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Financial Statements and Cash Flows
RWJ-Chapter 2
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Understanding Financial Statements

The crux of investments is to value firms (or stocks)

Various models to value common stocks
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DCF
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Multiples
No matter which model we are going to use, the key inputs we
needed are mostly based on a firm’s financial statements
We will learn the basic tools to analyze financial statements
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Information for Financial Statements
Analysis
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1) Published annual reports
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(1) Financial Statements
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Balance Sheet (B/S)
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Income Statement (I/S)
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Statement of Cash Flows
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(2) Notes to financial statements
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(3) Letters to stockholders
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(4) Auditor’s report (independent accountants)
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(5) Management’s discussion and analysis
2) Reports filed with the government
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Sources of Information
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Annual reports
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SEC
 EDGAR
(http://www.sec.gov/edgar.shtml)
 10K & 10Q reports
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Balance Sheet
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Balance sheet summarizes the assets owned by a firm
The value of the assets, and the mix (debt and equity) used to
finance these assets at a point in time
Assets
Fixed Assets
Current Assets
Financial Investments
Intangible Assets
Total Assets
Liabilities & Equity
Current Liabilities
Debt (Long-term)
Equity
Stockholder’s Equity
Total Liabilities & Equity
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Summary of B/S
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An accountant’s snapshot of the firm’s accounting value
as of a particular date.
The Balance Sheet Identity is:
Assets ≡ Liabilities + Stockholder’s Equity
Stockholder’s equity is defined to be the difference
between the assets and the liabilities of the firm. Equity
is what stockholders would have remaining after the
firm discharged its operations.
Liabilities and equity-side reflects the types and
proportions of financing, which depend on
management’s choice of capital structure, as between
debt and equity and current debt and long-term debt.
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Assets
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Fixed Assets:
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Assets that are purchased for long-term use and are not likely to be
converted quickly into cash, such as land, buildings, and equipment.
GAAP requires the valuation of historical cost, adjusted for any
estimated loss in value from the aging of these assets
(Depreciation)
Many firms in the U.S. use straight line depreciation, while
Japanese and German firms often use accelerated depreciation
Straight line versus Accelerated Depreciation
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Accelerated depreciation leads reported income that is
understated.
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Example- Straight Line
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An asset costs $33,000 has a residual value of $3,000, and
expected to last 4 years
(i) Calculate annual depreciation
(ii) what happen if you are able to sell this asset after two year
at selling price of $20,000?
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Example-Accelerated Depreciation
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An asset costs $33,000, and expected to last 5 years
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(i) Calculate annual depreciation
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(ii) what happen if you are able to sell this asset after two year
at selling price of $20,000?
Recovery
year
Applicable
Percentage
1
0.200
2
0.320
3
0.192
4
0.1152
5
0.1152
6
0.0576
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Assets
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Current Assets:
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
Account Receivables:
 It represents money owed by entities to the firm on the sale of
products on credit
Cash and Marketable Securities:
 Cash: One of the few assets for which accountants and financial
analysts should agree on the value
 Marketable Securities: Investments made by firms in securities or
assets of other firms, as well as T-bills or bonds
Inventory
 The total amount of goods and/or materials contained in a store or
factory at any given time
 Closely related to COGS
 LIFO vs FIFO
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Assets
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Intangible Assets:
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Patents and Trademarks
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Internal
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External
Goodwill
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By product of acquisitions
When a firm acquires another firm, the purchase price is first
allocated to tangible assets, and the excess price is then
allocated to any intangible assets
Nothing but excess price by actual price (MV) and book value of
the company
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Liabilities and Equity
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Current Liabilities:
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Accounts payable:
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Short-term Borrowing:
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Short-term loans (due in less than a year) to finance the
operations or current asset needs of the business
Short-term portion of long-term borrowing
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It represents credit received from suppliers and other vendors
It represents the portion of the long-term debt or bonds that is
coming due in the next year
Other short-term liabilities:
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It includes wages due to its employees and taxes due to the
government
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Liabilities and Equity
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Long-Term Debt:
