Financial Statements
LEARNING OBJECTIVES
1. Explain the foundations of the balance
sheet and income statement
2. Use the cash flow identity to explain cash
flow.
3. Provide some context for financial reporting.
4. Recognize and view Internet sites that
provide financial information.
2.1 Financial Statements
 Four main financial statements:
 Balance sheet
 Income Statement
 Statement of Retained Earnings
 Statement of Cash Flow
 Our focus..
 Interrelationship between the balance sheet and
the income statement
 The process by which these statements can be used
to project a firm’s future cash flows
2.1 Financial Statements
(A) The Balance Sheet
 Represents the assets owned by the company and the
claims against those assets
 Based on the accounting identity:
Assets  Liabilities + Owners’ Equity
(2.1)
Figure 2.1 Balance sheet
2.1 Balance Sheet
Has five main sections:
1. Cash account

2.
Where did the $65 million decline come from?
Working capital accounts

3.
Net working capital = Current assets – Current liabilities (2.2)
Long-term asset accounts


4.
Plant and equipment; land and buildings
Gross value – accumulated depreciation = Net value
Long-term liabilities (debt) accounts

5.
Loans maturing in over one year
Ownership accounts


Shareholders’ equity
Retained earnings—accumulated total since inception
2.1 The Income Statement
• Shows the expenses and revenues generated by a
firm over a past period, typically a quarter or a year.
•
Net income = Revenues – expenses (2.3)
•
EBIT = Revenues – operating expenses (2.4)
2.1 Income Statement
2.1 The Income Statement
 Net income is not the same as cash flow
 Firm earned an income of $5,642 million
 Cash account decreased by $65 million
 3 reasons:
 Accrual accounting
 Noncash expense items --depreciation
 Preference to classify interest expense as part of
financial cash flow
2.2 Cash Flow Identity
The cash flow identity states that the cash flow on
the left-hand side of the balance sheet (the cash
generated by the company) is equal to the cash flow
on the right-hand side of the balance sheet (the
cash flow given to the lenders and owners of the
company).
CASH FLOW FROM ASSETS  CASH FLOW TO CREDITORS
+ CASH FLOW TO OWNERS
Figure 2.5 Cash Flow Identity and components
2.2 The First Component:
Cash Flow From Assets
 Three components:



