1 FINC3131 Business Finance Chapter 3: Income Statements Balance Sheets Cash Flow Statement

1

FINC3131Business Finance

Chapter 3:

Income Statements Balance Sheets

Cash Flow Statement

2

Importance of Financial Statements

Form the basis for understanding the financial position of a business

Provide information regarding the financial policies and strategies and insight into future performance

10-K and 10-Q

3

Income Statement Overview 1 Also called

• earnings statement• profit & loss statement

Matches revenues & expenses over a period of time, e.g., past fiscal quarter or year

‘Flow’ measure statement• Each value on an income statement represents cumulative

amount of that item through the accounting period

Profit vs. Cash flow• Seldom the same

4

Income Statement Overview 2Income StatementCompany Name

For the time period ending date

Net Sales- Cost of Goods Sold- Operating Expenses- Depreciation= Operating Profit- Interest Expense= Profit Before Taxes- Taxes= Net Income

•Operating income

•Earnings before interest & taxes (EBIT)

•Earnings before taxes (EBT)

•Earnings

•Net profit

5

Income Statement Items 1• Net sales

= Gross sales – (returns & allowances)

• Cost of Goods Sold (COGS)

include raw material and labor costs

6

Income Statement Items 2 Operating expenses

• Include management salaries, advertising expenditures, repairs & maintenance, R&D, general & administrative expenses, lease payments.

Interest expense• Cost of borrowing money

Taxes• Federal, state and/or local levels

Net income• ‘bottom line’ of income statement• Base profit earned during accounting period

7

Income Statement Items 3 Earnings per common share (EPS)

Net income available to common shareholders

# common shares outstanding

indicator of firm’s current performance

Income Statement Items 3 Companies with complex capital

structures, which means existence of convertible securities (such as bonds convertible into common stock) and stock options, must calculate two amounts for earnings per share: basic and diluted.

8

Where does Net Income go?

NI = Retained Earnings + Dividend Payout

Common Dividends per share (DPS)common stock dividends paid

# common shares outstanding

9

IBM’s Income Statement Where to find?

10

11

ExamplePrepare a multi-step income statement for the ABC company for the year ending Dec 31, 2006, given the information below:

Advertising expenditures 68,000Cost of goods sold 2,433,000Depreciation 78,000Gross sales 3,210,000Interest expenses 64,000Lease payment 52,000Management salary 240,000Material purchase 2,425,000R&D expenditures 35,000Repair and maintenance costs 22,000Returns and allowances 48,000Taxes 51,000

12

SolutionGross Sales 3,210,000

Return and Allowance 48,000

Net Sales 3,162,000

Cost of Goods Sold 2,433,000

Gross Profit 729,000

Operating Expenses 417,000

Depreciation 78,000

EBIT 234,000

Interest Expense 64,000

EBT 170,000

Tax 51,000

Net Income 119,000

13

Overview of Balance Sheet Show what a company owns vs. owes at

a specific point in time. Categorizes company’s resources as:

• Assets• Liabilities• Owner’s equity

Balance sheet identity:

Total Assets = Total Liabilities + Shareholders’ Equity

14

Assets Liabilities and Owners Equity

CashMarketable securities Accounts ReceivableInventories

Total Current Assets

Gross Fixed Assets(less Accum. Depreciation)

Net Fixed AssetsOther long-term investments such as stock and bonds

Total Assets

Notes PayableAccounts PayableAccrued ExpensesCurrent Portion of LTD

Total Current LiabilitiesLong term (L.T.) Debt

Total LiabilitiesPreferred StockCommon StockRetained Earnings

Total Liabilities and equity

Liquidity

Assets Claims on Assets

Balance Sheet Overview

S.T. Funds

L.T. Capital

15

Balance Sheet Items: Current Assets 1

Current asset : Easily converted into cash within a year Cash

• Most liquid asset; frequently represented by demand deposits

Marketable Securities: e.g. short-term T-bills Accounts Receivable (A/R) Occurs because

company sells products/services on credit

16

Inventory• Raw materials, work in process (WIP), finished goods• Different valuation methods: FIFO, LIFO, average cost

Total current assets

= Cash + Marketable Securities + A/R + Inventory

Balance Sheet Items: Current Assets 2

17

Balance Sheet Items: Long-term assets 1

Fixed assets• Equipment, buildings, vehicles, computers etc• Permanent nature; needed for business operations• Reported at book value

= original historical cost – allowable depreciation Gross fixed assets (GFA): original cost of assets Accumulated depreciation (AD)

• Straight-line • Accelerated cost recovery

Net fixed assets (NFA) = gross fixed assets – accumulated depreciation

Example: GFA, AD, NFA.