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Other Long-term Liabilities:
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Leases, Employee Benefits, Pension Plans, Health Care Benefits
These are long-term obligations that are not captured in the long-term
debt items
In the past two decades accountants moved toward quantifying these
liabilities and showing them as long-term liabilities
Equity:
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
Long-term loan from a bank or other financial institutions
Long-term bond issued to financial markets
It reflects the original proceeds received by the firm when issued the
equity
Retained Earnings:
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Net Income kept for further investment
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U.S. COMPOSITE CORPORATION
Balance Sheet
2008 and 2009
(in $ millions)
Assets
Current assets:
Cash and equivalents
Accounts receivable
Inventories
2008
$104
455
553
2009
$160
688
555
Total current assets
$1,112 $1,403
Fixed assets:
Net Property, plant, and
equipment
$1,644 $1,709
Liabilities (Debt)
and Stockholder's Equity
Current Liabilities:
Accounts payable
Notes payable
Total current liabilities
Long-term debt
2008
2009
$232
196
$266
123
$428
$389
408
454
600
640
1,320
1,629
Stockholder's equity:
Common stock and paid in surplus
Accumulated retained earnings
Total assets
Total equity
$1,920 $2,269
$2,756 $3,112 Total liabilities and stockholder's equity $2,756 $3,112
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Balance Sheet Analysis
When analyzing a balance sheet, the financial manager
should be aware of three concerns:
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(1) Liquidity
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(2) Debt versus equity
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(3) Value versus cost
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Liquidity
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Refers to the ease and quickness with which assets can be
converted to cash.
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Current assets are the most liquid. Fixed assets are the least
liquid.
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Some fixed assets are intangible.
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The more liquid a firm’s assets, the less likely the firm is to
experience problems meeting short-term obligations.
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
Liquid assets frequently have lower rates of return than fixed
assets. For example, cash generates no or little investment
income.
To the extent that a firm invests in liquid assets, it sacrifices an
opportunity to invest in more profitable investments.
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Value versus Cost
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Under GAAP audited financial statements of firms in the U.S.
carry assets at cost.
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Market value is a completely different concept.
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Market value is the price at which willing buyers and sellers
trade the assets. It would be only coincidence if accounting
value (book value) and market value were the same.
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Many users of financial statements want to know the value of
the firm, not its cost.
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In this class, whenever we mention value, we mean market
value, not the cost (or book value).
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When we say that the goal of a financial manager is to increase
the value of the stock, we mean the market value of the stock.
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Income Statement
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The income statement measures performance over a specific
period of time.
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It provides information on the revenues and expenses of the
firm, and resulting income made by the firm, during a period
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The accounting definition of income is
Revenue – Expenses ≡ Income
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More Specifically
Revenue
Cost of Goods Sold (COGS)
Gross Profit
Operating Expense
EBITDA
Depreciation & Amortization
EBIT (Operating Income)
Interest
Taxes
Net Income (NI) or Earnings
Retained
Earnings (R/E)
Dividends
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U.S. COMPOSITE CORPORATION
Income Statement
2009
(in $ millions)
The operations
section of the income
statement reports the
firm’s revenues and
expenses from
principal operations
Net sales
Cost of goods sold
Depreciation
$1,509
- 750
- 65
Earnings before interest and taxes
$694
Interest expense
Taxable income
Taxes (34%)
- 70
$624
- 212
Net income
Retained earnings:
Dividends:
$412
$309
$103
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U.S. COMPOSITE CORPORATION
Income Statement
2009
(in $ millions)
Net sales
Cost of goods sold
Depreciation
The non-operating
section of the income
statement includes all
financing costs, such
as interest expense.
Earnings before interest and taxes
$1,509
- 750
- 65
$694
Interest expense
Taxable income
Taxes (34%)
- 70
$624
- 212
Net income
Retained earnings:
Dividends:
$412
$309
$103
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U.S. COMPOSITE CORPORATION
Income Statement
2009
(in $ millions)
Net sales
Cost of goods sold
Depreciation
Earnings before interest and taxes
Usually a separate
section reports as a
separate item the
amount of taxes levied
on income
$1,509
- 750
- 65
$694
Interest expense
Taxable income
Taxes (34%)
- 70
$624
- 212
Net income
Retained earnings:
Dividends:
$412
$309
$103
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U.S. COMPOSITE CORPORATION
Income Statement
2009
(in $ millions)
Net sales
Cost of goods sold
Depreciation
Earnings before interest and taxes
Net income is the
“bottom line”
$1,509
- 750
- 65
$694
Interest expense
Taxable income
Taxes (34%)
- 70
$624
- 212
Net income
Retained earnings:
Dividends:
$412
$309
$103
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Income Statement Analysis
There are two things to keep in mind when analyzing an
income statement:
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(1) GAAP
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(2) Non Cash Items
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Generally Accepted Accounting
Principles
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Recognition principle: Recognize revenue when the earnings
process is complete and the value of an exchange of goods or
