Chapter 3 Understanding Financial Statements and Cash Flows Copyright © 2011 Pearson Prentice Hall. All rights reserved. Learning Objectives Compute a company’s profits as reflected by its income statement. Determine a firm’s financial position at a point in time based on its balance sheet Measure a company’s cash flows. Compute taxable income and income taxes owed. © 2011 Pearson Prentice Hall. All rights reserved. 3-1 Slide Contents Principles used in this Chapter 1. The Income Statement 2. The Balance Sheet 3. Measuring Cash Flows 4. Income Taxes and Finance © 2011 Pearson Prentice Hall. All rights reserved. 3-2 Principles Applied in this Chapter Principle 1: Cash flow is what matters Principle 5: Conflicts of interest cause agency problems © 2011 Pearson Prentice Hall. All rights reserved. 3 3-3 1. The Income Statement It is also known as Profit/Loss Statement It measures the results of firm’s operation over a specific period. The bottom line of the income statement shows the firm’s profit or loss for a period. Sales – Expenses = Profits © 2011 Pearson Prentice Hall. All rights reserved. 3-4 Income Statement Terms Revenue (Sales) Money derived from selling the company’s product or service Cost of Goods Sold (COGS) The cost of producing or acquiring the goods or services to be sold Operating Expenses Expenses related to marketing and distributing the product or service and administering the business Financing Costs The interest paid to creditors Tax Expenses Amount of taxes owed, based upon taxable income © 2011 Pearson Prentice Hall. All rights reserved. 3-5 Figure 3-1 © 2011 Pearson Prentice Hall. All rights reserved. 3-6 Figure 3-1 (cont.) © 2011 Pearson Prentice Hall. All rights reserved. 3-7 Table 3-1 © 2011 Pearson Prentice Hall. All rights reserved. 3-8 Common-size Income Statement Common-size income statement restates the income statement items as a percentage of sales. Common-size income statement makes it easier to compare trends over time and across firms in the industry. © 2011 Pearson Prentice Hall. All rights reserved. 3-9 Table 3-2 © 2011 Pearson Prentice Hall. All rights reserved. 3-10 Profit-to-Sales analysis from Common-size income statement See Table 3-2 Gross profit margin (or percentage of sales going towards gross profit) is 23.3% Operating profit margin (or percentage of sales going towards operating profit) is 12.5% Net profit margin (or percentage of sales going towards net profit) is 7% © 2011 Pearson Prentice Hall. All rights reserved. 3-11 2. The Balance Sheet The balance sheet provides a snapshot of a firm’s financial position at a particular date. It includes three main items: assets, liabilities and equity. Assets (A) are resources owned by the firm Liabilities (L) and owner’s equity (E) indicate how those resources are financed A=L+E The transactions in balance sheet are recorded historically at cost price, so the book value of a firm may be very different from its current market value. © 2011 Pearson Prentice Hall. All rights reserved. 3-12 Figure 3-3 © 2011 Pearson Prentice Hall. All rights reserved. 3-13 Balance Sheet Terms: Assets Current assets comprise assets that are relatively liquid, or expected to be converted into cash within 12 months. Current assets typically include: Cash Accounts Receivable (payments due from customers who buy on credit) Inventory (raw materials, work in process, and finished goods held for eventual sale) Other assets (ex.: Prepaid expenses are items paid for in advance) © 2011 Pearson Prentice Hall. All rights reserved. 3-14 Balance Sheet Terms: Assets Fixed Assets – Include assets that will be used for more than one year. Fixed assets typically include: Machinery and equipment Buildings Land Other Assets – Assets that are neither current assets nor fixed assets. They may include long-term investments and intangible assets such as patents, copyrights, and goodwill. © 2011 Pearson Prentice Hall. All rights reserved. 3-15 Balance Sheet Terms: Liabilities Debt (Liabilities) Money that has been borrowed from a creditor and must be repaid at some predetermined date. Debt could be current (must be repaid within twelve months) or long-term (repayment time exceeds one year). © 2011 Pearson Prentice Hall. All rights reserved. 3-16 Balance Sheet Terms: Liabilities Current Debt: Accounts payable (Credit extended by suppliers to a firm when it purchases inventories) Accrued expenses (Short term liabilities incurred in the firm’s operations but not yet paid for) Short-term notes (Borrowings from a bank or lending institution due and payable within 12 months) Long-Term Debt Borrowings from banks and other sources for more than 1 year © 2011 Pearson Prentice Hall. All rights reserved. 