18

Balance Sheet Items: Long-term assets 2

Total assets = Current assets + long-term assets

Assets (LHS of balance sheet) must be financed by a combination of liabilities and owner’s equity (RHS of balance sheet)

firms should try to finance assets with the lowest cost funds available. Not only is it important for a firm’s financial managers to focus on assets, they must focus on the structure and composition of liabilities and net worth as well.

19

Balance Sheet Items:Liabilities & Equity 1

Current liabilities1. Notes payable

2. Accounts payable

3. Accrued expenses (accruals)

4. Current portion of long-term debt 1+2+3+4 = total current liabilities

Long-term debt1. Liabilities with maturities in excess of 1 year

20


Total liabilities• = current liabilities + L.T. debt

Preferred stock• Like debt: Pays fixed periodic dollar amount• Like equity: If payment is not made,

company is not in default• Preferred dividends are usually cumulative;

no voting rights

21


Common stock• Common stock at par

No. of shares outstanding =common stock book value

Par value per share

• Additional paid-in capital (capital surplus) Additional money generated when company sold stock

Retained earnings• Cumulative total of all net income reinvested into

the company• Annual addition to retained earnings

= net income – dividends paid Example: RE, NI, dividend, annual RE

22


Common Shareholders’ equity

= common stock at par +

additional paid-in capital +

retained earnings

Common equity also known as:• Net worth, owners’ equity or book value of

firm’s equity

• What is the market value of the firms’ equity?

23

Market Value Added (MVA)

Market Value of Equity 2010:• (100,000)($6.00) = $600,000.

Book Value of Equity 2010:• $557,632.

MVA = $600,000 - $557,632 = $42,368.

24


Total liabilities and equity = total liabilities +

preferred stock (if any) +

shareholders’ equity

• Must equal total assets

IBM’s Balance Sheet Where to find?

25

26

exampleFrom the following accounts, prepare a balance sheet for the BCD company for the year ending Dec 31, 2006:

Gross fixed assets 284,950Inventory 136,500Accrued expenses 11,850Accumulated depreciation 82,310Notes payable 32,570Preferred stock 8,000Retained earnings 89,280Current portion of L-T debt 4,080Long-term debt 134,300Accounts receivable 105,770Additional paid-in capital 71,600Accounts payable 50830Common stock ($0.20 par) 60,000Cash ?

Solution

27

cash x notes payable 32570

A/R 105770 Accounts payable 50830

Incentory 136500 current portion of LT debt 4080

Current Asset 242270+x Accrued expenses 11850

Current liability 99330

long-term debt 134300

total liability 233630

Gross fixed asset 284950 common stock 60000

accumulated dep. 82310 additional paid-in 71600

Net fixed asset 202640 prefered stock 8000

retained earnings 89280

Equity 228880

total asset 444,910+x Liability and Equity 462510

example What does the balance sheet summarize

for a business enterprise?

(a) Operating results for period

(b) Financial position at a point in time

(c) Financing and investment activities for a period

(d) Profit or loss at a point in time

28

Effect of Debt vs. Equity Financing on Return

29

assets $12 miloperating income $5 mil

case 1 12 mil equity 0 debtcase 2 1 mil equity 11 mil debtr=10%

case 1 case 2operating income 5 5less: interest 0 1.1Taxable income 5 3.9less: tax (30%) 1.5 1.17Net Income 3.5 2.73

Return on Equity 3.5/12=29% 2.73/1=273%Income availabe toasset funders(operating income - tax) 3.5 3.83return on asset funder's investment 3.5/12=29% 3.83/12=31.92%

30

Manipulating financial dataExamples:

• Adjusting credit terms to affect net sales • Switching inventory valuation methods• Choice of depreciation method: straight-line

method smoothes earnings • Discretionary expense items such as R&D

Example (million)

31

Net Sales 400

COGS 260

Gross Profit 140

Operating Expenses 70

Operating Income 70

Interest Paid 20

Earnings before taxes 50

Taxes 30

Net Income 20

Questions

1. Was the company profitable?

2. Did the company indeed receive 20 million cash as profit in its bank account?

32

33

Learning Objectives of Statement of Cash Flows

Understand difference between net profit and net cash flow.

Construct statement of cash flows using indirect method.

Use the statement of cash flows to analyze a company.

34

Net profit vs. net cash flow

Net profit firm performance

under accrual method of accounting

Easily manipulated

Net cash flow firm performance in

terms of ability to generate cash

Harder to manipulate

Net profit does not equal net cash flow

35

Statement of Cash Flows Provides information about cash inflows

and outflows during an accounting period Focuses on CASH. Has THREE sections:

• Cash flow from Operating Activities (OCF)• Cash flow from Investing Activities (ICF)• Cash flow from Financing Activities (FCF )

36

Useful TipCash flow from Operating Activities

+

Cash flow from Investing Activities

+

Cash flow from Financing Activities

= CHANGE in cash account for the period!

