CHAPTER 4. FINANCIAL STATEMENTS
Accounting standards require statements that show the financial position, earnings, cash flows,
and investment (distribution) by (to) owners. These measurements are reported, respectively, by the
following statements: balance sheet, income statement, statement of cash flows, and statement of
changes in equity. These statements can be constructed in a variety of different ways and levels of
detail. An important consideration is that the financial framework of the firm should compliment the
physical performance measures of the firm.
A typical indicator used as a measure of the firm’s financial health is its cash position. Cash
flows are an important, but often misleading, indicators of the financial health of a firm. Two
necessary conditions for long-term survival in any firm are profitability and feasibility. Profitability
is defined as the difference between a firm’s revenues and its expenses. Feasibility is the solvency
or short-term ability of the firm to meet its obligations when they become due. If a firm is not both
profitable and feasible over time, it cannot survive. In the short run, a firm can be feasible but not
profitable. For a limited time, the firm can generate cash flows to remain solvent by borrowing,
refinancing existing debt, selling inventory, liquidating capital assets, increasing accounts payable, or
depleting its capital base. Unfortunately, these techniques are only temporary solutions and don’t
substitute for long-run profitability. Focusing on only the firm’s "cash position" can, and has, led to
devastating results for firms. An appropriately constructed set of financial statements will allow a
firm to monitor both profitability and solvency and diagnose any difficulties the firm has in these
areas.
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Balance Sheet
A balance sheet is a listing of a firm’s assets, debt claims, and equity claims at a particular
point in time. People are usually taught to think of it as a "snap shot" of the firm on a given date.
As a result, it is important to know the date for which the balance sheet was constructed. Table 2.4
presents 1995-97 year-end balance sheets for the hypothetical HiQuality Nursery company, which
might be organized as sole proprietorship, partnership, or corporation.
The underlying principal for any balance sheet is the fundamental accounting equation:
Assets
/ Liabilities + Equity.
In other words, every dollar of the firm’s assets must be financed either by a liability (debt borrowed
by the firm) or equity claim (capital supplied by the firm’s owners), or some combination of the two.
This principal results in the separation of assets from liabilities and equity on the balance sheet. We
can check the above equality by noting that the total value of assets at the bottom of the balance sheet
is equal to the total value of liabilities and equity for each year.
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Table 4.1 Year-End Balance Sheets for HiQuality Nursery
HiQuality Nursery
Balance Sheets ($000)
Year
1997
1996
1995
$ 600
1,200
5,200
$ 930
1,640
3,750
$1,200
1,560
3,150
7,000
6,320
5,910
Prop, Plant, and Equip
Other Assets
2,800
600
2,990
690
3,270
710
LONG TERM ASSETS
3,400
3,680
3,980
10,400
10,000
9,890
Notes Payable
Current Portion LTD
Accounts Payable
Accrued Liabilities
1,270
450
4,000
800
1,500
500
3,000
958
1,400
700
2,400
870
CURRENT LIABILITIES
6,600
5,958
5,370
TOTAL LONG TERM DEBT
1,985
2,042
2,560
TOTAL EQUITY
1,815
2,000
1,960
10,400
10,000
9,890
ASSETS
Cash and Mkt Securities
Accounts Receivable
Inventory
CURRENT ASSETS
TOTAL ASSETS
LIABILITIES
TOTAL DEBT AND EQUITY
The firm’s assets and liabilities are typically listed in order of liquidity or payment. For
example, current assets are expected to be liquidated within the next year and are listed above long-
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term assets, which are not expected to be liquidated during the upcoming year. Likewise, current
liabilities are debts due within the upcoming year and are listed above long-term liabilities, which are
debts that will not come due during the next year. Equity, which represents residual ownership of
the firm’s assets, has no fixed due date and is consequently listed last. Items within each category on
the balance sheet are also listed in order of liquidity or payment.
