FINC3131
Business Finance
Chapter 3:
Income Statements
Balance Sheets
Cash Flow Statement
1
Importance of Financial Statements
 Form the basis for understanding the
financial position of a business
 Provide information regarding the
financial policies and strategies and
insight into future performance
 10-K and 10-Q
2
Income Statement Overview

Also called
• earnings statement
• profit & loss statement
 Matches revenues & expenses over a period of time,
e.g., past fiscal quarter or year
 ‘Flow’ measure statement
•

Each value on an income statement represents cumulative
amount of that item through the accounting period
Profit vs. Cash flow
•
Seldom the same
3
4
Income Statement Structure
Income Statement
Company Name
For the time period ending date
•Earnings before
taxes (EBT)
Net Sales
- Cost of Goods Sold
- Operating Expenses
- Depreciation and Amort.
= Operating Profit
- Interest Expense
= Profit Before Taxes
- Taxes
= Net Income
•Operating income
•Earnings before
interest & taxes (EBIT)
•Earnings
•Net profit
5
EBITDA
•
Earning before interest tax depreciation
and amortization
6
Income Statement Items
•
Net sales
= Gross sales – (returns & allowances)
•
Cost of Goods Sold (COGS)
include raw material and labor costs
7
Income Statement Items
 Operating expenses
•
Include management salaries, advertising expenditures,
repairs & maintenance, R&D, general & administrative
expenses, lease payments.
 Interest expense
•
Cost of borrowing money
 Taxes
•
Federal, state and/or local levels
 Net income
•
•
‘bottom line’ of income statement
Base profit earned during accounting period
8
Income Statement Items
 Earnings per common share (EPS)
Net income available to common shareholders
# common shares outstanding
indicator of firm’s current performance
9
Where does Net Income go to?
NI = Retained Earnings + Dividend Payout
Common Dividends per share (DPS)
common stock dividends paid
# common shares outstanding
10
Example
Levo Inc.’s latest net income was $2 million,
and it has 200,000 common shares
outstanding. The company wants to pay out
40% of its income as dividend. How much is
the earnings per share? How much is the
dividend per share?
11
Example
Prepare a multi-step income statement for the ABC company
for the year ending Dec 31, 2006, given the information below:
Advertising expenditures
Cost of goods sold
Depreciation
Gross sales
Interest expenses
Lease payment
Management salary
Material purchase
R&D expenditures
Repair and maintenance costs
Returns and allowances
Taxes
68,000
2,433,000
78,000
3,210,000
64,000
52,000
240,000
2,425,000
35,000
22,000
48,000
51,000
12
Solution
Gross Sales
Return and Allowance
3,210,000
48,000
Net Sales
3,162,000
Cost of Goods Sold
2,433,000
Gross Profit
729,000
Operating Expenses
417,000
Depreciation
EBIT
Interest Expense
78,000
234,000
64,000
EBT
170,000
Tax
51,000
Net Income
119,000
13
Example
BB Ltd. recently reported an EBITDA of $10
million and net income of $2 million. It had
$3 million of interest expense, and its
corporate tax rate was 40%. What was its
charge for Depreciation and Amortization?
14
IBM’s Income Statement
 Where to find?
15
Overview of Balance Sheet
 Show what a company owns vs. owes at
a specific point in time.
 Categorizes company’s resources as:
•
•
•
Assets
Liabilities
Owner’s equity
 Balance sheet identity:
Total Assets = Total Liabilities + Shareholders’ Equity
16
Balance Sheet Overview
Assets
Liquidity
Cash
Marketable securities
Accounts Receivable
Inventories
Total Current Assets
Gross Fixed Assets
(less Accum. Depreciation)
Net Fixed Assets
Other long-term investments
such as stock and bonds
Total Assets
Assets
Liabilities and Owners Equity
Notes Payable
Accounts Payable
Accrued Expenses
Current Portion of LTD
Total Current Liabilities
Long term (L.T.) Debt
Total Liabilities
Preferred Stock
Common Stock
Retained Earnings
Total Liabilities and equity
Claims on Assets
S.T.
Funds
L.T.
Capital
17
18
Balance Sheet Items:
Current Assets 1
Current asset :

