-Chapter Three

Understanding Financial Statements and Cash Flows

Chapter 3

Keown, Martin, Petty - Chapter 3

2

Objectives Understand what important information is included in the income statement

and the balance sheet of a firm

Explain the significance of the cash flow statement

Explain the difference between net income and cash flow for the firm

Keown, Martin, Petty - Chapter 33 - 3

Basic Financial Statements

Income statementIncome statement - indicates the amount of profits (or losses) generated by- indicates the amount of profits (or losses) generated by a firm over a given time period, often 1 year. a firm over a given time period, often 1 year. Balance sheetBalance sheet - provides a snapshot of the firm’s financial position at- provides a snapshot of the firm’s financial position at a specific point in timea specific point in time

Cash flow statementCash flow statement - shows the actual funds generated/used by the firm for the - shows the actual funds generated/used by the firm for the given period of timegiven period of time


REVENUE REVENUE -- EXPENSES = PROFIT EXPENSES = PROFIT

Income StatementIncome Statement

Sales

• Cost of Goods SoldCost of Goods Sold• Operating ExpensesOperating Expenses (marketing, administrative, (marketing, administrative, depreciationdepreciation))• Financing CostsFinancing Costs• TaxesTaxes


Income Statement Terminology

Revenue (Sales)Revenue (Sales) Money derived from selling the company’s product or serviceMoney derived from selling the company’s product or service

Cost of Goods Sold (COGS)Cost of Goods Sold (COGS) The cost of producing or acquiring the goods or services to be soldThe cost of producing or acquiring the goods or services to be sold

Operating ExpensesOperating Expenses Expenses related to marketing and distributing the product or Expenses related to marketing and distributing the product or

service and administering the businessservice and administering the business Financing costsFinancing costs

The interest paid to creditors and the dividends paid to preferred The interest paid to creditors and the dividends paid to preferred stockholdersstockholders

Tax ExpensesTax Expenses Amount of taxes owed, based upon taxable incomeAmount of taxes owed, based upon taxable income


SALESSALES

Cost of Goods SoldCost of Goods Sold

= = GROSS PROFITGROSS PROFIT

Operating Expenses Operating Expenses

= = OPERATING INCOME (EBIT)OPERATING INCOME (EBIT)

Interest ExpenseInterest Expense

= EARNINGS BEFORE TAXES (EBT)= EARNINGS BEFORE TAXES (EBT)

Income TaxesIncome Taxes

= NET INCOME= NET INCOME


SALESSALES










SALESSALES










Net Income Available to Net Income Available to ShareholdersShareholders

DividendsDividendsDividendsDividends Retained Retained EarningsEarningsRetained Retained EarningsEarnings


Balance Sheet

Examines the firm’s financial position at a Examines the firm’s financial position at a specific specific point in timepoint in time

Assets = Liabilities + Owner’s EquityAssets = Liabilities + Owner’s Equity

Assets are resources owned by the firmAssets are resources owned by the firm Liabilities and Owner’s equity indicate how those Liabilities and Owner’s equity indicate how those

resources are financedresources are financed


Balance Sheet Terminology Current Assets or gross working capitalCurrent Assets or gross working capital

Comprise assets that are relatively liquid, or Comprise assets that are relatively liquid, or expected to be converted into cash within a expected to be converted into cash within a year.year.

Current AssetsCurrent Assets typically include: typically include: CashCash Accounts Receivable Accounts Receivable

payments due from customers who buy on creditpayments due from customers who buy on credit InventoryInventory

raw materials, work in process, and finished goods held for raw materials, work in process, and finished goods held for eventual saleeventual sale

Prepaid expensesPrepaid expensesexpenses paid for in advanceexpenses paid for in advance


Fixed AssetsFixed Assets Assets held for more than Assets held for more than one year. Typically Include:one year. Typically Include: MachineryMachinery EquipmentEquipment Land and BuildingsLand and Buildings

Other AssetsOther Assets Assets that are not current Assets that are not current assets or fixed assetsassets or fixed assets PatentsPatents CopyrightsCopyrights Goodwill Goodwill


