Corporate Finance
Lecture Two – 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.
4. Recognize and view Internet sites that
provide financial information.
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,
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
(2.1)
Figure 2.1 Balance sheet
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
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)
2.1 (B) Income Statement example
Figure 2.2
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
2.1 (C) The Statement of Retained
Earnings
Figure 2.4
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
CASH FLOW
FROM ASSETS = TO CREDITORS
CASH FLOW
+
TO OWNERS
Figure 2.5 Cash Flow Identity
and components
2.2 (A) The First Component:
Cash Flow From Assets
3 components:
• Operating cash flow (OCF)
• Net capital spending (NCS)
• Change in net working capital (∆NWC)
• Cash flow from assets = OCF – NCS - ∆NWC
OCF = EBIT + Depreciation – Taxes
NCS = End. Net
– Beg. Net
+ Depreciation
Fixed Assets Fixed Assets
∆NWC=Ending NWC – Beginning NWC
2.2 (A) The First Component:
Cash Flow From Assets (continued)
OCF = EBIT + Depreciation – Taxes
Figure 2.3
2.2 (A) The First Component:
Cash Flow From Assets (continued)
NCS = End. Net
–
Fixed Assets
Beg. Net
+
Fixed Assets
Depreciation
NCS= ($11,961 - $10,788) + $1,406 = $2,579
2.2 (A) The First Component:
Cash Flow From Assets (continued)
∆NWC=Ending NWC – Beginning NWC
Net working capital for 2007 = $9,130 - $6,860 = $2,270
Net working capital for 2006 = $10,454 - $9,406 = $1,048
Change in NWC = $2,270 - $1,048 = $1,222
2.2 (A) The First Component:
Cash Flow From Assets (continued)
• Putting it all together….
• Cash flow from Assets = OCF – NCS - ∆ NWC
=$7,287-$2,579-$1,222
=$3,486
2.2 (B) The Second Component:
Cash Flow To Creditors
Cash Flow to Creditors = Interest Expense  Net New Borrowing
from Creditors
Net New Borrowing = Ending Long-term Liabilities  Beginning Long-Term
Liabilities
Cash Flow to Creditors = $239 (-$378)  $617
2.2 (C) The Third Component:
Cash Flow To Owners
Cash flow to owners = Dividends - Net new borrowing
owners
= $2,869
= $2,869
-
$0
from
2.2 (C) Putting It All Together: The
Cash Flow Identity
Cash flow from assets =
cash flow from creditors + cash flow to owners
$3,486 = $617 +
$2,869
2.3 Financial Performance
Reporting
• Annual reports to shareholders
• Quarterly (10-Q) and annual (10-K) reports
filed with the SEC
– Regulation Fair Disclosure (Reg. FD)
– Notes to the Financial Statements
2.4 Financial Statements on the Internet
• EDGAR (www.sec.gov/edgar.shtml)
• Yahoo! Finance (http://finance.yahoo.com.)
• Many, many more websites with wealth of
information
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 longterm debt and fixed assets does the firm
have?
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
Additional Problems with Answers
Problem 2
Income Statement. The Top Class Company had revenues of
$925,000in 2009. 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.
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
$925,000
325,000
600,000
125,000
475,000
55,000
420,000
142,800
277,200
Additional Problems with Answers
Problem 3
Retained Earnings: The West Hanover Clay Co. had, at the
beginning of the fiscal year, November 1, 2009, retained
earnings of $425,000. During the year ended October 31, 2010,
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.
Additional Problems with Answers
Problem 3 (Answer)
Statement of Retained Earnings for
the year ended October 31, 2010
Balance of Retained Earnings, 11/1/2009……….$425,000
Add: Net income after taxes, 10/31/2010………. $820,000
Less: Dividends paid for year-end 10/31/2010…$287,000
Balance of Retained Earnings, 10/31/2010….. $958,000
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.
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
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, 2009:
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?
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
$250,000