Econ 4400
Lecture Notes on Accounting (Chapter 2)
Chapter Outline
2.1 The Balance Sheet
2.2 The Income Statement
2.3 Net Working Capital
2.4 Financial Cash Flow
2.5 Summary and Conclusions
Appendix 2A
Financial Statement Analysis
Appendix 2B
Statement of Cash Flows
Sources of Information
• Statistics Canada:
• balance sheets, income statements, selected
ratios
• Corporate Websites
• Investor Relations
• SEDAR
• Sedar.com for Canadian corporate filings
• TSX
• www.tmxmoney.com
• OSC
2.1 The Balance Sheet
• An accountant’s snapshot of the firm’s accounting
value as of a particular date.
• Lists two types of items: Assets and Liabilities.
• The Balance Sheet Identity is:
Assets ≡ Liabilities + Stockholder’s Equity
Bookkeeping
Balance Sheet
•Snapshot of assets and liabilities
Assets
Current Assets
-cash and equivalents (liquid financial assets)
-accounts receivable
-inventories
-other highly liquid assets: commodities, bitcoin, ….
Fixed Assets
-net property and equipment ( purchase and installation price – depreciation)
-investment in other companies
-goodwill (difference between purchase price of an asset and associated book value)
- intangibles
Balance Sheet
Liabilities
Short-Term Liabilities
-short-term debt (less than 1yr)
-accounts payable
Long-term Debt
-bank credit
-long-term debt
-minority interest
Assets ≡ Liabilities + Shareholders’ Equity
Note. What is the difference between book value and market
value?
The Balance Sheet of the
Canadian Composite Corporation
CANADIAN COMPOSITE CORPORATION
Balance Sheet
20X2 and 20X1
(in $ millions)
Liabilities (Debt)
Assets
Current assets:
Cash and equivalents
Accounts receivable
Inventories
Other
Total current assets
20X2
$140
294
269
58
$761
20X1
$107
270
280
50
$707
Fixed assets:
Property, plant, and equipment
$1,423 $1,274
Less accumulated depreciation
-550
-460
Net property, plant, and equipment
873
814
Intangible assets and other
245
221
Total fixed assets
$1,118 $1,035
Total assets
$1,879
$1,742
The and
assets
are listed
order20X1
Stockholder's
Equity in 20X2
Current Liabilities:
by
the length
of time it $213 $197
Accounts
payable
Notes payable
50
53
normally
would take a firm
Accrued expenses
223
205
Totalongoing
current liabilities
with
operations$486
to $455
Long-term liabilities:
convert
them into cash.
Deferred taxes
Long-term debt
Total long-term liabilities
$117
471
$588
$104
458
$562
Stockholder's equity:
Preferred stock
$39
$39
Common stock ($1 per value)
55
32
Capital surplus
347
327
Accumulated retained earnings
390
347
Less treasury stock
-26
-20
Total equity
$805
$725
Total liabilities and stockholder's equity $1,879 $1,742
Clearly, cash is much more
liquid than property, plant and
equipment.
Balance Sheet Analysis
When analyzing a balance sheet, the financial manager should be
aware of three concerns:
1. Liquidity
2. Debt versus equity
3. Value versus cost
•
Accounting Liquidity
• Refers to the ease and speed with which assets can be converted to
cash.
• Current assets are the most liquid.
• Some fixed assets are intangible.
• The more liquid a firm’s assets, the less likely the firm is to experience
problems meeting short-term obligations.
• Liquid assets frequently have lower rates of return than fixed assets.
Debt versus Equity
• Generally, when a firm borrows it gives the bondholders first claim on
the firm’s cash flow.
• Thus shareholder’s equity is the residual difference between assets
and liabilities.
Value versus Cost
• Under GAAP audited financial statements of firms in Canada carry
assets at historical cost adjusted for depreciation.
• Market value is a completely different concept. It is the price at which
willing buyers and sellers trade the assets.
2.2 The Income Statement
• The income statement measures performance over
a specific period of time.
• The accounting definition of income is
Revenue  Expenses  Income
Income Statement
• Describes firm’s performance over a segment of time.
