FIN 3000
Chapter 3:
Financial Statements
Liuren Wu
Overview
1.
An overview of the firm’s financial statements
1.
The income statement
1.
Corporate taxes
1.
The balance sheet
1.
The cash flow statement
FIN3000, Liuren Wu
Learning objectives
• Understand the content of the 4 basic financial statements. Focus
on:
1. Income statement
2. Balance sheet statement
3. Cash flow statement
• Evaluate firm profitability using the income statement.
• Estimate a firm’s tax liability using the corporate tax schedule and
distinguish between the average and marginal tax rate.
FIN3000, Liuren Wu
Principles used in this chapter
• Principle 1: Money has a time value.
– We need to recognize that financial statements do not adjust for
time value of money.
• Principle 3: Cash flows are the source of value.
– Financial statements provide an important starting point in
determining the firm’s cash flow.
– We should be able to distinguish between reported earnings
and cash flow. It is possible for a firm to report positive earnings
but have no cash!
• Principle 4: Market prices reflect information.
– Firm’s financial statements provide important information that
is used by investors in forming expectations about firm’s future
prospects and subsequently, the market prices.
FIN3000, Liuren Wu
Basic financial statements
Three types of financial statements are mandated by the accounting
and financial regulatory authorities:
1. Income statement – how much money you made last year?
• Revenue, expense, profits over a year or quarter.
2. Balance sheet – what’s your current financial situation?
A snap shot on a specific date of:
• Assets (value of what the firm owns)
• Liabilities (value of firm’s debts)
• Shareholder’s equity (the money invested by the company
owners)
3. Cash flow statement – how did the cash come and go?
• Cash received/cash spent by the firm over a period of time.
FIN3000, Liuren Wu
Why study financial statements?
1.
Assess current performance through financial statement analysis.
– Next chapter provides more tools for the analysis.
2.
Monitor and control operations.
– Both insiders (such as managers, board of directors) and
outsiders (such as suppliers, creditors, investors) use the
statements to monitor and control the firm’s operations.
3.
Forecast future performance.
– Financial planning models are typically built using the financial
statements.
FIN3000, Liuren Wu
Three accounting principles
1.
Revenue recognition principle: Revenue should be included in the
income statement for the period in which:
–
–
2.
Matching principle: Expenses are matched with the revenues they
helped produce.
–
3.
Its goods/services were exchanged for cash or accounts receivable.
It has completed what it must do to be entitled to the cash.
For example, employees’ salaries are recognized when the product
produced as a result of that work is sold, and not when the wages
were paid.
Historical cost principle: Most assets and liabilities are reported in
the financial statements at historical cost.
–
–
For example, the price the firm paid to acquire them.
The historical cost generally does not equal the current market value
of the assets or liabilities.
FIN3000, Liuren Wu
An income statement
• Sales
– Minus cost of goods sold
• = Gross Profit
– Minus operation expenses
• Selling expenses
• General and administrative expenses
• Depreciation and amortization expense
• = Operating income (EBIT)
– Minus interest expense
• = Earning before taxes (EBT)
– Minus income taxes
• = Net income (EAT)
FIN3000, Liuren Wu
Sample income statement
FIN3000, Liuren Wu
Evaluating a firm’s EPS
• We can use the income statement to determine the earnings per
share (EPS) and dividends.
• EPS = Net income/number of shares outstanding
• Example: A firm reports a net income $90 million and has 35 million
shares outstanding, what will be the earnings per share (EPS)?
EPS = net income/number of shares
= $90 million/$35 million
= $2.57
FIN3000, Liuren Wu
Evaluating a firm’s dividends per share
• Dividends per share = dividends paid/number of shares
• Example: A firm reports dividend payment of $20 million of its
income statement and has 35 million shares outstanding. What will
be the dividends per share?
Dividends per share = dividend payment/number of shares
= $20 million/35 million
= $0.57
FIN3000, Liuren Wu
Connecting the income statement and the balance sheet
• What can the firm do with the net income?
