Chapter 3: Financial Statements, Cash

Flows, and Taxes

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 Learning Objectives
1 • Explain the balance sheet identity and why a balance sheet
must balance

• Describe how market-value balance sheets differ from

2 book-value balance sheets

• Identify the basic equation for the income statement and

3 the information it provides

• Understand the calculation of cash flows from operating,

4 investing, and financing activities required in the statement
of cash flows

• Explain how the four major financial statements discussed

5 in this chapter are related

• Identify the cash flow to a firm’s investors using its

6 financial statements 2
 Financial Statements
o PURPOSE OF FINANCIAL STATEMENTS
• Provide stakeholders a foundation for evaluating
the financial health of a firm
creditors customers
employees general Public
management regulators
stockholders suppliers
• Evaluate a firm’s internal environment
efficiency
effectiveness
risk level 3
 Financial Statements
o PURPOSE OF FINANCIAL STATEMENTS
• Evaluate a firm’s interaction with the external
environment
corporate citizenship
social responsibility
assessment of the external environment
response to the external environment
• Provide information about the performance of
the firm
stakeholders want to compare actual vs. potential
performance 4
 Financial Statements
o ANNUAL REPORT
• Summarizes the overall performance of a firm for
the most recent fiscal year
• Information
the company, its products, its activities, and its future
summary of financial performance for the most recent
year
audited financial statements, five-year summary of
financial data

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 1. The Balance Sheet
o FIRM ASSETS & FUNDING AT A POINT IN TIME

ASSETS L + OE

TOTAL ASSETS = TOTAL LIABILITIES + TOTAL STOCKHOLDERS’ EQUITY

(3.1)
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 The Balance Sheet
Snowboarding Components
Balance Sheet (Partial)
January 31, 2009 Snowboarding Components
ASSETS
Balance Sheet (Partial)
Current assets
Cash $ 6.500
January 31, 2009
Short-term investments 2.100 LIABILITIES
Accounts receivable 4.400 Current liabilities
Merchandise inventory 27.500 Accounts payable $ 15,300
Prepaid expenses 2.400 Wages payable 3,200
Total current assets $ 42.900 Notes payable 3,000
Long-term investments
Current portion of long-term liabilities 7,500
Notes receivable 1.500
Investments in stocks and bonds 18.000
Total current liabilities $ 29,000
Land held for future expansion 48.000 Long-term liabilities:
Total investments 67.500 Notes payable (net of current portion) 150,000
Plant assets Total liabilities $ 179,000
Equipment $ 33.200 EQUITY
Buildings 170.000 203.200 T. Hawk, Capital 164,800
Less accumulated depreciation 53.000 150.200
Total liabilities and equity $ 343,800
Land 73.200
Intangible assets 10.000
Total assets $ 343.800
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 The Balance Sheet
o CURRENT ASSETS
• Assets likely to be converted to cash within a year (or
one operating cycle)
marketable securities
accounts receivable
Inventory
o CURRENT LIABILITIES
• Liabilities scheduled to be paid within a year (or one
operating cycle)
accounts payable
accrued wages
debt with less than a year’s maturity
taxes 8
 The Balance Sheet
o NET WORKING CAPITAL

NET WORKING CAPITAL =

TOTAL CURRENT ASSETS – TOTAL CURRENT LIABILITIES (3.2)

• Net working capital is a measure of a firm’s ability to meet its

short-term obligations as they come due.
• One way that firms maintain their liquidity is by holding more
current assets.

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 The Balance Sheet
o NET WORKING CAPITAL EXAMPLE
• Diaz Manufacturing
Total current assets = $1,039.8 million
Total current liabilities = $377.8 million
Net working capital = Total current assets
- Total current liabilities
= $1,039.8 million - $377.8 million
= $662.0 million
Is is positive or negative?

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 The Balance Sheet

o INVENTORY
ACCOUNTING
• Inventory (least
liquid current asset)
reported using one
of two methods

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 The Balance Sheet
How a firm values its inventory affects both its balance
sheet and its income statement

Cost of goods sold

=
Beginning inventory + Purchases -
Ending inventory

Gross profit = Net sales – Cost of goods sold

Net income = Gross Profit – Operating expenses

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Cost of goods sold = Net income
 The Balance Sheet
o INVENTORY ACCOUNTING
• When the cost of inventory is increasing
FIFO reporting says a firm sold the less expensive inventory and
leads to
– higher balance in inventory
– lower cost-of-goods-sold
– higher taxable income
– higher income taxes
– higher net income
LIFO reporting says a firm sold the more expensive inventory
and leads to
– lower balance in inventory
– higher cost-of-goods-sold
– lower taxable income
– lower income taxes
– lower net income
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 The Balance Sheet
o INVENTORY ACCOUNTING
• When the cost of inventory is decreasing
FIFO reporting says a firm sold the more expensive inventory
and leads to
– lower balance in inventory
– higher cost-of-goods-sold
– lower taxable income
– lower income taxes
– lower net income
LIFO reporting says a firm sold the less expensive inventory
and leads to
– higher balance in inventory
– lower cost-of-goods-sold
– higher taxable income
– higher income taxes
– higher net income
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 The Balance Sheet
o LONG-TERM ASSETS
• Real (Plant) Assets
land
buildings
equipment
• Intangible Assets
goodwill
patents
copyrights