3-17 Balance Sheet Terms: Equity Equity: Shareholder’s investment in the firm in the form of preferred stock and common stock. Preferred stockholders enjoy preference with regard to payment of dividend and seniority at settlement of bankruptcy claims. Treasury Stock: Stock that have been re-purchased by the company. Retained Earnings: Cumulative total of all the net income over the life of the firm, less common stock dividends that have been paid out over the years. Note retained earnings are not equal to hard cash! © 2011 Pearson Prentice Hall. All rights reserved. 3-18 Balance Sheet: A = L + E ASSETS (A) Current Assets Fixed Assets Total Assets LIABILITIES (L) Current Liabilities Long-Term Liabilities Total Liabilities OWNER’S EQUITY (E) Preferred Stock Common Stock Retained earnings Total Owner’s Equity Total liabilities + Equity © 2011 Pearson Prentice Hall. All rights reserved. 3-19 Table 3-3 © 2011 Pearson Prentice Hall. All rights reserved. 3-20 Net Working Capital Net Working Capital = Current assets – current liabilities Larger the net working capital, better the firm’s ability to repay its debt Net working capital can be positive or zero or negative. It is generally positive. An increase in net working capital may not always be good news. For example, if the level of inventory goes up, current assets will increase and thus net working capital will also increase. However, increasing inventory level may well be a sign of inability to sell. © 2011 Pearson Prentice Hall. All rights reserved. 3-21 Debt Ratio Debt ratio is the percentage of assets that are financed by debt. Debt ratio is an indication of “financial risk.” Generally, higher the ratio, the more risky the firm is, as firms have to pay interest on debt regardless of the earnings or cash flow situation. © 2011 Pearson Prentice Hall. All rights reserved. 3-22 3. Measuring Cash Flows Profits in the financial statements are calculated on “accrual basis” rather than “cash basis” (see next slide for accrual basis accounting). Thus profits are not equal to cash. © 2011 Pearson Prentice Hall. All rights reserved. 3-23 Accrual Basis Accounting Accrual basis is the principle of recording revenues when earned and expenses when incurred, rather than when cash is received or paid. Thus sales revenue recorded in the income statement includes both cash and credit sales. Treatment of long-term assets: Asset acquisitions (that will last more than one year, such as equipment) are not recorded as an expense but are written off every year as depreciation expense. © 2011 Pearson Prentice Hall. All rights reserved. 3-24 Figure 3-6 How to measure a firm’s cash flows © 2011 Pearson Prentice Hall. All rights reserved. 3-25 Three sources of cash flows Cash flows from Operations (ex. Sales revenue, labor expenses) Cash flows from Investments (ex. Purchase of new equipment) Cash flows from Financing (ex. Borrowing funds, payment of dividends) © 2011 Pearson Prentice Hall. All rights reserved. 3-26 Three sources of cash flows (cont.) If we know the cash flows from operations, investments and financing, we can understand the firm’s cash flow position better, that is, how cash was generated and how it was used. © 2011 Pearson Prentice Hall. All rights reserved. 3-27 Income Statement Conversion: From Accrual to Cash Basis Two steps: Add back depreciation (as it is a non-cash expense) to net income Subtract any uncollected sales (i.e. increase in accounts receivable) and cash payment for inventories (i.e. increase in inventories less increase in accounts payables) © 2011 Pearson Prentice Hall. All rights reserved. 3-28 Figure 3-7 © 2011 Pearson Prentice Hall. All rights reserved. 3-29 Sources and Uses Sources Cash inflow – occurs when we “sell” something Decrease in asset account Accounts receivable, inventory, and net fixed assets Increase in liability or equity account Accounts payable, other current liabilities, and common stock Uses Cash outflow – occurs when we “buy” something Increase in asset account Cash and other current assets Decrease in liability or equity account Notes payable and long-term debt 3-30 Statement of Cash Flows Statement that summarizes the sources and uses of cash Changes divided into three major categories Operating Activity – includes net income and changes in most current accounts Investment Activity – includes changes in fixed assets Financing Activity – includes changes in notes payable, long-term