Chapter 3 Understanding Financial Statements, Taxes, and...

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

Understanding Financial Statements, Taxes, and Cash Flows

Chapter 3

Copyright © 2011 Pearson Prentice Hall. All rights reserved.3-2

Slide Contents

• Learning Objectives

• Principles Used in This Chapter

1. An Overview of the Firm’s Financial Statements

2. The Income Statement

3. Corporate Taxes

4. The Balance Sheet

5. The Cash Flow Statement

• Key Terms


Learning Objectives

1. Describe the content of the four basic financial statements and discuss the importance of financial statement analysis to the financial manager.

2. Evaluate firm profitability using the income statement.

3. Estimate a firm’s tax liability using the corporate tax schedule and distinguish between the average and marginal tax rate.


Introduction

4. Use the balance sheet to describe a firm’s investments in assets and the way it has financed them.

5. Identify the sources and uses of cash flow for a firm using the firm’s Cash Flow Statement.


Principles Used in This Chapter

• Principle 1: Money Has a Time Value.

– We need to recognize that financial statements do not adjust for time value of money.

• Principle 3: Cash Flows Are the Source of Value.

– Financial statements provide an important starting point in determining the firm’s cash flow.


Principles Used in This Chapter (cont.)

• Principle 4: Market Prices Reflect Information.

– Firm’s financial statements provide important information that is used by investors in forming expectations about firm’s future prospects and subsequently, the market prices.


3.1 An Overview of the Firm’s Financial Statements


Basic Financial Statements

• Following four types of financial statements are mandated by the accounting and financial regulatory authorities:

1. Income statement

2. Balance sheet

3. Cash flow statement


Basic Financial Statements (cont.)

• 1. Income Statement:

–An income statement provides the following information for a specific period of time (for example, a year or 6 months or 3 months):

•Revenue,

•Expenses, and

•Profit.



• 2. Balance sheet:

–Balance sheet provides a snap shot of the following on a specific date (for example, as of December 31, 2010)

• Assets (value of what the firm owns),

• Liabilities (value of firm’s debts), and

• Shareholder’s equity (the money invested by the company owners).



• 3. Cash flow statement:

– It reports cash received and cash spent by the firm over a period of time (for example, over the last 6 months).


What is the Focus of this Chapter?

• Discuss the basic Content and Format of:

– Income statement,

–Balance sheet, and

–Cash flow statement


Why Study Financial Statements?

• Analyzing a firm’s financial statement can help managers carry out three important tasks:

1. Assess current performance through financial statement analysis,

2. Monitor and control operations, and

3. Forecast future performance.


Why Study Financial Statements? (cont.)

1. Financial statement analysis:

– Financial statement analysis allows us to assess (claim) the present financial condition of a firm.

– Chapter 4 introduces the tools and techniques used to carry out financial statement analysis.



2. Financial monitor and control:

– Financial statements are used by both insiders (such as managers, board of directors) and outsiders (such as suppliers, creditors) to monitor and control the firm’s operations.

– For example, a creditor may analyze a firm’s financial statements to decide whether or not to renew company’s loan.



3. Financial forecasting and planning:

– Financial planning models are typically built using the financial statements.


What are the Accounting Principles Used to Prepare Financial Statements?

• The following three fundamental principles are adhered to by accountants when preparing financial statements:

1. The revenue recognition principle,

2. The matching principle, and

3. The historical cost principle.

• An understanding of these basic principles allows us to be a more informed user of financial statements.


What are the Accounting Principles Used to Prepare Financial Statements? (cont.)

1. The revenue recognition principle:

– It states that the revenue should be included in the firm’s income statement for the period in which:

• Its goods and services were exchanged for cash.

The firm has completed what it must do to be entitled (engaged) to the cash.



2. The matching principle:

– This principle determines whether specific costs or expenses can be attributed to this period’s revenues.

– The expenses are matched with the revenues they helped produce.

• For example, employees’ salaries are recognized when the product produced as a result of that work is sold, and not when the wages were paid.



3. The historical cost principle:

– This principle provides the basis for determining the dollar values the firm reports in its balance sheet.

– Most assets and liabilities are reported in the firm’s financial statements at historical cost i.e. the price the firm paid to acquire them.

The historical cost generally does not equal the current market value of the assets or liabilities.


3.2 The Income Statement


An Income Statement

• An income statement is also called a profit and loss statement.

• An income statement measures the amount of profits generated by a firm over a given time period (usually a year or a quarter).


An Income Statement (cont.)