Debt or LiabilitiesDebt or Liabilities Money that has been borrowed and must be Money that has been borrowed and must be

repaid at some predetermined daterepaid at some predetermined date Debt Capital Debt Capital

financing provided by a creditorfinancing provided by a creditor Current, short-term and long-termCurrent, short-term and long-term Current or short-term must be repaid within the next Current or short-term must be repaid within the next

12 months12 months


Current LiabilitiesCurrent Liabilities:: Accounts PayableAccounts Payable

Credit extended by suppliersCredit extended by suppliers Other PayablesOther Payables

Interest and taxes that are owedInterest and taxes that are owed Accrued expensesAccrued expenses

Liabilities incurred, but not yet paidLiabilities incurred, but not yet paid Short-term NotesShort-term Notes

Borrowings from a bank or lending institution due Borrowings from a bank or lending institution due and payable within 12 monthsand payable within 12 months

Long-Term DebtLong-Term Debt Loans from banks or other institutions for Loans from banks or other institutions for

longer than 12 monthslonger than 12 months


EquityEquity Includes the shareholder’s investmentIncludes the shareholder’s investment

Preferred stockPreferred stock Common stockCommon stock

Retained EarningsRetained Earnings cumulative total of all the net income over the cumulative total of all the net income over the

life of the firm, less common stock dividends life of the firm, less common stock dividends that have been paid outthat have been paid out


Balance SheetAssetsAssets Liabilities & EquityLiabilities & Equity

Current AssetsCurrent Assets CashCash Marketable SecuritiesMarketable Securities Accounts ReceivableAccounts Receivable InventoriesInventories

Prepaid ExpensesPrepaid Expenses

Fixed AssetsFixed Assets Machinery & EquipmentMachinery & Equipment Buildings and LandBuildings and Land

Other AssetsOther AssetsInvestments & patents,Investments & patents,

copyrights, goodwillcopyrights, goodwill

Current LiabilitiesCurrent Liabilities Accounts PayableAccounts Payable

Accrued ExpensesAccrued Expenses

Short-term NotesShort-term Notes

Long-Term LiabilitiesLong-Term LiabilitiesLong-term Notes Long-term Notes

MortgagesMortgages

EquityEquityPreferred Stock Preferred Stock

Common Stock (Par value)Common Stock (Par value)

Paid-in CapitalPaid-in Capital

Retained EarningsRetained Earnings


Terms

Net Working CapitalNet Working CapitalCurrent assets – current liabilitiesCurrent assets – current liabilities

Debt/Equity Mix (Debt Ratio)Debt/Equity Mix (Debt Ratio)Amount of debt a firm borrows per dollar of equityAmount of debt a firm borrows per dollar of equity

Accrual Basis AccountingAccrual Basis AccountingRecording revenues when earned and expenses when Recording revenues when earned and expenses when

incurred, rather than when cash is exchangedincurred, rather than when cash is exchanged Free Cash FlowsFree Cash Flows

Cash flow that is free and available to be distributed to Cash flow that is free and available to be distributed to the firm’s investors.the firm’s investors.


Example: Study problem 3-1

Belmond, Inc.

Keown, Martin, Petty - Chapter 3 19


Example: Study problem 3-1

Belmond, Inc.

ASSETS

Current assetsCash $ 16,550 Accounts receivable 9,600 Inventories 6,500 Total current assets $ 32,650 Gross buildings & equipment $122,000 Accumulated depreciation 34,000 Net buildings & equipment $ 88,000 Total assets $120,650


LIABILITIES AND EQUITY

LiabilitiesShort-term notes payable $ 600 Accounts payable 4,800 Total current liabilities $ 5,400 Long-term debt 55,000 Total liabilities $ 60,400 EquityCommon stock $ 45,000 Retained earnings 15,250 Total equity $ 60,250 Total liabilities and equity $120,650


Belmond, Inc.Income Statement

Sales $ 12,800 Cost of goods sold 5,750 Gross profits $ 7,050 General & admin expense $ 850 Depreciation expense 500 Total operating expense $ 1,350 Operating income (EBIT) $ 5,700 Interest expense 900 Earnings before taxes $ 4,800 Taxes 1,440 Net income $ 3,360


Cash Flow Cash Flow

Why can a firm’s net income be different Why can a firm’s net income be different

from its cash flows?from its cash flows?

