Understanding Financial Statements and Cash Flows

Chapter 3

Chapter Objectives

Compute a company’s profits as reflected by an income statement.

Determine a firm’s accounting book value, as presented in a balance sheet.

Measure a company’s free cash flows.

Basic Financial Statements

Income Statement Balance Sheet Statement of Cash Flows

Income Statement

Also know as Profit/Loss Statement

Indicates the amount of profits generated by a firm over a given period of time – Flow value

Sales – Costs & Expenses = Profit

Income Statement Terminology

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

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

sold Operating Expenses

Expenses related to marketing and distributing the product or service and administering the business

Financing costs The interest paid to creditors and the dividends paid to

preferred stockholders Tax Expenses

Amount of taxes owed, based upon taxable income

Income Statement Structure

SalesLess cost of goods sold= Gross profitLess operating expenses= Operating incomeLess interest expense= Earnings before taxesLess corporate taxes= Earnings before preferred dividends (Net

Income)Less preferred stock dividends= Net income available to common

stockholders

Starbucks Corporation Income Statement 2003 ($M)

SalesSales $4,076 $4,076

Cost of Goods SoldCost of Goods Sold 3,2073,207

Gross ProfitGross Profit $ 869 $ 869

Operating ExpensesOperating Expenses

Marketing expenses and general and Marketing expenses and general and

Administrative expenses $227Administrative expenses $227

Depreciation ExpenseDepreciation Expense 206206

Total Operating ExpensesTotal Operating Expenses $ 433$ 433

Operating ProfitsOperating Profits $ 436 $ 436

Interest ExpenseInterest Expense 3 3

Earnings before taxesEarnings before taxes $ 433 $ 433

Income taxesIncome taxes 165165

Net incomeNet income $ $ 268268

Balance Sheet

Examines the firm’s financial position at a specific point in time – Stock value

Assets = Liabilities + Owner’s Equity Assets are resources owned by the firm Liabilities and Owner’s equity indicate

how those resources were financed

Types of Assets

Current Assets or gross working capital Comprise assets that are relatively liquid, or expected to be converted into cash within a year.

Current Assets typically include: Cash Accounts Receivable

payments due from customers who buy on credit Inventory

raw materials, work in process, and finished goods held for

eventual sale Prepaid expenses

expenses paid for in advance

Fixed Assets Assets held for more than one year. Typically Include: Machinery Equipment Land and Buildings

Other Assets Assets that are not current assets or fixed assets Patents Copyrights Goodwill

Types of Assets

Debt or Liabilities Money that has been borrowed and

must be repaid at some predetermined date

Debt Capital financing provided by a creditor Current, short-term and long-term Current or short-term debt must be

repaid within the next 12 months

Types of Financing

Current Debt – Short Term Accounts Payable

Credit extended by suppliers Other Payables

Interest and taxes that are owed Accrued expenses

Liabilities incurred, but not yet paid Short-term Notes

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

Long-Term Debt Loans from banks and issuance of bonds to

investors for longer than 12 months

Debt Capital

Equity Includes the shareholder’s investment (Par

and Additional paid in capital) Preferred stock Common stock

Retained Earnings Cumulative total of all the net income over the life

of the firm, less dividends that have been paid out Treasury Stock

Stock that was once outstanding and has been repurchased by the company (reduces equity)

Types of Financing

Balance Sheet Layout

ASSETS Current Assets Fixed Assets

Total Assets

LIABILITIES Current Liabilities Long-Term Liabilities

Total Liabilities OWNER’S EQUITY

Preferred Stock Common Stock Retained earnings

Total Owner’s Equity

Total liabilities + OE

Additional Terms Net Working Capital

Current assets (Gross Working Capital) – Current liabilities

Accrual Basis AccountingRecording revenues when earned and expenses

when incurred, rather than when cash is exchanged

Free Cash FlowsCash flow that is free and available to be distributedto the firm’s investors

Fundamental Principle of Cash Flows

Cash Flows generated through a firm’s assets always equal its Cash Flows paid to or received by the company’s investors (creditors and stockholders)

Cash Flows from Assets = Cash Flows from Financing

These two perspectives give the same answer

Cash Flows from Assets Cash Flow generated by the firm’s assetsFree Cash Flow =

After-tax cash flow from operations -- less--

Changes in net working capital-- less --

Changes in long term assets

Starbucks Free Cash Flows ($M)

After-tax cash flows from operationsAfter-tax cash flows from operations $477 $477

Less 2003 investments in:Less 2003 investments in:

Investments in net working capital $ 4Investments in net working capital $ 4

Investments in Long Term Assets Investments in Long Term Assets 566566

Total investmentsTotal investments $ 570$ 570

Free cash flowsFree cash flows $ (93)$ (93)

Cash Flows from Assets

After-Tax Cash Flows From Operations

Operating Income+ Depreciation= Earnings before interest, taxes,

depreciation, and amortization- Income taxes= After-tax cash flows from operations

Change in Net Working Capital

Change in net working capital = (change in current assets) - (change in current liabilities)

Increase in net working capital uses up cash

Decrease in net working capital frees up cash

Change in Long Term Assets

Change in gross fixed assets, not net fixed assets (recall net fixed assets = gross fixed assets – accumulated depreciation)

A decrease in long-term assets indicates that the firm is selling assets, which is a “source” of cash or increases cash

An increase in long-term assets indicates that the firm is purchasing assets, which is a “use” of cash or causes cash to go down

Cash Flows from Financing

Cash Flows investors provide to and receive from the firm

Financing Activities which generate cash include: An increase in debt (a source of cash)

Issuing new notes or bonds An increase in equity (another source of

cash) Issuing new stock

Cash Flows from Financing

Financing Activities which decrease cash include: Payment of interest Payment of dividends A decrease in debt (a use of cash)

Repays a note or bond A decrease in equity (a use of cash)

Repurchase of outstanding stock

Cash Flows from Financing

What does Cash Flows tell us?

Principle 3 – Cash, not profits, is King Positive Cash Flows - good or bad?

Depends, is it due to operations or financing?

Negative Cash Flows – good or bad? Depends, it is due to operations or

investment?