Easily converted into cash within a year
 Cash
•
Most liquid asset; frequently represented by demand deposits
 Marketable Securities: e.g. short-term T-bills
 Accounts Receivable (A/R) Occurs because
company sells products/services on credit
19
Balance Sheet Items:
Current Assets 2
 Inventory
•
•
Raw materials, work in process (WIP), finished goods
Different valuation methods: FIFO, LIFO, average cost
Total current assets
= Cash + Marketable Securities + A/R +
Inventory
20
Balance Sheet Items:
Long-term assets 1
Fixed assets
•
•
•


Gross fixed assets (GFA): original cost of assets
Accumulated depreciation (AD)
•
•

Equipment, buildings, vehicles, computers etc
Permanent nature; needed for business operations
Reported at book value
= original historical cost – allowable depreciation
Straight-line
Accelerated cost recovery
Net fixed assets (NFA)
= gross fixed assets – accumulated depreciation
Example: GFA, AD, NFA.
21
Balance Sheet Items:
Long-term assets 2
 Total assets
= Current assets + long-term assets
 Assets (LHS of balance sheet) must be
financed by a combination of liabilities and
owner’s equity (RHS of balance sheet)
 firms should try to finance assets with the
lowest cost funds available. Not only is it
important for a firm’s financial managers to
focus on assets, they must focus on the
structure and composition of liabilities and net
worth as well.
22
Balance Sheet Items:
Liabilities & Equity 1
 Current liabilities
1.
2.
3.
4.

Notes payable
Accounts payable
Accrued expenses (accruals)
Current portion of long-term debt
1+2+3+4 = total current liabilities
 Long-term debt
1. Liabilities with maturities in excess of 1 year
23
Balance Sheet Items:
Liabilities & Equity 2
 Total liabilities
• = current liabilities + L.T. debt
 Preferred stock
•
•
•
Like debt: Pays fixed periodic dollar amount
Like equity: If payment is not made,
company is not in default
Preferred dividends are usually cumulative;
no voting rights
24
Balance Sheet Items:
Liabilities & Equity 3
 Common stock
•
Common stock at par

•
No. of shares outstanding =
common stock book value
Par value per share
Additional paid-in capital (capital surplus)