debt, and equity accounts, as well as dividends 3-31 Sample Statement of Cash Flows Cash, beginning of year Operating Activity Financing Activity Decrease in Notes Payable Net Income Decrease in LT Debt Plus: Depreciation Decrease in C/S (minus RE) Decrease in A/R Decrease in Inventory Dividends Paid Net Cash from Financing Increase in A/P Increase in Other CL Net Increase in Cash Less: Increase in other CA Net Cash from Operations Investment Activity Sale of Fixed Assets Net Cash from Investments Cash End of Year Sample Balance Sheet 2009 2008 2009 2008 Cash 696 58 A/P 307 303 A/R 956 992 N/P 26 119 Inventory 301 361 Other CL 1,662 1,353 Other CA 303 264 Total CL 1,995 1,775 Total CA 2,256 1,675 LT Debt 843 1,091 Net FA 3,138 3,358 C/S 2,556 2,167 Total Assets 5,394 5,033 Total Liab. & Equity 5,394 5,033 Numbers in millions of dollars 3-33 Sample Income Statement Revenues 5,000 Cost of Goods Sold (2,006) Expenses (1,740) Depreciation (116) EBIT 1,138 Interest Expense (7) Taxable Income Taxes 1,131 (442) Net Income 689 EPS 3.61 Dividends per share 1.08 Numbers in millions of dollars, except EPS & DPS 3-34 Table 3-5 © 2011 Pearson Prentice Hall. All rights reserved. 3-35 In Class Exercise - I 48. Wise's Corner Grocer had the following current account values. What effect did the change in net working capital have on the firm's cash flows for 2009? 2008 2009 Cash 87 112 AR 309 321 Inventory 919 868 AP 617 714 A. net use of cash of $37 B. net use of cash of $83 C. net source of cash of $83 D. net source of cash of $111 E. net source of cash of $135 © 2011 Pearson Prentice Hall. All rights reserved. 3-36 In Class Exercise - II During the year, Kitchen Supply increased its accounts receivable by $130, decreased its inventory by $75, and decreased its accounts payable by $40. How did these three accounts affect the firm's cash flows for the year? A. $245 use of cash B. $165 use of cash C. $95 use of cash D. $95 source of cash E. $165 source of cash © 2011 Pearson Prentice Hall. All rights reserved. 3-37 In Class Exercise - III A firm generated net income of $878. The depreciation expense was $47 and dividends were paid in the amount of $25. Accounts payables decreased by $13, accounts receivables increased by $22, inventory decreased by $14, and net fixed assets decreased by $8. There was no interest expense. What was the net cash flow from operating activity? A. $876 B. $902 C. $904 D. $922 E. $930 © 2011 Pearson Prentice Hall. All rights reserved. 3-38 4. Income Taxes and Finance Computing Taxable Income for Corporation Gross Income Dollar sales from a product or service less cost of production or acquisition Taxable Income Gross income less tax deductible expenses, plus interest income received and dividend income received Tax Deductible Expenses Include Operating expenses (marketing, depreciation, administrative expenses) and interest expense Dividends paid are not deductible © 2011 Pearson Prentice Hall. All rights reserved. 3-39 Table 3-6 Computing Taxable Income ($000’s) © 2011 Pearson Prentice Hall. All rights reserved. 3-40 Table 3-7 So if taxable income is 16,000,000, how much is the tax liability? © 2011 Pearson Prentice Hall. All rights reserved. 3-41 Figure 3-4 © 2011 Pearson Prentice Hall. All rights reserved. 3-42 Table 3-4 © 2011 Pearson Prentice Hall. All rights reserved. 3-43 Key terms Accounts Payable Accounts Receivable Accrual basis accounting Accrued expenses Accumulated depreciation Additional paid-in-capital Balance sheet Cash Common size financial statements Common stock Cost of goods sold Current assets © 2011 Pearson Prentice Hall. All rights reserved. Debt Debt ratio Depreciation expenses EBIT Earnings before taxes Earnings per share Equity Financing cash flows Financing cost Fixed assets Free cash flows Gross fixed assets 3-44 Key terms (cont.) Gross Profit Gross profit margin Income statement Inventories Long-term debt Mortgage Net fixed assets Net income Net profit margin Net working capital Operating expenses © 2011 Pearson Prentice Hall. All rights reserved. Operating income Operating profit margin Operating working capital Par value Preferred stockholders Profit margins Retained earnings Short-term liabilities Short-term notes (debt) Taxable income Trade credit Treasury stock 3-45 Now… ThInK Circuit City went bankrupt in year 2009. It was second in the industry only after Best Buy. Now looking back, can you find any clues from the financial statements of Circuit city to make predictions such that Circuit city was in trouble? © 2011 Pearson Prentice Hall. All rights reserved. 3-46