1. The accounting profits are calculated on an 1. The accounting profits are calculated on an

accrual basis rather than a cash basis.accrual basis rather than a cash basis.

2. Impact of Financing Activities.2. Impact of Financing Activities.


Statement of Cash Flows:

Even if a company reports a large net income Even if a company reports a large net income during a year, during a year, the amount of cash the amount of cash reported reported on its year-end balance sheet may be the on its year-end balance sheet may be the same or even lower than its beginning cash.same or even lower than its beginning cash.

To solve for the reasons why cash has changed To solve for the reasons why cash has changed you look at the Income Statement for the you look at the Income Statement for the period and the change in the balance sheet period and the change in the balance sheet over that same year.over that same year.

Keown, Martin, Petty - Chapter 3 25


Traditional Statement of Cash Flows Three sectionsThree sections:: Cash flows from Operating ActivitiesCash flows from Operating Activities Cash flows from Investing ActivitiesCash flows from Investing Activities Cash flows from Financing ActivitiesCash flows from Financing Activities


Operating Activities – Operating Activities – Direct MethodDirect Method

Cash collected from customersCash collected from customersCash collected from customersCash collected from customers

Cash paid to suppliersCash paid to suppliersCash paid to suppliersCash paid to suppliers--

Operating cash outflows (expense items) Operating cash outflows (expense items) and interest paymentsand interest payments

Operating cash outflows (expense items) Operating cash outflows (expense items) and interest paymentsand interest payments

--

Cash tax paymentsCash tax paymentsCash tax paymentsCash tax payments

--


Operating Activities – Indirect Method

Operating Income (EBIT)Operating Income (EBIT)+ Depreciation+ Depreciation- Income tax expense- Income tax expense= After-tax cash flows from operations= After-tax cash flows from operations

+/- Change in operating working capital+/- Change in operating working capital- - (change in current assets)- - (change in current assets)- - (change in current liabilities)- - (change in current liabilities)


Investment ActivitiesInvestment Activities

Cash flows related to the firm’s long-Cash flows related to the firm’s long-term investments:term investments: Fixed assetsFixed assets

Change in Change in grossgross fixed assets fixed assets Investments & patentsInvestments & patents Other assetsOther assets


Financing Activities

A firm can either receive money from or distribute money A firm can either receive money from or distribute money to its investors. The firm can:to its investors. The firm can:

1.1. Pay interest to lendersPay interest to lenders2.2. Pay dividends to stockholdersPay dividends to stockholders3.3. Increase or decrease in long-term debtIncrease or decrease in long-term debt4.4. Issue stock to new shareholders or repurchase stock Issue stock to new shareholders or repurchase stock

from current shareholdersfrom current shareholders


Cash Cash Flow Flow PatternPattern

From From operationsoperations

From From investmentsinvestments

From From financingfinancing

ObservationsObservations

Firm #1Firm #1 + +

- - ++

Firm is using its cash flows from Firm is using its cash flows from operations and new financing to operations and new financing to expand operationsexpand operations

Firm #2Firm #2 ++ + + --

Firm is using its cash flow from Firm is using its cash flow from operations and selling off assets to operations and selling off assets to pay down debt and pay ownerspay down debt and pay owners

Firm #3Firm #3 ++ -- --

Firm is using cash flow from Firm is using cash flow from operations to expand the business operations to expand the business and to pay down debt and pay and to pay down debt and pay ownersowners

Firm #4Firm #4 -- ++ ++

Firm is encountering cash flow Firm is encountering cash flow problems from operations which problems from operations which are being covered by selling are being covered by selling assets and borrowing more and /or assets and borrowing more and /or acquiring more equity financingacquiring more equity financing


Read/get comfortable with concepts in Read/get comfortable with concepts in Appendix of Chapter 3.Appendix of Chapter 3.

Economy & Finance

-Chapter Three