You are on page 1of 35

Financial Statements and

Cash Flow

Key Concepts and Skills


Understand the information provided
by financial statements
Differentiate between book and market
values
Know the difference between average
and marginal tax rates
Know the difference between
accounting income and cash flow
Calculate a firms cash flow

Chapter Outline
2.1 The Balance Sheet
2.2 The Income Statement
2.3 Taxes
2.4 Net Working Capital
2.5 Financial Cash Flow
2.6 The Accounting Statement of
Cash Flows

2.1 The Balance Sheet


An accountants snapshot of the firms
accounting value at a specific point in time
The Balance Sheet Identity is:
Assets Liabilities + Stockholders Equity

Composite Corporation Balance


Sheet
2007
Current assets:
Cash and equivalents
Accounts receivable
Inventories
Other
Total current assets

$140
294
269
58
$761

2006
$107
270
280
50
$707

Fixed assets:
Property, plant, and equipment
$1,423 $1,274
Less accumulated depreciation
(550)
(460)
Net property, plant, and equipment
873
814
Intangible assets and other
245
221
Total fixed assets
$1,118 $1,035

Total assets

$1,879

$1,742

The assets are listed in2007


order2006by
Current Liabilities:
the
length
Accounts
payable of time it would
$213
$197
Notes payable
50
53
normally
take
a
firm
with
Accrued expenses
223
205
Total currentoperations
liabilities
$486
$455
ongoing
to convert
Long-term
liabilities:
them into
cash.
Deferred taxes
Long-term debt
Total long-term liabilities

$117
471
$588

$104
458
$562

Stockholder's equity:
Preferred stock
$39
$39
Common stock ($1 per value)
55
32
Capital surplus
347
327
Accumulated retained earnings
390
347
Less treasury stock
(26)
(20)
Total equity
$805
$725
Total liabilities and stockholder's equity $1,879 $1,742

Clearly, cash is much more


liquid than property, plant, and
equipment.

Balance Sheet Analysis

When analyzing a balance sheet,


the Finance Manager should be
aware of three concerns:
1. Liquidity
2. Debt versus equity
3. Value versus cost

Liquidity
Refers to the ease and quickness with
which assets can be converted to cash
without a significant loss in value
Current assets are the most liquid.
Some fixed assets are intangible.
The more liquid a firms 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.

ABC ltd has current assets of Rs.5000, net fixed assets of


Rs.23,000, current liabilities of Rs.4300 and long term debt of
Rs. 13,000. What is the value of the shareholders equity
account for this firm? How much is the net working capital?
S.H.E.=10,700
N.W.C.=700

Debt versus Equity


Creditors generally receive the first
claim on the firms cash flow.
Shareholders equity is the residual
difference between assets and
liabilities.

Value versus Cost


Under Generally Accepted Accounting
Principles (GAAP), audited financial
statements of firms in the U.S. carry
assets at cost.
Market value is the price at which the
assets, liabilities, and equity could
actually be bought or sold, which is a
completely different concept from
historical cost.

XYZ Ltd purchased new machinery three years ago for Rs.
7mn. The machinery can be sold today for Rs.3.2mn. XYZ ltd
current balance sheet shows net fixed assets of Rs.4mn,
current liabilities of Rs. 2.2mn and net working capital of
0.9mn. If all the current assets were liquidated today, the
company would receive Rs. 2.8mn. What is the book value of
the companys assets today? What is the market value?
B.V.=7.1mn
M.V.=6mn

The following table presents the long-term liabilities and stockholders equity
of a company one year ago. During the past year the company issued 10mn
shares at a total price of 26mn and issued Rs.8 mn in long term debt. The
company generated Rs. 7mn in net income and paid Rs.4mn in dividends.
Construct the current balance sheet reflecting the changes that occurred at
the company during the year.

Long term debt


Preferred stock
Common Stock (Rs
1 par value)
Capital Surplus
Accumulated RE

60
18
25
49
89


Long term debt
Shareholders equity
Preferred stock
Common Stock
Capital Surplus
Accumulated RE

Total long term Liabilities &


Equity

Last
year

Current
year
60

68

18
25
49
89

18
35
65
92

241

278

2.2 The Income Statement


Measures financial performance over
a specific period of time
The accounting definition of income
is:
Revenue Expenses Income

Income Statement
The operations
section of the
income statement
reports the firms
revenues and
expenses from
principal
operations.

