Foundations of Finance
Arthur J. Keown
J. William Petty
John D. Martin
David F. Scott, Jr.
Chapter 3
Understanding Financial Statements
and Cash Flows
Chapter 3 Understanding Financial Statements and Cash Flows
Chapter Objectives
• Compute a company’s profits as
reflected by an income statement.
• Determine a firm’s accounting book
value, as presented in a balance
sheet.
• Measure a company’s free cash
flows.
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Foundations of Finance
Pearson Prentice Hall
Chapter 3 Understanding Financial Statements and Cash Flows
Principles Used in this Chapter
Principle 3: Cash-Not Profits-Is King
Principle 7: Managers Won’t Work for
the Owners Unless It’s in Their Best
Interest
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Pearson Prentice Hall
Chapter 3 Understanding Financial Statements and Cash Flows
Basic Financial Statements
• Income Statement
• Balance Sheet
• Statement of Cash Flows
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Pearson Prentice Hall
Chapter 3 Understanding Financial Statements and Cash Flows
Income Statement
• Profit/Loss Statement
• Indicates the amount of profits
generated by a firm over a given
period of time
• Sales – Expenses = Profit
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Foundations of Finance
Pearson Prentice Hall
Chapter 3 Understanding Financial Statements and Cash Flows
Income Statement
Terminology
• 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 and the dividends paid to
preferred stockholders
• Tax Expenses
– Amount of taxes owed, based upon taxable income
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Foundations of Finance
Pearson Prentice Hall
Chapter 3 Understanding Financial Statements and Cash Flows
Income Statement
Sales
Less cost of goods sold
= Gross profit
Less operating expenses
= Operating income
Less interest expense
= Earnings before taxes
Less corporate taxes
= Earnings before preferred dividends
Less preferred stock dividends
= Net income available to common
stockholders
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Foundations of Finance
Pearson Prentice Hall
Chapter 3 Understanding Financial Statements and Cash Flows
Starbucks Corporation
Income Statement 2003 ($M)
Sales
Cost of Goods Sold
Gross Profit
Operating Expenses
Marketing expenses and general and
Administrative expenses
$227
Depreciation Expense
206
Total Operating Expenses
Operating Profits
Interest Expense
Earnings before taxes
Income taxes
Net income
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$4,076
3,207
$ 869
$ 433
$ 436
3
$ 433
165
$ 268
Pearson Prentice Hall
Chapter 3 Understanding Financial Statements and Cash Flows
Balance Sheet
• Provides a firm’s financial position at a
specific point in time
• Assets are resources owned by the firm
• Liabilities and owner’s equity indicate how
those resources are financed
Total Assets =
Liabilities (debt) + Shareholder’s Equity
Or…A= L+OE
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Foundations of Finance
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Chapter 3 Understanding Financial Statements and Cash Flows
Balance Sheet Terminology
• Current assets or gross working capital
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 expenses
Prepaid expenses are those items paid for in
advance
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Foundations of Finance
Pearson Prentice Hall
Chapter 3 Understanding Financial Statements and Cash Flows
Balance Sheet Terminology
• Fixed Assets – Assets held for more than
one year. Typically Include:
– Machinery and equipment
– Buildings
– Land
• Other Assets – Assets that are not current
assets or fixed assets
– Patents
– Copyrights
– Goodwill
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Foundations of Finance
Pearson Prentice Hall
Chapter 3 Understanding Financial Statements and Cash Flows
Balance Sheet Terminology
• Debt (Liabilities)
– Money that has been borrowed and must
be repaid at some predetermined date
– Debt Capital
• financing provided by a creditor
• Current or short-term debt and long-term debt
• Current or short-term must be repaid within
the next 12 months
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Foundations of Finance
Pearson Prentice Hall
Chapter 3 Understanding Financial Statements and Cash Flows
Balance Sheet Terminology
• Current Liabilities:
– 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
– Loans from banks or other institutions for longer than
12 months
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Foundations of Finance
Pearson Prentice Hall
Chapter 3 Understanding Financial Statements and Cash Flows
Balance Sheet Terminology
• Equity
• Includes the shareholder’s investment
– Preferred stock
– Common stock
• Treasury Stock
– stock that was once outstanding and has 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
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Foundations of Finance
Pearson Prentice Hall
Chapter 3 Understanding Financial Statements and Cash Flows
Balance Sheet
• ASSETS
– Current Assets
– Fixed Assets
• Total Assets
• LIABILITIES
– Current Liabilities
– Long-Term Liabilities
• Total Liabilities
• OWNER’S EQUITY
– Preferred Stock
– Common Stock
– Retained earnings
• Total Owner’s Equity
• Total liabilities + OE
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Chapter 3 Understanding Financial Statements and Cash Flows
Terms
• Net Working Capital
Current assets – current liabilities
• Debt Ratio
Percentage of debt a firm uses to finance its
assets
• Accrual Basis Accounting
Recording revenues when earned and expenses
when incurred, rather than when cash is
exchanged
• Free Cash Flows
Cash flow that is free and available to be
distributed to the firm’s investors.
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Foundations of Finance
Pearson Prentice Hall
Chapter 3 Understanding Financial Statements and Cash Flows
Free Cash Flows
Free cash flows:
(After-tax cashflows from operations)
Less
(Increase or decrease in net working
capital)
Less
(Increase or decrease in gross fixed
assets)
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Foundations of Finance
Pearson Prentice Hall
Chapter 3 Understanding Financial Statements and Cash Flows
Traditional Statement of Cash
Flows
• Three sections:
– Cash flows from Operating
Activities
– Cash flows from Investing
Activities
– Cash flows from Financing
Activities
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Foundations of Finance
Pearson Prentice Hall
Chapter 3 Understanding Financial Statements and Cash Flows
After-Tax Cash Flows From
Operations
Operating Income (EBIT)
+ Depreciation
- Income tax expense
= After-tax cash flows from
operations
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Foundations of Finance
Pearson Prentice Hall
Chapter 3 Understanding Financial Statements and Cash Flows
Change in Operating Working
Capital
Change in operating working capital =
(change in current assets) (change in current liabilities)
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Foundations of Finance
Pearson Prentice Hall
Chapter 3 Understanding Financial Statements and Cash Flows
Compute the Change in Fixed
Assets
• The final step involves
computing the change in Gross
Fixed Assets (not net Fixed
Assets)
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Foundations of Finance
Pearson Prentice Hall
Chapter 3 Understanding Financial Statements and Cash Flows
Starbucks Free Cash Flows
($M)
After-tax cash flows from operations
$477
Less 2003 investments in:
Investments in net working capital $ 4
Investments in Long Term Assets
Total investments
$ 570
Free cash flows
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566
$ (93)
Foundations of Finance
Pearson Prentice Hall
Chapter 3 Understanding Financial Statements and Cash Flows
Financing Cash Flows
A firm can either receive money from or
distribute money to its investors. The
firm can:
1. Pay interest to lenders
2. Pay dividends to stockholders
3. Increase or decrease in long-term debt
4. Issue stock to new shareholders or
repurchase stock from current
shareholders
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Foundations of Finance
Pearson Prentice Hall