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 The Balance Sheet
o LONG-TERM ASSETS
• Real assets decline with use and are depreciated
Depreciation expense reduces taxable income and income taxes.
Assets are depreciated using either the straight line or accelerated
depreciation method.
Net plant and equipment = Total plant and equipment - Accumulated depreciation

Balance Sheet Income Statement

Cost
Acquisition
Expense
Cost Allocation
(Unused) (Used)

• Intangible assets lose value over time and are amortized

(equivalent to depreciated) 16
 The Balance Sheet
o LONG-TERM LIABILITIES
• Long-term debt
bank loans
mortgages
bonds with a maturity longer than one year
o EQUITY
• Common Stock
ownership with control in a firm
preemptive right
• Preferred Stock
ownership without control in a firm
features make it an equity security that resembles debt
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 The Balance Sheet
o OTHER BALANCE SHEET ACCOUNTS
• Retained earnings
Profit kept and used to acquire assets.
• Treasury stock
Shares of its own stock a firm holds rather than sell
them to the public.

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Diaz Manufacturing Balance Sheets as
of December 31

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 2. Market Value vs. Book Value
o RECORDING ASSET VALUE
• Assets are traditionally reported at
historical cost on a balance sheet
• Balance sheet amount does not reflect
current market value – only the acquisition
cost
Past Present Future

ACCOUNTING FINANCE 20
 Market Value vs. Book Value
o ASSET VALUATION
• Better information is provided to
management and investors by marking-to-
market — reporting balance sheet items at
current market values
difficult to determine market values of assets
• The difference between the market values
of assets and liabilities is a realistic estimate
of the market value of shareholders’ equity
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 Market Value vs. Book Value
Items Market value vs. Reasons
book value
1. Assets
- Current Reasonably close Short life cycle
- Long-term Not likely to be equal - Long life cycle
- Depreciation (if any)
2. Liabilities Different but by smaller amounts than assets
- Current Generally close Short maturities
- Long-term Substantially different - Interest rate
- Company performance
- The probability of default
3. Stockholders’ E = A – L => market value is a better but not always
Equity an exact estimate 22
Market Value vs. Book Value
Marvel Airline’s example

Why the decline in assets?

Why the decline in stockholders’ equity?
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 3. The Income Statement
o INCOME STATEMENT: OVERVIEW
• Measures the profitability of a firm for a reporting
period
• Revenue is income from selling products and
services – for cash or credit
• Expenses include costs of providing products and
services, and asset utilization (depreciation and
amortization)

Net income = Revenues – Expenses (3.3)

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Diaz Manufacturing Income
Statements
Revenues (1)
Expenses (2)
Expenses (3)

Expenses (4)

Expenses (5)
Expenses (6)
(1)
–
(2)+(3)+(4)+(5)+(6)
Net income
No. of shares
outstanding

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 The Income Statement
o DEPRECIATION
• The cost of a physical asset, such as plant or
machinery, is written off over its lifetime. This is
called depreciation, a non-cash expense
• Firms use one of these depreciation methods
straight-line depreciation
accelerated depreciation
– Firms may choose to use one for internal purposes and
another for tax purposes or for statements released to the
public.

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 The Income Statement
o AMORTIZATION
• Amortization expense is related to using
intangible assets
Goodwill (no longer since 2006 -> impairment test)
Patents
Licenses
– Like depreciation, it is a non-cash expense.

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 The Income Statement
o EXTRAORDINARY ITEM
• Income or expense associated with events that
are infrequent and abnormal
separated from the results of ordinary income
shown separately on the income statement

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 The Income Statement
o EBITDA AND EBIT
• Earnings-before-interest-taxes-
depreciation-and-amortization (EBITDA)
income from selling goods and services minus
the cost of providing them
• Earnings-before-interest-and-taxes
(EBIT)
EBITDA minus depreciation and amortization

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 The Income Statement
o EBT AND NI
• Earnings-before-taxes (EBT)
EBIT minus interest expense
taxable income
• Net income (NI)
EBT minus taxes

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 Statement of Retained Earnings
o RETAINED EARNINGS
• Shows cumulative effect of adjustments to
shareholders’ equity resulting from profit, losses,
and paying dividends
• Shows changes in the account for a period based
on profit, loss, or dividend paid

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Diaz Manufacturing Statement of
Retained Earnings

Balance sheet

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 4. Statement of Cash Flows
o STATEMENT OF CASH FLOWS
• Summarizes cash outflows and cash inflows during
a period
• Cash flows result from operating activities,
investing activities, and financing activities
• Net cash flows equals cash inflows minus cash
outflows

