ch03

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CHAPTER 3

Financial Statements,

Cash Flows, and Taxes

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Quick Links

The Income Statement

Statement of Retained Earnings Cash Flows

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The Balance Sheet

This financial statement identifies all the assets and liabilities of a firm at a point in time.

 _{Left side of the balance shows all assets}

the firm owns and uses to generate revenues.

 _{Right side represents the liabilities of the}

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 _{Balance sheet also lists the capital raised from}

its shareholders.

 _{Shareholders of the firm’s common equity are}

listed last.

 _{Shareholders will be paid with whatever}

remains after paying all other suppliers of funds.

 _{Assets listed in order of their liquidity.}

 _{Liabilities listed in order in which they must be}

paid.

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Current Assets and Liabilities

 _{Current assets include all assets likely to be}

converted to cash within a year (or within an operating cycle).

 _{These include cash and marketable}

securities, accounts receivables, and inventory.

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Current Assets and Liabilities

 _{Current Liabilities include all liabilities that}

have to be paid within a year.

 _{Bank loans and other borrowings with}

less than a year’s maturity, accounts payables, accrued wages and taxes

The Balance Sheet

Net working capital= Total current assets

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Net working capital example - Diaz Manufacturing

Total current assets = $1,039.8 million Total current liabilities = $377.8 million Net working capital =?

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Inventory Accounting

 _{FIFO (First in first out) refers to practice of}

recognizing a sale as being made up of inventory purchased earlier.

 _{LIFO (Last in first out) calls for firm to}

attribute any sale made to the most recently acquired.

 _{Book Example?}

 _{Inventory (least liquid of current assets)}

usually reported in one of two ways on balance sheet.

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Inventory Accounting

 _{During rising prices, FIFO reporting leads to}

higher current asset value and higher net income.

 _{Firms may switch from one to another only}

under extraordinary circumstances and not frequently.

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Long-Term Assets

 _{Intangible assets also listed here.}

 _{Goodwill, patents, copyrights, etc.}

 _{Real assets firm acquires to produce its}

products and generate cash flows.

 _{Land, buildings, plant and equipment.}

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Long-Term Assets

 _{All long-term real assets that deteriorate}

with use are depreciated.

 _{Intangible assets are amortized.}

 _{Depreciating assets allow a firm to lower}

taxable income and reduce taxes.

 _{Firms are allowed to depreciate assets}

using straight line method or accelerated depreciation method allowed by IRS.

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Long-Term Liabilities

 _{Long-term debt of the company.}

 _{Includes bank loans, mortgages, and bonds}

with a maturity of one year or longer.

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Equity – There are two sources of equity funds

 _{Preferred Equity}

_{Has features that make it a}

combination of a fixed income security and an equity security.

 _{Common Equity}

_{Common equity represents the true}

ownership of the firm.

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More Balance Sheet Accounts

 _{Retained earnings}

_{Results from funds the firm has}

reinvested from its earnings.

_{These funds are not cash–they already}

have been put to work.

 _{Treasury stock}

_{This account reflects the value of}

the shares that the firm has repurchased from investors.

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The Income Statement

 _{Measures the profitability of a firm for any}

reporting period.

 _{Revenues represent value of products and}

services sold by firm–include both cash and credit sales.

 _{Expenses range from cost of producing}

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The Income Statement

Revenues = $1,563.7 million Expenses = $1,445.2 million Net Income = ?

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 The cost of any physical asset, such as plant

or machinery, is written off over its lifetime. This is called depreciation and is a non-cash expense.

The Income Statement: Depreciation

 _{Firms use one of these for depreciating}

an asset:

_{Straight line method}

_{Accelerated depreciation method}

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 Amortization expenses are related to the

writing off of the value of intangible assets, such as:

 Goodwill, Patents, Licenses, etc.

The Income Statement: Amortization

 _{It is also a non-cash expense like depreciation.}

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Extraordinary Items

 _{Extraordinary Items refer to income or}

expenses associated with events that are not expected to happen on a regular basis.

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 _{Earnings before interest, taxes, depreciation and} amortization (EBITDA) .

 Earnings generated from operations prior to payment of expenses not directly connected to production of products.

Bottom Line Accounts

 _{After netting out the expenses related to}

depreciation and amortization, we arrive at earnings before interest and taxes (EBIT).

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 _{Subtracting taxes from EBT yields net}

income or net income after taxes.

 _{This amount tells us amount available}

to management to pay dividends, pay off debt, or reinvest in firm.

Bottom Line Accounts

 _{Earnings before taxes (EBT) represents the}

taxable income for the period.

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Statement of Retained

Earnings

 _{This account will show changes whenever}

a firm reports a loss or profit and when a cash dividend is declared.

 _{This financial statement shows the}

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Exhibit 3.3: Diaz Mfg

Statement of Retained

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Cash Flows

Net Cash Flow versus Net Income

 _{While accountants focus on net income,}

shareholders would be more interested in net cash flows.

 _{These two are not the same, because of}

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Cash Flows

Net Cash Flow versus Net Income

 _{We can estimate the net cash flow from operating}

activities (NCFOA) as:

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Cash Flows

NCFOA example – Diaz Manufacturing

Net Income = $118.5 million

Depreciation and Amortization = $83.1 million NCFOA = ?

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The Statement of Cash Flows

 _{Helps to measure cash outflows and cash}

inflows generated during any period.

 _{Indicates cash flows resulting from}

 _{Operating activities, investing activities,}

and financing activities.

 _{Sum of cash flows measures net cash}

flows of firm during a given period.

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Organization of the Statement of Cash Flows

 _{Cash inflows result from producing and}

selling goods and services.

 _{Cash outflows are tied to the purchase of}

raw materials, inventory, salaries and wages, utilities, rent, interest and other related expenses.

Cash Flows

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 _{Cash inflows and outflows arise out of the}

acquisition and selling of long-term assets necessary to operate the business.

investing activities.

 _{Also result from}

 _{Buying and selling financial assets}

Cash Flows

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 _{Cash Inflows–when a firm issues debt or}

equity securities, or borrows money from banks or other lenders.

 _{Cash Outflows–if they pay interest or}

dividends on the investor’s funds, pay off debt, or purchase treasury stock.

Cash Flows

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Exhibit 3.5: Interrelations

among the Financial

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In-class discussion

 End of chapter questions