1. Pay dividends to shareholders.
2. Reinvest in the firm.
•
Example: Review examples 1 & 2. How much was retained or
reinvested by the firm?
Amount retained = net income – dividends
= $90m - $20m = $70m
•
The firm’s balance on retained earnings will increase by $70
million on the balance sheet.
FIN3000, Liuren Wu
Interpreting firm profitability
• What can we learn from Boswell Inc.’s income statement?
1. The firm has been profitable as its revenues exceeded its
expenses.
2. The gross profit margin (GPM)
= gross profits/sales
= $675 million/$2,700 million
= 25%
GPM indicates the firm’s “mark-up” on its cost of goods sold per
dollar of sales.
FIN3000, Liuren Wu
Interpreting firm profitability (con.)
3. The operating profit margin
= net operating income (EBIT)/sales
= $382.5 million/$2,700 million
= 14.17%
4. Net profit margin
= net profits (Net income)/sales
= $204.75 million/$2,700 million
= 7.58%
These profit margins (gross profit margin, operating profit margin, and
net profit margin) should be closely monitored and compared to
previous years and those of competing firms.
FIN3000, Liuren Wu
GAAP and earnings management
• While the firms must adhere to set of accounting principles, GAAP
(Generally Accepted Accounting Principles), there is considerable
room for managers to influence the firm’s reported earnings.
• Managers have an incentive to tamper with reported earnings as
their pay depends upon it and investors care about it.
FIN3000, Liuren Wu
Checkpoint 3.1
Constructing an Income Statement
Use the following information to construct an income statement for
Gap, Inc. (GPS). The Gap is a specialty retailing company that sells
clothing, accessories, and personal care products under the Gap, Old
Navy, Banana Republic, Piperlime, and Athleta brand names. Use the
scrambled information below to calculate the firm’s gross profits,
operating income, and net income for the year ended January 31,
2009. Calculate the firm’s earnings per share and dividends per share.
Interest expense
$1,000,000
Revenues (Sales)
Cost of goods sold
$9,079,000,00
0
Common stock dividends $243,000,000
D
Operating
expenses $3,899,000,00
d
Income taxes
0
Shares outstanding
716,296,296
FIN3000, Liuren Wu
$14,526,000,000
$617,000,000
FIN3000, Liuren Wu
FIN3000, Liuren Wu
Checkpoint 3.1: Check yourself
Reconstruct the Gap’s income statement assuming the firm is able to
cut its cost of goods sold by 10% and the firm pays taxes at 40% tax
rate. What is the firm’s net income and earnings per share?
FIN3000, Liuren Wu
Step 1: Picture the problem
Revenues
Less: Cost of goods sold
Equals Gross
profit
Less: Operating expenses
Equals: net
Operating income
Less: Interest expense
Equals: earnings
Before taxes
Less: Income taxes
Equals:
NET INCOME
FIN3000, Liuren Wu
Step 2: Decide on a solution strategy
• Given the account balances, constructing the income statement will
entail substituting the appropriate balances into the template of
Step 1.
FIN3000, Liuren Wu
Step 3: Solve
Revenues = $14,526,000,000
Less: Cost of goods sold
= $8,171,100,000
Equals: profit
=$6,354,900,000
Less: Operating expenses
=$3,899,000,000
Equals: net
Operating income
=$2,455,900,000
Less: Interest expense
=$1,000,000
Equals: earnings
Before taxes
=$2,454,900,000
Less: Income taxes (40%)
=$9,819,600,000
Equals:
NET INCOME
=$1,472,940,000
FIN3000, Liuren Wu
Step 3: EPS and dividends per share
• Earnings per share:
= net income/number of shares
= $1,472,940,000/716,296,296
= $2.06
• Dividends per share
= dividends/number of shares
= $243,000,000/716,296,296
= $0.34
FIN3000, Liuren Wu
Step 4: Analyze
• The firm is profitable since it earned net income of $1,472,940,000
• The shareholders were able to earn $2.06 per share. However, the
dividends per share were only $0.34, indicating that the difference
of $1.72 was reinvested in the corporation.