37

Another Useful TipNo matter which section you are doing (operating,

investing or financing), IF the change is a cash INFLOW, you add that

change. + IF the change is a cash OUTFLOW, you

subtract that change. -inflow: decreases in assets or increases in liabilities or

equity.outflow: increases in assets or decreases in liabilities or

equity.

38

Cash flows from operating activities

Net income

+ Depreciation

+ Decrease in any asset account related to IS

- Increase in any asset account related to IS

- Decrease in any liability account related to IS

+ Increase in any liability account related to IS

= Net cash flow from operating activities

IS means Income

Statement

39

Cash flows from operating activities 3

Asset accounts related: Accounts receivable Inventories

Liability accounts related: Accounts payable Accruals

Warning: Notes payable NOT included! Belongs to financing activities.

40

Cash flows from operating activities 4

Asset Liability

Decreases Add

(cash inflow)

Subtract

(cash outflow)

Increases Subtract

(cash outflow)

Add

(cash inflow)

41

Cash flows from investing activities 1

Investing activities:

• Buying or selling productive assets

(plant & equipment)

• Buying or selling financial securities that

expire after 1 year

(e.g., stock of other companies, bonds)

42


Inflows: Means:Decrease in gross fixed assets Firm sells long-lived assets such as

gross property, plant and equipment

Decrease in long-term investments

Firm sells debt or equity securities of other firms

Outflows:Increase in gross fixed assets Firm buys long-lived assets such as

gross property, plant and equipment

Increase in long-term investments

Firm buys debt or equity securities of other firms

43


Investing activities refer to changes on the lower left-hand side of balance sheet

Warning: we want changes in GROSS fixed assets. We don’t want the changes in net fixed assets!

BUT, if gross fixed assets not reported in balance sheet, ….?

44

Useful relationships1) Change in gross fixed assets

= change in net fixed assets

+ depreciation

2) Depreciation (on IS)

= change in accumulated depreciation (on BS)

45

Assets Liabilities and Owners Equity

CashMarketable securities Net A/RInventories

Total Current Assets

Gross Fixed Assets(less Accum. Depreciation)

Net Fixed AssetsOther long-term assets such asstocks and bonds

Total Assets

Notes PayableAccounts PayableAccrued ExpensesCurrent Portion of LTD

Total Current LiabilitiesLong term (L.T.) Debt

Total LiabilitiesPreferred StockCommon StockRetained Earnings

Total Liabilities and equity

Liquidity

Assets Claims on Assets

Balance Sheet Overview

S.T. Funds

L.T. Capital

46

Cash flows from financing activities 1

Financing activities:

• Loans from creditors (long-term, short-term)

• Repayment of principal

• Sale or repurchase of stock (common or

preferred) from firm’s equity holders

• Payment of dividends

47


Inflows: Means:

•increase in notes payable •increase in long-term debt

Firm borrows money

•increase in common stock Firm sells equity securities

Outflows:

•decrease in notes payable•decrease in long-term debt

Firm repays debt

•decrease in common stock Firm buys back shares

•Payment of dividends Firm pays cash to shareholders

48


Financing activities refer to:• Items on lower right-hand side of balance

sheet (long-term debt, equity)

• Changes in notes payable (short-term bank loans).

Useful relationship:

Dividends paid

= net income – change in retained earnings

IBM’s Statement of Cash Flow Where to find?

49

50

Solve Assignment 3.1

51

Analyzing Statement of Cash Flows 1

Statement of CF can help you analyze a company:

1) Relationship between net income and net cash flow from operations (OCF)

If net income positive, but OCF is negative, could mean:

Company is growing rapidly Financial mis-management

52


2) Net cash flow from investing activities (ICF)

If negative, company is making investments Buying plant & equipment (improve

efficiencies) Buying another company’s stock (strategic

reasons, e.g., joint venture)

If positive, company is liquidating assets. Why? Financial distress?

53


3) Does company have sufficient cash to pay dividends?

OCF should exceed dividends.

If dividends exceed OCF, why? Company liquidated assets to pay dividends? Company issued equity or borrow to pay

dividends? Neither situation is good.

54


4) Changes in debt Look at cash flow from financing

activities Big increases in debt (either short-term

or long-term) are not good. Substituting short-term debt for long-term

debt may indicate worsening financial health.

Summary Income Statement Balance Sheet Statement of Cash Flow Assignment:

1. Textbook problems (page 86):3-2, 3-3, 3-4, 3-8, 3-9

2. additional cash flow assignment on course web

55

Documents

1 FINC3131 Business Finance Chapter 3: Income Statements Balance Sheets Cash Flow Statement