Chapter 3
Understanding
Financial
Statements and
Cash Flows
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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.
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Slide Contents
Principles used in this Chapter
1.
The Income Statement
2.
The Balance Sheet
3.
Measuring Cash Flows
4.
Income Taxes and Finance
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Principles Applied
in this Chapter
 Principle 1:
Cash flow is what matters
 Principle 5:
Conflicts of interest cause agency problems
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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
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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
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Figure 3-1
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Figure 3-1 (cont.)
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Table 3-1
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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.
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Table 3-2
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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%
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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.
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Figure 3-3
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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)
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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.
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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).
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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
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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!
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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
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Table 3-3
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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.
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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.
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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.
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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.
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Figure 3-6
How to measure a firm’s cash flows
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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)
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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.
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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)
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Figure 3-7
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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
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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
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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
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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
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Table 3-5
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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
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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
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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
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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
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Table 3-6
Computing Taxable Income ($000’s)
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Table 3-7
So if taxable income is 16,000,000, how much is the tax liability?
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Figure 3-4
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Table 3-4
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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
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


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

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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
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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
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







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

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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
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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?
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