Lecture 2

Accounting Statements
Financial Statements,
and
Taxes, and Cash Flow

Cash Flow

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Chapter 2

Financial Statements,
Taxes, and Cash Flow

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Sources of Information
 Annual reports
 Wall Street Journal
 Internet
 NYSE (www.nyse.com)
 Nasdaq (www.nasdaq.com)
 SEC
 EDGAR
 10K & 10Q reports

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 The Balance Sheet
• An accountant’s snapshot of the firm’s
accounting value as of a particular date.
• The Balance Sheet Identity is:
A s s e t s  L ia b ilit ie s  S t o c k h o ld e r ' s E q u it y
• 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
The assets are listed in order by the U.S. COMPOSITE CORPORATION
length of time it normally would take a Balance Sheet
firm with ongoing operations to 20X2 and 20X1
convert them into cash.
(in $ millions)
Clearly, cash is much more liquid than
property, plant and equipment. 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: Deferred taxes $117 $104
Property, plant, and equipment $1,423 $1,274 Long-term debt 471 458
Less accumulated depreciation -550 -460 Total long-term liabilities $588 $562
Net property, plant, and equipment 873 814
Intangible assets and other 245 221 Stockholder's equity:
Total fixed assets $1,118 $1,035 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 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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Value versus Cost
 Under GAAP audited financial statements of
firms in the U.S. carry assets at cost.
 Market value is a completely different
concept.

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

R e v e n u e  E x p e nse s  In c o m e

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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
income statement Depreciation - 90
Operating income $190
reports the firm’s Other income 29
revenues and Earnings before interest and taxes $219
expenses from Interest expense - 49
principal Pretax income $170
Taxes - 84
operations Current: $71
Deferred: $13
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-operating Cost of goods sold - 1,655
section of the Selling, general, and administrative expenses - 327
income statement Depreciation - 90
Operating income $190
includes all Other income 29
financing costs, Earnings before interest and taxes $219
such as interest Interest expense - 49
expense. Pretax income $170
Taxes - 84
Current: $71
Deferred: $13
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

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
Usually a separate Interest expense - 49
section reports as a Pretax income $170
Taxes - 84
separate item the
Current: $71
amount of taxes Deferred: $13
levied on income. 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

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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 Income Statement Analysis

 There are three things to keep in mind when

analyzing an income statement:
1. GAAP
2. Non Cash Items
3. Time and Costs

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Generally Accepted Accounting
Principles
1. 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

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Income Statement Analysis

2. Non Cash Items

 Depreciation is the most apparent. No firm
ever writes a check for “depreciation”.
 Another noncash item is deferred taxes,
which does not represent a cash flow.

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Income Statement Analysis

3. Time and Costs

 In the short run, certain equipment, resources, and
commitments of the firm are fixed, but the firm can
vary such inputs as labor and raw materials.
 In the long run, all inputs of production (and hence
costs) are variable.
 Financial accountants do not distinguish between
variable costs and fixed costs. Instead, accounting
costs usually fit into a classification that
distinguishes product costs from period costs.
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 Net Working Capital

N e t W o r k in g C a p it a l  C u r r e n t A s s e t s - C u r r e n t L ia b ilit ie s

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- 20X2 and 20X1
(in $ millions)
$455 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 $1,423 $1,274
Less accumulated depreciation -550 -460
$275 million in 20X2$588
Long-term debt
from
471 458
Total long-term liabilities
$562
Net property, plant, and equipment 873 814 $252 million in 20X1.
Intangible assets and other 245 221 Stockholder's equity:
Total fixed assets $1,118 $1,035 $23 million
Preferred stock
Common stock ($1 par value)
$39
55
$39
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Capital surplus 347 327
$275m = $761m- $486m This increase of $23 million is
Accumulated retained earnings 390 347
an investment of the firm.
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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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 received from the firm’s
assets must equal the cash flows to the firm’s
creditors and stockholders.