• Compute gross profit margin, operating profit margin, and net
profit margin.
FIN3000, Liuren Wu
Corporate taxes
• A firm’s income tax liability is calculated using its taxable income
and the tax rates on corporate income.
Taxable Income
Marginal Tax Rate
$0 - $50,000
15%
$50,001 - $75,000
25%
$75,001 - $100,000
34%
$100,001 - $335,000
39%
$355,001 - $10,000,000
34%
$10,000,001 - $15,000,000
35%
$15,000,001 - $18,333,333
38%
Over $18,333,333
35%
FIN3000, Liuren Wu
Corporate tax rates
• The table reveals the following:
– Tax rates range from 15% to 39%
– Tax rates are progressive i.e. larger corporations with higher
profits will tend to pay more taxes compared to smaller firms
with lower profits
Note: In addition to federal taxes, a firm may face State and City
taxes.
FIN3000, Liuren Wu
Marginal and average tax rates
• While analyzing the tax consequences of new business venture, the
appropriate tax rate is the marginal tax rate.
• Marginal tax rate is the tax rate that the company will pay on its
next dollar of taxable income.
• Average tax rate is total taxes paid divided by the taxable income.
FIN3000, Liuren Wu
Marginal and average tax rates (con.)
• Example: What is the average and marginal tax liability for a firm
reporting $100,000 as taxable income?
Taxable
Income
Marginal
tax rate
Incremental
tax liability
Cumulative
tax liability
Average
tax rate
$50,000
15%
7,500
7,500
15.00%
$75,000
25%
6,250
13,750
18.33%
$100,000
34%
8,500
22,250
22.25%
FIN3000, Liuren Wu
Marginal and average tax rates (con.)
• Average tax rate
= Total tax liability/total taxable income
= $22,250/$100,000
= 22.25%
• Marginal tax rate
= 39% as the firm will have to pay 39% on its
next dollar of
taxable income i.e. if its taxable income increases from $100,000
to $100,001.
FIN3000, Liuren Wu
The balance sheet
• The balance sheet provides a snapshot of the firm’s financial
position on a specific date. It is defined by:
Total assets = Total liabilities/total shareholder’s equity
(asset) = (sources of funding)
• Total assets represents the resources owned by the firm.
• Total liabilities represent the total amount of money the firm owes
its creditors.
• Total shareholder’s equity refers to the difference in the value of
the firm’s total assets and the firm’s total liabilities.
FIN3000, Liuren Wu
Asset value calculation
• In general, GAAP requires that the firm report assets on its balance
sheet using the historical costs.
• Cash and assets held for sale (such as marketable securities) are an
exception to the rule. These assets and reported using the lower of
their cost or current market value.
• Assets whose value is expected to decline over time (such as
equipment) is reported as “net equipment” which is equal to the
historical cost minus accumulated depreciation.
• The net value reported on balance sheet could be significantly
different from the market value of the asset.
FIN3000, Liuren Wu
FIN3000, Liuren Wu
Assets and liabilities
• Current assets consists of firm’s cash plus other assets the firm
expects to convert to cash within 12 months or less, such as
receivables and inventory.
• Fixed assets are assets that the firm does not expect to sell within
one year. For example, plant and equipment, land.
• Current liabilities represent the amount that the firm owes to
creditors that must be repaid within a period of 12 months or less
such as accounts payable, notes payable.
• Long-term liabilities refer to debt with maturities longer than a year
such as bank loans, bonds.
FIN3000, Liuren Wu
The stockholder’s equity
Two components:
1.
The amount the company received from selling stock to investors.