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 Diaz Manufacturing
Statement of Cash Flows

trong bng chia ra 3hoatj ng

Uses of cash
Net income: sources of cash ly c t income statement
Additions: • Increases in assets
- D&A : D dành cho TS hu hình và A dành cho TS vô hình
- Increase...payable: (bên liabilities)(bên n) tng lên các khon • Decreases in liabilities and
phi tr->n tng
-Decrease ....assets: Gim TS ngn hn: tin tng equity
- Increase...taxes: tng lên nhng khon thu thu nhp cha np
(dùng cm t accrued) -> bên n -> tng tin • EX: additional inventory,
Subtractions: (tr i) retirement of debt,
- Increase...receiavble: tng lên các khon phi thu
- .....inventories: tng lên hàng d tr purchase of treasury
Dòng tin ròng
Phân bit
stock, dividend
-Investing: vô ngng TSC và long term payment,…
-Financing: TS tài chính (Financial product) (CP, TP)
S âm: sd tin, property,equipment nm này ln hn nm trc
Trong trng hp :khi Investing bán TS i là use of cách ->
dòng tin dng
Sources of cash
Incre....debt: n tng-> tin tng
mua nhng treasure stock: CP ngân qu (nhng cp ã phát hành • Decreases in assets
ra, ly qu ó mua li nhng cp ngoài TT) -> tin gim
Incre...note.payable: (uses of cash) • Increases in liabilities and
equity
• EX: sales of plant assets,
bond/stock issuance…
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 Cash Flows
o STATEMENT OF CASH FLOWS ORGANIZATION
• Operating Activities
cash inflows
– sell goods and services
+
cash outflows tng n,cng

– raw materials gim TS, cng

cng
– inventory
– salaries and wages tng TS, tr
tr tr
– utilities
– rent

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 Cash Flows
o STATEMENT OF CASH FLOWS ORGANIZATION
• Investing Activities
cash outflows and inflows due to
– buying and selling long-term assets such as plant and
mua và bán nhng TS dài hn
equipment mua: tr
bán: cng
– buying and selling bonds and stocks issued by other firms
TP, CP phát hình ca công ty khác
nu công ty mình phát hành là H Financing

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 Cash Flows
o STATEMENT OF CASH FLOWS ORGANIZATION
• Financing Activities
cash inflow
– issue debt
– issue equity
– borrow money
cash outflow
– pay interest or dividends
– repay loan principal
– purchase treasury stock
Balance sheet : tính net working capital: short term current liabilite- short term .. asset
tính Net income t net income statement -> bng Cash flow statement

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5. Interrelations Among the Financial
net income

Statements
D&A income statement bng vi D&A trong cash flow
D&A có trong balance sheet tính ra fixed assets
cash vào cui nm ngoái so vi cash vào cui nm này
bng vi net cash in Cash flow statement
16.6+271.9=288.5
Gia balance sheet vi income statement : D&A
Gia cash flow vi balance sheet: có D&A, net cash
trong cash flow bng chênh lch gia cash u nm vi cui
nm trong balance sheet

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 6. Cash Flows
o NET CASH FLOWS VERSUS NET INCOME
• Accountants focus on net income and
shareholders focus on net cash flows. These are
not the same because of delays in inflows and
outflows, and non-cash revenues and expenses

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 Cash Flows
o CASH FLOWS TO INVESTORS
• Cash flows available to investors from operating
activities (CFOA)
CFOA = EBIT – Current Taxes

+ Noncash expenses (3.4)

- Depreciation and
amortization
- Depletion charge
- Deferred taxes
- Prepaid expenses
- Deferred revenues
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 Cash Flows
o CFOA EXAMPLE
• Diaz Manufacturing
EBIT = $168.4 million
Current Taxes = $44.3 million
Non-cash expenses = $83.1 million

CFOA = EBIT – Current Taxes + Non - Cash Expenses

= $168.4m - $44.3m + $83.1m

= $207.2 million

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 Cash Flows
o CASH FLOWS TO WORKING CAPITAL
• To compute the net cash flows into or out of
working capital

CFNWC = NWCCurrent Period - NWCPrevious Period (3.5)

NET WORKING CAPITAL = TOTAL CURRENT ASSETS – TOTAL CURRENT LIABILITIES (3.2)

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 Cash Flows
o CFNWC EXAMPLE
• Diaz Manufacturing
NWC 2011 = $662.0 million
NWC 2010 = $342.0 million

CFNWC 2011
= NWC 2011
– NWC 2010

= $662.0m - $342.0

= $320.0 million
What does this number indicate?

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 Cash Flows
o CASH FLOWS INVESTED IN LONG-TERM ASSETS
• To compute the net cash flows from the
purchases and sales of long-term assets

CFLTA = Long - term assets Current Period - Long - term assets Previous Period (3.6)

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 Cash Flows
o PUTTING IT ALL TOGETHER
• CFNWC and CFLTA are subtracted from CFOA
because investments in both net working capital
and long-term assets reduce the cash flow
available to investors

CFI = CFOA - CFNWC - CFLTA (3.7)

Is a negative or positive number good?

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What we have learned …
What we have learned …
END OF CHAPTER 3

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