Corporate Finance
Twelfth Edition
Stephen A. Ross / Randolph W. Westerfield / Jeffrey F. Jaffe / Bradford D.
Jordan / Joe Smolira (digital co-author)
Chapter 2
Financial Statements and Cash
Flow
Key Concepts and Skills
Understand the information provided by financial statements
Differentiate between book and market values
Know the difference between average and marginal tax rates
Know the difference between accounting income and cash
flow
Calculate a firm’s cash flow
2-1
Chapter Outline
2.1 The Balance Sheet
2.2 The Income Statement
2.3 Taxes
2.4 Net Working Capital
2.5 Cash Flow of the Firm
2.6 The Accounting Statement of Cash Flows
2.7 Cash Flow Management
2-2
Sources of Information
Annual reports
Wall Street Journal
Internet
• NYSE (www.nyse.com)
• NASDAQ (www.nasdaq.com)
• Textbook (www.mhhe.com)
SEC
• EDGAR (Electronic Data Gathering, Analysis, and Retrieval system)
• 10K & 10Q reports
2-3
2.1 The Balance Sheet
An accountant’s snapshot of the firm’s accounting value at a
specific point in time
The Balance Sheet Identity is:
2-4
The Balance Sheet of the U.S.
Composite Corporation (1 of 2)
The assets are listed in order by the length of time it would normally take a firm
with ongoing operations to convert them into cash.
Clearly, cash is much more liquid than property, plant, and equipment.
2-5
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
2-6
Liquidity
Refers to the ease and quickness with which assets can be
converted to
—without a significant
.
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
than fixed assets.
2-7
Balance Sheet
Long-term financing =
.
2-8
2-8
Debt versus Equity
generally receive the first claim
on the firm’s cash flow.
are entitled to only the residual
value.
Shareholders’ equity =
.
2-9
Value versus Cost
Under generally accepted accounting principles (GAAP),
audited financial statements of firms in the U.S. carry assets
at cost.
is the price at which the assets, liabilities, and
equity could actually be bought or sold, which is a
completely different concept from
.
2-10
Example
Klingon Corporation
2-11
2-11
2.2 The Income Statement
Measures financial performance over a specific period of
time
The accounting definition of income is:
2-12
The Income Statement of the U.S.
Composite Corporation - I
The operations
section of the income
statement reports the
firm’s revenues and
expenses from
principal operations.
2-13
The Income Statement of the U.S.
Composite Corporation - II
The nonoperating
section of the
income statement
includes all
financing costs, such
as interest expense.
2-14
The Income Statement of the U.S.
Composite Corporation - III
Usually a separate
section reports the
amount of taxes
levied on income.
2-15
The Income Statement of the U.S.
Composite Corporation - IV
Net income is the
“bottom line.”
2-16
The Income Statement
• Net income is often expressed on a per-share basis and
called
.
• Net income =
.
• The addition to retained earnings is added to the
on the balance account.
2-17
Income Statement Analysis
There are three things to keep in mind when analyzing an
income statement:
1. Generally Accepted Accounting Principles (GAAP)
2. Noncash Items
3. Time and Costs
2-18
Calculating EPS and Dividends per share
Income Statement ($ in thousand)
Sales
Costs
Depreciation
EBIT
Interest
EBT
Taxes (35%)
Net income
Dividends
Addition to retained earnings
$817,000
343,000
51,000
$423,000
38,000
$385,000
134,750
$250,250
$100,100
$150,150
Shares outstanding = 200,000,000 shares
EPS = ?
Dividend per share = ?
2-19
Calculating EPS and Dividends per share
Income Statement ($ in thousand)
Sales
Costs
Depreciation
EBIT
Interest
EBT
Taxes (35%)
Net income
Dividends
Addition to retained earnings
$817,000
343,000
51,000
$423,000
38,000
$385,000
134,750
$250,250
$100,100
$150,150
Shares outstanding = 200,000,000 shares
EPS =
Dividend per share =
.
.
2-20
GAAP
The matching principle 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.
2-21
GAAP and IFRS
• In recent years, U.S. accounting standards have become
more closely tied to international Financial Reporting
Standards (IFRS).
• Financial Accounting Standards Board (FASB), which is
in charge of U.S.
policies, and the international
Accounting Standards Board, which is in charge of
.
polices, have been working toward a convergence of
policies since 2002, but a final resolution has yet to be
reached.