Assets
Assets represent the resources available to the firm to be used to generate earnings and
includes everything owned that has value. Current assets are represented by cash and near-cash
assets that are expected to be liquidated during the next year. Current assets are typically assets
whose liquidation will not significantly disrupt the operation of the firm. Besides cash, current assets
often include marketable securities, accounts receivable, notes receivable, and inventories.
Marketable securities are interest bearing deposits which are low risk in terms of principal balance
and can easily be converted to cash if needed. Accounts receivable are sales that have been made
but not collected from customers. Notes receivable are debt payments due to the firm during the
upcoming year.
Finally, inventories represent the value of inputs used in production or
manufacturing of goods that have not been sold. Inventories are often the least liquid of the current
assets and their value is often not known until the assets are sold.
Noncurrent long-term assets are assets that yield service over a period of time and are
expected to remain in the firm beyond the upcoming year. Liquidation of fixed assets typically would
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disrupt the operations of the firm. Fixed assets include such items as machinery, equipment,
automobiles, breeding stock, contracts, long-term notes receivable, and real estate.
Book Value versus Market Value
Assets are recorded at a value equal to their acquisition costs. Many fixed assets wear out
or lose value over time. This loss in value is accounted for by depreciating, or lowering the
acquisition cost, of the assets over time. The value of each asset on the balance sheet (acquisition
cost - accumulated depreciation) is called the asset’s book value.
A difficulty with financial
statement analysis is that an asset’s book value almost always differs significantly from the asset’s
market value which is what the firm can actual get if it sells the asset.
In order to understand why book value is not equal to market value, let’s think about what
determines market value. We’ll show this more formally later, but it turns out that the value of an
asset generally depends on the following three characteristics of the future cash flows the asset is
expected to generate:
1.
the size and/or number of expected future cash flows;
2.
the timing of expected future cash flows; and
3.
the risk and variability of future cash flow.
In general, the larger the size and/or number of expected future cash flows, the larger the
assets market value will be. Likewise, the sooner you expect to get the cash flows, the higher the
market value of the asset (think about the time value of money concept). Finally, everything else held
constant, the greater the risk or variability of an asset’s future cash flows, the lower the market value
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of the asset. Hopefully, these ideas make some intuitive sense to you; if not, don’t worry. We will
revisit these concepts in detail later.
One final note on market value. In some cases, an asset’s value may not be solely based on
the future cash flows an asset will generate; the asset may provide other nonmonetary services. For
example, you might be able to purchase a $50,000 house that has a higher level of expected future
after-tax cash flows than the $100,000 house you are also considering; that is, you think you can
make more (or spend less) money by investing in the $50,000 house; however, you might buy the
$100,000 house because it will be a nicer place to live and you are willing to sacrifice some of your
wealth to increase your living standard. In other words, the house you live in is both an investment
and a consumption good. As we discussed in Chapter 1, whenever you mix management and
ownership, you can get results that aren’t solely based on value maximization.
Liabilities and Equity
Liabilities are obligations to repay debt that has been incurred. Current liabilities are
normally paid during the upcoming year. These typically include accounts payable, current principal
and interest payments, and accrued expenses. Accounts payable are expenditures that have been
made, to purchase inputs used in production, for example, but not paid yet. Current principal and
interest, often called notes payable, are the short-term debt obligations and/or the portion of longterm debt obligations that are due during the upcoming year. Accrued expenses are expenses that
have been incurred through the operation of the firm but are not due for payment yet. Examples of
accrued expenses include taxes payable and salary and wages payable. Noncurrent or long-term
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liabilities are obligations that will be payable sometime after the upcoming year. These are usually
long-term notes payable, mortgages, or bond obligations.
Equity, or net worth, is always the difference between the total book value of assets and the
total liabilities of the firm. The value of the equity is an estimate of what owners of the firm would
have left after selling all the assets and paying all liabilities. Therefore, this is a major item of concern
in financial statements. In a corporation, the firm owns the assets and shareholders own shares of
stock in the corporation. In large corporations whose shares are traded on organized exchanges, the
value of the stock can differ substantially from the book value of the stock. Why do you think this
is the case?
