Principles of Finance1  

 

Dr : Fouzan AL-Qaisi EM:f.qaisi@aum,edu.jo

AMERICAN UNIVERSITY OF MADABA (AUM)

MADABA-JORDAN

Chapter

McGraw-Hill/IrwinCopyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Review of Accounting2

Chapter 2

Financial Statements,Taxes, and Cash Flow

Copyright © 2012 McGraw-Hill Education. All rights reserved.

Key Concepts and Skills

• Know the difference between book value and market value

• Know the difference between accounting income and cash flow

• Know the difference between average and marginal tax rates

• Know how to determine a firm’s cash flow from its financial statements

• Understand the different point of view between accounting and finance

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Chapter Outline

• The Balance Sheet• The Income Statement• Price-earnings Ratio• Tax-free Investments (Deprecation)• Statement of Cash Flows• Accounting versus Finance

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Basic Financial Statements

• Income Statement• Balance Sheet• Statement of Cash Flows

•Income StatementIncome Statement

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Income Statement

• Device to measure the profitability of a firm over a period of time– It covers a defined period of time– It is presented in a stair-step or progressive

fashion to examine profit or loss after each type of expense item is deducted

Income Statement

• The income statement is more like a video of the firm’s operations for a specified period of time.

• You generally report revenues first and then deduct any expenses for the period

• Matching principle – (GAAP) Generally Accepted Accounting Principles

• says to show revenue when it accrues and match the expenses required to generate the revenue

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Income Statement (cont’d)

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)

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Income Statement (cont’d)

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Return to Capital

• Three primary sources of capital: – Bondholders– Preferred stockholders– Common stockholders

• Earnings per share– Interpreted in terms of number of outstanding

shares– May be paid out in dividends or retained by

company for subsequent reinvestment• Statement of retained earnings

– Indicates disposition of earnings

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Statement of Retained Earnings

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Price-Earnings (P/E) Ratio

• Multiplier applied to earnings per share to determine current value of common stock

• Some factors that influence P/E:– Earnings and sales growth of the firm– Risk (volatility in performance) – Debt-equity structure of the firm– Dividend payment policy– Quality of management

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Price-Earnings (P/E) Ratio (cont’d)

• Allows comparison of the relative market value of many companies based on $1 of earnings per share– Indicates expectations about the future of a

company

• Price-earnings ratios can be confusing

Limitations of the Income Statement

1. Income statements include judgments and estimates, which mean that items that might be relevant but cannot be reliably measured are not reported and that some reported figures have a subjective component.

2. With respect to accounting methods, one of the limitations of the income statement is that income is reported based on accounting rules and often does not reflect cash changing hands.

3. Income statements can also be limited by fraud, such as earnings management, which occurs when managers use judgment in financial reporting to intentionally alter financial reports to show an artificial increase (or decrease) of revenues, profits, or earnings per share figures.

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Limitations of the Income Statement

• Flexibility in reporting transactions might result in differing measurements of income gained from similar events at the end of a time period

•Balance SheetBalance Sheet

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Balance Sheet

• Indicates what the firm owns and how these assets are financed in the form of liabilities or ownership interest– Delineates the firm’s holdings and obligations– Items are stated on an original cost basis

rather than at current market value

Balance Sheet

• The balance sheet is a snapshot of the firm’s assets and liabilities at a given point in timegiven point in time

• Assets are listed in order of decreasing liquidity– Ease of conversion to cash– Without significant loss of value

• Balance Sheet Identity– Assets = Liabilities + Stockholders’ Equity

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The Balance Sheet - Figure 2.1

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Balance Sheet Items

• Asset Side• Liquidity: Asset accounts are listed in order of liquidity

– 1-Current assets• Items that can be converted to cash within 12 months

– Cash Money– Marketable securities

• Temporary investments of excess cash– Accounts receivable

• Allowance for bad debts to determine their anticipated collection value

– Inventory• Includes raw materials, goods in progress, or finished goods

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Balance Sheet Items (cont’d)

– Prepaid expenses• Represent future expense items that are already paid

for– 2-Investments

• Long-term commitment of funds• Includes stocks, bonds, or investments in other

companies– 3-Fixed Assets Plant and equipment

• Carried at original cost minus accumulated depreciation

• Accumulated depreciation– Sum of past and present depreciation charges on currently

owned assets

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Balance Sheet Items (cont’d)

– liabilities and stockholders’ equity side• Depreciation expense is the current year’s charge

– Total assets: Financed through liabilities or stockholders’ equity

– 1-Current liabilities• Short-term obligations

– Accounts payable– Notes payable– Accrued expense– 2-Long Term Debit

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Stockholder’s Equity

• 3-Stockholder’s Equity• Represents total contribution and ownership

interest of preferred and common stockholders– Preferred stock– Common stock– Capital paid in excess of par– Retained earnings

Total assets = Total liabilities + Equity

04/22/23 Statement of Cash Flow 27

KRAMER CORPORATIONIncome StatementDecember 31, 2008

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Statement of Financial Position (Balance Sheet)

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KRAMER CORPORATIONComparative Balance Sheets

(continued on next slide)

Year-End Year-End Assets: 2007 2008

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KRAMER CORPORATIONComparative Balance Sheets (cont.)

