Chapter OutlineIncome StatementPrice-earnings RatioBalance SheetStatement of Cash FlowsTax-free Investments (Deprecation)

Basic Financial StatementsIncome StatementBalance SheetStatement of Cash Flows

Income StatementDevice to measure the profitability of a firm over a period of timeIt covers a defined period of timeIt is presented in a stair-step or progressive fashion to examine profit or loss after each type of expense item is deducted

Income Statement (contd)Sales Cost of Goods Sold (COGS) = Gross Profit (GP)

GP Expenses = Earnings Before Interest and Taxes (EBIT) or Operating Income (OI)

EBIT Interest = Earnings Before Taxes (EBT)

EBT Taxes = Earnings After Taxes (EAT) or Net Income (NI)

Income Statement (contd)

Return to CapitalThree primary sources of capital: BondholdersPreferred stockholdersCommon stockholdersEarnings per shareInterpreted in terms of number of outstanding sharesMay be paid out in dividends or retained by company for subsequent reinvestmentStatement of retained earnings Indicates disposition of earnings

Statement of Retained Earnings

Price-Earnings (P/E) RatioMultiplier applied to earnings per share to determine current value of common stockSome factors that influence P/E:Earnings and sales growth of the firmRisk (volatility in performance) Debt-equity structure of the firmDividend payment policyQuality of management

Price-Earnings (P/E) Ratio (contd)Allows comparison of the relative market value of many companies based on $1 of earnings per shareIndicates expectations about the future of a companyPrice-earnings ratios can be confusing

Price-earnings Ratios for Selected US Companies

Limitations of the Income StatementIncome gained/lost during a given period is a function of verifiable transactionsStockholders, hence, may perceive only a much smaller gain/loss from actual day-to-day operationsFlexibility in reporting transactions might result in differing measurements of income gained from similar events at the end of a time period

Balance SheetIndicates what the firm owns and how these assets are financed in the form of liabilities or ownership interestDelineates the firms holdings and obligationsItems are stated on an original cost basis rather than at current market value

Balance Sheet ItemsLiquidity: Asset accounts are listed in order of liquidityCurrent assetsItems that can be converted to cash within 12 monthsMarketable securitiesTemporary investments of excess cashAccounts receivable Allowance for bad debts to determine their anticipated collection valueInventoryIncludes raw materials, goods in progress, or finished goods

Balance Sheet Items (contd)Prepaid expensesRepresent future expense items that are already paid forInvestmentsLong-term commitment of fundsIncludes stocks, bonds, or investments in other companiesPlant and equipmentCarried at original cost minus accumulated depreciationAccumulated depreciationSum of past and present depreciation charges on currently owned assets

Balance Sheet Items (contd)Depreciation expense is the current years chargeTotal assets: Financed through liabilities or stockholders equityShort-term obligationsAccounts payableNotes payableAccrued expense

Stockholders EquityRepresents total contribution and ownership interest of preferred and common stockholdersPreferred stockCommon stockCapital paid in excess of parRetained earnings

Statement of Financial Position (Balance Sheet)

Concept of Net Worth

Net worth/book value = Stockholders equity preferred stock componentMarket value is of primary concern to the:Financial managerSecurity analystStockholders

Limitations of the Balance SheetMost of the values are based on historical/original cost priceTroublesome when it comes to plant and equipment inventoryFASB ruling on disclosure of inflation adjustments no longer in force It is purely a voluntary act on the part of the company

Limitations of the Balance Sheet (contd)Differences between per share values may be due to:Asset valuationIndustry outlookGrowth prospectsQuality of managementRisk-return expectations

Comparison of Market Valueto Book Value per Share

Statement of Cash FlowsEmphasizes critical nature of cash flow to the operations of the firmIt represents cash/cash equivalents items easily convertible to cash within 90 daysCash flow analysis helps in combating discrepancies faced through accrual method of accounting

Statement of Cash Flows (contd)Advantage of accrual methodAllows matching of revenues and expenses in the period in which they occur to appropriately measure profitsDisadvantage of accrual methodAdequate attention not directed to actual cash flow position of firm

Concepts Behind the Statement of Cash Flows

Determining Cash Flows from Operating ActivitiesTranslation of income from operations from an accrual to a cash basisDirect methodEvery item on the income statement is adjusted from accrual to cash accountingIndirect method Net income represents the starting pointRequired adjustments are made to convert net income to cash flows from operations

Indirect Method

Comparative Balance Sheets

Cash Flows from Operating Activities

Determining Cash Flows from Investing ActivitiesInvesting activities:Long-term investment activities in mainly plant and equipmentIncreasing investments represent a use of fundsDecreasing investments represent a source of funds

Determining Cash Flows from Financing ActivitiesFinancial activities apply to the sale/retirement of:BondsCommon stockPreferred stockOther corporate securitiesPayment of cash dividendsSale of firms securities is a source of fundsPayment of dividends and repurchase of securities is a use of funds

Overall Statement Combining the Three Sections

Analysis of the Overall StatementHow are increases in long-term assets being financed?Preferably, adequate long-term financing and profits should existShort-term funds may be used to carry long-term needs could be a potential high-risk situationExample: trade credit and bank loans

Depreciation and Funds FlowDepreciation Attempt to allocate the initial cost of an asset over its useful lifeCharging of depreciation does not directly influence the movement of funds

Comparison of Accounting and Cash Flows

Free Cash FlowFree Cash Flow = Cash flow from operating activities Capital expenditures DividendsCapital expendituresMaintain productive capacity of firmDividendsMaintain necessary payout on common stock and to cover any preferred stock obligationsFree cash flow is used for special financing activitiesExample: leveraged buyouts

Income Tax ConsiderationsCorporate tax ratesProgressive: the top rate is 40% including state and foreign taxes if applicable. The lower bracket is 1520%Cost of a tax-deductible expense

Depreciation as a Tax ShieldNot a new source of fundProvides tax shield benefits measurable as depreciation times the tax rateCorporation ACorporation BEarnings before depreciation and taxes$400,000$400,000Depreciation 100,000 0 _________ _________ Earnings before taxed 300,000 400,000Taxes (40%) 120,000 160,000 _________ _________ Earnings after taxes 180,000 240,000+Depreciation charged without cash outlay 100,000 0 _________ _________ Cash flow $280,000 $240,000Difference$40,000