• describes how money flows in and out of a company
over that segment time.
Operating Revenues (Sales) – Total Operating Expenses =
Operating Profit
+ Other revenue
- Other cost
=
EBITDA
(Earnings before Interest, Tax, Depreciation and
Amortization)
Income Statement
• EBITDA- Depreciation and Amortization =
EBIT (Earnings Before Interest and Taxes)
• EBIT – Net Interest on Debt =
Taxable Income (= Earnings Before Taxes)
• Taxable Income – Taxes =
Net Income
Net Income
-amount of money earned in a given period
-can be paid out as dividend or can be added to retained earnings
Income Statement
So why not just report cash flows instead of income?
When reporting accounting income good new projects increase
corporate earnings but the may decrease cash flow
temporarily. You want income to correspond to wealth gained
in the period, not some spurious cash outflow. You want to tax
wealth increases, not some cash transfers.
On the other hand, income statements are sometimes easier to
manipulate (e.g. Enron, WorldCom). Company in financial
distress can still report stable income with help of creative
accounting.
Income Statement
CANADIAN COMPOSITE CORPORATION
Income Statement
20X2
(in $ millions)
The operations
section of the
income statement
reports the firm’s
revenues and
expenses from
principal
operations
Total operating revenues
Cost of goods sold
Selling, general, and administrative expenses
Depreciation
Operating income
Other income
Earnings before interest and taxes
Interest expense
Pretax income
Taxes
Current: $71
Deferred: $13
Net income
Retained earnings:
Dividends:
$2,262
- 1,655
- 327
- 90
$190
29
$219
- 49
$170
- 84
$86
$43
$43
Income Statement
CANADIAN COMPOSITE CORPORATION
Income Statement
20X2
(in $ millions)
The nonoperating section
of the income
statement includes
all financing costs,
such as interest
expense.
Total operating revenues
Cost of goods sold
Selling, general, and administrative expenses
Depreciation
Operating income
Other income
Earnings before interest and taxes
Interest expense
Pretax income
Taxes
Current: $71
Deferred: $13
Net income
Retained earnings:
Dividends:
$2,262
- 1,655
- 327
- 90
$190
29
$219
- 49
$170
- 84
$86
$43
$43
Income Statement
CANADIAN COMPOSITE CORPORATION
Income Statement
20X2
(in $ millions)
Usually a separate
section reports as a
separate item the
amount of taxes
levied on income.
Total operating revenues
Cost of goods sold
Selling, general, and administrative expenses
Depreciation
Operating income
Other income
Earnings before interest and taxes
Interest expense
Pretax income
Taxes
Current: $71
Deferred: $13
Net income
Retained earnings:
Dividends:
$2,262
- 1,655
- 327
- 90
$190
29
$219
- 49
$170
- 84
$86
$43
$43
Income Statement
CANADIAN COMPOSITE CORPORATION
Income Statement
20x2
(in $ millions)
Net income is the
“bottom line”.
Total operating revenues
Cost of goods sold
Selling, general, and administrative expenses
Depreciation
Operating income
Other income
Earnings before interest and taxes
Interest expense
Pretax income
Taxes
Current: $71
Deferred: $13
Net income
Retained earnings:
Dividends:
$2,262
- 1,655
- 327
- 90
$190
29
$219
- 49
$170
- 84
$86
$43
$43
Income Statement
Corporate Income vs Corporate Cash Flow
• Corporate Income is money earned in a period
• Corporate Cash Flow is dollars that flow in a period.
Differences
1) Depreciation – affects income but not cashflow
2) Purchase of a new asset – b/c payment is subtracted over time
3) Deferred payments – accounts receivable and payable
4) Deferred taxes
Income Statement Analysis
•
There are three things to keep in mind when analyzing an income
statement:
1. Generally Accepted Accounting Principles (GAAP)
2. Non Cash Items
3. Time and Costs
Generally Accepted Accounting
Principles
1. GAAP
• The matching principal of GAAP dictates that revenues be
matched with expenses. Thus, income is reported when it is
earned, even though no cash flow may have occurred.
• For example,when goods are sold for credit, sales and profits
are reported.