Additional money generated when company sold stock
 Retained earnings
•
Cumulative total of all net income reinvested into
the company
• Annual addition to retained earnings
= net income – dividends paid
Example: RE, NI, dividend, annual RE
25
Balance Sheet Items:
Liabilities & Equity 4
 Common Shareholders’ equity
= common stock at par +
additional paid-in capital +
retained earnings
 Common equity also known as net worth
26
Market Value Added (MVA)
Suppose there are 100,000 shares of
common stock, and the stock market price
is $6.00 per share. The book value of
these common stock is $550,000.
Market Value: (100,000)($6.00) = $600,000.
MVA = $600,000 - $550,000 = $50,000.
Or
6 - 550000/100000= $0.5/share
27
Balance Sheet Items:
Liabilities & Equity 5
Total liabilities and equity
= total liabilities +
preferred stock (if any) +
shareholders’ equity
•
Must equal total assets
28
IBM’s Balance Sheet
 Where to find?
29
example
From the following accounts, prepare a balance sheet for the BCD
company for the year ending Dec 31, 2006:
Gross fixed assets
Inventory
Accrued expenses
Accumulated depreciation
Notes payable
Preferred stock
Retained earnings
Current portion of L-T debt
Long-term debt
Accounts receivable
Additional paid-in capital
Accounts payable
Common stock ($0.20 par)
Cash
284,950
136,500
11,850
82,310
32,570
8,000
89,280
4,080
134,300
105,770
71,600
50830
60,000
?
30
Solution
cash
x
notes payable
32570
50830
A/R
105770
Accounts payable
Incentory
136500
current portion of LT debt
Current Asset
242270+x
Gross fixed asset
284950
accumulated dep.
82310
Net fixed asset
202640
Accrued expenses
11850
Current liability
99330
long-term debt
134300
total liability
233630
common stock
60000
additional paid-in
71600
prefered stock
retained earnings
total asset
444,910+x
4080
8000
89280
Equity
228880
Liability and Equity
462510
31
How many new shares issued in 2004?
Cash
2004
5,500
2003
2,900
Accounts receivable
Inventories
4,000
6,200
2,000
9,000
15,700
84,300
100,000
13,900
87,000
100,900
Notes payables
Accounts payables
Accrued expenses
1,500
8,600
700
1,900
6,600
900
Total current liabilities
Long-term debt
10,800
37,500
9,400
42,000
Common stock ($2 par value)
12,000
8,000
Additional paid-in capital
Retained earnings
14,520
25,180
9,500
32,000
100,000
100,900
Total current assets
Net fixed assets
Total Assets
Total liabilities & equity
32
Effect of Debt vs. Equity
Financing on Return
assets
operating income
equity
debt
r=10%
case 1
$12 mil
$5 mil
case 2
$12 mil
$5 mil
$12 mil
0
$1 mil
$11 mil
5
0
5
1.5
3.5
5
1.1
3.9
1.17
2.73
operating income
less: interest
Taxable income
less: tax (30%)
Net Income
Return on Equity
3.5/12=29%
2.73/1=273%
33
Manipulating financial data
Examples:
• Adjusting credit terms to affect net sales
• Switching inventory valuation methods
• Choice of depreciation method: straight-line
method smoothes earnings
• Discretionary expense items such as R&D
34
Example (million)
Net Sales
400
COGS
260
Gross Profit
140
Operating Expenses
70
Operating Income
Interest Paid
Earnings before taxes
Taxes
Net Income
70
20
50
30
20
35
Questions
1. Was the company profitable?
2. Did the company indeed receive 20
million cash as profit in its bank account?
36
Learning Objectives of Statement of
Cash Flows
 Understand difference between net profit
and net cash flow.
 Construct statement of cash flows using
indirect method.
 Use the statement of cash flows to
analyze a company.
37
Net profit vs. net cash flow
Net profit does not equal net cash flow
Net profit
Net cash flow
 firm performance
 firm performance in
under accrual
terms of ability to
method of accounting
generate cash
 Easily manipulated
 Harder to
manipulate
38
Statement of Cash Flows
 Provides information about cash inflows
and outflows during an accounting period
 Focuses on CASH.
 Has THREE sections:
•
•
•
Cash flow from Operating Activities (OCF)
Cash flow from Investing Activities (ICF)
Cash flow from Financing Activities (FCF )
39
40
Useful Tip
Cash flow from Operating Activities
+
Cash flow from Investing Activities
+
Cash flow from Financing Activities
= CHANGE in cash account for the period!
41
Another Useful Tip
No matter which section you are doing (operating,
investing or financing),
 IF the change is a cash INFLOW, you add that
change. +
 IF the change is a cash OUTFLOW, you
subtract that change. inflow: decreases in assets or increases in liabilities or
equity.
outflow: increases in assets or decreases in liabilities or
equity.
42
Cash flows from
operating activities
Net income
+ Depreciation
IS means
Income
Statemen
t
+ Decrease in any asset account related to IS
-
Increase in any asset account related to IS
Decrease in any liability account related to IS
+ Increase in any liability account related to IS
= Net cash flow from operating activities
43
Cash flows from
operating activities 3
Asset accounts related:


Accounts receivable
Inventories
Liability accounts related:


