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Interpreting
Financial
Statements
CHAPTER ONE

Copyright 2016 by McGraw-Hill Education. All rights reserved.

Key Points
Accounting is the scorecard of business.
Managers who understand accounting can
diagnose ills and prescribe remedies.
Chapter 1 reviews accounting concepts that are
essential for financial management.

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The Cash Flow Cycle

Finance and operations are integrated.
Cash Fixed Assets Inventory AR Cash
Where is production (operations) in this cycle?
Where does the initial cash come from?
Where is the working capital cycle?
Where is investment in this cycle?

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Figure 1.1 The Cash FlowProduction Cycle

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More Questions
What is depreciation?
Did we miss AP? If so, where does it fit in?
Cash Fixed Assets Inventory AR Cash
Are profits and cash flow the same?
Does depreciation have anything to do with this
question?

HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 11E Ch. 1 5

The Balance Sheet

The balance sheet is a financial snapshot.
Assets = Liabilities + Shareholders Equity
What do these items measure?
What is double-entry bookkeeping?
What happens to the numbers in a balance sheet
when a company borrows money from a bank?
Whats Worldwide Sports story in Table 1.1?

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TABLE 1.1 Worldwide Sports Financial Transactions 2014

($ thousands)

HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 11E Ch. 1 7

Questions
How much did WWS sell?
What was the value of WWS merchandise
purchases?
How much did WWS borrow, and what rate of
interest did they pay?
Are assets equal to the sum of liabilities and
shareholders equity?
Move from snapshots to videos income
statement and statement of cash flows

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FIGURE 1.2 Ties among Financial Statements

HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 11E Ch. 1 9

Photo credit: Stryker Corp.

Stryker Corporation
Used as example throughout text

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Medical technology industry

Specializes in orthopedic products
Headquartered in Kalamazoo, Michigan
Sales > $9 billion
Listed on NYSE
Member of S&P 500

HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 11E Ch. 1 11

TABLE 1.2 Stryker Corporation Balance Sheets ($ millions)

December 31 Change in
2012 2013 Account
Assets
Cash $ 1,395 $ 1,339 $ (56)
Marketable securities 2,890 2,641 (249)
Accounts receivable, less reserve for possible losses 1,430 1,518 88
Inventories 1,265 1,422 157
Other current assets 1,168 1,415 247
Total current assets 8,148 8,335
Gross property, plant, and equipment 2,232 2,497 265
Less accumulated depreciation and amortization 1,284 1,416 132
Net property, plant, and equipment 948 1,081 133
Goodwill and intangible assets, net 3,566 5,833 2,267
Other assets 544 494 (50)
Total assets $ 13,206 $ 15,743
Liabilities and Shareholders' Equity
Long-term debt due in one year 16 25 9
Taxes payable 70 131 61
Trade accounts payable 288 314 26
Accrued compensation 467 535 68
Accrued expenses 1,035 1,652 617
Total current liabilities 1,876 2,657
Long-term debt 1,746 2,739 993
Other long-term liabilities 987 1,300 313
Total liabilities 4,609 6,696
Common stock 38 38
Additional paid-in capital 1,098 1,160
Retained earnings 7,461 7,849
Total shareholders' equity 8,597 9,047 450
Total liabilities and shareholders' equity 13,206 15,743

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TABLE 1.3 Stryker Corporation Income Statements ($ millions)

December 31
2012 2013
Net sales $ 8,657 $ 9,021
Cost of goods sold 2,604 2,762
Gross profit 6,053 6,259
Selling, general and administrative expenses 3,501 4,077
Research, development and engineering expenses 471 536
Depreciation and amortization 277 307
Total operating expenses 4,249 4,920
Operating income 1,804 1,339
Interest expense 63 83
Other nonoperating expense 36 44
Total nonoperating expenses 99 127
Income before income taxes 1,705 1,212
Provision for income taxes 407 206
Net income $ 1,298 $ 1,006

HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 11E Ch. 1 13

Key Concepts
Current assets and liabilities
Shareholders equity
Income statement
Revenues expenses = Net income
Operating and non-operating segments

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Measuring Earnings
Accrual accounting and matching principle
Depreciation
Straight-line vs. accelerated
Taxes
2 sets of books: one to report financial condition of
company to investors and the second to compute taxes

HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 11E Ch. 1 15

Tax Arithmetic
Provision for income taxes on income statement
+ increase in prepaid income taxes on asset side of
balance sheet
increase in income taxes payable and deferred
income taxes on liabilities side of balance sheet
= Taxes paid

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Example of Taxes Paid

From Strykers income statement, 2013
Provision for Income Taxes = 206
From Strykers balance sheet, 2012 to 2013
Increase in Taxes Payable = 61
(No Deferred Taxes or Prepaid Taxes are listed)
Taxes Stryker paid
206 61 = $145 million

HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 11E Ch. 1 17

You try it.

Calculate Home Depots taxes paid in year
ended Feb. 2014.
Excerpt from Balance Sheet

Excerpt from Income Statement

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R&D
Expense it all!
Why?
Difficult to estimate effective time horizon
Result? Earnings understate profitability.

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Sources & Uses

Income statement only pertains to items sold
Income statement included noncash expenses
For cash flows, need something else
Where does a company get its cash, and where
does it spend its cash?

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Sources & Uses of Cash

Sources Uses
Decreases in assets Increases in assets
Increases in liabilities & equity Decreases in liabilities & equity

HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 11E Ch. 1 21

Examples from Strykers Why is a

decrease
Balance Sheet in cash a
source?

December 31 Change in
2012 2013 Account
Assets
Cash $ 1,395 $ 1,339 $ (56) Source
Accounts receivable 1,430 1,518 88 Use
Inventories 1,265 1,422 157 Use
Gross property, plant, and equipment 2,232 2,497 265 Use

Liabilities and Shareholders' Equity

Trade accounts payable 288 314 26 Source
Long-term debt 1,746 2,739 993 Source
Retained earnings 7,461 7,849 388 Source

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TABLE 1.4 Stryker Corporation, Sources and Uses Statement, 2013 ($ millions)
Sources
Reduction in cash 56
Reduction in marketable securities 249
Reduction in other assets 50
Increase in long-term debt due in one year 9
Increase in taxes payable 61
Increase in trade accounts payable 26
Increase in accrued compensation 68
Increase in accrued expenses 617
Increase in long-term debt 993
Increase in other long-term liabilities 313
Increase in total shareholders' equity 450
Total sources $ 2,892

Uses
Increase in accounts receivable 88
Increase in inventories 157
Increase in other current assets 247
Increase in net property, plant, and equipment 133
Increase in net goodwill and intangible assets 2,267
Total uses $ 2,892

HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 11E Ch. 1 23

You try it. Identify the sources and uses.

Sequoia Corp.
Year-end Balance Sheets, 2013 and 2014 ($ millions)

2013 2014 Sources Uses

Cash & Securities 75 55
Inventory 80 70
Accounts receivable 70 90
Total current assets 225 215

Net fixed assets 720 810

Total assets 945 1025

Accounts payable 75 85
Short-term debt 205 190
Total current liabilities 280 275

Long-term debt 325 350

Common stock 50 55
Paid-in capital 150 175
Retained earnings 140 170
Total shareholders equity 340 400
Total liabilities and equity 945 1025
TOTALS >>>>

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Statement of Cash Flows

Rearrangement of sources and uses?
In practice, there are additional issues.
Tax benefit from exercise of stock options
When employees exercise stock options and incur a tax
liability, the company gets to take this tax as a deduction.
e.g., Cisco Systems tax benefit exceeded its net income in
2000

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Cash Flow and Net Income

Which is the better measure of performance?
Net income includes estimates, allocations, and
approximations.
Cash flow from operations is actual cash.
Low or negative cash flow does not necessarily
imply poor performance.
Cash flow statements can record items such as AR
and employee stock options differently from
sources and uses.