• Income statement can be expressed as follows:

Revenues (or Sales) – Expenses = Profits



• An income statement will contain the following basic elements:

1. Revenues (Sales)

2. Expenses

• Cost of goods sold, Interest expenses, SGA (selling, general and administrative) expense, depreciation expense, Income tax expense

3. Profits

• Gross profit, net operating income (also known as EBIT), earnings before taxes (EBT), and net income



• Sales– Minus Cost of Goods Sold

• = Gross Profit• Minus Operating Expenses

– Selling expenses– General and Administrative expenses– Depreciation expense

• = Operating income (EBIT)• Minus Interest Expense• = Earnings before taxes (EBT)• Minus Income taxes

• = Net income (EAT)

– EBIT = Earnings before interest and taxes; EBT = Earnings before taxes; EAT = Earnings after taxes


Sample Income Statement

The firm has been profitable as its revenues exceeded its expenses.


Interpreting Firm Profitability using the Income Statement (cont.)

What can we learn from H.J. Boswell Inc.’s income statement (Table 3-1)?

1. The gross profit margin (GPM)

= gross profits ÷ sales

= $675 million ÷ $2,700 million

= 25%

– 25% should be compare with (time series, peer group averages etc.)



2. The operating profit margin

= net operating income ÷ sales

= $382.5 million ÷ $2,700 million

= 14.17%

• The operating profit margin is equal to the ratio of net operating income or EBIT divided by firm’s sales.



3. Net profit margin:

= net profits ÷ sales

= $204.75 million ÷ $2,700 million

= 7.58%

• Net profit margin indicates the percentage of revenues left after all expenses (including interest and taxes) have been considered.



• These profit margins (gross profit margin, operating profit margin, and net profit margin) should be closely monitored and compared to previous years and those of competing firms.


Evaluating a Firm’s EPS and Dividends

What can we learn from H.J. Boswell Inc.’s income statement (Table 3-1)?

• We can use the income statement to determine the earnings per share (EPS) and dividends per share.

• EPS = Net income÷ Number of shares outstanding


Evaluating a Firm’s EPS and Dividends (cont.)

• Example 1: A firm reports a net income $90 million and has 35 million shares outstanding, what will be the earnings per share (EPS)?

• EPS = Net income ÷ Number of shares

= $90 million ÷ $35 million

= $2.57



• We can determine the dividends paid by the firm to each shareholder by dividing the total amount of dividend (reported on the income statement) by the total number of shares outstanding.

• Dividends per share = Dividend Payment on its Net income ÷ Number of shares



• Example 2: A firm reports dividend payment of $20 million on its income statement and has 35 million shares outstanding. What will be the dividends per share?

• Dividends per share = Dividend Payment on its Net income ÷ Number of shares

= $20 million ÷ $35 million

= $0.57


Connecting the Income Statement and the Balance Sheet

• What can the firm do with the net income?:

1. Pay dividends to shareholders, and/or

2. Reinvest in the firm


Connecting the Income Statement and the Balance Sheet (cont.)

• Example 3: Review examples 1 & 2. How much was retained or reinvested by the firm?

• Amount retained = Net Income –Dividends

= $90m - $20m = $70m

• The firm’s balance on retained earnings will increase by $70 million on the balance sheet.


3.3 Corporate Taxes


Corporate Taxes

• A firm’s income tax liability is calculated using its taxable income and the tax rates on corporate income.

• See the table on next slide for corporate tax rates.


Corporate tax rates


Corporate tax rates

• The table reveals the following:

–Tax rates range from 15% to 39%

–Tax rates are progressive i.e. larger corporations with higher profits will tend to pay more taxes compared to smaller firms with lower profits.


Marginal and Average Tax Rates

• Marginal tax rate is the tax rate that the company will pay on its next dollar of taxable income.

• Average tax rate is total taxes paid divided by the taxable income.



• Example 3: What is the average and marginal tax liability for a firm reporting $100,000 as taxable income.

TaxableIncome

Marginal tax rate

Incremental Tax Liability

Cumulative Tax Liability

Average Tax Rate

$50,000 15% 7,500 7,500 15.00%

$75,000 25% 6,250 13,750 18.33%

$100,000 34% 8,500 22,250 22.25%



• Average tax rate

– = Total tax liability ÷ Total taxable income

– = $22,250 ÷ $100,000

– = 22.25%

• Marginal tax rate

– = 39% as the firm will have to pay 39% on its next dollar of taxable income i.e. if its taxable income increases from $100,000 to $100,001.

(See, another example of 200.000 Income)


3.4 The Balance Sheet


The Balance Sheet

• The balance sheet provides a snapshot of the firm’s financial position on a specific date.

• The balance sheet is defined by the following equation:

Total Assets = Total Liabilities + Total Shareholder’s Equity


The Balance Sheet (cont.)

• Total assets represents the resources owned by the firm.

• Total liabilities represent the total amount of money the firm owes its creditors

• Total shareholders’ equity refers to the difference in the value of the firm’s total assets and the firm’s total liabilities.



