Ch 2
Financial Statements, Taxes, and
Cash Flow
1
Issues in Ch.2

Three financial statements
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Balance sheet
Income statement
Operating cash flow
The difference between accounting income
and cash flow in financial decision-making
process
 The difference between accounting value
(or book value) and market value of the
firm

2
Three Financial Statements
Balance Sheet
 Income Statement
 Cash Flow Statement

3
Accounting identity
Assets = Liabilities + Shareholders’ equity
Or
Shareholders’ equity = Assets – Liabilities
Another name for Shareholders’ equity is
“residual claim.”
4
Balance Sheet
The Balance Sheet is snap shot of the
firm’s current condition
 The asset side of the balance sheet
reflects the investment decisions made by
the firm
 The liabilities and equity side reflect all of
the financing decisions made over the
same period

5
Balance Sheet
6
Balance Sheet of The firmCurrent
(SnapAssets
Shot of
the Firm)
have a
life of less than 1 year
and include:
Shareholders’ Equity = Assets - Liabilities
•Cash
•Account receivable
•Inventory
Assets = Liabilities + Shareholders’ Equity
Current Liabilities have a
life of less than 1 year
and include:
•Short-term liability
•Bank loans
•Machine, Equipment
•Long-term
borrowings
•Patents
•Accounts Payable
CA - CL
7
Pop Quiz – Can you link them?
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Accounts Receivable
Long-term assets
Patents
Notes payable
Accounts payable
Long-term debt
Common stock
Retained earnings

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Net income minus dividend
Intellectual property
Loans the firm took and must
pay back within one year
Long-term borrowings
Money owed to the firm by its
customers
Money the firm owes to its
supplier
Equipment, plant
Amount of stock issued by the
firm
8
Please construct for Bobcats Co. the following
statements using the information below:



Balance sheet
Income statement
Operating Cash Flow (OCF)
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Accounts Payable
= $70,000
Tax Rate
= 34%
Retained Earnings
= $100,000
Interest Expense
= $10,000
Inventory
= $50,000
Depreciation Expense
= $100,000
Notes Payable
= $80,000
Sales
= $800,000
Machinery, Buildings (net)= $400,000
Long-Term Debt
= $200,000
Cash
= $30,000
Cost of Goods Sold
=$400,000
Patents, Trademarks
=$150,000
Accounts Receivable
= $20,000
Operating Expense
= $100,000
Common Stock
=?
Stock price
= $20 per share
Number of outstanding stocks = 20,000 shares
9
Put the balance sheet below.
10
Liquidity of Assets
The order of assets on the balance sheet reflects their
liquidity. (decreasing order of liquidity)
 Liquidity is the speed at which the asset can be converted
to cash with little or no loss in value
 Liquid firms are less likely to experience financial distress
 But, liquid assets earn a lower return
 Liquid Assets
 Account receivable and possibly inventory
 Non-liquid Assets
 specialized fixed asset (e.g., equipment) and intangible
assets (e.g., patents and trademarks)

11
Net Working Capital
 Net
Working Capital
Current Assets minus Current Liabilities
 Positive when the cash that will be received
over the next 12 months exceeds the cash
that will be paid out
 Usually positive in a healthy firm

12
Book Value vs. Market Value
 Find
the book value of Bobcats.
Historical cost or the amount the investors
originally paid for.
 Recorded amount in financial statements

 GAAP

says “You record historical cost!”
Simply the recorded value of stockholders’
equity or sum of retained earning and common
stock items in balance sheet
13
Book Value vs. Market Value
 Find
the market value of Bobcats.
Is NOT on the financial statements but more
important one
 True value of the firm or the value observed in
the marketplace.
 The amount of cash we would get if we actually
sell the firm now.
 Simply the current stock price * number of
outstanding stocks

14
Then, what is the intrinsic value?
 Intrinsic
value
The present value of an asset’s expected
future cash flows.
 The fair value, given the amount, timing, and
riskiness of future cash flows.
 If MV > IV  Overvalued
 If MV < IV  Undervalued

15
Book Value vs. Market Value
Market value and book value are often very
different. Why?
 Which one is more important to the decisionmaking process?
 The goal of the financial manager is to maximize
the market value of the stock.