It may be shown as common stock in the balance sheet or it may
be divided into two components: par value and additional paid in
capital above par. Par value is the stated or face value a firm puts
on each share of stock. Paid in capital is the additional amount the
firm raised when it sold the shares.
– For example, DLK corporation’s par value per share is $2.00 and the
firm has 30 million shares outstanding such that the par value of the
firm’s common equity is $60 million. If the stocks were issued to
investors for $240 million, $180 million represents paid in capital.
2.
The amount of the firm’s retained earnings: the portion of net
income that has been retained (i.e., not paid in dividends) from
prior years operations.
FIN3000, Liuren Wu
Firm liquidity and net working capital
• Liquidity refers to the speed with which the asset can be converted
to cash without loss of value.
• For example, a firm’s bank account is perfectly liquid. Other types of
assets are less liquid as they more difficult to sell and convert to
cash such as PPE (property, plant and equipment).
• For the overall firm, liquidity generally refers to the firm’s ability to
covert its current assets (accounts receivable and inventories) into
cash so that it can pay its bills (current liabilities) on time.
• We can thus measure a firm’s liquidity by computing the net
working capital = current assets – current liabilities.
FIN3000, Liuren Wu
Firm liquidity and net working capital
• If a firm’s net working capital is significantly positive, it is in a good
position to pay its debts on time and is consequently very liquid.
• Lenders consider the net working capital as an important indicator
of firm’s ability to repay its loans.
FIN3000, Liuren Wu
FIN3000, Liuren Wu
Checkpoint 3.2
Constructing a Balance Sheet
Construct a balance sheet for Gap, Inc. (GPS) using the following list of
jumbled accounts for January 31, 2009. Identify the firm’s total assets
and net working capital.
Net property, plant, and
equipment
$2,933,000,000 Accounts receivable
$0
Cash
$1,756,000,000 Long-term liabilities $1,019,000,000
Current liabilities
$2,158,000,000 Common equity
$4,387,000,000
Other current assets
$743,000,000 Inventories
$1,506,000,000
Other long-term assets
$626,000,000 Accounts payable
$2,067,000,000
FIN3000, Liuren Wu
FIN3000, Liuren Wu
FIN3000, Liuren Wu
Step 4: Analyze
• The firm has invested a total of $7.564B in asserts, funded by
$2.158B current liability, $1.019B long-term liability, and $4.387B
owner equity.
• The firm as $4.005B in current assets and $2.158B in current
liability, leaving the firm with a net working capital of $4.005-2.1581.87B
FIN3000, Liuren Wu
Checkpoint 3.2: Check yourself
Reconstruct the Gap’s balance sheet to reflect the repayment of $1
billion in short-term debt using a like amount of the firm’s cash. What
is the balance for total assets and current liabilities?
FIN3000, Liuren Wu
Step 1: Picture the problem
Current Assets
Cash
Accounts Receivable
Inventories
Other current assets
Total current assets
Long-term (fixed) assets
Gross PPE
Less: Accumulated depreciation
Net property, plant and equip.
Other long-term assets
Total long-term assets
Total Assets
Current Liabilities
Accounts payable
Short-term debt
Other current liabilities
Total current liabilities
Long-term Liabilities
Long-term debt
Owner’s Equity
Par value of common stock
Paid-in-capital
Retained earnings
Total equity
Total Liabilities and
Owners’ equity
FIN3000, Liuren Wu
Step 2: Decide on a solution strategy
• We are given the account balances so in order to construct the
balance sheet we need to substitute the appropriate balances into
the template developed in step 1.
• Deduct $1B from both cash and current liability.