Income Statement Analysis
2. Non Cash Items
• These are expenses that do not affect cash flow directly.
• Depreciation is the most apparent. No firm ever writes a
cheque for “depreciation.”
• Another noncash item is deferred taxes, which does not
represent a cash flow.
Income Statement Analysis
3. Time and Costs
• In the short run, certain equipment, resources, and commitments of
the firm are fixed, but the firm can vary such inputs as labour and
raw materials.
• In the long run, all inputs of production (and hence costs) are
variable.
• Financial accountants do not distinguish between variable costs and
fixed costs. Instead, accounting costs usually fit into a classification
that distinguishes product costs from period costs.
2.3 Net Working Capital
Net Working Capital ≡ Current Assets – Current Liabilities
• NWC is +ve when current assets are greater than
current liabilities.
• A firm can invest in NWC. This is called change in
NWC .
• The change in NWC is usually +ve in a growing firm.
The Balance Sheet of the C.C.C.
CANADIAN COMPOSITE CORPORATION
Balance Sheet
20X2 and 20X1
(in $ millions)
$252m = $707- $455
Assets
Current assets:
Cash and equivalents
Accounts receivable
Inventories
Other
Total current assets
20X2
$140
294
269
58
$761
20X1
$107
270
280
50
$707
Fixed assets:
Property, plant, and equipment
$1,423 $1,274
Less accumulated depreciation
-550
-460
Net property, plant, and equipment
873
814
Intangible assets and other
245
221
Total fixed assets
$1,118 $1,035
$275m = $761m- $486m
Total assets
$1,879
$1,742
Liabilities (Debt)
and Stockholder's Equity
Current Liabilities:
Accounts payable
Notes payable
Accrued expenses
Total current liabilities
20X2
$213
50
223
$486
20X1
$197
53
205
$455
Long-term liabilities:
Deferred taxes
Long-term debt
Total long-term liabilities
Here we see NWC grow
$117 to $104
471
458
$275 million in 20X2 from
$588
$562
$252 million in 20X1.
Stockholder's equity:
Preferred stock
$39
$39
$23
million
Common stock ($1 par value)
55
32
Capital surplus
347
327
Accumulated retained earnings
390
347
Less treasury stock
-26
-20
Total equity
$805
$725
Total liabilities and stockholder's equity $1,879 $1,742
This increase of $23 million is
an investment of the firm.
2.4 Financial Cash Flow
• *In finance, the most important item that can be
extracted from financial statements is the actual
cash flow of the firm.
• Since there is no magic in finance, it must be the
case that the cash received from the firm’s assets
must equal the cash flows to the firm’s creditors and
stockholders.
CF ( A)  CF ( B)  CF ( S )
Financial Cash Flow of the C.C.C.
CANADIAN COMPOSITE CORPORATION
Financial Cash Flow
20X2
(in $ millions)
Cash Flow of the Firm
Operating cash flow
(Earnings before interest and taxes
plus depreciation minus taxes)
Capital spending
(Acquisitions of fixed assets
minus sales of fixed assets)
Additions to net working capital
Total
Cash Flow of Investors in the Firm
Debt
(Interest plus retirement of debt
minus long-term debt financing)
Equity
(Dividends plus repurchase of
equity minus new equity financing)
Total
$238
Operating Cash Flow:
EBIT
-173
-23
$42
$36
6
$42
Depreciation
$219
$90
Current Taxes ($71)
OCF
$238
Financial Cash Flow of the C.C.C.
CANADIAN COMPOSITE CORPORATION
Financial Cash Flow
20X2
(in $ millions)
Cash Flow of the Firm
Operating cash flow
(Earnings before interest and taxes
plus depreciation minus taxes)
Capital spending
(Acquisitions of fixed assets
minus sales of fixed assets)
Additions to net working capital
Total
Cash Flow of Investors in the Firm
Debt
(Interest plus retirement of debt
minus long-term debt financing)
Equity
(Dividends plus repurchase of
equity minus new equity financing)
Total
$238
Capital Spending
-173
-23
$42
$36
6
$42
Purchase of fixed assets
Sales of fixed assets
Capital spending
$198
(25)
$173
Financial Cash Flow of the C.C.C.