Total operating revenues


Cost of goods sold
Selling, general, and administrative expenses
Depreciation
Operating income
Other income
Earnings before interest and taxes
Interest expense
Pretax income
Taxes
Current: $71
Deferred: $13
Net income
Addition to retained earnings
Dividends:

$2,262
1,655
327
90
$190
29
$219
49
$170
84

$86
$43
$43

Income Statement
The non-operating
section of the
income statement
includes all
financing costs,
such as interest
expense.

Total operating revenues


Cost of goods sold
Selling, general, and administrative expenses
Depreciation
Operating income
Other income
Earnings before interest and taxes
Interest expense
Pretax income
Taxes
Current: $71
Deferred: $13
Net income
Addition to retained earnings:
Dividends:

$2,262
1,655
327
90
$190
29
$219
49
$170
84

$86
$43
$43

Income Statement

Usually a separate
section reports the
amount of taxes
levied on income.

Total operating revenues


Cost of goods sold
Selling, general, and administrative expenses
Depreciation
Operating income
Other income
Earnings before interest and taxes
Interest expense
Pretax income
Taxes
Current: $71
Deferred: $13
Net income
Addition to retained earnings:
Dividends:

$2,262
1,655
327
90
$190
29
$219
49
$170
84

$86
$43
$43

Income Statement

Net income is the


bottom line.

Total operating revenues


Cost of goods sold
Selling, general, and administrative expenses
Depreciation
Operating income
Other income
Earnings before interest and taxes
Interest expense
Pretax income
Taxes
Current: $71
Deferred: $13
Net income
Retained earnings:
Dividends:

$2,262
1,655
327
90
$190
29
$219
49
$170
84

$86
$43
$43

ABC Ltd has sales of Rs.527,000, costs of Rs.280,000,


depreciation expense of Rs.38,000, interest expense of
Rs.15,000 and a tax rate of 35%. What is the net income for
the firm? Suppose the company paid out Rs.48,000 as cash
dividends. What is the addition to retained earnings?
N.I.: 126,100
R.E.: 78,100

Income Statement Analysis

There are two things to keep in


mind when analyzing an income
statement:
1. Generally Accepted Accounting
Principles (GAAP)
2. Non-Cash Items

GAAP
The matching principal of GAAP
dictates that revenues be matched
with expenses.
Thus, income is reported when it is
earned, even though no cash flow
may have occurred.

Non-Cash Items
Depreciation is the most apparent.
No firm ever writes a check for
depreciation.
Another non-cash item is deferred
taxes, which does not represent a
cash flow.
Thus, net income is not cash.

During the year, a company had gross sales of Rs.1 mn. The
firms cost of goods sold and selling expense were 0.3mn and
0.2mn respectively. The company also had notes payable of
Rs.1mn. These notes carried an interest rate of 10%.
Depreciation was 0.1mn. The tax rate for the company is 35%.
1.What was the companys net income?
2.What was the companys operating cash flow?
N.I.: 195,000
OC.F.: 395,000

2.3 Taxes
The one thing we can rely on with
taxes is that they are always
changing
Marginal vs. average tax rates
Marginal the percentage paid on the
next dollar earned
Average the tax bill / taxable income

Other taxes

Marginal versus Average


Rates
Suppose your firm earns $4 million in
taxable income.
What is the firms tax liability?
What is the average tax rate?
What is the marginal tax rate?

If you are considering a project that


will increase the firms taxable
income by $1 million, what tax rate
should you use in your analysis?