services is known and can be reliably determined. Thus,
income is reported when it is earned, even though no cash flow
may have occurred.
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
Midland co. sells goods for $1 million. The goods cost $900,000. So
the company will have profit of $100,000.
But the company has not yet collected the cash from the sale. So,
the net cash flow is -$900,000.
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Non-Cash Items
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Depreciation is the most apparent. No firm ever writes a check
for “depreciation”.
In practice, the difference between cash flows and accounting
income can be quite dramatic.
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For example Conseco Corp. reported a net loss of $194 million for
2007. But it also reported a positive cash flow of $ 703 million for the
same fiscal year!
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Net Working Capital
Working Capital ≡ Current Assets – Current Liabilities
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If the change in NWC is positive, it is a cash outflow. (you are
investing more in NWC). If the change in NWC is negative, it is
a cash inflow
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U.S. COMPOSITE CORPORATION
Balance Sheet
2008 and 2009
(in $ millions)
$1014m = $1403- $389
Assets
Current assets:
Cash and equivalents
Accounts receivable
Inventories
2008
$104
455
553
Total current assets
2009
$160
688
555
$1,112 $1,403
Fixed assets:
Property, plant, and equipment $1,423 $1,274
Less accumulated depreciation -550
-460
Net property, plant, and equipment873
814
Intangible assets and other
245
221
Total fixed assets
$1,118 $1,035
$684m = $1112m- $428m
Total assets
$1,879 $1,742
Liabilities (Debt)
and Stockholder's Equity
Current Liabilities:
Accounts payable
Notes payable
Total current liabilities
2008
2009
$232
196
$266
123
$428
$389
Long-term liabilities:
Deferred taxes
$117
$104
Here
we
see
NWC
grow
to
$1,014
Long-term debt
471
458
Total long-term
million
in 2009liabilities
from $684 $588
million$562
in
2008.
Stockholder's equity:
Preferred stock
$39
$39
Common stock ($1 par value)
55
32
Capital surplus
347
327
Accumulated retained earnings
390
347
Less
stock of $330 million
-26 is an
-20
Thistreasury
increase
Total equity
$805
$725
investment
of
the
firm.
Total liabilities and stockholder's equity
$1,879 $1,742
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Financial Cash Flows
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
In finance, the most important item that can be extracted from
financial statements is the actual cash flow of the firm.
Since there is no magic in finance, it must be the case that the
cash flow received from the firm’s assets must equal the cash
flows to the firm’s creditors and stockholders.
CF(A)≡ CF(B) + CF(S)
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U.S. COMPOSITE CORPORATION
Financial Cash Flow
20X2
(in $ millions)
Cash Flow of the Firm
Operating cash flow
$547
(Earnings before interest and taxes
plus depreciation minus taxes)
Capital spending
(130)
(Ending net fixed assets
minus beginning fixed assets plus dep.)
Additions to net working capital
(330)
Total
$87
Cash Flow of Investors in the Firm
Debt
Equity
Total
$24
63
$87
Operating Cash Flow:
EBIT
Depreciation
$694
$65
Current Taxes
($212)
OCF
$547
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U.S. COMPOSITE CORPORATION
Financial Cash Flow
20X2
(in $ millions)
Cash Flow of the Firm
Operating cash flow
$547
(Earnings before interest and taxes
plus depreciation minus taxes)
Capital spending
(130)
(Ending net fixed assets
minus beginning net fixed assets plus dep.)
Additions to net working capital
(330)
Total
$87
Cash Flow of Investors in the Firm
Debt
Equity
Total
$24
63
$42
Capital Spending
Ending net fixed assets
$1,709
Beginning net fixed assets
(1644)
Depreciation
Net Capital Spending
65
$130
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U.S. COMPOSITE CORPORATION
Financial Cash Flow
20X2
(in $ millions)
Cash Flow of the Firm
Operating cash flow
(Earnings before interest and taxes
plus depreciation minus taxes)
Capital spending
$547
(130)
Additions to net working capital
Total
(330)
$87
Cash Flow of Investors in the Firm
Debt
$24
Equity
63
Total
$87
NWC grew from $684 million in
2008 to $1014 million in 20X1.
This increase of $330 million is
the addition to NWC.
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U.S. COMPOSITE CORPORATION
Financial Cash Flow
20X2
(in $ millions)
Cash Flow of the Firm
Operating cash flow
$547
(Earnings before interest and taxes
plus depreciation minus taxes)
Capital spending
(130)
(Ending net fixed assets
minus beginning net fixed assets plus dep.)
Additions to net working capital
(330)
Total
$87
Cash Flow of Investors in the Firm
Debt
Equity
Total
$24
63
$87
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U.S. COMPOSITE CORPORATION
Financial Cash Flow
20X2
(in $ millions)
Cash Flow of the Firm
Operating cash flow
(Earnings before interest and taxes
plus depreciation minus taxes)
Capital spending
$547
(130
Additions to net working capital
Total
(330)
$87
Cash Flow of Investors in the Firm
Debt
(Interest minus net new borrowing)
$24
Equity
63
(Dividends minus net new equity raised)
Total
$87
Cash Flow to Creditors
Interest paid
$70
Net new borrowing
(46)
Total
24
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U.S. COMPOSITE CORPORATION
Financial Cash Flow
20X2
(in $ millions)
Cash Flow of the Firm
Operating cash flow
(Earnings before interest and taxes
plus depreciation minus taxes)
Capital spending
$547
(130)
Additions to net working capital
Total
(330)
$87
Cash Flow of Investors in the Firm
Debt
(Interest minus net new borrowing)
$24
Equity
63
(Dividends minus net new equity raised)
Total
$87
Cash Flow to Stockholders
Dividends
$103
Net new equity raised
(40)
Total
$63
Net new equity raised is the
change in common stock and
paid–in-surplus from B/S.
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U.S. COMPOSITE CORPORATION
Financial Cash Flow
20X2
(in $ millions)
Cash Flow of the Firm
Operating cash flow
$547
(Earnings before interest and taxes
plus depreciation minus taxes)
Capital spending
(130)
(Ending net fixed assets
minus beginning net fixed assets plus dep.)
Additions to net working capital
(330)
Total
$87
Cash Flow of Investors in the Firm
Debt
(Interest minus net new borrowing)
$24
Equity
63
(Dividends minus net new equity raised)
Total
$87
The cash flow received from the
firm’s assets must equal the
cash flows to the firm’s creditors
and stockholders:
CF ( A) 
CF ( B )  CF ( S )
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Cash Flow Summary
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Free Cash Flows

