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Chapter 3
Understanding Financial
Statements and Cash Flows
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Learning Objectives
Compute a company’s profits as reflected by its income statement.
Determine a firm’s financial position at a point in time based on its balance sheet
Measure a company’s cash flows.
Compute taxable income and income taxes owed.
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Slide Contents
Principles used in this Chapter
1. The Income Statement
2. The Balance Sheet
3. Measuring Cash Flows
4. Income Taxes and Finance
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Principles Applied in this Chapter
Principle 1: Cash flow is what matters
Principle 5: Conflicts of interest cause agency problems
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1. The Income Statement
It is also known as Profit/Loss Statement
It measures the results of firm’s operation over a specific period.
The bottom line of the income statement shows the firm’s profit or loss for a period.
Sales – Expenses = Profits
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Income Statement Terms
Revenue (Sales) Money derived from selling the company’s product or service
Cost of Goods Sold (COGS) The cost of producing or acquiring the goods or services to be sold
Operating Expenses Expenses related to marketing and distributing the product or
service and administering the business
Financing Costs The interest paid to creditors
Tax Expenses Amount of taxes owed, based upon taxable income
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Figure 3-1
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Figure 3-1 (cont.)
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Table 3-1
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Common-size Income Statement
Common-size income statement restates the income statement items as a percentage of sales.
Common-size income statement makes it easier to compare trends over time and across firms in the industry.
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Table 3-2
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Profit-to-Sales analysis from Common-size income statement
See Table 3-2 Gross profit margin (or percentage of
sales going towards gross profit) is 23.3% Operating profit margin (or percentage
of sales going towards operating profit) is 12.5%
Net profit margin (or percentage of sales going towards net profit) is 7%
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2. The Balance Sheet
The balance sheet provides a snapshot of a firm’s financial position at a particular date.
It includes three main items: assets, liabilities and equity. Assets (A) are resources owned by the firm Liabilities (L) and owner’s equity (E) indicate how those
resources are financed A = L + E
The transactions in balance sheet are recorded historically at cost price, so the book value of a firm may be very different from its current market value.
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Figure 3-3
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Current assets comprise assets that are relatively liquid, or expected to be converted into cash within 12 months. Current assets typically include: Cash Accounts Receivable (payments due from customers who
buy on credit) Inventory (raw materials, work in process, and finished
goods held for eventual sale) Other assets (ex.: Prepaid expenses are items paid for in
advance)
Balance Sheet Terms: Assets
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Fixed Assets – Include assets that will be used for more than one year. Fixed assets typically include: Machinery and equipment Buildings Land
Other Assets – Assets that are neither current assets nor fixed assets. They may include long-term investments and intangible assets such as patents, copyrights, and goodwill.
Balance Sheet Terms: Assets
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Debt (Liabilities) Money that has been borrowed from a creditor
and must be repaid at some predetermined date. Debt could be current (must be repaid within
twelve months) or long-term (repayment time exceeds one year).
Balance Sheet Terms: Liabilities
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Current Debt: Accounts payable (Credit extended by suppliers to a firm
when it purchases inventories) Accrued expenses (Short term liabilities incurred in the firm’s
operations but not yet paid for) Short-term notes (Borrowings from a bank or lending
institution due and payable within 12 months)
Long-Term Debt Borrowings from banks and other sources for more than 1
year
Balance Sheet Terms: Liabilities
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Equity: Shareholder’s investment in the firm in the form of preferred stock and common stock. Preferred stockholders enjoy preference with regard to payment of dividend and seniority at settlement of bankruptcy claims.
Treasury Stock: Stock that have been re-purchased by the company.
Retained Earnings: Cumulative total of all the net income over the life of the firm, less common stock dividends that have been paid out over the years. Note retained earnings are not equal to hard cash!
Balance Sheet Terms: Equity
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Balance Sheet: A = L + E
ASSETS (A) Current Assets Fixed Assets
Total Assets
LIABILITIES (L) Current Liabilities Long-Term Liabilities
Total Liabilities
OWNER’S EQUITY (E) Preferred Stock Common Stock Retained earnings
Total Owner’s Equity Total liabilities + Equity
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Table 3-3
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Net Working Capital
Net Working Capital = Current assets – current liabilities
Larger the net working capital, better the firm’s ability to repay its debt
Net working capital can be positive or zero or negative. It is generally positive.
An increase in net working capital may not always be good news. For example, if the level of inventory goes up, current assets will increase and thus net working capital will also increase. However, increasing inventory level may well be a sign of inability to sell.
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Debt Ratio
Debt ratio is the percentage of assets that are financed by debt.
Debt ratio is an indication of “financial risk.” Generally, higher the ratio, the more risky the firm is, as firms have to pay interest on debt regardless of the earnings or cash flow situation.
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3. Measuring Cash Flows
Profits in the financial statements are calculated on “accrual basis” rather than “cash basis” (see next slide for accrual basis accounting).
Thus profits are not equal to cash.
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Accrual Basis Accounting
Accrual basis is the principle of recording revenues when earned and expenses when incurred, rather than when cash is received or paid. Thus sales revenue recorded in the income statement
includes both cash and credit sales.
Treatment of long-term assets: Asset acquisitions (that will last more than one year, such as equipment) are not recorded as an expense but are written off every year as depreciation expense.
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Figure 3-6 How to measure a firm’s cash flows
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Three sources of cash flows
Cash flows from Operations (ex. Sales revenue, labor expenses)
Cash flows from Investments (ex. Purchase of new equipment)
Cash flows from Financing (ex. Borrowing funds, payment of dividends)
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Three sources of cash flows (cont.)
If we know the cash flows from operations, investments and financing, we can understand the firm’s cash flow position better, that is, how cash was generated and how it was used.
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Income Statement Conversion: From Accrual to Cash Basis
Two steps: Add back depreciation (as it is a non-cash
expense) to net income Subtract any uncollected sales (i.e.
increase in accounts receivable) and cash payment for inventories (i.e. increase in inventories less increase in accounts payables)
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Figure 3-7
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Table 3-5
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4. Income Taxes and Finance
Computing Taxable Income for Corporation Gross Income
Dollar sales from a product or service less cost of production or acquisition
Taxable Income Gross income less tax deductible expenses, plus interest
income received and dividend income received Tax Deductible Expenses Include Operating expenses (marketing, depreciation,
administrative expenses) and interest expense Dividends paid are not deductible
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Table 3-6Computing Taxable Income ($000’s)
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Table 3-7
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Figure 3-2
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Figure 3-2 (cont.)
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Figure 3-4
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Table 3-4
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Key terms
Accounts Payable Accounts Receivable Accrual basis accounting Accrued expenses Accumulated depreciation Additional paid-in-capital Balance sheet Cash Common size financial
statements Common stock Cost of goods sold Current assets
Debt Debt ratio Depreciation expenses EBIT Earnings before taxes Earnings per share Equity Financing cash flows Financing cost Fixed assets Free cash flows Gross fixed assets
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Key terms (cont.)
Gross Profit Gross profit margin Income statement Inventories Long-term debt Mortgage Net fixed assets Net income Net profit margin Net working capital Operating expenses
Operating income Operating profit margin Operating working capital Par value Preferred stockholders Profit margins Retained earnings Short-term liabilities Short-term notes (debt) Taxable income Trade credit Treasury stock