CANADIAN COMPOSITE CORPORATION
Financial Cash Flow
20X2
(in $ millions)
Cash Flow of the Firm
Operating cash flow
(Earnings before interest and taxes
plus depreciation minus taxes)
Capital spending
(Acquisitions of fixed assets
minus sales of fixed assets)
Additions to net working capital
Total
Cash Flow of Investors in the Firm
Debt
(Interest plus retirement of debt
minus long-term debt financing)
Equity
(Dividends plus repurchase of
equity minus new equity financing)
Total
$238
-173
-23
$42
$36
6
$42
NWC grew to $275
million in 20X2 from
$252 million in 20X1.
This increase of $23
million is the addition to
NWC.
Financial Cash Flow of the C.C.C.
CANADIAN COMPOSITE CORPORATION
Financial Cash Flow
20X2
(in $ millions)
Cash Flow of the Firm
Operating cash flow
(Earnings before interest and taxes
plus depreciation minus taxes)
Capital spending
(Acquisitions of fixed assets
minus sales of fixed assets)
Additions to net working capital
Total
Cash Flow of Investors in the Firm
Debt
(Interest plus retirement of debt
minus long-term debt financing)
Equity
(Dividends plus repurchase of
equity minus new equity financing)
Total
$238
-173
-23
$42
$36
6
$42
Financial Cash Flow of the C.C.C.
CANADIAN COMPOSITE CORPORATION
Financial Cash Flow
20X2
(in $ millions)
Cash Flow of the Firm
Operating cash flow
(Earnings before interest and taxes
plus depreciation minus taxes)
Capital spending
(Acquisitions of fixed assets
minus sales of fixed assets)
Additions to net working capital
Total
Cash Flow of Investors in the Firm
Debt
(Interest plus retirement of debt
minus long-term debt financing)
Equity
(Dividends plus repurchase of
equity minus new equity financing)
Total
$238
Cash Flow to Creditors
-173
-23
$42
Interest
Retirement of debt
$42
73
Debt service 122
$36
6
$49
Proceeds from new debt
sales
(86)
Total
36
Financial Cash Flow of the C.C.C.
CANADIAN COMPOSITE CORPORATION
Financial Cash Flow
20X2
(in $ millions)
Cash Flow of the Firm
Operating cash flow
(Earnings before interest and taxes
plus depreciation minus taxes)
Capital spending
(Acquisitions of fixed assets
minus sales of fixed assets)
Additions to net working capital
Total
Cash Flow of Investors in the Firm
Debt
(Interest plus retirement of debt
minus long-term debt financing)
Equity
(Dividends plus repurchase of
equity minus new equity financing)
Total
$238
Cash Flow to Stockholders
-173
Dividends
$43
Repurchase of stock
-23
$42
6
Cash to Stockholders 49
Proceeds from new stock issue
(43)
$36
Total
6
$42
$6
Financial Cash Flow of the C.C.C.
CANADIAN COMPOSITE CORPORATION
Financial Cash Flow
20X2
(in $ millions)
Cash Flow of the Firm
Operating cash flow
(Earnings before interest and taxes
plus depreciation minus taxes)
Capital spending
(Acquisitions of fixed assets
minus sales of fixed assets)
Additions to net working capital
Total
Cash Flow of Investors in the Firm
Debt
(Interest plus retirement of debt
minus long-term debt financing)
Equity
(Dividends plus repurchase of
equity minus new equity financing)
Total
$238
-173
-23
$42
$36
6
$42
The cash received from
the firm’s assets must
equal the cash flows to the
firm’s creditors and
stockholders:
CF ( A) 
CF ( B )  CF ( S )
2.5 Summary
Conclusions
• Financialand
statements
provide important information
regarding the value of the firm.
• A financial manager should be able to determine
cash flow from the financial statements of the firm.
• Knowing how to determine cash flow helps the
financial manager make better decisions.
• You should keep in mind:
• Measures of profitability do not take risk or timing of
cash flows into account.
• Financial ratios are linked to one another.