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TABLE 1.5 Stryker Corporation, Cash Flow Statement, 2013 ($ millions)

Cash Flows from Operating Activities
Net income $ 1,006
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization 307
Deferred income taxes 23
Stock based compensation expense 76
Restructuring charges 50
Changes in assets and liabilities:
Increase in accounts receivables (89)
Increase in inventories (77)
Increase in accounts payable 1
Increase in accrued expenses and other liabilities 657
Decrease in accrued income taxes (124)
Other 56
Net cash provided by operating activities 1,886

Cash Flows from Investing Activities

Capital expenditures (195)
Acquisitions (2,320)
Net decline in investments 298
Net cash used by investing activities (2,217)
Cash flows from financing activities
Repurchase of common stock (317)
Dividends paid (401)
Long-term debt issuance, net of retirements 1,005
Other financing activities 13
Effect of exchange rate changes on cash (25)
Net cash provided by financing activities 275

Net increase (decrease) in cash (56)

Cash at beginning of year 1,395
Cash and marketable securities at end of year $ 1,339

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Market Value vs. Book Value

The financial statements are a mix of historical
amounts and mark-to-market amounts.
Book values are historical.
Market values are forward-looking.
Intangible assets not appearing in the financial
statements include patents, brand reputation,
superior technology, human capital of workforce,
etc.

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Fair Value Accounting

Some quirks revealed by financial crisis of 2008
Drop in market value of debt
Fair value accounting required firms to record this
change as a gain, because they were able to
repurchase the debt at a lower price than they
originally issued (sold it).
Effect reversed when market rebounded

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Distortion and Discretion

Panic selling during financial crisis appears to have
decreased market prices below fundamental
values.
Distressed prices led creditors to take steps, such as
demanding payment of debt and/or requiring
collateral.
Prices fell further, leading to a vicious cycle, with
yet more panic.

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TABLE 1.6 The Book Value of Equity is a Poor Surrogate for the Market
Value of Equity, December 31, 2013
Value of Equity Ratio, Market
($ millions) Value to
Company Book Market Book Value
Aetna Inc. 14,026 27,154 1.9
Apache Corp 33,396 32,829 1.0
Coca-Cola Co 33,173 170,181 5.1
Delta Air Lines Inc. 11,643 29,502 2.5
Duke Energy Corp 41,330 50,281 1.2
Facebook Inc. 15,470 153,431 9.9
General Motors Co 39,498 51,630 1.3
Google Inc. 87,309 374,288 4.3
Harley-Davidson Inc. 3,009 14,651 4.9
Hewlett-Packard Co. 27,269 61,452 2.3
Intel Corp. 58,256 128,218 2.2
Stryker Corp. 9,047 28,403 3.1
Tesla Motors Inc. 667 25,658 38.5
United States Steel Co. 3,348 3,995 1.2
Wal-Mart Stores Inc. 76,255 247,098 3.2

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Goodwill
Intangible on the balance sheet
Goodwill is the difference between acquisition
price and the fair value of the asset acquired.
Fair value corresponds to either the book value or
the replacement value of the target, whichever is
more appropriate.
For Stryker, how important is goodwill?

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Economic Income and

Accounting Income
Realized vs. unrealized income
Marketable securities are marked to market, but
not others.
Imputed costs: economic income recognizes the
cost of equity as well as the cost of debt, while
accounting income does not.

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IFRS
International Financial Reporting Standards
2005, Europe adopts IFRS
Japan and U.S.?
Effect of Enron and WorldCom accounting
scandals?

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Philosophy of IFRS
Consolidated balance sheets vs. those of parent,
expensing R&D, fair value accounting
Principles vs. rules

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