Principles of Finance
Chapter 3: Understanding the Financial Statements
3.1: An Overview of the firm’s financial Statements
There are four main financial statements:
● Income Statement: includes the revenues the firm has earned the expenses it
has incurred to earn those revenues and the profits it has earned over the specific
period of time. Quarter or annual
● Balance Sheet: contains information about the firm’s assets (eveything of a value
that a firm owns), liabilities (the company’s debts and obligations) and the
stockholders equity (the money invested by the company’s owners). It shows the
values for a particular date.
● Cash flow statement: reports cash received and spent by the firm over a spefic
period of time.
● Statement of stockholders equity: provides a detailed account of activities in the
firm’s common and preferred stock accounts and retained earnings.
There are reasons to study financial statements:
● Financial statement analysis: The basic objective of financial statement analysis
is to assess the financial condition of the firm being analyzed. In a sense, the
analyst performs a financial analysis so he or she can see the firm’s financial
performance the same way an outside investor would see it
● Financial control. Managers use financial statements to monitor and control the
firm’s operations. The performance of the firm is reported using accounting
measures that com- pare the prices of the firm’s products and services with the
estimated costs of providing them to buyers.
● Financial forecasting and planning: those statements describe the firm’s
operations hence we build the financial forecasts and plans on those statements.
There are principles we have to follow when creating the financial statements:
● Revenue recongition principle: the firm recognizes the revenue only when they
deliver the service
● The matching principle: you attribute costs directly to the revenue you generate.
You match the labor costs for example not at the end of the months but rather
when you generate the revenue or make a sale that was dependent on that labor.
● The hisorical cost principle: most of the assets on the balance sheet are
recorded as the company’s historical purchasing price. It does not reflect the
market cost of the assets.
○ Some marketable securities and cash equivalents are reported on their
lower end or the current valuation. The change in the value of those to
reflect the current market price is called Making the Market.
3.2: The Income Statement
●
●
Revenue (Sales) - Expenses = Profit
Earnings Per Share
3.3: Corporate Taxes
There is a dividend exclusion for corporate holdings to avoid double taxation. Not all
dividends received from the corporation are taxeed similarly.
3.4: The Balance Sheet
●
●
Total Assets=Liabilities + Shareholder Equity
GAAP requires firms to report their assets at the historical costs. Except for cash and
marketable securities which are reported at the lower end of their value.
●
Gross Plant and Equipment: the sum of the original acquisition prices for plant and
equipment still owned by the firm
Accumulated depreciation: The sum of all all the depreciation expenses charged
against the prior year’s revenues for fixed assets that the firm owns
Net Plant Equipment: the depreciated value of the firm’s plants and equipment.
Current Assets: consists of the firm’s cash plus theassets the firm expects to convert
into cash within the year.
Fixed Assets: firm does not expect to sell them within th eyear. Includes plant and
equipment, land, and other investments that are expected to be held for an extended
period of time.
Current Liabilities: amount of athe money owed within the 12 months
Stockholder’s equity: common stock + retained earnings.
●
●
●
●
●
●
Net working capital refers to the liquidity of the firm. It is calculated by current assets-current
liabilities.
Historical Cost, Book Values, and Market Values
● Book values reflect the historical costs of acquiring assets
● Market value refers to the actual market price of the asset
● Book values are depreciated on the balance sheet due to the tax and accounting
reasons
● There is a difference between them add usually the book value is less than the
market value.
3.5: Cash Flow Statement
Reports the changes in the cash balance over the period of the year. It reflects the cash
changes and tracks the movement of the cash in the firm
● Change in cash: Ending - Beginning
● Source of Cash/Use of cash: activity that brings the cash in the firm and the
activity that takes the money away from the firm.