• In general, GAAP requires that the firm report assets on its balance sheet using the historical costs.

• Note, the net value reported on balance sheet could be significantly different from the market value of the asset.



• The balance sheet includes the following main components:

1.Assets – Found on the left-hand side of the balance sheet. It includes current assets and fixed assets.

2.Sources of financing – Found on the right-hand side of the balance sheet. It includes current liabilities, long-term liabilities, and owner’s equity.



• Current assets consists of firm’s cash plus other assets the firm expects to convert to cash within 12 months or less, such as account receivables (claim for payment from a business to its customer/clients) and inventory (refers to the goods and materials that a business hold).

• Fixed assets are assets that the firm does not expect to sell within one year. For example, plant and equipment, land.



• Current liabilities represent the amount that the firm owes to creditors that must be repaid within a period of 12 months or less such as accounts payable (money owed by a business to its suppliers), notes payable.

• Long-term liabilities refer to debt with maturities longer than a year such as bank loans, bonds.



• The stockholder’s equity is broken down into two components:

(1) The amount the company received from selling stock to investors.

It may be shown as common stock in the balance sheet or it may be divided into two components: par value and additional paid in capital above par.

Par value is the stated or face value a firm puts on each share of stock.

Paid in capital: refers to capital contributed to a corporation by investors through purchase of stock



(2) The amount of the firm’s retained earnings.

Retained earnings are the portion of net income that has been retained (i.e. not paid in dividends) from prior years operations.

• Thus stockholder’s equity

= Par value of common stock + Paid in Capital + Retained Earnings



• We can also express stockholders’ equity as follows:

Shareholders' equity = Total Assets – Total

Liabilities


3.5 The Cash Flow Statement


The Cash Flow Statement

• The Cash Flow Statement is used by firms to explain changes in their cash balances over a period of time by identifying all of the sources and uses of cash.


Sources and Uses of Cash

• Source of cash is any activity that brings cash into the firm. (For example, sale of equipment.)

• Use of cash is any activity that causes cash to leave the firm. (For example, payment of taxes.)


Cash Flow Analysis

• In general (use of cash), an increase in an asset account =

use of casha decrease in a liability account =

use of cash• In general (source of cash),

a decrease in an asset account = source of cash

an increase in a liability account = source of cash


Balance Sheet for H.J. Boswell, Inc.


Cash Flow Analysis

• Why did the cash balance decline by $4.5 million from 2009 to 2010?

1.Accounts receivable increased by $22.5 million representing an increase in uncollected cash from credit sales. Thus it represents $22.5m of use of cash to invest in accounts receivable.


Cash Flow Analysis (cont.)

2. Inventory increased by $148.50 million indicating use of cash to procure inventory.

3. Equipment increased by $175.50 million indicating use of cash to invest in equipment.

In general,

– an increase in an asset account = use of cash

– a decrease in an asset account = source of cash



4. Accounts Payable, credit extended to the firm, increased by $4.5million. Thus source of cash increased by $4.5million due to accounts payable.

5. Long-term debt increased by $51.75 million indicating a source of cash.

6. Short-term debt decreased by $9 million indicating use of cash to pay off the debt.



7. Retained earnings increased by $159.75 million representing a source of cash to the firm from the firm’s operations.

In general,

– An increase in a liability account = source of cash

– A decrease in a liability account = use of cash



• Change in cash balance = Sources of cash – Use of Cash = $216 - $220.50 = -$4.50

Sources of Cash Uses of Cash

Increase in Accounts Payable = $4.50

Increase in Accounts Receivable $22.50

Increase in long-term debt =$51.75

Increase in inventory = $148.50

Increase in retained earnings = $159.75

Increase in net plant and equipment = $40.50

Decrease in short-term notes = $9

Total Sources of cash = $216.00

Total Uses of cash = $220.50



• An analysis of H.J. Boswell’s operations reveals the following for 2010:

– The firm used more cash than it generated, resulting in a deficit of $4.5 million

– The primary source of cash flow was retained earnings ($159.75 million) followed by long-term debt ($51.75 million)

– The largest use of cash was for acquiring inventory at $148.5 million.


Key Terms

• Total assets, liabilities and shareholders’ equity

• Current assets, Current liabilities

• Accounts receivable, Accounts payable

• Average, Marginal tax rate

• Revenues, Expenses and Profits

• Balance sheet, Income statement and Cash flow statement


Key Terms (cont.)

• Current liabilities and Long-term debt

• Net working capital

• Stockholders’ equity - Par value, Paid inCapital, Retained earnings

• Earnings, Dividends per share

• Earnings before interest and taxes (EBIT) / Operating Income

• Uses and Sources of cash

Chapter 3 Understanding Financial Statements, Taxes, and...

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