The equity portion of the balance sheet looks different for a corporation than for a partnership
or sole proprietorship, simply because of the nature of the equity. Corporations report equity in terms
of the amount of initial value of the different types of stock that the shareholders own. Similarly,
withdrawals are reported as dividends in corporate reporting.
Income Statement
The balance sheet provides useful information about a firm’s financial situation at a single
point in time. Nevertheless, it doesn’t tell you much about a firm’s performance over time. Looking
at the change in retained earnings on the balance sheet from one period to the next gives a clue as to
whether the firm earned a profit, or realized a loss, but that is all the information that is discernable
about a firm’s profit-loss situation from the balance sheet. An income statement breaks a firm’s
revenues and expenses into different components that determine the firm’s profitability. Table 4.2
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shows the 1996 and 1997 income statements for HiQuality Nursery. Unlike the balance sheet which
is a picture of the firm’s assets at a particular point in time, the income statement is a record of what
has happened to the firm’s operations between two points in time in terms of profits and losses.
Total revenue is made up the gross receipts or sales that are generated by the firm during the
accounting period. Expenses during the period are then deducted from total revenue to determine
the firm’s profitability during the period. Cost of goods sold reflect the direct cost to the firm to
produce, manufacture, or purchase the goods that were sold to generate the firm’s revenue. Cost
of goods sold is typically the largest expense in most businesses. Operating expenses, or overhead,
represent the costs of operating and administrating the business beyond those expense items included
in the cost of goods sold.
These expenses typically include such things as sales expenses,
administrative expenses, general office expenses, rents, salaries, and utilities. Depreciation is the
accounting measure of the decline in the value of the firm’s fixed assets during the period and can be
thought of as the cost to replace the long-term assets used up during the period.
Earnings before interest and taxes (EBIT) represents the firm’s profits from operations.
In other words, this is the profit the firm generates before paying the interest costs of the firm’s debt
financing and the tax obligations of the firm. Subtracting interest expenses from EBIT gives the firm’s
earnings before taxes (EBT) which is the firm’s profits after paying all expenses except taxes; EBT
is sometimes called profit before taxes.
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Table 4.2 Income Statement for HiQuality Nursery
HiQuality Nursery
Income Statements ($000)
Year
Net Sales
Cost of Sales
Operating Expenses
Depreciation
EARNING BEFORE INTEREST AND TAXES
Interest
EARNINGS BEFORE TAXES
Taxes
NET INCOME AFTER TAXES
1997
1996
$40,000
$38,000
28,000
11,000
350
25,600
11,330
470
650
600
480
465
170
135
68
64
102
71
Subtracting the firm’s tax liabilities from EBT gives the firm’s net income after taxes (NIAT),
which is the firm’s profit after taxes and is generally what we think about when we talk about a firm’s
profits. This is the amount of profit the firm generated during the accounting period after paying all
expenses including the debt servicing costs and taxes. NIAT is also the profit that is available to be
reinvested in the firm or withdrawn by the owners. Subtracting the amount of cash withdrawn by the
owner(s) from NIAT leaves the amount of profits reinvested in the firm, which is called retained
earnings. It is important to note that retained earnings is the link between the income statement and
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the balance sheet. The amount of retained earning during the accounting period must equal the
difference between the retained earnings on the balance sheet at the end of the period and the retained
earnings at the beginning of the accounting period; that is, the change in retained earnings between
the two periods.
Net Working Capital
Net working capital (NWC) is defined as current assets minus current liabilities and provides
a measure of the firm’s liquidity. If NWC is positive then the assets which are expected to be
converted to cash during the upcoming year will likely be sufficient to meet the liabilities due during
the upcoming year. HiQuality Nursery’s net working capital is positive each year, suggesting the firm
was capable of meeting short term debt obligations by using only the assets expected to be liquidated
during the upcoming year.