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17
Income Statement
 The
income statement is the measurement
of performance
 You generally report revenues first and
then deduct any expenses for the period
Income = Revenue - Expenses
18
Income Statement (Example)
Sales
COGS
Other expenses
Deprec.
Tot. op. costs
EBIT
Int. expense
EBT
Taxes (40%)
Net income
2012
3,432,000
2,864,000
340,000
18,900
3,222,900
209,100
62,500
146,600
58,640
87,960
2013
5,834,400
4,980,000
720,000
116,960
5,816,960
17,440
176,000
(158,560)
(63,424)
(95,136)
19
Put the income statement for
Bobcats Co. below.
20
Two Issues on Income Statement
 Non-cash
item
 Realization principle
21
Noncash items

A typical noncash item is depreciation
expense

Hypothetical number

Noncash items are irrelevant to firm valuation
in general because they do not represent true
cash inflow or outflow

However, noncash items are still important to
understand the firm’s financial condition
because they affect the firm's tax liability
(and, therefore, cash flow)
22
GAAP Allows Accrual Basis
Accounting!
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Matching principle: GAAP says to show revenue
when it accrues and match the expenses required
to generate the revenue
Recognition Principle: GAAP says to recognize
revenue when the earnings process is virtually
complete and the value of an exchange of goods or
services is known or can be reliably determined.
What does this mean?


Records revenue when it is earned, whether or not the
revenue has been received in cash.
Records expense when they are incurred, even if the
money has not actually been paid out.
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Example

Suppose DELL computer sold computers to the
University on credit at the beginning of the year.
The University will pay cash at the end of the year.

Accounting journals
Now, Accounts Receivable
Revenue
Expenses
Inventory
Later, Cash
AR
XXXX
XXXX
XXXX
XXXX
XXXX
XXXX
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Profits and cash flows are not the
same thing!
 The
potential problem with GAAP to
understand the firm’s financial condition

Mismatch between the time when the income
(cost) is realized and the time when the revenue
(cost) is collected
This is because GAAP requires that sales be
recorded on the income statement when made,
not when cash is received
 GAAP also requires that we record cost of goods
sold when the corresponding sales are made,
regardless of whether we have actually paid our
suppliers yet
25

GAAP versus Cash Flow Time
Line
26
Profits and cash flows are not the same
thing!
 In
the earlier example, DELL will not receive
cash until the end of the year.
 There is an opportunity cost or timing
mismatch between the recognition of
revenue and the receipt of cash flow in the
DELL example.
 As a result, net income is not equal to cash
flow generated during the period.
 In general, financial managers are more
concerned with cash flow than accounting
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income.
So, what can we conclude?
The accrual accounting and noncash items
results in inequality between cash flows and
net income (or earnings).
 Finance Emphasizes the Importance of
Timing
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Timing of Cash Flow Matters
Accrual Accounting May Obscure Timing
“You Can’t Deposit Net Income, Only Cash”
Therefore, we must present cash flow
statement to understand the firm’s financial
condition better.
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The Managerial Finance Function

Relationship to Accounting
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Finance and accounting differ with respect
to decision-making.
While accounting is primarily concerned
with the presentation of financial data,
the financial manager is primarily concerned
with analyzing and interpreting this information
for decision-making purposes.
The financial manager uses this data as a vital tool
for making decisions about the financial aspects
of the firm.
The Managerial Finance Function

Relationship to Accounting

One major difference in perspective and
emphasis between finance and accounting is
that accountants generally use the accrual
method, while in finance
the focus is on cash flows.
The Sources and Uses of Corporate
Cash
Sources
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Decrease in any asset
Increase in any liability
Net profits after taxes
Depreciation and other
non-cash charges
Sale of stock
Uses
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Increase in any asset
Decrease in any liability
Net loss
Dividends paid
Repurchase or retirement
of stock
31
Put the operating cash flow (OCF)
for Bobcats Co. below.

