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Corporate Finance
Chapter Two
Ross  Westerfield  Jaffe 2
Sixth Edition

Financial Statements and

Cash Flow

Anwar Zahid
Lecturer
Independent University, Bangladesh (IUB)
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The Balance Sheet

• 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

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The Balance Sheet of the
Canadian Composite Corporation
CANADIAN COMPOSITE CORPORATION
Balance Sheet
20X2 and 20X1
(in $ millions)
Liabilities (Debt)
Assets 20X2 20X1 The assets are listed 20X2 in order
and Stockholder's Equity 20X1
Current assets: Current Liabilities:
Cash and equivalents $140 $107 by the length of time
Accounts payable $213 it
$197
Accounts receivable
Inventories
294
269
270
280
normally would take 223
Notes payable
Accrued expenses
a50 firm 53
205
Other
Total current assets
58
$761
50
$707
with ongoing operations
Total current liabilities$486 to
$455

convert them into cash.

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
Clearly, cash is much more
Common stock ($1 per value) 55 32
Capital surplus 347 327
liquid than property, plant
Accumulated retained earnings 390 347
and 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. Liquidity
2. Debt versus equity
3. Value versus cost

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Liquidity
• Refers to the ease and speed 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 carry assets at historical cost adjusted
for depreciation.

• Book Value ..?

• Market value is a completely different
concept. It is the price at which willing
buyers and sellers trade the assets.

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The Income Statement

• The income statement measures performance

over a specific period of time.
• The accounting definition of (net)income is
R e v e nue  E xp e nse s  In c o m e

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Income Statement
CANADIAN 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 statement
Operating income $190
reports the firm’s Other income 29
revenues and Earnings before interest and taxes $219
Interest expense - 49
expenses from Pretax income $170
principal Taxes - 84
operations Current: $71
Deferred: $13
Net income $86
Retained earnings: $43
Dividends: $43

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Income Statement
CANADIAN COMPOSITE CORPORATION
Income Statement
20X2
(in $ millions)

Total operating revenues $2,262

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

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Income Statement
CANADIAN 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
Net income $86
charged on
Retained earnings: $43
income. Dividends: $43

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Income Statement
CANADIAN 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. Generally Accepted Accounting Principles
(GAAP)
2. Non Cash Items
3. Time and Costs

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Generally Accepted Accounting Principles (GAAP)

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.
•For example-when goods are sold $500 but on
credit sales $100 and cash sale $400.
According to GAAP rules, Total sales amount will be
recorded $500 in sales revenue not only cash sales
$400
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Income Statement Analysis

2. Non Cash Items

• These are expenses that do not affect cash flow
directly.
• Depreciation is the most apparent. No firm ever
writes a cheque for “depreciation.”

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Income Statement Analysis

3. Time and Costs

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Net Working Capital (N.W.C) Concept

N.W.C = CURRENT ASSETS – CURRENT LIABILITIES

• NWC is +ve when current assets are greater

than current liabilities.
• The change in NWC is usually +ve in a
growing firm.
• NWC can be negative or zero.

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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 (CFA) received from the firm’s
assets must equal the cash flows to the firm’s
creditors (CFB) and stockholders (CFS).

C F (A )  C F (B )  C F (S )

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