2-22
GAAP and IFRS
• 台灣二階段採用國際會計準則(IFRS)
• 2013年為上市、上櫃及金融業「首次採用」
• 2015年為非上市、非上櫃之公開發行及信用合作社
「首次採用」
2-23
Noncash Items
Accounting income ≠ cash flow
is the most apparent. No firm ever writes a
check for “depreciation.”
Another noncash item is
, which does not
represent a cash flow.
Thus, net income is not cash.
2-24
Time and Costs
In the
, certain equipment, resources, and
commitments of the firm are fixed, but the firm can vary
such inputs as labor and raw materials.
In the
, all inputs of production (and hence costs)
are variable.
2-25
Time and Costs
Financial accountants do not distinguish between variable
costs and fixed costs. Instead, accounting costs usually fit
into a classification that distinguishes
from
.
•
include raw materials, direct labor
expense, and manufacturing overhead, reported as
on the income statement.
•
include selling, general, and administrative
expenses.
2-26
2.3 Taxes
Average versus marginal tax rates
▪
:
the tax bill / taxable income
▪
:
the percentage paid on the next dollar earned
Average tax rates vary widely across different companies
and industries.
2-27
Average versus Marginal Rates
Suppose your firm earns $4 million in taxable income.
• What is the firm’s tax liability?
• What is the average tax rate?
• What is the marginal tax rate?
If you are considering a project that will increase the firm’s
taxable income by $1 million, what tax rate should you use in
your analysis?
• Normally the
tax rate is relevant for
financial decision making.
• The reason is that any new cash flows will be taxed at that
tax rate.
2-28
Example: Average vs. Marginal
Rates
• Tax liability = 4,000,000
• Tax liability =
.15(50,000) + .25(75,000 – 50,000) + .34(100,000
– 75,000) + .39(335,000 – 100,000) +
.34(4,000,000 – 335,000) = $1,360,000
• Average rate = ?
• Marginal rate = ?
2-29
Example: Average vs. Marginal
Rates
• Tax liability = 4,000,000
• Tax liability =
.15(50,000) + .25(75,000 – 50,000) + .34(100,000
– 75,000) + .39(335,000 – 100,000) +
.34(4,000,000 – 335,000) = $1,360,000
• Average rate =
• Marginal rate =
.
.
2-30
2.4 Net Working Capital
NWC usually grows with the firm.
2-31
The Balance Sheet of the U.S.
Composite Corporation (2 of 2)
2-32
2.5 Cash Flow of the Firm
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
must equal the
.
.
𝐶𝐹 𝐴 = 𝐶𝐹 𝐵 + 𝐶𝐹 𝑆
2-33
Financial Cash Flow of the U.S.
Composite Corporation - I
2-34
Financial Cash Flow of the U.S.
Composite Corporation - II
2-35
Financial Cash Flow of the U.S.
Composite Corporation - III
NWC grew from $252
million in 2018 to $271
million in 2019.
This increase of $19 million
is the addition to NWC.
2-36
Financial Cash Flow of the U.S.
Composite Corporation - IV
2-37
Financial Cash Flow of the U.S.
Composite Corporation - V
2-38
Financial Cash Flow of the U.S.
Composite Corporation - VI
2-39
Financial Cash Flow of the U.S.
Composite Corporation - VII
The cash flow received from
the firm’s assets must equal
the cash flows to the firm’s
creditors and stockholders:
2-40
Cash Flow From Assets
• Cash flow identity:
.
.
=
• Cash Flow From Assets (CFFA)
=
–
–
.
.
.
2-41
2-41
Cash Flow From Assets
• OCF =
.
• NCS =
.
.
• Changes in NWC =
.
.
2-42
2-42
Cash Flow From Assets
• CF to Creditors =
=
.
.
• CF to Stockholders=
=
.
.
2-43
2-43
Example: Balance Sheet and
Income Statement Info
• Current Accounts
▪ 2015: CA = 3625; CL = 1787
▪ 2014: CA = 3596; CL = 2140
• Fixed Assets and Depreciation
▪ 2015: NFA = 2194; 2014: NFA = 2261
▪ Depreciation Expense = 500
• Long-term Debt and Equity
▪ 2015: LTD = 538; Common stock & APIC = 462
▪ 2014: LTD = 581; Common stock & APIC = 372
• Income Statement
▪ EBIT = 1014; Taxes = 368
▪ Interest Expense = 93; Dividends = 285
2-44
2-44
Example: Cash Flows
•
•
•
•
OCF = ?