OCF= EBIT + Depreciation Expense - Taxes
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Cash Flows: Comprehensive View
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Example: U.S. Corporation
Balance Sheet
Assets
Current Assets
Cash
Accounts Receivable
Inventory
Total
Fixed Assets
Net Fixed assets
Total assets


CFFA
OCF
2009
2010
$104
455
553
$1,112
$160
688
555
$1,403
$1,644
$1,709
$2,756
$3,112
=
=
=
NCS
=
depreciation
=
ΔNWC
=
=
CFFA
=
Liabiities & Owners' Equity
2009
Current Liabilities
Accounts Payable
$232
Notes Payable
196
Total
$428
Long-term debt
Owners' equity
Common stock and
paid-in surplus
Retained earnings
Total
Total Liabilties &
Owners Equity
2010
$266
123
$389
$408
$454
600
1,320
$1,920
640
1,629
$2,269
$2,756
$3,112
U.S. Corporation
Income Statement
Net sales
Cost of goods sold
Depreciation
Earnings before interest and taxes
Interest Paid
Taxable income
Taxes
Net Income
Dividends
Addition to retained earnings
$1,509
750
65
$694
70
$624
212
$412
$103
$309
OCF – NCS - ΔNWC
EBIT + depreciation – taxes
$694 + 65 – 212 = $547
ending net FA– beginning net FA +
$1709 – 1644 + 65 = $130
ending NWC – beginning NWC
($1403 – 389) – ($1112 – 428) = $330
547 – 130 – 330 = $87
34
Example: U.S. Corporation
U.S. Corporation
Income Statement
U.S. Corporation
Balance Sheet
Assets
Current Assets
Cash
Accounts Receivable
Inventory
Total
Fixed Assets
Net Fixed assets
Total assets

CFFA
CF/CR
CF/SH

CFFA
Liabiities & Owners' Equity
2009
2010
$104
455
553
$1,112
$160
688
555
$1,403
$1,644
$1,709
$2,756
$3,112
Current Liabilities
Accounts Payable
Notes Payable
Total
Long-term debt
Owners' equity
Common stock and
paid-in surplus
Retained earnings
Total
Total Liabilties & Owners
Equity
2009
2010
$232
196
$428
$266
123
$389
$408
$454
600
1,320
$1,920
640
1,629
$2,269
$2,756
$3,112
Net sales
Cost of goods sold
Depreciation
Earnings before interest and taxes
Interest Paid
Taxable income
Taxes
Net Income
Dividends
Addition to retained earnings
= CF/CR + CF/SH
= interest paid – net new borrowing
= $70 – ($454 – 408) = $24
= dividends paid – net new equity
= $103 – ($640 – 600) = $63
= $24 + $63 = $87
$1,509
750
65
$694
70
$624
212
$412
$103
$309
35
36
Pop Quiz 1

Which one of the following assets is generally
the LEAST liquid?
A) plant and equipment
B) inventory
C) patents and goodwill
D) cash
E) accounts receivable
37
Pop Quiz 2

A firm's balance sheet shows current assets of $95, net
fixed assets of $250, long-term debt of $40, and owners
equity of $200. What is the value of the firm's current
liabilities if that is the only remaining balance sheet
item?
A) -$ 50
B) $ 50
C) $105
D) $145
E) $545
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Pop Quiz 3
Q: Explain why net income and operating cash flow
differ in amount.
A:Depreciation is a noncash expense and interest
paid is a financing cash flow. While both of these
affect operating cash flows indirectly through
taxes, they do not directly affect the operating
cash flows. They do directly reduce net income.
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Pop Quiz 4
Q:How is liquidity both beneficial and harmful to a
firm?
A:Liquidity is beneficial because a firm must have
sufficient cash available to meet its obligations.
Liquidity is harmful because liquid assets earn
minimal rates of return as compared to less
liquid assets.
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Pop Quiz 5
Which two of the following determine when revenue is
recorded on the financial statements based on the GAAP?
I. when
service
II. when
III. when
IV. when
location
a.
b.
c.
d.
e.
payment is collected for the sale of a good or
the earnings process is virtually completed
the value of a sale can be reliably determined
a product is physically delivered to the buyer’s
I and II only
I and IV only
II and III only
II and IV only
I and III only
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