Year
Current Assets
1995
$5,910,000
$5,370,000
$540,000
1996
$6,320,000
$5,958,000
$362,000
1997
$7,000,000
$6,600,000
$400,000
-
Current Liabilities
=
Net Working Capital
Typically, you would like to see a positive NWC in a firm. A firm’s investment (or deinvestment) in
working capital can be measured by the change in NWC during the year. HiQuality Nursery’s change
in NWC during 1997 is measured by taking the difference between its 1997 and 1996 NWC; in other
words NWC = $400,000 - $362,000 = $38,000 (the symbol
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variable, in this case, NWC). This suggests that HiQuality has increased investment in NWC.
Normally you would like to see NWC increase over time in a growing firm.
Changes in Owners Equity
Because of the importance of measuring equity, a detailed statement of the reasons for
changes in equity is sometimes reported. The statement of changes in owner’s equity reports the same
information as contained in the balance sheet but provides detail on the reasons underlying the change
in equity. The equity position in a business can change as the result of profit or losses from the firm’s
operations, withdrawals by the firm’s owners, and/or new equity contributions by owners.
The statement of changes in owners equity generally takes on the following structure:
+
-
NIAT
Dividends
capital contributions
repurchase of equity capital
Change in equity
Financial Cash Flow
The firm’s balance sheet shows its financial position at a point in time, while the income
statement gives a measure of the firm’s profits over time. Nevertheless, we have mentioned several
times that an equally important measure is the firm’s after-tax cash flow (ATCF). NIAT differs from
a firm’s cash flow because NIAT includes a number of non-cash items and because cash inflows and
outflows also occur from nonoperating sources. For example, depreciation is generally a major
expense item on the income statement for most firms. This is, however, a noncash cash accounting
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expense; in other words, no cash was spent even though there is an expense on the income statement.
Clearly, NIAT underestimates a firm’s cash flows from operations by at least the amount of
depreciation expense.
Remember that the balance sheet requires that Assets = Liabilities + Equity. Similarly it must
be the case that the cash flows from a firm’s assets (CFa) must equal the cash flows to the firms
creditors (CFc) and equity holders (CFe):
CFa = CFc + CFe
The Statement of Cash Flows identifies the sources and uses of cash during the period
between two balance sheets. It replaces a similar statement called the Sources and Uses of Funds
Statement as a result of changes in the Generally Accepted Accounting Principles (GAAP) in 1988.
The general structure of the Statement of Cash Flows is
+
+
cash flows from operations
cash flows from investment activities
cash flows from financing activities
change in cash position
This format separates cash flows into the three major management areas: 1) operation
management, 2) asset management, and 3) financial management. The cash flows from operations
are associated with the management of the firm’s operations and reflect the cash flows generated by
the firm in producing and delivering its goods and services. The cash flows from investment activities
come from the purchase and sale of capital assets that occur as a result of the firm’s asset management
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strategies. The cash flows from financing activities result from borrowing new debt, repayment of
old debt, raising new equity capital, and returning capital to owners as a result of the firm’s financial
management practices. The primary purpose of the Statement of Cash Flows is to detail the sources
of cash flows in order to assess the firm’s ability to generate future cash flows, meet obligations, pay
dividends, and obtain future financing. The Statement isolates the difference between income from
operations and cash flows, as well as the effects of the firm’s investment and financing activities.
Table 4.3 Shows the Statement of Financial Cash Flow for the HiQuality Nursery Company.
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Table 4.3 Financial Cash Flow HiQuality Nursery
HiQuality Nursery
Statement of Cash Flows ($000)
Year
CASH FLOWS FROM OPERATIONS
1997
1996
Net Income
$ 102
$ 71
Depreciation Expense
Change in Acct. Rec.