Appendix 2A Financial Statement
Analysis
•
Financial ratios provide information about five areas of financial
performance:
1.
2.
3.
4.
5.
Short-term solvency
Activity
Financial leverage
Profitability
Market value
Short-term solvency ratios
• Measure the firm’s ability to meet recurring financial obligations
Current ratio 
Total current assets
Total current liabilitie s
• A higher current ratio indicates greater liquidity
Short-term solvency ratios (continued)
Quick ratio 
Quick assets
Total current liabilities
• Quick assets = Current assets – inventories
• Quick ratio determines firm’s ability to pay off current liabilities
without relying on the sale of inventories.
Activity ratios
• Measure how effectively the firm’s assets are being managed
Total asset turnover 
Total operating revenues
Average total assets
• Example: retail and wholesale trade firms
tend to have high asset turnover ratios
compared to manufacturing firms
Activity ratios (continued)
Receivable s turnover 
Total operating revenues
Average receivables
Average collection period 
Days in period (i.e.365)
Receivable s turnover
• These ratios provide information on the
success of the firm in managing its
investment in accounts receivable.
Activity ratios (continued)
Inventory
turnover
Days in inventory 

Cost of goods sold
Average inventory
Days in period (i.e.365)
Inventory turnover
• Measure how quickly inventory is produced
and sold.
Financial leverage ratios
• Measure the extent to which a firm relies on debt financing .
Debt ratio 
Total debt
Total assets
Debt ratio 
Total debt
Total assets
Total assets
Equity multiplier 
Total equity
Financial leverage ratios (continued)
Interest coverage 
Earnings before interest and taxes (EBIT)
Interest expense
• Interest coverage ratio is directly connected
to the firm’s ability to pay interest.
Profitability ratios
Net profit margin 
Net income
Total operating revenue
• trade firms and service firms tend to have low
and high profit ratios respectively.
Profitability ratios (continued)
DuPont system of financial control
Return on assets  Profit margin x Asset turnover
Return on assets 
Net income
Total operating revenue
x
Total operating revenue
Average total assets
• Firms tend to face a trade-off between turnover and margin
Profitability ratios (continued)
Return on equity 
Net income
Average shareholders equity
ROE  Profit margin x Asset turnover X Equity multiplier
ROE 
Net income
Total operating revenue
Average total assets
x
x
Total operating revenue
Average total assets
Average shareholders' equity
• The difference between ROA and ROE is due
to financial leverage.
Market value ratios
Price - Earnings ratio 
Market price/shar e
current annual earnings /share
• P/E ratio shows how much investors are
willing to pay for $1 of earnings per share.
• It also reflects investors’ views of the growth
potential of different sectors.
Market value ratios (continued)
Market - to - Book ratio 
Market price/share
Book value/share
• The M/B ratio compares the market value of
the firm’s investments to their cost .
• a M/B value < 1 indicates that the firm has
not been successful in creating value for its
shareholders.
Remarks on ratios
• Financial ratios are linked to one another.
• Measures of profitability do not take risk or timing
of cash flows into account.
Things to Look for in Financial Statements
Liquidity – does the company have enough short-term assets to cover
short-term liabilities?
Short-term Assets / Short-term Liabilities
Illiquid if number is too low, < 1
Liquid if > 1
Note, if this number is significantly greater than 1, this is a bad sign b/c company is either
underinvested or holds unnecessary amounts of cash.
Things to Look for in Financial Statements
Profitability
1) Historical Profitability
Book value of equity / market value of equity
If <<< 1 profitable
If >>> 1 non-profitable
2) Present Profitability (the bigger, the better)
a) Net Income / Assets
b) Net Income / Equity Value
c) Net Income + Interest Expense / Assets
Things to Look for in Financial Statements
Future Growth Potential
Market Value / Earnings (P/E ratio) or
Price Per Share / Earnings Per Share
What is the standard (average) range for P/E?
Range – 7 to 40 or 50
Average – 15-20 (TSX)
P/E is a poor, if not entirely useless, measure for companies with
negative income, in particular for many young companies that
work on R&D and report zero revenues.