FIN3000, Liuren Wu
Step 3: Solve
Cash
Inventories
Other current
assets
756,000,000
1,506,000,000
743,000,000
Current liabilities
1,158,000,000
Total current
assets
3,005,000,000
Total current
liabilities
1,158,000,000
Net Property,
Plant and
equipment
2,993,000,000
Long-term
liabilities
1,019,000,000
Other long-term
assets
626,000,000
Common Equity
4,387,000,000
Total Assets
$6,564,000,000 Total Liabilities
and Equity
FIN3000, Liuren Wu
$6,564,000,000
Step 4: Analyze
• We can make the following observations from Gap’s Balance sheet:
– The total assets of $6,564,000,000 is financed by a combination
of current liabilities, long-term liabilities and owner’s equity.
Owner’s equity accounts for $4,387,000,000 of the total.
– The firm has a healthy net working capital of $1,847,000,000
(3,005,000,000 – 1,158,000,000)
FIN3000, Liuren Wu
Debt versus equity financing
• The right-hand side of the balance sheet reveals the sources of
money used to finance the purchase of the firm’s assets listed on
the left-hand side of the balance sheet.
• It shows how much was borrowed (debt financing) and how much
was provided by firm’s owners (equity financing, through the sale of
equity or retention of prior year’s earnings).
– Payment: Payment for debt holders is generally fixed (in the
form of interest); Payment for equity holders (dividends) is not
fixed nor guaranteed.
– Seniority: Debt holders are paid before equity holders in the
event of bankruptcy.
– Maturity: Debt matures after a fixed period while equity
securities do not mature.
FIN3000, Liuren Wu
The cash flow statement
• The Cash Flow Statement is used by firms to explain changes in
their cash balances over a period of time by identifying all of the
sources and uses of cash.
– Source of cash is any activity that brings cash into the firm. For
example, sale of equipment.
– Use of cash is any activity that causes cash to leave the firm. For
example, payment of taxes.
Change in Cash
Balance for 2010
=
Ending Cash
Balance for 2010
FIN3000, Liuren Wu
-
Ending Cash
Balance for 2010
FIN3000, Liuren Wu
Cash flow analysis
• Why did the cash balance decline by $3.5 million from 2009 to
2010?
1. Accounts receivable increased by $22.5 million representing
an increase in uncollected cash from credit sales. It represents
$22.5m of use of cash to invest in accounts receivable.
2. Inventory increased by $148.50 million indicating use of cash
to procure inventory.
3. Equipment increased by $175.50 million indicating use of cash
to invest in equipment.
• In general,
– An increase in an asset account = use of cash
– A decrease in an asset account = source of cash
FIN3000, Liuren Wu
Cash flow analysis (con.)
4.
5.
6.
7.
•
Account payable, credit extended to the firm, increased by $4.5
million. Thus, source of cash increased by $4.5 million due to
account payable.
Long-term debt increased by $51.75 million indicating a source of
cash.
Short-term debt decreased by $9 million indicating use of cash to
pay off the debt.
Retained earnings increased by $159.75 million representing a
source of cash to th firm from the firm’s operations.
In general,
– An increase in a liability account = source of cash
– A decrease in liability = use of cash
FIN3000, Liuren Wu
Cash flow analysis (con.)
• Change in cash balance = sources of cash – use of cash = $216 $220.50 = $4.50
Sources of Cash
Uses of Cash
Increase in Accounts Payable =
$4.50
Increase in Accounts Receivable
$22.50
Increase in long-term debt
=$51.75
Increase in inventory = $148.50
Increase in retained earnings =
$159.75
Increase in net plant and
equipment = $40.50
Decrease in short-term notes = $9
Total Sources of cash = $216.00
Total Uses of cash = $220.50
FIN3000, Liuren Wu
Cash flow analysis (con.)
• An analysis of H.J. Boswell’s operations reveals the following for
2010:
– The firm used more cash than it generated, resulting in a deficit
of $4.5 million.
– The primary source of cash flow was retained earnings ($159.75
million) followed by long-term debt ($51.75 million).
– The largest use of cash was for acquiring inventory at $148.5
million.