C F (A )  C F (B )  C F (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)
Capital spending -173
EBIT $219
(Acquisitions of fixed assets
minus sales of fixed assets) Depreciation $90
Additions to net working capital -23
Total $42 Current Taxes ($71)
Cash Flow of Investors in the Firm
Debt $36 OCF $238
(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
(Acquisitions of fixed assets Purchase of fixed assets $198
minus sales of fixed assets)
Sales of fixed assets (25)
Additions to net working capital -23
Total $42 Capital Spending $173
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)
NWC grew from $275
Capital spending -173 million in 20X2 from
(Acquisitions of fixed assets
minus sales of fixed assets)
$252 million in 20X1.
Additions to net working capital -23
Total $42 This increase of $23
Cash Flow of Investors in the Firm million is the addition to
Debt $36 NWC.
(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 -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
(Earnings before interest and taxes
plus depreciation minus taxes)
Cash Flow to Creditors
Capital spending -173
(Acquisitions of fixed assets Interest
minus sales of fixed assets) $49
Additions to net working capital -23
Total $42 Retirement of debt 73
Cash Flow of Investors in the Firm
Debt $36 Debt service 122
(Interest plus retirement of debt
minus long-term debt financing) Proceeds from new debt
Equity 6
(Dividends plus repurchase of sales (86)
equity minus new equity financing)
Total $42 Total 36
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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 Cash Flow to Stockholders
plus depreciation minus taxes)
Capital spending -173 Dividends $43
(Acquisitions of fixed assets
Repurchase of stock 6
minus sales of fixed assets)
Additions to net working capital -23 Cash to Stockholders 49
Total $42
Proceeds from new stock issue
Cash Flow of Investors in the Firm
Debt $36
(43)
(Interest plus retirement of debt
minus long-term debt financing) Total $6
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 received from
(Earnings before interest and taxes the firm’s assets must equal
plus depreciation minus taxes)
Capital spending -173 the cash flows to the firm’s
(Acquisitions of fixed assets creditors and stockholders:
minus sales of fixed assets)
Additions to net working capital -23
Total $42
Cash Flow of Investors in the Firm C F ( A) 
Debt $36
(Interest plus retirement of debt C F (B )  C F (S )
minus long-term debt financing)
Equity 6
(Dividends plus repurchase of
equity minus new equity financing)
Total $42
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Exercise
 Based on the following info. for ABC
Corporation:
 Income statement for 20X4
 Balance sheet for 20X3 & 20X4

 Calculation for 20X4

 cash flow from assets for ABC,
 Cash flow to creditors,
 Cash flow to stockholders
 Use a 34% tax rate throughout

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Exercise (Continues)
ABC Corporation
Income Statement
For the period of year 20X4
Sales $3,990
Less: COGS ($2,137)
Less: Selling, general & admin. Exp $0
Less: Depreciation ($1,018)
Operating Income $835
Add: Other Income $0
EBIT $835
Less: Interest Expenses ($267)
Pretax Income $568
Taxes (34%) ($193)
Net Income $375
Dividends $225
Addition to Retained Earnings $150
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 Exercise (Continues)
ABC Corporation
Balance Sheet as of Dec. 31, 20X3 & 20X4
20X3 20X4 20X3 20X4
Current assets $2,140 $2,346 Current Liabilities $994 $1,126
Net Fixed assets $6,770 $7,087 Long-term debt $2,869 $2,956
Owners' Equity $5,047 $5,351
Total Liabilities &
Total Assets $8,910 $9,433 Owners' equity $8,910 $9,433

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Exercise (Continues)
 Cash Flow of ABC from assets (=investment):
 Operating Cash Flow
• EBIT + Depreciation – Current Taxes
 Less: Net Capital Spending
• Purchase of fixed asset – Sales of fixed assets
 Less: Change in NWC
• Difference between 20X3 & 20X4’s NWC

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Exercise (Continues)
 Cash Flow from investment =
 OCF =
 Capital Spending =

 Change in NWC =

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Exercise (Continues)
 Cash Flow to Creditors:
 Interest paid
 Less: Net New Borrowing

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Exercise (Continues)
 Cash Flow to Stockholders
 Dividends paid
 Less: Net New Equity
• Increase in Equity between 2 years – additions to retained
earning

 Cash Flow from assets = Cash Flow to Creditors +

Cash Flow to Stockholders

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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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Homework
 Chapter 2 (Asia Global 2nd Edition)
 #14 (P.42)
 #19 (P.43)

 #21 (P.43)

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