There are two types of Cash Flows:
(1) This is the cash flows generated by a company’s operating
activities and available to all who provided capital to the firm
(Debt and Equity Holders)
𝑂𝐹𝐶𝐹 = 𝐸𝐵𝐼𝑇 − 𝑇𝑎𝑥 + 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 − 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐸𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒
−∆𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 − ∆𝑂𝑡ℎ𝑒𝑟 𝐴𝑠𝑠𝑒𝑡𝑠
Current Assets –Current Liabilities
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Free Cash Flows
(2) “free” cash flows to equity (stock holders), which is derived
from after operating free cash flows have been adjusted for debt
payments (interest and principal)
𝐹𝐶𝐹 = 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 + 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 − 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐸𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒
+𝑁𝑒𝑤 𝐷𝑒𝑏𝑡 𝐼𝑠𝑠𝑢𝑒 − 𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 𝐷𝑒𝑏𝑡 𝑃𝑎𝑦𝑚𝑒𝑛𝑡𝑠
−∆𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 − ∆𝑂𝑡ℎ𝑒𝑟 𝐴𝑠𝑠𝑒𝑡𝑠
Current Assets –Current Liabilities
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Question:

Which one to use?
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Cash Flows
Assets
Cash
outflow
Cash
inflow
Liabilities
Cash
inflow
Cash
outflow
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Limitations of Financial Ratios


Accounting statements:

A reasonably good job of categorizing the assets owned by a firm

A partial job of assessing the value of these assets

A poor job of reporting uncertainty about asset value
Accounting principles:


The accounting view of asset value is to a great extent grounded in the
notion of historical cost, which is the original cost of the asset. Historical cost
is the best estimate of the value of an asset.
Conservative approach to estimate the value .

At the end of 2011, book value of Google is $58.1 billion

At the end of 2011, the market value of Google is $211.04 billion (stock price= $645)
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Limitations of Financial Ratios

These values are based on specific dates



Capture values of assets and liabilities on a specific date
Ratios using balance sheet may not reflect company’s situation
during rest of the year
Example: A company that reports $1 million in cash on last day of
fiscal year may have only $100 K two days later after paying
salaries and suppliers