FIN3000, Liuren Wu
Cash flow analysis summary
Sources of Cash
Uses of Cash
Decrease in an asset account
Increase in an asset account
Increase in a liability account
Decrease in a liability account
Increase in an owner’s equity
account
Decrease in an owners’ equity
account
FIN3000, Liuren Wu
Cash flow statement
• The format for a traditional cash flow statement is as follows:
Beginning Cash Balance
+ Cash Flow from Operating Activities
+ Cash Flow from Investing Activities
+ Cash Flow from Financing Activities
= Ending Cash Balance
• Operating activities represent the company’s core business
including sales and expenses. Basically any activity that affects net
income for the period.
• Investing activities include the cash flows that arise out of the
purchase and sale of long-term assets such as plant and equipment.
• Financing activities represent changes in the firm’s use of debt and
equity such as issue of new shares, payment of dividends.
FIN3000, Liuren Wu
FIN3000, Liuren Wu
Checkpoint 3.3:
Interpreting the cash flow statement
Chesapeake Energy Inc. (CHK) is the largest producer of natural gas in
the United States and is headquartered in Oklahoma City. The firm’s
cash flow statements for 2004 through 2007:
FIN3000, Liuren Wu
Analyze
•Chesapeake has had positive & growing cash flows from operations
in all 4 years.
–The primary contributor were the firm’s net income and
depreciation expense.
–Working capital is a source of cash in 3 out of 4 years,
indicating the net reduction in the firm’s investment in working
capital.
•Chesapeake has been very aggressive in new fixed assets and
acquisitions of new oil and gas properties. Total investments have
been roughly two times the cash flow from operation, which meant
that the firm had to raise a substantial amount of money.
•Chesapeake has been a regular issuer of both equity and debt.
$13.5 billion was raised in the 4-year period. Chesapeake has made
relatively modest modest cash distributions and retained most
earnings.
FIN3000, Liuren Wu
Checkpoint 3.3: Check yourself
Go to http:finance.google.com/finance
Get the cash flow statements for the most recent four-year period
for Exco Resources (XCO).
How does their cash from investing activities compare to their cash
flow from operating activities in 2009?
FIN3000, Liuren Wu
Step 1: Picture the problem
• The cash flow statement uses information from the firm’s
balance sheet and income statement to identify the net sources
and uses of cash for a specific period of time.
• The sources and uses of cash are organized into cash from
operating activities, investing activities, and financing activities.
• The format for a traditional cash flow statement is as follows:
Beginning Cash Balance
+ Cash Flow from Operating Activities
+ Cash Flow from Investing Activities
+ Cash Flow from Financing Activities
= Ending Cash Balance
• Here we have to compare the cash flow from operating activities
and investment activities in 2007 for Exco Resources (XCO).
FIN3000, Liuren Wu
Step 2: Decide on a solution strategy
• We can compare the cash flow from operating activities and cash
flow from investing activities by looking at the cash flow
statement.
• The cash flow statement can be retrieved from
http://finance.google.com/finance.
FIN3000, Liuren Wu
Step 3: Solve
• Cash flow from operating activities
– EXCO had a positive cash flow from operating activities of
$577.83 million in in 2007. In 2006, the cash flow from
operating activities was much lower at $227.86.
– The primary contributors to the operating cash flow in 2007
were the firm’s depreciation/depletion expense and noncash expense. Net working capital is a use of cash.
• Cash flow from investing activities:
– Cash flow from investing activities were ($2,396.44) million in
2007.
– EXCO had invested heavily in capital expenditures in 2007
with a total expense of $2,846.97 million.
FIN3000, Liuren Wu
Step 4: Analyze
• The cash flow statement for 2007 depicts a profitable firm with
positive cash flow from operations.
• The firm has been aggressively investing in fixed assets to the tune
of almost 4 times its operating cash flows.
• The firm has been able to successfully raise money from capital
markets by issuing stocks of nearly $2,000 million.
FIN3000, Liuren Wu