Operating cash flow (OCF)
Net capital spending (NCS)
Change in net working capital (∆NWC)
 Cash flow from assets = OCF – NCS - ∆NWC
 OCF = EBIT + Depreciation – Taxes
 NCS = End. Net Fixed Assets – Beg. Net Fixed Assets
+ Depreciation
 ∆NWC=Ending NWC – Beginning NWC
2.2 The First Component:
Cash Flow From Assets
OCF = EBIT + Depreciation – Taxes
OCF = Net Income + Depreciation
+ Interest Expense
2.2 The First Component:
Cash Flow From Assets (continued)
NCS = End Net Fixed Assets – Beg Net Fixed Assets
+ Depreciation
NCS= ($11,961 - $10,788) + $1,406 = $2,579
2.2 The First Component:
Cash Flow From Assets
∆NWC = Ending NWC – Beginning NWC
Net working capital for 2007 = $9,130 - $6,860 = $2,270
Net working capital for 2006 = $10,454 - $9,406 = $1,048
Change in NWC = $2,270 - $1,048 = $1,222
2.2 The First Component:
Cash Flow From Assets
 Putting it all together….
 Cash flow from Assets = OCF – NCS - ∆ NWC
= $7,287 - $2,579 - $1,222
= $3,486
 Versus Net Income of $5,642
2.2 The Second Component:
Cash Flow To Creditors
Cash Flow to Creditors = Interest Expense  Net New Borrowing from Creditors
Net New Borrowing = End Long-term Liabilities  Beg Long-Term Liabilities
Cash Flow to Creditors = $239 - (-$378) = $617
2.2 The Third Component:
Cash Flow To Owners
Cash flow to owners =
Dividends - Net new borrowing from owners
= $2,869
= $2,869
-
$0
2.2 Putting It All Together: The
Cash Flow Identity
CASH FLOW FROM ASSETS  CASH FLOW TO
CREDITORS + CASH FLOW TO OWNERS
$3,486  $617 + $2,869
The company generated $3,486 million and it was
distributed to the lenders ($617 million) and the
owners ($2,869 million)
2.3 Financial Performance
Reporting
 Annual reports to shareholders
 Quarterly (10-Q) and annual (10-K) reports filed
with the SEC
 Regulation Fair Disclosure (Reg. FD): Companies must
release all material information to all investors at the
same time.
– Notes to the Financial Statements: A wealth of
information about the firm
2.4 Financial Statements on the Internet
 EDGAR (www.sec.gov/edgar.shtml)
 Yahoo! Finance (http://finance.yahoo.com.)
 Many, many more Web sites with rich stores of
information
ADDITIONAL PROBLEMS WITH ANSWERS
Problem 1
Balance Sheet. Chuck Enterprises has current
assets of $300,000, and total assets of $750,000. It
also has current liabilities of $125,000, common
equity of $250,000, and retained earnings of
$85,000. How much long-term debt and fixed
assets does the firm have?
ADDITIONAL PROBLEMS WITH ANSWERS
Problem 1
Current Assets + Fixed Assets = Total Assets
 $300,000 + Fixed Assets = $750,000
 Fixed Assets = $750,000 - $300,000 = $450,000
 Total Assets ≡ Current Liabilities + Long-term debt
Common equity + Retained Earnings
 $750,000 = $125,000 + Long-term debt + $250,000 + 85,000
 Long-term debt = $750,000 - $125,000-$250,000 - $85,000
 Long-term debt = $290,000
ADDITIONAL PROBLEMS WITH ANSWERS
Problem 2
Income Statement. The Top Class Company had
revenues of $925,000 in 2009. Its operating
expenses (excluding depreciation) amounted to
$325,000, depreciation charges were $125,000, and
interest costs totaled $55,000. If the firm pays a
average tax rate of 34 percent, calculate its net
income after taxes.
ADDITIONAL PROBLEMS WITH ANSWERS
Problem 2
Revenues
Less operating expenses
= EBITDA
Less depreciation
= EBIT
Less interest expenses
= Taxable Income
Less taxes (34%)
= Net Income after taxes
$925,000
325,000
600,000
125,000
475,000
55,000
420,000
142,800
277,200
ADDITIONAL PROBLEMS WITH ANSWERS
Problem 3
Retained Earnings: The West Hanover Clay Co. had,
at the beginning of the fiscal year, November 1, 2009,
retained earnings of $425,000. During the year ended
October 31, 2010, the company generated net income
after taxes of $820,000 and paid out 35 percent of its
net income as dividends. Construct a statement of
retained earnings and compute the year-end balance
of retained earnings.
ADDITIONAL PROBLEMS WITH ANSWERS
Problem 3
Statement of Retained Earnings for
the year ended October 31, 2010
Balance of Retained Earnings, 11/1/2009……….$425,000
Add: Net income after taxes, 10/31/2010………. $820,000
Less: Dividends paid for year-end 10/31/2010…$287,000
Balance of Retained Earnings, 10/31/2010….. $958,000
ADDITIONAL PROBLEMS WITH ANSWERS
Problem 4
Working Capital: D.K. Imports, Incorporated reported
the following information at its last annual meeting:
Cash and cash equivalents = $1,225,000;
Accounts payables = $3,200,000
Inventory = $625,000;
Accounts receivables = $3,500,000;
Notes payables = $1,200,000;
Other current assets = $125,000.
Calculate the company’s net working capital.
ADDITIONAL PROBLEMS WITH ANSWERS
Problem 4
Net Working Capital = Current Assets - Current Liabilities
(Cash & Cash Equivalents + Accts. Rec. + Inventory +
other current assets) - (Accounts Payables + Notes
Payables)
($1,225,000+$3,500,000+$625,000+$125,000) ($3,200,000+$1,200,000)
$5,475,000 - $4,400,000
Net Working Capital =$1,075,000
ADDITIONAL PROBLEMS WITH ANSWERS
Problem 5
Cash Flow from Operating Activities: The Mid-American
Farm Products Corporation provided the following financial
information for the quarter ending September 30, 2009:
Depreciation and amortization = $75,000
Net Income = $225,000
Increase in receivables = $95,000
Increase in inventory = $69,000
Increase in accounts payables = $80,000
Decrease in marketable securities = $34,000.
What is the cash flow from operating activities generated
during this quarter by the firm?
ADDITIONAL PROBLEMS WITH ANSWERS
Problem 5
Net Income
Add depreciation and amortization
Add decrease in marketable securities
Add increase in accounts payables
Less increase in accounts receivables
Less increase in inventory
$225,000
75,000
34,000
80,000
95,000
69,000
Cash flow from operating activities
$250,000