2.4 Net Working Capital


Net Working Capital
Current Assets Current Liabilities
NWC usually grows with the firm

Balance Sheet
$252m = $707- $455
2007
Current assets:
Cash and equivalents
Accounts receivable
Inventories
Other
Total current assets

$140
294
269
58
$761

2006
$107
270
280
50
$707

Fixed assets:
Property, plant, and equipment
$1,423 $1,274
Less accumulated depreciation
(550)
(460
Net property, plant, and equipment
873
814
Intangible assets and other
245
221
Total fixed assets
$1,118 $1,035

$275m = $761m- $486m

2007
Current Liabilities:
Accounts payable
Notes payable
Accrued expenses
Total current liabilities

$1,879

$1,742

$197
53
205
$455

Long-term liabilities:
Deferred taxes
Long-term debt
Total long-term liabilities

Here we see NWC grow


$117to $104
471
458
$275 million in 2006 from
$588
$562
$252 million in 2005.
Stockholder's equity:
Preferred stock
$39
$39
$23
million
Common stock ($1 par value)
55
32
Capital surplus
347
327
This
increase
of
$23
million
is
Accumulated retained earnings
390
347
Lessinvestment
treasury stock
(26)
(20)
an
of the firm.
Total equity

Total assets

$213
50
223
$486

2006

$805

$725

Total liabilities and stockholder's equity $1,879

$1,742

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 2007.
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

Cash Flow from Operations


To calculate cash
flow from operations,
start with net income,
add back non-cash
items like
depreciation and
adjust for changes in
current assets and
liabilities (other than
cash).

Operations
Net Income
Depreciation
Deferred Taxes
Changes in Assets and Liabilities
Accounts Receivable
Inventories
Accounts Payable
Accrued Expenses
Notes Payable
Other
Total Cash Flow from Operations

$86
90
13
-24
11
16
18
-3
-8
$199

Cash Flow from Investing


Cash flow from
investing activities
involves changes in
capital assets:
acquisition of fixed
assets and sales of
fixed assets (i.e., net
capital expenditures).

Acquisition of fixed assets


Sales of fixed assets
Total Cash Flow from Investing Activities

-$198
25
-$173

Cash Flow from Financing


Cash flows to and
from creditors and
owners include
changes in equity and
debt.

Retirement of debt (includes notes)


Proceeds from long-term debt sales
Dividends
Repurchase of stock
Proceeds from new stock issue
Total Cash Flow from Financing

-$73
86
-43
-6
43
$7

Statement of Cash Flows


The statement of
cash flows is the
addition of cash
flows from
operations,
investing, and
financing.

Operations
Net Income
Depreciation
Deferred Taxes
Changes in Assets and Liabilities
Accounts Receivable
Inventories
Accounts Payable
Accrued Expenses
Notes Payable
Other
Total Cash Flow from Operations
Investing Activities
Acquisition of fixed assets
Sales of fixed assets
Total Cash Flow from Investing Activities
Financing Activities
Retirement of debt (includes notes)
Proceeds from long-term debt sales
Dividends
Repurchase of stock
Proceeds from new stock issue
Total Cash Flow from Financing
Change in Cash (on the balance sheet)

$86
90
13
-24
11
16
18
-3
-8
$199
-$198
25
-$173
-$73
86
-43
-6
43
$7
$3
3

Given the Income statement and Balance sheet for XYZ Ltd. Do
the following:
1.Determine the Cash Flow From Operations, Investing and
Financing
2.Explain the changes in cash during the year.
Income
statement
Revenue
Expenses
Depreciatio
n
Net Income
Dividends

For 2014
500
300
75
125
65

Assets
2014
2013
Cash
45
10
Other CA
145
120
Net Fixed Assets
250
150

Total Assets
440
280

Liabilities and Equity

Current Liabilities
70
60
Long-term debt
90
0
Stockholder's equity
280
220

Total Liabilities &

Cash from operations


Net Income
Add: Dep
Change in CA
Change in CL

CFO
Cash from Investing
Change in FA
CFI
Cash from Financing
Debt
Dividends

CFF

Change in Cash

125
75
-25
10

185

-175
-175

90
-65

25

35

Quick Quiz
What is the difference between book
value and market value? Which should
we use for decision making purposes?
What is the difference between
accounting income and cash flow? Which
do we need to use when making
decisions?
What is the difference between average
and marginal tax rates? Which should we
use when making financial decisions?
How do we determine a firms cash flows?
What are the equations, and where do we
find the information?