Year-End Year-End 2007 2008

Net Working Capital and Liquidity

• Net Working Capital– = Current Assets – 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

• Liquidity– Ability to convert to cash quickly without a significant loss in value– Liquid firms are less likely to experience financial distress– But liquid assets typically earn a lower return– Trade-off to find balance between liquid and illiquid assets

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Market Value vs. Book Value

• The balance sheet : The balance sheet : provides the book value of the assets, liabilities, and equity.

• Market value : Market value : is the price at which the assets, liabilities ,or equity can actually be bought or sold.

• Market value Market value and book valuebook value are often very different. Why?

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Concept of Net Worth

Net worth/book value = Stockholders’ equity – preferred stock component

• Market value Market value is of primary concern to the:– Financial manager– Security analyst– Stockholders

Limitations of the Balance Sheet

1. Balance sheets do not show true value of assets. Historical cost Historical cost is criticized for its inaccuracy since it may not reflect current market valuation.

2. Some of the current assets are valued on an estimated basis, so the balance sheet is not in a position to reflect the true financial position of the business. such as Inventory .,marketble securities

3. The balance sheet can not reflect those assets which cannot be expressed in monetary terms, such as skill, intelligence, honesty, and loyalty of workers.

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• Statement of Cash FlowsStatement of Cash Flows

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Statement of Cash FlowsStatement of Cash Flows

• Emphasizes critical nature of cash flow to the operations of the firm– It represents cash/cash equivalents items easily

convertible to cash within 90 days• Cash flow analysis helps in combating

discrepancies faced through accrual method of accounting

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Statement of Cash Flows (cont’d)

• Advantage of accrual method– Allows matchingmatching of revenues and expenses in

the period in which they occur to appropriately measure profits

• Disadvantage of accrual method– Adequate attention not directed to actual cash actual cash

flow position of firm

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Concepts Behind the Statement of Cash Flows

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Determining Cash Flows from Operating Activities

• Translation of income from operations from an accrual to a cash basis

• Direct method– Every item on the income statement is adjusted

from accrual to cash accounting• Indirect method

– Net income represents the starting point– Required adjustments are made to convert net

income to cash flows from operations

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Indirect Method

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Comparative Balance Sheets

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KRAMER CORPORATIONComparative Balance Sheets

(continued on next slide)

Year-End Year-End Assets: 2007 2008

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KRAMER CORPORATIONComparative Balance Sheets (cont.)

Year-End Year-End 2007 2008

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Income Statement (cont’d)

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Cash Flows from Operating Activities

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Determining Cash Flows from Investing Activities

• Investing activities:– Long-term investment activities in mainly plant

and equipment• Increasing investments represent a use of funds• Decreasing investments represent a source of funds

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Determining Cash Flows from Financing Activities

• Financial activities apply to the sale/retirement of:– Bonds– Common stock– Preferred stock– Other corporate securities– Payment of cash dividends

• Sale of firm’s securities is a source of funds• Payment of dividends and repurchase of securities is

a use of funds

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Overall Statement Combining the Three Sections

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Depreciation and Funds Flow

• Depreciation – Attempt to allocate the initial cost of an asset

over its useful life• Charging of depreciation does not directly

influence the movement of funds

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Comparison of Accounting and Cash Flows

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Free Cash Flow

Free Cash Flow = Cash flow from operating activities – Capital expenditures – Dividends– Capital expenditures

• Maintain productive capacity of firm– Dividends

• Maintain necessary payout on common stock and to cover any preferred stock obligations

• Free cash flow is used for special financing activities– Example: leveraged buyouts

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Income Tax Considerations

• Corporate tax rates– Progressive: the top rate is 40% including state

and foreign taxes if applicable. The lower bracket is 15–20%

• Cost of a tax-deductible expense

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Depreciation as a Tax Shield

• Not a new source of fund• Provides tax shield benefits measurable as

depreciation times the tax rateCorporation A Corporation B

Earnings 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

The Concept of Cash Flow

• Cash flow is one of the most important pieces of information that a financial manager can derive from financial statements

• The statement of cash flows does not provide us with the same information that we are looking at here

• We will look at how cash is generated from utilizing assets and how it is paid to those that finance the purchase of the assets

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Cash Flow From Assets

• Cash Flow From Assets (CFFA) = Cash Flow to Creditors + Cash Flow to Stockholders

• Cash Flow From Assets = Operating Cash Flow – Net Capital Spending – Changes in NWC

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Quick Quiz• What is the difference between book value and

market value? Which should we use for decision-making purposes?

• What is the difference between accounting income and cash flow? Which do we need to use when making decisions?

• What is the difference between average and marginal tax rates? Which should we use when making financial decisions?

• How do we determine a firm’s cash flows? What are the equations, and where do we find the information?

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