciating the historical cost.
Balance sheet reports the book value (equal to
historical cost less the accumulated depreciation).
• Generally, the book value is not equal to the
current market value of the firm’s assets.
Table 3.2 H. J. Boswell, Inc. (1 of 9)
Balance Sheets ($ millions), December 31, 2015 and
2016
Legend:
Assets: The Left-Hand Side of the Balance Sheet
Current Assets. Assets that the firm expects to
convert to cash in 12 months or less. Examples
include cash, accounts receivable, inventories, and
other current assets.
• Cash. Every firm must have some cash on hand at
all times because cash expenditures can sometimes
exceed cash receipts.
• Accounts receivable. The amounts owed to the firm
by it customers who purchased on credit.
Table 3.2 H. J. Boswell, Inc. (4 of 9)
• Inventory. Raw materials that the firm utilizes to
build its products, partially completed items or
work in process, and finished goods held by the
firm for eventual sale.
• Other current assets. All current assets that do not
fall into one of the named categories (cash, accounts
receivable, and so forth). Prepaid expenses
(prepayments for insurance premiums, for example)
are a common example of an asset in this catch-all
category.
Gross Plant and Equipment. The sum of the
original acquisition prices of plant and equipment
still owned by the firm.
Accumulated Depreciation. The sum of all the
depreciation expenses charged against the prior
year’s revenues for fixed assets that the firm still
owns.
Net Plant and Equipment. The depreciated value of
the firm’s plant and equipment.