Change in Inventory
Change in Current Liabilities
350
440
-1450
642
470
-80
-600
588
84
449
-70
-170
-57
-287
-344
-518
-31
-549
-330
-270
Net Cash from Operations
CASH FLOWS FROM INVESTMENTS
Net cash from investments
CASH FLOWS FROM FINANCING ACTIVITIES
Payment of LTD
Payment of dividends
Net cash from financing
CHANGE IN CASH POSITION
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The cash flow generated by the firm’s assets is often called the cash flow from operations and
is equal to the firm’s NIAT plus depreciation expense less the change in accounts receivable and
inventory plus the change in current liabilities. HiQuality’s operating cash flows are:
+
+
NIAT
Depreciation Expense
Change in Accounts Receivable
Change in Inventory
Change in Current Liabilities
Net Cash Flow From Operations
Adding depreciation expense to NIAT adjusts the firm’s profit for noncash expenses and converts
profits to an after-tax cash flows basis. Increasing (decreasing) accounts receivable or inventory uses
(generates) cash and decreases (increases) the cash flow from operations. Likewise, an increase
(decrease) in current liabilities generates (uses) cash, increasing (decreasing) the cash flows from
operations.
The cash flows from investments focuses on the reinvestment in and/or sale of the firm’s longterm assets. Purchasing fixed assets uses cash flow, while the sale of fixed assets generates cash flow
for the firm. For example, if you go out and sell your car, you generate some cash inflow. If you
then turn around and purchase a new car, you will have spent cash creating a cash outflow. The net
cash from investments is equal to amount of long term assets purchased less the amount sold. The
cash outflow from investment can be calculated as the beginning long-term assets less depreciation
expense less ending long-term assets.
Beginning LT Assets
- Depreciation Expenses
- Ending LT Assets
Net Cash Outflow from Investments
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The depreciation expense is the amount of assets used up during the period through
operations. The change in long-term assets represents the actual change in long-term assets during
the period and will differ from the depreciation expense if assets have been purchased or sold during
the period.
Cash flows from financing activities reflect cash flows from long-term debt and/or equity
financing. The net cash flow from financing activities is equal to the change in long-term debt less
the amount of withdrawals plus the amount of new equity capital less the amount of equity capital
repurchased:
+
-
Change in long-term debt
Amount of dividends
Amount of new equity capital
Amount of equity repurchased
Net Cash flow from financing
Increasing (decreasing) long-term borrowing increases (decreases) available cash. The
payment of dividends uses cash while a new equity contributions provides additional cash.
Repurchasing equity from same owners would require the use of cash and decrease cash flow.
Cash Versus Accrual Accounting
Another factor which causes actual cash flows to differ from profit measures and accounting
cash flow is the use of accrual accounting. Accrual accounting recognizes revenues in the period
they are earned and expenses in the period they are incurred. For example, you might sell corn in
December 1997 but not receive cash for it until January 1998. In this case you earned your revenue
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in 1997, even though you didn’t receive cash for it until 1998. Accrual accounting doesn’t care about
the timing of actual cash inflows and outflows.
An alternative available to many small businesses is to use a cash accounting system for tax
reporting purposes. Cash accounting recognizes revenues and expenses in the period in which they
are received. Using a cash accounting system in our corn example above, you would not count the
revenue from the corn sale until the cash was received in 1994 even though the grain was sold in
1997. Cash accounting allows firms to make some adjustments to revenues and expenses which
allows them to manage their tax liability to some extent.
Accrual accounting, on the other hand, provides a more accurate reflection of the firm’s
profitability and gives a better picture of the firm’s situation for monitoring and control purposes. As
a result, many small businesses use cash accounting for tax purposes and accrual accounting for
management purposes. It should be noted that businesses in which inventories are held are required
by the IRS to use an accrual based accounting system. However, most types of farm businesses are
excluded from this requirement and are allowed to use the cash basis of accounting for tax purposes.
It is usually not difficult to adjust financial statements from cash accounting to accrual accounting;
and this should be done for businesses that use a cash accounting system for tax purposes in order
to provide better information on the financial performance of the firm.
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