Accounts payable
Accruals
44
Cash flows from
operating activities 4
Asset
Liability
Decreases
Add
(cash inflow)
Subtract
(cash outflow)
Increases
Subtract
(cash outflow)
Add
(cash inflow)
45
Cash flows from
investing activities 1
 Investing activities:
•
Buying or selling productive assets
(plant & equipment)
•
Buying or selling financial securities that
expire after 1 year
(e.g., stock of other companies, bonds)
46
Cash flows from
investing activities 2
Inflows:
Means:
Decrease in gross fixed assets
Firm sells long-lived assets such as
gross property, plant and equipment
Decrease in long-term
investments
Firm sells debt or equity securities of
other firms
Outflows:
Increase in gross fixed assets
Firm buys long-lived assets such as
gross property, plant and equipment
Increase in long-term
investments
Firm buys debt or equity securities of
other firms
47
Cash flows from
investing activities 3
 Investing activities refer to changes on
the lower left-hand side of balance sheet
 Warning: we want changes in GROSS
fixed assets. We don’t want the changes
in net fixed assets!
 BUT, if gross fixed assets not reported in
balance sheet, ….?
48
Useful relationships
Change in gross fixed assets
= change in net fixed assets + depreciation
49
Balance Sheet Overview
Assets
Liabilities and Owners Equity
Cash
Marketable securities
Net A/R
Inventories
Total Current Assets
Notes Payable
Accounts Payable
Accrued Expenses
Current Portion of LTD
Total Current Liabilities
Long term (L.T.) Debt
Gross Fixed Assets
Total Liabilities
(less Accum. Depreciation)
Preferred Stock
Net Fixed Assets
Common Stock
Other long-term assets such as Retained Earnings
stocks and bonds
Total Liabilities and equity
Total Assets
Assets
Claims on Assets
50
Cash flows from
financing activities 1
Financing activities:
•
Loans from creditors (long-term, short-term)
•
Repayment of principal
•
Sale or repurchase of stock (common or
preferred) from firm’s equity holders
•
Payment of dividends
51
Cash flows from
financing activities 2
Inflows:
•increase in notes payable
•increase in long-term debt
•increase in common stock
Outflows:
•decrease in notes payable
•decrease in long-term debt
•decrease in common stock
Means:
Firm borrows money
•Payment of dividends
Firm pays cash to
shareholders
Firm sells equity securities
Firm repays debt
Firm buys back shares
52
Cash flows from
financing activities 3
Financing activities refer to:
•
Items on lower right-hand side of balance
sheet (long-term debt, equity)
•
Changes in notes payable (short-term bank
loans).
Useful relationship:
Dividends paid
= net income – change in retained earnings
53
IBM’s Statement of Cash Flow
 Where to find?
54
Solve Assignment 3.1
55
Analyzing Statement
of Cash Flows 1
Statement of CF can help you analyze a
company:
1) Relationship between net income and net
cash flow from operations (OCF)
 If net income positive, but OCF is negative,
could mean:
 Company is growing rapidly
 Financial mis-management
56
Analyzing Statement
of Cash Flows 2
2) Net cash flow from investing activities
(ICF)
If negative, company is making investments
 Buying plant & equipment (improve
efficiencies)
 Buying another company’s stock (strategic
reasons, e.g., joint venture)
If positive, company is liquidating assets.
Why? Financial distress?
57
Analyzing Statement
of Cash Flows 3
3) Does company have sufficient cash to
pay dividends?
OCF should exceed dividends.
If dividends exceed OCF, why?
 Company liquidated assets to pay dividends?
 Company issued equity or borrow to pay
dividends?
 Neither situation is good.
58
Analyzing Statement
of Cash Flows 4
4) Changes in debt
 Look at cash flow from financing
activities
 Big increases in debt (either short-term
or long-term) are not good.
 Substituting short-term debt for long-term
debt may indicate worsening financial
health.
59
Summary




Income Statement
Balance Sheet
Statement of Cash Flow
Assignments for self-practice:
1. Textbook problems (page 86):3-2, 3-3,
3-4, 3-8, 3-9
2. additional cash flow problems on
course web
60