NCS = ?
Changes in NWC = ?
CFFA = ?
• CF to Creditors = ?
• CF to Stockholders = ?
• CFFA = ?
2-45
2-45
Example: Cash Flows
• OCF =
• NCS =
• Changes in NWC
=
• CFFA =
• CF to Creditors =
• CF to Stockholders =
CFFA =
• The CF identity holds.
.
.
.
.
.
.
.
2-46
2-46
2.6 The Accounting Statement of
Cash Flows
There is an official accounting statement called the statement
of cash flows.
This helps explain the change in accounting cash, which for
U.S. Composite is $41 million in 2019.
The three components of the statement of cash flows are:
• Cash flow from operating activities
• Cash flow from investing activities
• Cash flow from financing activities
2-47
U.S. Composite Corporation Cash
Flow from Operating Activities
To calculate cash flow
from operating activities,
start with net income, add
back noncash items like
depreciation and adjust
for changes in current
assets and liabilities
(other than cash).
2-48
U.S. Composite Corporation Cash
Flow from Investing Activities
Cash flow from investing
activities involves
changes in capital assets:
acquisition of fixed assets
and sales of fixed assets
(i.e., net capital
expenditures).
2-49
U.S. Composite Corporation Cash
Flow from Financing Activities
Cash flows to and from
creditors and owners
include changes in
equity and debt.
2-50
U.S. Composite Corporation
Statement of Cash Flows
The statement of cash
flows is the addition of
cash flows from
operations, investing
activities, and financing
activities.
2-51
2.7 Cash Flow Management
Earnings can be manipulated using subjective decisions
required under GAAP
Total cash flow is more objective, but the underlying
components may also be “managed”
• Moving cash flow from the investing section to the
operating section may make the firm’s business appear
more stable
2-52
Quick Quiz
What is the difference between book value and market value?
Which should we use for decision-making purposes?
2-53
Book Value vs. Market Value
• The balance sheet provides the
of the assets, liabilities, and equity.
•
is the price at which the assets,
liabilities, or equity can actually be bought or sold.
•
is more important to the decision-
.
making process.
2-54
2-54
Quick Quiz
What is the difference between accounting income and cash
flow?
Which do we need to use when making decisions?
2-55
Noncash items
• Accounting income ≠ cash flow
• An income statement contains
• The most important of noncash items is
.
.
• The depreciation deduction is simply another application of
the
in accounting.
2-56
Quick Quiz
What is the difference between average and marginal tax
rates?
Which should we use when making financial decisions?
2-57
Average vs. marginal tax rates
▪
:
the tax bill / taxable income
▪
:
the percentage paid on the next dollar earned
2-58
2-58
Quick Quiz
How do we determine a firm’s cash flows?
What are the equations, and where do we find the
information?
2-59
Cash Flow From Assets
• Cash flow identity:
.
.
=
• Cash Flow From Assets (CFFA)
=
–
–
.
.
.
2-60
2-60
Cash Flow From Assets
• OCF =
.
• NCS =
.
• Changes in NWC =
.
2-61
2-61
Cash Flow From Assets
• CF to Creditors =
=
.
.
• CF to Stockholders=
=
.
.
2-62
2-62
Comprehensive Problem
• Current Accounts
▪ 2015: CA = 4,400; CL = 1,500
▪ 2014: CA = 3,500; CL = 1,200
• Fixed Assets and Depreciation
▪ 2015: NFA = 3,400; 2014: NFA = 3,100
▪ Depreciation Expense = 400
• Long-term Debt and Equity (R.E. not given)
▪ 2015: LTD = 4,000; Common stock & APIC = 400
▪ 2014: LTD = 3,950; Common stock & APIC = 400
• Income Statement
▪ EBIT = 2,000; Taxes = 300
▪ Interest Expense = 350; Dividends = 500
• Compute the CFFA
2-63
2-63
Comprehensive Problem
• OCF =
• NCS =
• Changes in NWC
=
• CFFA =
.
.
• CF to Creditors =
• CF to Stockholders =
CFFA =
.
.
.
.
.
2-64