Chapter 2
Financial
Statements
Learning Objectives
1. Explain the foundations of the balance
sheet and income statement
2. Use the cash flow identity to explain
cash flow.
3. Provide some context for financial
reporting.
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2.1 Financial Statements
• Four main financial statements:
–
–
–
–
Balance sheet
Income Statement
Statement of Retained Earnings
Statement of Cash Flow
• Our focus..
– Interrelationship between the balance sheet and
the income statement –
– The process by which these statements can be
used to project a firm’s future cash flows,
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2.1 Financial Statements
(continued)
(A) Balance Sheet
• Represents the assets owned by the
company and the claims against those
assets
• Based on the accounting identity:
Assets  Liabilities + Owners’ Equity
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(2.1)
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Figure 2.1 Balance sheet
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2.1 (A) Balance Sheet
Has 5 main sections:
1. Cash account
• Where did the $65 million decline come from?
2. Working capital accounts
• Net working capital = Current assets – Current liabilities (2.2)
3. Long-term asset accounts
• Plant and equipment; land and buildings
• Gross value – accumulated depreciation = Net value
4. Long-term liabilities (debt) accounts
• Loans maturing in over 1 year
5. Ownership accounts
• Shareholders’ equity
• Retained earnings—accumulated total since inception
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2.1 (B) The Income Statement
• Shows the expenses and revenues
generated by a firm over a past period,
typically a quarter or a year.
• Net income = Revenues – expenses (2.3)
• EBIT = Revenues – operating expenses (2.4)
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2.1 (B) Income Statement
example
Figure 2.2
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2.1 (B) The Income Statement
(continued)
• Net income is not the same as cash flow
• Firm earned an income of $5,642 million
• Cash account decreased by 65 million
• 3 reasons:
• Accrual accounting
• Non-cash expense items --depreciation
• Preference to classify interest expense as part of
financial cash flow
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2.1 (C) The Statement of
Retained Earnings
Figure 2.4
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2.2 Cash Flow Identity and the
Statement of Cash Flows
The cash flow identity states that the cash
flow on the left-hand side of the balance sheet
is equal to the cash flow on the right-hand
side of the balance sheet.
CASH FLOW
FROM ASSETS
=
CASH FLOW
TO CREDITORS
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+
CASH FLOW
TO OWNERS
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Additional Problems with Answers
Problem 1
Balance Sheet. Chuck Enterprises has
current assets of $300,000, and total assets
of $750,000. It also has current liabilities of
$125,000, common equity of $250,000, and
retained earnings of $85,000. How much
long-term debt and fixed assets does the
firm have?
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Additional Problems with Answers
Problem 1 (Answer)
Current Assets + Fixed Assets = Total Assets
$300,000+Fixed Assets = $750,000
Fixed Assets = $750,000 - $300,000 = $400,000
Total Assets = Current Liabilities + Long-term debt
+Common equity + Retained Earnings
$750,000 = $125,000 + Long-term debt + $250,000 +
85,000
Long-term debt = $750,000 - $125,000-$250,000 $85,000
Long-term debt = $290,000
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Additional Problems with Answers
Problem 2
Income Statement. The Top Class Company had
revenues of $925,000 in 2014. Its operating expenses
(excluding depreciation) amounted to $325,000,
depreciation charges were $125,000, and interest
costs totaled $55,000. If the firm pays a marginal tax
rate of 34 percent, calculate its net income after
taxes.
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Additional Problems with Answers
Problem 2 (Answer)
Revenues
Less operating expenses
= EBITDA
Less depreciation
= EBIT
Less interest expenses
= Taxable Income
Less taxes (34%)
= Net Income after taxes
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$925,000
325,000
600,000
125,000
475,000
55,000
420,000
142,800
277,200
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Additional Problems with Answers
Problem 3
Retained Earnings: The West Hanover Clay Co. had,
at the beginning of the fiscal year, November 1,
2013, retained earnings of $425,000. During the year
ended October 31, 2014, the company generated net
income after taxes of $820,000 and paid out 35
percent of its net income as dividends. Construct a
statement of retained earnings and compute the
year-end balance of retained earnings.
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Additional Problems with Answers
Problem 3 (Answer)
Statement of Retained Earnings for
the year ended October 31, 2014
Balance of Retained Earnings, 11/1/2013……….$425,000
Add: Net income after taxes, 10/31/2014………. $820,000
Less: Dividends paid for year-end 10/31/2014…$287,000
Balance of Retained Earnings, 10/31/2014….. $958,000
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Additional Problems with Answers
Problem 4
Working Capital: D.K. Imports, Incorporated reported
the following information at its last annual meeting:
Cash and cash equivalents = $1,225,000;
Accounts payables = $3,200,000
Inventory = $625,000;
Accounts receivables = $3,500,000;
Notes payables = $1,200,000;
Other current assets = $125,000.
Calculate the company’s net working capital.
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Additional Problems with Answers
Problem 4 (Answer)
Net Working Capital = Current Assets – Current Liabilities
(Cash & Cash Equivalents + Accts. Rec. + Inventory +
other current assets) - (Accounts Payables + Notes
Payables)
($1,225,000+$3,500,000+$625,000+$125,000) ($3,200,000+$1,200,000)
$5,475,000 - $4,400,000
Net Working Capital $1,075,000
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Additional Problems with Answers
Problem 5
Cash Flow from Operating Activities: The Mid-American Farm
Products Corporation provided the following financial information
for the quarter ending September 30, 2014:
Depreciation and amortization  $75,000
Net Income  $225,000
Increase in receivables $95,000
Increase in inventory  $69,000
Increase in accounts payables  $80,000
Decrease in marketable securities  $34,000.
What is the cash flow from operating activities generated during
this quarter by the firm?
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Additional Problems with Answers
Problem 5 (Answer)
Net Income
225,000
Add depreciation and amortization
75,000
Add decrease in marketable securities
34,000
Add increase in accounts payables
80,000
Less increase in accounts receivables
95,000
Less increase in inventory
69,000
Cash flow from operating activities
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$250,000
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